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By Yoel Kranz and Gil Menna
Yoel Kranz is a partner in Goodwin Procter’s REITs and Real Estate M+A Practice. He has over 18 years of experience in advising public and private companies in corporate mergers and acquisitions, represents a diverse group of corporate issuers of securities, both public and private, and serves as ongoing corporate and securities counsel for public companies, including numerous REITs.
Gil Menna is a co-chair of Goodwin’s REITs and Real Estate M+A Practice. He also participates in the firm’s Mergers & Acquisitions, Capital Markets, Public Companies, Real Estate Tax and Private Investment Funds practices. He is a former member of Goodwin’s Management and Executive committees, and former chair of the firm’s global Real Estate Capital Markets Group.
The topic of corporate governance for public REITs continues to be front and center. This is true not only of those companies that have faced or are facing activist campaigns or other perceived threats, but of all REITs, large and small, across all sectors. REIT investors—whether dedicated, income-based, index oriented or otherwise—are increasingly sensitive to corporate governance developments and have become more vocal about their governance preferences.
Not surprisingly, public REITs have listened and heard, and over the past three to five years large numbers of REITs have adopted, and continue to adopt, important governance enhancements. At the beginning of 2017, for example, over 75 percent of all public equity REITs had adopted either majority voting or a director resignation policy for uncontested elections, only 17 percent of REIT boards were classified and only 2.6 percent maintained an active shareholder rights plan (or “poison pill”). By contrast, 74 percent of the companies making up the Russell 2000 Index still elected directors by pure plurality voting at the beginning of 2016, a full 45 percent of index members still had classified boards and nearly 6 percent currently maintain an active shareholder rights plans, per Capital IQ Inc., a division of Standard & Poor’s.
Of course there are also governance areas where the MSCI US REIT Index (RMZ) as a whole diverges somewhat from much larger-cap indices. For example, at the beginning of 2017 only 8 percent of S&P 500 companies still had classified boards, per the 2016 Spencer Stuart Board Index. Moreover, a majority of REITs incorporated in Maryland retain the ability to unilaterally classify their boards under the Maryland Unsolicited Takeover Act (MUTA).
We have had numerous occasions in recent years to emphasize that, in our view, corporate governance is not a “one-size-fits-all” proposition. We do not recommend any particular set or subset of governance positions as a blunt-instrument approach for all public REITs. Rather we recommend that the board of each public REIT regularly evaluate the company’s corporate governance profile in light of all relevant facts and circumstances to determine whether the profile is one that provides the board, in its business judgment, with the tools and flexibility to fulfill its overarching duty to maximize stockholder value over the long term. Not all REITs of all sizes, across all sectors and in all circumstances will best serve their stockholders by making identical choices in corporate governance.
To provide some color and context to REIT boards when undertaking this evaluation, in the table below we have listed an array of corporate governance metrics currently in use, under consideration and/or being monitored in the public REIT market today. For example, all of these metrics are evaluated or noted in one form or another by Institutional Investor Services Inc. (ISS) in formulating its proprietary “QualityScore.” We have reviewed data on these metrics as of June 1, 2017, for each of the 155 REITs included in the RMZ index on that date, and further subdivided the data by sub-industry as classified by the RMZ. Brief commentary on each metric follows the table.
Classified Board. One of the most potent anti-takeover device, directors on a classified board are typically divided into three classes, only one of which is elected each year. This means that even a super-majority of stockholders cannot replace a majority of the board in a single election season.
Combined CEO and Chairman. A slight majority of REITs have elected to separate the CEO and chairman roles. Among those which have not, a large majority designate an independent director on the board as the “lead independent director.”
Insiders on Board (other than CEO). Some corporate governance watchers discourage populating a board with anyone other than independent directors. Others believe that adding insider voices to overall board discussion can be beneficial.
Percentage of Women on Board. Diversity in the boardroom rightfully continues to be a focus across industries and sectors, including among public REITs.
Outside Directors with 6+ Years Tenure. Board refreshment is likewise an important current focus in the world of corporate governance. Most commentators believe an optimal board is composed of a mix of directors with long-term company experience and new directors bringing a fresh perspective.
Majority Voting and/or Director Resignation Policy. Majority voting generally means that a director nominee cannot be elected to the board unless a majority of votes cast are cast in favor of the nominee’s election. A director resignation policy (sometimes known as “plurality plus”) requires that a sitting director receiving less than a majority of FOR votes in an uncontested election tender his/her resignation to the board for its consideration.
Current Shareholder Rights Plan. Less prevalent among public REITs, a shareholder rights plan (or “poison pill”) establishes a level of stock ownership (typically 10 percent or 15 percent) which a stockholder cannot exceed without incurring significant dilution to its holdings. We note that the organizational documents of almost all REITs already include a mechanism that limits actual or constructive ownership in excess of a stated limit (typically 9.8 percent).
Restriction on Shareholder Rights Plan. A minority of REITs have affirmatively adopted corporate policies or bylaws prohibiting the company from adopting a rights plan without stockholder approval (or imposing an automatic sunset on any plan adopted without stockholder approval that is not subsequently ratified by stockholders).
Proxy Access (any formulation). Proxy access refers to provisions in a company’s bylaws that enable stockholders to use the company’s own proxy materials to nominate up to a specified number of director nominees.
Supermajority Vote Required to Amend Charter. Important corporate governance changes that require an amendment of the company charter may be more difficult to effect if more than a simple majority vote is required.
Stockholders Can Amend Bylaws. Proxy advisory firms have recently focused on the ability of stockholders to directly and unilaterally amend a company’s bylaws. For many REITs incorporated in Maryland, the exclusive right to amend the bylaws is vested in the board of directors.
