A Lesson for Boardroom Battles

Proxy access may be dead in the United States, but it lives in Israel, to the great regret of Taro Pharmaceutical Industries.

Taro is facing a proxy battle involving two external directors nominated by the asset management firm BlueMountain Capital Management. While unfortunate for Taro, it all shows an alternative universe of what, for better or worse, could have happened had proxy access been in place in the United States.

Taro Pharmaceuticals is a $3 billion pharmaceutical company founded and organized under the laws of Israel. But like many other Israeli companies, it is not listed on the Tel Aviv Stock Exchange. Instead Taro’s stock is listed and traded only on the New York Stock Exchange.

As securities lawyers know, this creates hybrid regulation governing the company. Because Taro is a foreign-based company, a so-called foreign private issuer, it is exempt from many of the United States securities laws. This includes the proxy rules as well as quarterly reporting requirements for American companies.

But it also means that Taro is still subject to Israeli rules governing companies incorporated there.

And Israel has rules intended to give substantial protection to minority shareholders. Israeli companies must have two external directors selected by noncontrolling shareholders. These directors serve three year terms and have certain defined duties, including sitting on the companies’ audit committee and signing off on any conflicted transactions with management or controlling shareholders.

This is not so unusual, and the United States effectively requires that boards of public companies without controlling shareholders have a majority of independent directors.

What is unusual is that Israel has adopted proxy access for these directors.

Proxy access was a Securities and Exchange Commission rule that allowed shareholders who in the aggregate owned at least 3 percent of the company for at least three years to nominate up to 25 percent of a company’s board. The kicker was that the company would have to include these names in its own proxy. This would spare the nominating shareholders the expense of hundreds of thousands of dollars, if not millions, required to prepare and circulate their own separate proxy statement.

The idea was to hold boards and directors more accountable, something that many feel is lacking. A recent study I co-authored found that, after the financial crisis, directors of financial institutions had only a 0.99 percent greater chance of being ousted for poor performance.

Proxy access was bitterly opposed by public companies and blocked by the United States Court of Appeals for the District of Columbia on controversial grounds, namely that the S.E.C. had not conducted sufficient cost-benefit analysis of the rule. In the wake of the rule’s defeat, the S.E.C. has moved on, and new proxy access rules are unlikely any time soon.

The case of Taro highlights the potential benefits and possible problems of proxy access. Taro has a controlling shareholder: India-based Sun Pharmaceuticals, which owns 66.5 percent of Taro, a stake it acquired in 2010.

In 2012, Sun offered to acquire the rest of Taro for $39.50 a share. The offer was approved by Taro’s board, including its two external directors. The Taro board found Sun’s offer to be fair. Notably, the final deal was a marked improvement over Sun’s initial offer of $24.50.

Still, the proposed buyout was criticized as being underpriced. Using these arguments, the investment funds IsZo Capital Management and Black Horse Capital Advisors successfully forced Taro and Sun to cancel the transaction.

One of the main reasons IsZo and Black Horse succeeded was another protection Israel has for minority shareholders. This is a flat-out requirement that any buyout by a controlling shareholder be approved by the majority of the noncontrolling shareholders. (This feature is also being employed to good effect by shareholders in the Dell buyout). Taro and Sun simply couldn’t get enough shareholders to approve the buyout under this threshold.

IsZo and Black Horse were right. Taro’s stock now trades at about $65 a share.

Now, BlueMountain is asking for accountability. BlueMountain is not normally an activist investor, but in this case, it wants to replace the external directors who signed off on the failed buyout.

The reason is simple: as IsZo stated in support of BlueMountain’s nominees, “We do not believe that the incumbents should be rewarded.”

And BlueMountain, which only owns 1.5 percent of the shares, is doing this in a simple way. It is using proxy access to nominate two new candidates as external directors. Taro has opposed this nomination and stated that it is not sure whether the candidates have adequate “financial and accounting expertise.”

Taro did not reply to an e-mail request for comment.

But Taro is on its back foot. First, BlueMountain doesn’t have to do much to oust the old external directors. Under Israeli law, the external directors need to get a majority of the minority vote as well as a majority of all the votes to be elected.

There is a twist. If that vote is not obtained, the candidates can be rejected if 2 percent of shares vote against them.

The consequence is that if a majority of the minority shareholders representing at least 2 percent of the shares vote against Taro’s candidates, then re-election of Taro’s candidates will be blocked even if Taro’s own candidates don’t win. If this happens, there would be no external directors on Taro’s board.

This would put Taro at a disadvantage, because it would need the approval of the external directors to sign off on conflict transactions, including any future potential buyout by Sun. Without external directors, no such transaction could take place.

BlueMountain is also aware of this and while it would like its own candidates to serve as external directors on the board, it has also said that it would settle for this type of stalemate.

Taro’s shareholder meeting on these nominations is scheduled for Sept. 12. But there are already lessons for the United States.

Proxy access was opposed because many companies thought it would be too disruptive to their business. Many other people, though, thought that the requirement for a three-year holding period would mean it would go unused.

The case of Taro shows that there are likely to be shareholders who will use proxy access and that, yes indeed, it will be used disruptively to oust directors. In Taro’s case, the provision is being used to hold directors accountable.

Still, this does not mean that proxy access is a good thing. It may arguably be good in Taro’s case, but in today’s activist environment, it could easily be used by hedge funds and institutional investors for less-useful purposes.

In the United States, proxy access is dead, but like zombies, regulatory ideas have a habit of being hard to kill. If proxy access does re-emerge, we will have some 120 Israeli companies that are like Taro - listed in the United States but with Israeli governance - as an example.