Cumulative Voting

The most important voting matter is the election of the board of directors. As indicated in Chapter 1, the board has primary responsibility for the stewardship of the corporation. If illegal or imprudent decisions are made, the board can be held legally accountable. Furthermore, members of the board of directors normally serve on a number of important subcommittees of the corporation, such as the audit committee, the long-range financial planning committee, and the salary and compensation committee. The board may be elected through the familiar majority rule system or by cumulative voting. Under majority voting, any group of stockholders owning over 50 percent of the common stock may elect all of the directors. Under cumulative voting, it is possible for those who hold less than a 50 percent interest to elect some of the directors. The provision for some minority interests on the board is important to those who, at times, wish to challenge the prerogatives of management.

The type of voting has become more important to stockholders and management with the threat of takeovers, leveraged buyouts, and other challenges to management’s control of the firm. In many cases, large minority stockholders, seeking a voice in the operations and direction of the company, desire seats on the board of directors. To further their goals, several have gotten stockholders to vote on the issue of cumulative voting at the annual meeting.

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How does this cumulative voting process work? A stockholder gets one vote for each share of stock he or she owns, times one vote for each director to be elected. The stockholder may then accumulate votes in favor of a specified number of directors.

Assume there are 10,000 shares outstanding, you own 1,001, and nine directors are to be elected. Your total votes under a cumulative election system are:

Let us assume you cast all your votes for the one director of your choice. With nine directors to be elected, there is no way for the owners of the remaining shares to exclude you from electing a person to one of the top nine positions. If you own 1,001 shares, the majority interest could control a maximum of 8,999 shares. This would entitle them to 80,991 votes.

These 80,991 votes cannot be spread thinly enough over nine candidates to stop you from electing your one director. If they are spread evenly, each of the majority’s nine choices will receive 8,999 votes (80,991/9). Your choice is assured 9,009 votes as previously indicated. Because the nine top vote-getters win, you will claim one position. Note that candidates do not run head-on against each other (such as Place A or Place B on the ballot), but rather that the top nine candidates are accorded directorships.

To determine the number of shares needed to elect a given number of directors under cumulative voting, the following formula is used:

The formula reaffirms that in the previous instance, 1,001 shares would elect one director.

If three director positions out of nine are desired, 3,001 shares are necessary.

Note that, with approximately 30 percent of the shares outstanding, a minority interest can control one-third of the board. If instead of cumulative voting a majority rule system were utilized, a minority interest could elect no one. The group that controlled 5,001 or more shares out of 10,000 would elect every director.

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Finance in ACTION Managerial Morningstar Raises Hewlett-Packard’s Stewardship Rating from “Poor” to “Standard”

Morningstar is a financial advisory service headquartered in Chicago and a company that provides stock and mutual fund ratings on thousands of companies. The following paragraph from their service defines their definition of “stewardship grades”:

Our corporate Stewardship Rating represents our assessment of management’s stewardship of shareholder capital, with particular emphasis on capital allocation decisions. Analysts consider companies’ investment strategy and valuation, financial leverage, dividend and share buyback policies, execution, compensation, related party transactions, and accounting practices. Corporate governance practices are only considered if they’ve had a demonstrated impact on shareholder value. Analysts assign one of three ratings: “Exemplary,” “Standard,” and “Poor.” Analysts judge stewardship from an equity holder’s perspective. Ratings are determined on an absolute basis. Most companies will receive a Standard rating, and this is the default rating in the absence of evidence that managers have made exceptionally strong or poor capital allocation decisions.

With this in mind, let’s explore some of the facts surrounding Morningstar’s “poor” rating for Hewlett-Packard (HP).

