What should corporate directors do when shareholders knock on their door this proxy season and ask to discuss, face to face, how they execute their job of overseeing management?

While there are no regulations that require boards to communicate directly with investors, all indications are that pressure on directors to meet with major investors is increasing.

 For years, corporate boards operated under the principal-agent theory of corporate governance in which there was a cozy relationship between the board and executive management. Over the past several years, there has been a shift towards a more shareholder-centric model of governance, where the board is expected to provide greater oversight of management with the interests of shareholders in mind. Indeed, shareholders have played a much larger part in shaping such critical areas as board composition, executive compensation, corporate governance best practices, and CEO succession planning. While there is much for the Securities and Exchange Commission to do on implementing Dodd-Frank provisions, the SEC has finalized requirements for additional disclosures in the proxy explaining what the company is doing in these areas. Moreover, the SEC gave investors the opportunity to have a mandatory, but non-binding, “say-on-pay” vote.

Executive compensation remains the top issue for investors. According to a survey by FTI Consulting, 81 percent of respondents say that executive compensation is very important to them and over half say they will scrutinize the criteria used to determine how executives are compensated more rigorously this year than last.

2012 was the second year of say-on-pay voting and companies have been largely successful in gaining favorable shareholder support for their executive compensation. Only 53 Russell 3000 companies (2.6 percent) failed to gain majority support in 2012, a slight uptick from 2011, according to a report by law firm Wachtell, Lipton, Rosen & Katz. While the say-on-pay vote is non-binding, the few companies that have lost shareholder votes on pay should take a hard look at how they are compensating executives and measuring executive pay in relation to the company's performance and in comparison with peers.

A Spencer Stuart 2012 U.S. Board Index found that 84 percent of S&P 500 companies have adopted a majority voting standard, 83 percent have declassified boards with annual elections for all members, and 84 percent of their directors are independent.” This demonstrates a strong degree of compliance with corporate governance best practices.

Over the past two proxy seasons, investors have become more active in their demands for greater disclosure in these issue areas and have pushed for direct communication with the board or selected board members, particularly the chairs of the nominating, compensation, audit, and governance committees.

Shareholder-centric governance has had another, more controversial, effect. It has facilitated the frequency and effectiveness of attacks by activist investors who seek to replace certain directors and gain seats on the board.

While there are no regulations that require boards to communicate directly with investors, all indications are that pressure on directors to meet with major investors is increasing.

A 2012 report from Activist Insight showed that activists in most cases got what they wanted. Fifty-eight of the 135 activist campaigns put forward board candidates and 80 percent were successful. The next most popular strategy was to advocate that the company sell itself, as activist investor Carl Icahn successfully accomplished at Par Pharmaceutical and Amylin Pharmaceuticals. An effort to get the company to spin-off or sell a business division occurred 26 times and the removal of the chief executive or other board members occurred in 23 cases. In 16 instances activists urged the company was to initiate a share repurchase plan. The report shows that the amount of money activists spent in acquiring their investment positions rose by 34 percent to over $12 billion in 2012, compared with less than $9 billion in 2011.

According to Martin Lipton of law firm Wachtell, Lipton, Rosen & Katz, the number of companies with a market-cap over $1 billion that have been targeted in 2012 through September increased by 289 percent compared with the same period in 2009. Many of these attacks were launched by hedge funds and other activist investors.

Lipton advises directors that their primary focus “should be on promoting and helping to develop the long-term and sustainable success of their company.” Note that this focus runs counter to the short-term goals on which many of the investor attacks are predicated. Lipton adds that activists tend to use the efficient market theory whereby the share price reflects the “intrinsic value of the underlying companies to support their short-term focus. Under this theory, any action that increases a company's immediate stock price must be good.”

Don't Go Too Far

A more usual request during the proxy season comes from major investors who are not branded as “activists” but take the initiative to request an opportunity to meet with directors, largely over board governance issues. Lipton says that, “A board need not, and should not, simply accede to every list of governance ‘best practices' promulgated each year by governance activists and proxy advisory firms. That said, a board should proactively consider how to best organize itself and its committees to meet the increasing demands and responsibilities being placed on the board.”

Since there is no legal or regulatory requirement for a board or selected board members to engage directly with investors, should a board decide to communicate with shareholders, they should address subjects that are within the domain of the board's responsibilities. Those are primarily the process of governance and not the specifics of a company's value creation strategy. That's an area senior executives typically address in their shareholder communications. Given the high interest in executive compensation, the chairman of the compensation committee should be able to address in broad terms the criteria for awarding the senior executive pay packages.

If board members have not engaged in direct discussions with investors, it is prudent to prepare them for such meetings. Coaching them with anticipated questions and proposed responses is a must. Guiding them to avoid going beyond the directors' role and responsibilities should also be part of that coaching.  Directors are often intimidated by Regulation Fair Disclosure with concern about unintentionally disclosing new material, nonpublic information. Including someone from the legal department in the coaching can help calm those concerns.

While investors are not covered by Reg. FD, long-time corporate governance expert John Wilcox, chairman of the international consultancy Sodali believes that, “When the shareholders elect directors, they are supposed to be making an informed decision—but how can they if there's no communication? Investors' own commitment to act responsibility requires this dialogue.”

Carolyn Brancato of the Conference Board believes that, “Engaging with investors may be one of the best ways to soften situations that might otherwise end up as undesired proxy proposals or lawsuits.”

The expectation that companies will be faced with an increase in shareholder proposals this year ups the ante on the importance of carefully preparing directors to meet with investors. While senior management should address many of the proposals, major shareholders may well ask for a meeting with at least some board members on issues associated with their oversight capacity. Boards that decline such meetings do so at their peril.