Supermajority Vote Required to Remove Directors. For REITs with this supermajority requirement, the vote of a simple majority would not be sufficient to remove a sitting director.
Require Stockholder Approval to Classify Board. Unless a company has affirmatively opted out of its provisions, the Maryland Unsolicited Takeover Act (MUTA) permits Maryland REITs to unilaterally elect to classify their boards, notwithstanding any contrary provision in their charter or bylaws. Of the 120 RMZ-member REITs organized in Maryland, 32 (or approximately 27 percent) have opted out of MUTA to date. In addition, a further 34 members of the RMZ are organized in jurisdictions other than Maryland which generally do not permit classifying the board without stockholder approval.
Exclusive Forum Provision. A sizable minority of REITs have adopted bylaw provisions that require stockholder derivative and similar lawsuits to be brought in a specific forum, typically the jurisdiction of incorporation.
Related-Party Transactions. These are business transactions entered into by a company with its own CEO or other members of its board of directors, including persons or entities affiliated with its CEO or other members of the board.
Dual-Class Voting Structure. A small number of REITs maintain a dual-class voting structure whereby pre-IPO investors or sponsors hold a class of “high vote” stock that commands a disproportionately higher voting power than the class of stock held by the investing public. In most of these situations, the dual-class structure was implemented to permit holders of operating partnership units to vote their full economic interest at the parent REIT level.
Looking further at the data set forth above for each constituent member of the RMZ, and comparing the governance data to each company’s historical performance—we found that the line between corporate governance and total shareholder return is not a straight one. For example, we reviewed correlation data between the most recent “QualityScore” assigned to each REIT by ISS and the five-year trailing total shareholder return (or such shorter period for REITs that have been public for less than five years) as reported by Bloomberg.
The data appears to show that REITs with higher scores in corporate governance do not, as a rule, outperform their peers with lower scores (or vice-versa) – there are simply too many other factors at play that more directly affect performance. To state the obvious, the “best” or “blue ribbon” corporate governance practices cannot overcome chronic underperformance on business fundamentals relative to a peer group. Conversely, numerous public REITs have consistently outperformed their peers over the long term, while also consistently scoring on the low end of the various quotients and metrics used by advisory firms to measure corporate governance.
Scholars have previously noted that the REIT market seems to depart from the generally accepted notion that “better corporate governance leads to higher relative valuations and better relative performance.” Some of the reasons for this apparent discrepancy that have been posited include the fact that REITs operate in a regulated environment and that the properties in their portfolios are typically easy to value.
Whatever the explanation for a perceived lack of correlation between governance and performance for public REITs, our view is that a company’s corporate governance profile is still a critical factor—albeit one of many—in making an investment decision. While the correlation data we reviewed reflects total stockholder return over a five-year period, it does not measure or reflect something that many investors may prize above all else: the ability to influence outcomes at an inflection point that may possibly involve a fundamental corporate transaction.
For example, a REIT with a classified board and plurality voting, which does not afford proxy access to stockholders, or the right to remove directors without cause, or the right to amend the bylaws—that kind of governance profile may make it more difficult for stockholders to be heard at a time when the company may be facing a strategic crossroads. A board and management team that is insulated from stockholders may be less incentivized to make strategic decisions based solely on maximizing stockholder value over the long term.
On the other hand, a REIT whose directors are all elected annually, has opted out of MUTA and committed to not adopt a stockholder rights plan, has adopted a liberal form of proxy access and the ability of stockholders to directly amend the bylaws, permits the removal of directors without cause and the ability of stockholders to fill vacancies on the board–that kind of governance profile can make it very difficult for the board and management to exercise their good faith fiduciary duties for the benefit of all stockholders (not only those most interested in event-driven volatility), arguably restricting the board’s ability to be thoughtful stewards of long-term stockholder value when it matters most.
We do not sense that REITs as a whole have over-reacted to the growing chorus of calls to improve corporate governance, nor do we believe that the REIT market governance “equilibrium” is off-kilter. We believe that the right approach in corporate governance is a subjective, case-by-case analysis, rather than a check-the-box list comparing “good” versus “bad” governance features. At any given time we believe that each REIT board should assess its company’s individual governance profile in light of all facts and circumstances then relevant to that particular sector and particular company. Moreover, since more permissive corporate governance for REITs does not translate automatically into better returns for stockholders, it follows that boards are not necessarily doing their stockholders a favor by chasing higher governance scores, no matter the cost.
We believe that truly good corporate governance is more meaningfully defined by real-world behavior—does the REIT have an engaged and thoughtful board of directors, comprising persons with relevant and useful experience, who consistently take action with the aim of maximizing stockholder value over the long term? Does the senior management team regularly and meaningfully engage with stockholders? Which and how many boxes on the corporate governance matrix can be checked becomes of secondary importance to these fundamental questions.
In our view, a corporate governance analysis should be undertaken holistically, with careful consideration not just of each particular metric but on the interconnectedness of each metric with others and other provisions in the REIT’s organizational documents. It is not enough to say, “MUTA is bad, let’s opt out,” or “ISS likes bylaw amendments by stockholders, let’s opt in”—since either of these, either alone or when used in conjunction with other available governance arrangements—can prove critical in permitting a board acting in good faith to maximize long-term shareholder value. The question should be: for this company, at this particular time, taking into account its long-term strategic objectives, what makes sense in terms of an overall governance profile? And by “makes sense,” we mean that bundle of board rights and stockholder rights that strikes the right balance between owners and managers for that particular REIT, the one that will ultimately inure for the benefit of the long-term value proposition that prompted the REIT’s creation in the first place.
Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.
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