Corporate boards may appear to be removed from the everyday workings of a corporation with the press focusing on the chief executive officer (CEO) as the main driver of a company’s success. However, corporate boards play a vital role in representing the owners of the corporation and are elected by the shareholders. Perhaps the most important job is choosing a new CEO. This is one area where HP seems to have failed too many times. Board members also deal with high-level decisions, which can be anything from choosing the auditor to evaluating large acquisitions and mergers or a new business line. They are supposed to act as an independent check on management, ensuring that corporate executives keep the interests of the shareholders in mind.

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After several scandals involving corporate governance in the early 2000s, emphasis has been focused on boards and good corporate governance practices. Important criteria are emphasized, such as the number of executives on the board relative to independent board members. Many advocates for independent boards of directors push for the separation of the chairman of the board and CEO roles. HP has tried both models and still has had trouble making good decisions. Investors will discount a company’s share price if the board is perceived as anything less than competent or independent. Consistent turnover of both executives and board members is viewed as a sign of instability and lack of leadership.

HP has generally been viewed as suffering from bad stewardship over the past decade. Several scandals involving management have been blamed on the hiring decisions and conduct of HP’s board members. In 2005, Carly Fiorina was asked to resign by the board and walked away with $42.6 million in severance pay and stock grants. In 2006, HP’s non-executive chairman Patricia Dunn was removed after she hired private investigators to illegally obtain phone records of board members. She was replaced as chairman by Mark Hurd, the CEO at that time. But in 2009, Mark Hurd was forced to step down as CEO after a scandal involving falsified expense reports and a sexual harassment claim by a former contractor. Leo Apotheker, the former CEO of SAP, replaced Hurd only to be removed 11 months later due to conflicts with the board over HP’s long-term strategy. He walked away with $25 million in severance and stock grants. The last three CEOs and chairmen who have been terminated or resigned under pressure have received over $83 million in severance and stock grants. This has not gone over well with stockholders.

Another area where the board has been faulted has been Hewlett-Packard’s consistent mismanagement of its merger and acquisition activity. HP’s board has a history of approving inflated purchase prices for acquisitions such as Compaq Computer, Electronic Data Systems, and Palm. In August 2011, during Leo Apotheker’s stint as chairman and CEO, the board approved a $10 billion purchase of Autonomy Corp. plc. A little over a year later, HP recorded an $8.8 billion non-cash expense against earnings to write down goodwill and intangibles. This write-off was mostly related to the Autonomy purchase and accounting irregularities that were not discovered during the acquisition process. These and other factors have led to a high degree of board turnover, with 7 of its 12 directors being replaced or resigning in 2011 under the new CEO and chairman Meg Whitman, who was previously responsible for running eBay quite successfully. She has succeeded in improving the corporate governance and decision making process at HP, and this accounts for Morningstar’s improved rating.

All of this activity has not been lost on shareholders. HP’s share price hit a high of $54.75 in April of 2010 and fell to a low of $11.35 in November of 2012 for a loss of 79 percent. With Whitman in charge, the stock price hit a high of $40 in early January 2015.

Sources: “Morningstar Equity Analyst Report,” Morningstar, May 21, 2015. Standard & Poor’s Stock Report, February 3, 2013, pp.1–10. http://money.cnn.com/2011/09/22/technology/hp_leo_apotheker_severance/index.htm. http://finance.yahoo.com/news/key-moments-hewlett-packards-recent-history-204439968-finance.html.

As a restatement of the problem: If we know the number of minority shares outstanding under cumulative voting and wish to determine the number of directors that can be elected, we use this formula:

Plugging 3,001 shares into the formula, we show:

If the formula yields an uneven number of directors, such as 3.3 or 3.8, you always round down to the nearest whole number (i.e., 3).

It is not surprising that 22 states require cumulative voting in preference to majority rule, that 18 consider it permissible as part of the corporate charter, and that only 10 make no provision for its use. Such consumer-oriented states as California, Illinois, and Michigan require cumulative voting procedures.

Delaware does not require cumulative voting and is viewed as having a legal system that is lenient on corporations; it should come as no surprise that many companies are legally registered in the State of Delaware.