INTRODUCTION I. THE BACKDROP: A BRIEF HISTORY OF THE RECENT AND ONGOING REVOLUTION IN CORPORATE GOVERNANCE A. The Shift in Control to Independent Directors B. Shareholder Influence over Board Composition and Conduct 1. Shareholder Control Rights Within the Corporation 2. The Initial Push for Shareholder Proxy Access 3. "Just-Vote-No" Campaigns 4. The Rise of the Majority Voting Standard 5. The Elimination of Broker Discretionary Voting in Director Elections 6. The Dodd-Frank Act and Further Anticipated Changes to the Governance Landscape i 7. Adoption of Shareholder Proxy Access II. THE PHILOSOPHICAL FOUNDATION OF THE GOVERNANCE REFORM MOVEMENT A. The Philosophy Behind the Assertion of Shareholder Power B. Application of that Philosophy to the Context of Public Pension Funds 1. The Trust Fund Objection 2. The Collective Efficiency Objection III. DOES THE FIRST AMENDMENT REQUIRE OPT-OUT RIGHTS? A. Opting Out of Agency Shop Service Fees B. Does the Use of Property by the State for Ideological Purposes Constitute a Form of Tax Immune to First Amendment Challenge? 1. United States v. Lee 2. Keller v. State Bar of California 3. Application in the Context of Public Pension Funds C. Does the Government Speech Doctrine Foreclose First Amendment Challenges to the Political and Ideological Activities of Public Pension Funds? 1. Johanns v. Livestock Marketing Association 2. Do the Political and Ideological Activities of a Public Pension Fund Constitute Speech by the Government? a. The California State Bar is a Private Rather Than Governmental Body b. The Court's Basis for Concluding that Speech by the Beef Board is Governmental c. The Degree of Government Control Over Speech by CalPERS More Closely Resembles the Case of the California State Bar 3. Using an Independent Instrumentality Test Helps to Delineate the Border Line Between Government and Non-Government Speech D. The Requirement of State Action 1. In the Context of Public Pension Funds 2. In the Context of Union Pension Funds in the Private Sector a. The RLA, NLRA Distinction b. Split Among the Circuits E. Are the Corporate Governance Activities of Public Pension Funds Commercial, Are They Political or Ideological, or Are They Both? 1. The Treatment of Solely Commercial Speech 2. Speech Can Easily Be Political or Ideological in Addition to Being Commercial in Nature 3. As Applied to Public Pension Fund Activities a. The Broad Social Movement b. Environmental Matters c. Diversity d. Animal Welfare e. Fund Objectives in Action F. The Reaction to Citizens United and the Link Between Corporate Governance and Other Policy Objectives CONCLUSION
We are in the midst of a sea change in the corporate governance landscape. Over the past decade, activist shareholders, public pension funds prominent among them, have effected a tangible shift in the balance of power between institutional shareholders and incumbent boards of directors of U.S. public companies. This drive toward greater shareholder influence will have consequences throughout American commercial and political life.
The drive for greater shareholder power has been fueled by the rise of mutual funds and pension funds as major holders of U.S. equity securities. But not all institutional holders share the same policy priorities. Mutual funds tend not to rock the corporate boat steered by incumbent boards, but labor union and public-sector pension funds often do. In recent years a panoply of activist shareholders has emerged, including not only pension funds but also religious organizations, socially oriented investment funds, and individuals. These investors have advocated and achieved numerous corporate governance reforms. These activists, however, have not restricted their policy objectives to matters of corporate governance. Many are pursuing a broad array of environmental, social, and political goals. The advocated corporate governance reforms are not seen as separate and distinct from their other objectives; instead, they see them as the necessary prerequisite to effecting broader changes in the conduct of corporate affairs. Both the broader social and policy goals and the changes to the corporate governance regime have engendered ideological disagreement.
Although many public-sector employees will agree with these broad goals for reform, many others will disagree. This Article addresses a point of intersection between the reform agenda of activist shareholders and First Amendment law: Do dissenting public sector employees have a right to opt out of having their pro rata portion of shares of publicly traded corporations held by public pension funds voted with respect to political or ideological matters in a manner with which the dissenting employees disagree? This Article argues on normative and doctrinal grounds that they do. This subject has not yet been addressed by either courts or the academic literature, and this Article's proposed solution would extend well-established First Amendment caselaw to a novel area of application.
