In Michael Lewis’ interesting podcast, Against the Rules, he relays the biblical story of King Solomon adjudicating a dispute between two women who claimed they were the parent of a baby. Solomon orders that the baby be cut in half and each half given to the respective claimants. In the story’s telling, the true mother obviously didn’t want this to occur and thus was willing to give the child to the other mother so the baby would be spared; whereas the pretender mother was content to watch the child die. Through this ruse Solomon is able to identify the true mother and give a just ruling. Although this author and Michael Lewis both do not view Solomon’s act as wise, the people of the time thought his judgement highly righteous; that is they thought he acted in an extremely just manner that brought truth to light and resulted in justice.

The people feared Solomon BECAUSE he was righteous. A king who was pliable with bribes or who would act in his own interests over those of the population was the norm, not the exception. Anyone who benefited under previous corrupt norms had every reason to be scared. The population was terrified of Solomon as his judgement set the foundation of a more just order that would in and of itself necessitate major change.

Public company boards are largely comprised of individuals that fear the righteous man. They benefit from opaque and highly protected structures that entrench their interests at the expense of shareholders. The board structures we have experienced in our careers fall into one of a few camps: the controlled, the well-intentioned but weak, or the strong board.

There are boards with a dominant member who is often, but not always the board chair or the CEO—who may or may not actually sit on the board. The majority of the board members typically follow this individual and offer little to no resistance to his or her agenda. The company in these cases becomes an extension of this individual’s ambitions rather an organization dedicated to increasing the wealth of its shareholders. In the worst case scenario, the controlling individual will legally bilk the company by granting himself egregious compensation or by running a sub-optimal strategy designed to maximize his personal payouts, at the expense of the firm’s long term growth. Worst still the board will often morph over time to a collection of the controlling individual’s associates or friends, thereby further worsening governance.

The first camp is reasonably rare. The second category, well-intentioned but weak boards, are (in our unscientific estimation) the most common type of board. In such examples, the majority of the members do a few hours of work a year on the company, read the content they are given on the plane ride to the board meeting, and only speak up if something occurs that will jeopardize the firm and by extension their board position. In these boards, there may be one or two individuals that really want change, but they typically lack the numbers to enact any major reforms. At the same time there are often board members who want the perks and paycheck that come with the board and who will do the minimum possible to retain their position. Companies with well-intentioned but weak boards can still perform decently over time but they can also allow a failing strategy to perpetuate itself for far longer than it should or allow company killing acquisitions to pass through unchallenged.

In contrast, a strong board is the opposite of a weak board. Board members take their fiduciary obligations seriously and strongly question management on any major strategy or capital allocation proposals. Where appropriate board members help with new business development and in obtaining partnerships. Board members craft performance-focused compensation schemes that align shareholder interests with those of management by putting a significant percentage of total compensation at risk. Finally, the members hold management accountable if and when they fail.

More often than not the commonality between the controlled board and the weak board is a lack of accountability that is brought about by staggered board elections. Board elections can occur in either annual or staggered forms. When it comes to companies with staggered boards, only a portion of the board is up for reelection every year. As a result, it is extremely hard for the company’s shareholders to obtain a sufficient number of board seats to enact major reform. Even if shareholders are successful in winning seats on a staggered board, the majority of the seats—especially in a controlled company—will still rest with those who oppose reform.

You may be asking yourself why boards retain a staggered board or oppose efforts to initiate annual elections. Our view is that it stems from fear of the light that righteous men and women will shine on the company. In an annual election the shareholders have the opportunity to vote against board members who fail to live up to their fiduciary duty. Annual elections encourage a higher degree of oversight from board members on management and discourage self-enriching behaviors, as shareholders with a sufficient number of votes can oust board members, management, or in extreme cases, the entire board and management. Although board turnover is not a panacea for every problem, annual elections at least provide the possibility for companies to be freed from the yoke of poor strategy, ossified management, or self-serving missions.

Cove Street would never go so far as to claim to be righteous, but we are strong believers in accountability and strong corporate governance. As a result, we have instituted a program to work with the Board of Directors in the holdings of our small cap strategy that still have a staggered board. We are proposing the adoption of a 3 year de-stagger strategy to be instituted in the 2020 Proxy. We of course prefer to work as partners of our holdings and want the company to claim the moral high ground, but we are prepared to formally propose the suggestion on the Proxy if there seems to be a difference of opinion on the matter. The last we checked, the win rate for said proposal is north of 80%.

Despite the “Woo-Woo” moment for ESG as an investment strategy in today’s world, we do not think that a de-staggered board is our only obstacle to untold riches. But it creates a clean sense that the objects up for election are being watched. And objects that are watched tend to behave differently. And in favor of the shareholders.

– Dean Pagonis, Analyst