Specifically, in several cases over the past few decades the Supreme Court has held that the First Amendment restricts the ability of the government to compel citizens to subsidize the political or ideological activities of private parties. To date, this caselaw has focused primarily, although not exclusively, on agency fees paid to labor unions. An employee who does not wish to join a union may nevertheless be compelled to pay to the union an amount equal to the dues otherwise required of union members. The union may not, however, use those compelled payments to fund political or ideological activities to which the employee objects and which are not germane to the collective bargaining arrangement supervised by the union. The seminal case in this area is Abood v. Detroit Board of Education, which addresses the issue in the context of public-sector unions. (1)
In Keller v. State Bar of California, (2) the Court extended the principles of Abood to state bar associations. The Court held that the bar may only compel subsidization of activities germane to the regulatory interests that compelled membership in the bar, and not the subsidization of political and ideological activities outside that scope. (3) There is good reason to conclude that the principles articulated in these cases would likewise apply to public-sector employees who are compelled by law to contribute to a statutorily mandated pension fund. Further, there is good reason to conclude that these principles would apply not only to the expenditure of contributed funds, but also and particularly to the exercise by public pension fund administrators of the voting rights (namely, a portion of the bundle of property rights) appurtenant to shares of publicly traded companies held by the funds. This Article argues that if, and to the extent that, a public pension fund engages in political or ideological activities not "germane" to the fund's core mission of providing retirement benefits to participants, through the exercise of voting rights appurtenant to shares of publicly traded corporations held by the fund, that employee should--by application of existing First Amendment principles--have a right to opt out of having his pro rata portion of such stock holdings voted in a manner with which he disagrees.
A counterargument to this conclusion might be based on the Supreme Court's 2005 decision in Johanns v. Livestock Marketing Association, (4) which rejected a First Amendment challenge to compelled subsidization of speech by the government: "Citizens may challenge compelled support of private speech, but have no First Amendment right not to fund government speech." (5) This "government speech" doctrine would pose a hurdle to the argument advanced in this Article if it applied to the political and ideological activities of a public pension fund.
Yet there are good grounds to conclude that the government speech doctrine does not apply in this context. The Court in Johanns indicated clearly that the State Bar of California, the association at issue in Keller, is a private, and not a governmental, entity for purposes of the government speech doctrine. (6) This is so despite the bar's character as a public corporation and the fact that its structure, purpose, operations, authority, and administration are all dictated in detail by statute, including the designation of a number of political appointees to the bar's board of governors. To take the specific example of the nation's leading public pension fund, the California Public Employees' Retirement System (CalPERS), there are good arguments that CalPERS should be viewed in the same manner. The government speech doctrine, therefore, would not preclude a First Amendment challenge.
In addressing this point, this Article suggests a new test that courts might employ as they develop government speech doctrine: an "independent instrumentality" test. If, and to the extent that, the government has established a body or organization that is not subject to effective control by the executive branch of government, and neither the legislature nor a democratically accountable arm of the executive branch has prescribed the specific content of its speech, that body or organization should be viewed as an independent instrumentality with sufficient autonomy that its political and ideological activities, if any, should be viewed as its own, and not the government's, for purposes of the government speech doctrine.
Because this Article addresses a novel legal issue at the intersection of recent corporate governance developments and the First Amendment, Part I reviews the efforts and successes of institutional shareholders in altering the corporate governance landscape over the past decade and the implications thereof for public pension fund activities in the future. Part I is descriptive rather than argumentative, and readers already familiar with these governance developments may easily skip directly to Part II (equitable argument) or Part III (First Amendment).
Part II turns to the philosophical rationale for the assertion of shareholder rights and advances equitable arguments in favor of applying similar philosophical principles to public pension funds. Part II makes the case that the same arguments advanced by institutional shareholders against the usurpation or diminishment of their shareholder control rights apply mutatis mutandis in favor of permitting public-sector employees to opt out of having their pro rata portion of fund assets voted in a manner with which they disagree. Each individual has a fundamental liberty interest that should not be trumped by paternalism, or by efficiency arguments, where the affected individual comes to a different judgment with respect to the use of his property than others who exercise authority over his property.
Part III argues that, to the extent employee contributions to a public pension fund are compulsory and the fund then exercises voting rights appurtenant to publicly traded shares held by the fund to advance political or ideological goals not germane to the fund's core mission of providing retirement benefits to participants, employees have a First Amendment right to opt out of having their pro rata portion of such shares voted in a manner with which they disagree. This Part examines how such a scenario involving a public pension fund should be analyzed under existing caselaw. It then formulates and proposes an independent instrumentality test for determining whether the political and ideological activities of a public pension fund or other public instrumentality should be ascribed to the government for purposes of the government speech doctrine. Part III concludes by examining the voting policies and conduct of public pension funds, with particular emphasis on the nation's largest fund, CalPERS. Such policies involve not only commercial but also political or ideological matters not germane to providing benefits to participants, thus triggering First Amendment protection for dissenting employees.
THE BACKDROP: A BRIEF HISTORY OF THE RECENT AND ONGOING REVOLUTION IN CORPORATE GOVERNANCE
The wave of major corporate scandals that broke in the opening years of the twenty-first century, epitomized by those at Enron and Worldcom, unleashed a fierce determination on the part of many legislators, regulators, and institutional shareholders to reform the governance of American corporations.
A. The Shift in Control to Independent Directors
The reaction to the scandals culminated in two fundamental reforms: (i) the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act); (7) and (ii) the new corporate governance listing standards of the New York Stock Exchange (NYSE) (8) and the NASDAQ Stock Market (NASDAQ), (9) which went into effect in late 2003. (10)
One of the Sarbanes-Oxley Act's primary changes to the governance of publicly traded corporations was to elevate the role of the audit committee and mandate that all audit committee members meet strict standards of independence. (11) Concerned that the ability of senior corporate executives to influence the award or withholding of auditing and consulting contracts with auditors had corrupted the willingness of auditors strictly to police management's financial disclosures, the Sarbanes-Oxley Act required that the audit committee exercise direct responsibility for the hiring, firing, compensation, and oversight of the auditors. (12) The new corporate-governance listing standards adopted by the NYSE and NASDAQ went even further, extending the principle of director independence to the board and its core committees generally. Henceforth, for companies listed on either of those markets, a majority of the board must satisfy independence criteria, (13) as do all of the directors sitting not just on the audit committee but also on the compensation committee and the newly mandated nominating committee (14) As a result of these rule changes, effective control of the vast majority of listed companies is now vested in directors independent of, and not subject to, reprisal or subtle subornation by, executive management.
B. Shareholder Influence over Board Composition and Conduct
For many activist shareholders, however, effective control by independent directors did not constitute sufficient governance reform. These shareholders sought to exercise greater influence over the conduct of corporate affairs.
1. Shareholder Control Rights Within the Corporation
Institutional shareholders and many others in government and private practice generally view shareholders as the true owners of corporations. They view directors as agents who must be directly accountable to the shareholders. Over the course of the past decade, these beliefs have driven a wide array of changes to the corporate governance landscape, all with the purpose of increasing shareholders' corporate control rights.
It is noteworthy that within academia there are noticeable differences in perspective in this regard, with not a few commentators asserting that shareholders cannot properly be characterized as owners of the corporation. (15) To inquire further into this difference in views would exceed the scope of this Article. What is relevant to the discussion, however, is the existence of the effort by institutional shareholders to increase their influence over the conduct of corporate affairs as well as the ramifications of current corporate structure for that effort. (16)
In a simple, "plain vanilla" corporate structure, the corporation has only issued one outstanding class of voting securities, common stock. Other classes of securities, such as debt, are in this simple scenario subject to extensive, negotiated contractual terms, but do not enjoy voting rights within the internal governance arrangements of the corporation itself.
In this simple case, there is a striking structural similarity between the indirect control rights of shareholders on a per share basis with respect to governance of the corporation, and the indirect control rights of the American populace at large on a per capita basis with respect to governance of the United States. (17) This has led to frequent use of terms such as "corporate democracy" and "shareholder suffrage." (18)
Specifically, in the American political sphere at both the federal and state levels, a constitution establishes a government, the central figures of which are periodically elected to office by the voting populace. Once elected to office, that government, and not the populace directly, exercises power and authority. The elected central officials appoint subordinate officers to conduct much of the day-to-day business of the government.
In the corporate sphere, "the business and affairs of [a] corporation are managed ... by or under the direction of a board of directors," (19) whose members typically stand for reelection once a year. Once elected, the board members in their collective capacity, and not the shareholders directly, exercise power over the business and affairs of the corporation. The board appoints senior executive officers to whom it delegates the day-to-day conduct of the business.
Major caveats to the foregoing are: (i) certain corporate changes or events (such as most mergers and amendments to the corporation's charter) are considered so fundamental that they require not just consent of the board but also the consent of the shareholders, (20) and (ii) the shareholders have the ability directly to enact bylaws governing any aspect of the business and affairs of the corporation. (21) The former is somewhat akin to the requirement in the U.S. Constitution that amendments thereto proposed by Congress or a constitutional convention must also be ratified by the legislatures of or conventions in three-fourths of the States. (22) The latter is somewhat akin to the right of voters in California to pass binding state constitutional amendments and legislation by direct popular initiative without the involvement of state legislature. (23) Importantly, the Delaware Supreme Court has made clear that the latter power of shareholders directly to enact bylaws cannot be used in a manner that strips the board of its ultimate authority and control over the affairs of the corporation--the exercise of shareholder control rights in Delaware is representative, not Athenian. (24)
Accordingly, institutional shareholders wishing to affect the conduct of a corporation's affairs generally can only do so indirectly, via the board of directors. Hence the consistent effort of institutional shareholders to gain greater influence over the decisions of incumbent board members through the exercise of shareholder voting rights either to sanction board members with whom they are displeased or to elect new members to the board of the shareholders' own choosing.
2. The Initial Push for Shareholder Proxy Access
For this reason, the overriding objective for activist shareholders over many years has been "shareholder proxy access." Each year, in connection with the annual shareholder meeting, during which a public company board is elected, the incumbent board picks its slate of nominees (which, not surprisingly, typically consists of the incumbents themselves, with perhaps a few changes), and sends out to all shareholders a proxy statement soliciting proxy authority to vote shareholders' shares in favor of those nominees. (25) Under state law default provisions, the board is generally under no obligation to include in that proxy statement the nominees of anyone else, including the nominees of any existing shareholders of the corporation. (26) Anyone who wishes to solicit proxies for a different slate of nominees must therefore prepare his own soliciting materials, vet them with counsel, file them with the Securities and Exchange Commission (SEC), and distribute them. (27) As a consequence of the expense and inconvenience of the endeavor, opposition proxy slates have been rare, and the slate nominated by the incumbents has generally gone into the annual shareholders' meeting unopposed.
Activist shareholders pushed the SEC to require that public companies' proxy statements include by law not only nominees of the incumbent board, but also nominees of shareholders. (28) The resulting company proxy statement would thus resemble a general political election ballot, with competing candidates directly facing off against each other side-by-side in the same proxy statement and on the same proxy card.
In 2003, the SEC put forth a limited shareholder-proxy-access proposal, (29) but the proposal hit political opposition and languished. Shareholder proxy access was then reproposed by the SEC under Chairman Schapiro in 2009, (30) was specifically authorized (though not required) by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) of 2010, (31) and was promulgated in final form by the SEC in August 2010. (32) Under the SEC's new rule, a shareholder or group of shareholders holding three percent of a public company's voting power for at least three years will generally have the right to require that a number of shareholder nominees equal to up to twenty-five percent of the board of directors be included in the company's own proxy statement alongside and in competition with incumbent board nominees. (33)
3. "Just-Vote-No" Campaigns
After the initial shareholder-proxy-access proposal had been stymied, however, and long before the SEC's recent promulgation of its new proxy-access rule, activist shareholders innovated the "just-vote-no" campaign to sanction disfavored incumbents. Even though an incumbent slate might be unopposed, a significant number of votes withheld from one or more nominees would signal shareholder displeasure and create political pressure for the targeted board member to step down. This just-vote-no technique made headlines in 2004 when a significant number of shareholders withheld votes from Disney board candidate Michael Eisner. (34)
4. The Rise of the Majority Voting Standard
Shareholders were not content, however, with a situation where even a significant "withhold" vote from a director could be ignored by the director and the board as a whole. Under the general state default plurality voting standard, the director candidates who received the most votes, whether or not they receive a majority of support, gain election. (35) In the typical election, no opposition candidates are fielded, which means that a director could be elected by far fewer than half the shares.
Shareholders wanted to ensure instead that a majority withhold vote from a director would have binding legal effect and compel the departure of the director. (36) They began to push public companies to adopt a majority voting standard, under which a director who fails to receive an affirmative vote in their favor does not gain reelection. (37)
The majority voting campaign played out through the SEC's Rule 14a-8 shareholder proposal process, (38) the central battleground of corporate governance struggles between shareholders and incumbent boards. In advance of the wave of annual shareholder meetings in late spring each year, numerous shareholders submit proposals to public companies for inclusion in the companies' proxy statements. If included, the resolutions stand a chance of garnering sufficient support to pass. In the absence of such inclusion, a shareholder would, as a practical matter, have to prepare, file, and distribute its own proxy solicitation materials to attempt to gain votes in favor of the proposal.
Companies often resist the inclusion of these shareholder proposals. The SEC mediates these disputes, which upon request by a company will either issue or decline to take a "no-action" (that is, no enforcement action) position with respect to a company's desire to exclude a given shareholder proposal from the company's proxy statement.
Although for technical reasons the overwhelming majority of these shareholder proposals are merely precatory (they urge the board to take some action but do not have a binding effect), they have proven over time to have significant admonitory and persuasive impact on boards of directors. (39) Very often, a precatory shareholder proposal receiving support of a majority of the shares will in fact be acted upon by the board. (40)
As a result, strong shareholder support, particularly during the 2006 proxy season, for the voluntary adoption of a majority voting standard to replace the default plurality voting standard in director elections led to adoption of the new standard among a majority of the Standard & Poor's 500 Index (S&P 500). (41) At such companies, a director who wishes to remain on the board from one year to the next now needs to garner an affirmative majority vote in their favor in order to do so. (42)
5. The Elimination of Broker Discretionary Voting in Director Elections
Achieving such majority support in favor of reelection has recently become more difficult as a result of an amendment to NYSE Rule 452 in 2009. (43) Under that rule, where shares are held by a shareholder through a broker, and that shareholder fails to indicate how she wants to vote, the broker has discretion to vote the shares as the broker sees fit with respect to "routine" matters. Before the amendment, uncontested director elections were considered routine, and brokers routinely voted uninstructed shares in favor of the incumbent board's slate of candidates. Because the breakdown in shareholding of public companies in the U.S. is roughly three-fourths held by institutions and one-fourth held by retail noninstitutional investors, and those retail shares often remain uninstructed because individual investors do not always have time or interest to pore over lengthy company proxy statements, every year the typical incumbent board went into the annual shareholder meeting with a sizable number of broker discretionary votes in favor of their reelection.
Activist shareholders argued forcefully that where the underlying true beneficial owner has not affirmatively chosen to vote their shares in a director election, it is not legitimate to permit an intermediary, such as a broker, to do so. These activist shareholders eventually prevailed upon the NYSE to propose, and the SEC to approve in 2009, an amendment to NYSE Rule 452 providing that uncontested director elections no longer be considered "routine," and brokers consequently may no longer cast discretionary votes with respect to uninstructed shares in uncontested director elections. (44) Because so many shares held by non-institutional investors through brokers remain uninstructed, much of the retail street vote has evaporated. Incumbent directors no longer enter the annual shareholder meeting with a significant number of votes in their favor because of broker discretionary voting. Control over the voting decision should proceed from the beneficial owner, not an intermediary.
Thus, at a company that has adopted a majority voting standard, a director who wishes to remain on the board from one year to the next must, as a practical matter, persuade a majority of the institutional holdings to vote in favor of reelection. This tangibly shifts toward shareholders the balance of influence between incumbent directors and shareholders. Whereas formerly a director might not have inordinately feared any practical consequence from institutional investor displeasure, now a director perceived as unresponsive to institutional investor concerns may quickly find himself off the board. The in terrorem effect of potential denial of reelection will presumably be sufficient to discipline directors to the will of institutional shareholders without the need for frequent actual denials of reelection.
6. The Dodd-Frank Act and Further Anticipated Changes to the Governance Landscape
In July 2010, President Obama signed the Dodd-Frank Act into law. (45) Continuing the recent trend toward incremental federalization of corporation law seen in the Sarbanes-Oxley Act, Dodd-Frank enacted several of the corporate governance reforms pursued by activists over the past decade and either authorized or mandated additional reforms that will further enhance shareholder influence over corporate affairs. (46)
For example, the Dodd-Frank Act requires the elimination of broker discretionary voting, not just with respect to director elections, but also any shareholder vote with respect to executive compensation "or any other significant matter," as determined by the SEC by rule. (47) Interestingly, the final statute does not require use of the majority voting standard, although the Senate bill included such a provision prior to reconciliation of the House and Senate texts. (48)
The Dodd-Frank Act specifically empowered, though did not require, the SEC by rule to mandate shareholder proxy access. (49) In August 2010, the SEC acted pursuant to this authorization to promulgate such a rule, as discussed below in Part I.B.7. The Act also requires disclosure of the reasons a company has or has not separated the roles of chairman of the board and chief executive officer. (50)
The Dodd-Frank Act also addresses executive compensation in a number of provisions. It requires nonbinding shareholder say-on-pay votes at least every three years, and more frequently than that if so mandated by shareholders. (51) It also requires a separate nonbinding shareholder vote to approve any acquisition-related executive compensation. (52) The Act also enhances compensation committee independence. (53)
The Dodd-Frank Act further requires disclosures concerning the relationship between executive compensation and company performance, as well as the ratio of the CEO's compensation to median compensation of all other …