Did you think the majority rules in California? Think Again – Cumulative Voting is the law for all California corporations
Conventional wisdom dictates that the majority shareholder of a board of directors has the ability to elect the majority of the board. Board rooms across California assume this majority rules result without realizing that 1) cumulative voting changes the entire game; and 2) cumulative voting is the law for all corporations in California that are not publicly traded.
Cumulative Voting: The Basics
The number of votes available to a shareholder in a given election is equal to the number of shares owned by the shareholder multiplied by the number of positions up for vote. Cumulative voting is a process of voting that allows a shareholder to cast all her votes toward a single nominee, or split her votes among several nominees in any proportion she chooses. By contrast, under conventional voting, shareholders may not cast more than one vote per share to any single nominee.
First, we will look at the results of an election under a conventional voting scheme. Let us assume that two shareholders, Susan and Tom, are voting in an election for a three director board. Susan, as the majority shareholder, holds 500 shares. While she would have 1,500 votes total (3 X 500 shares), Susan would be limited to 500 votes per nominee. Tom, as the minority shareholder, holds 300 shares. While he would have 900 votes total (3 x 300 shares), Tom would be limited to 300 votes per nominee.
Thus, the election would proceed as follows, with the director nominees listed across the top and the shareholder voters listed down the left-hand side:
Figure 1: Results in a Conventional Voting Scheme
The result is that Susan as the majority shareholder is able to elect Jane, Jessica and Janis on the Board of Directors, thereby controlling all positions on the Board. Tom is completely shut out of the election because at most, he could only apply 300 votes toward each of his nominees, which will always be defeated by Susan’s 500 votes per nominee. The majority, as represented by Susan, always wins in this scenario.
Under a cumulative voting scheme, however, the minority shareholder position is strengthened. Tom could “cumulate” all 900 of his votes toward one nominee, 450 each to two nominees, or allocate his votes in any combination of his preference. The result is that Tom has a stronger chance of being able to elect at least one out of the three directors through cumulative voting:
Figure 2: Results in a Cumulative Voting Scheme
In addition to providing Tom a better chance of obtaining representation on the board of directors, cumulative voting creates incentives for Susan and Tom to negotiate their votes for the most optimal outcome according to their strongest preferences. For example, let us assume that while Susan does not prefer Jim to be on the board of directors over her slate of nominees, she is dead set against John’s candidacy. Likewise, while Tom does not prefer Janis to be on the board of directors over his top three choices, he is absolutely against Jessica’s candidacy. Susan and Tom can negotiate to vote their strong preferences (or negative preferences). Thus, Susan and Tom’s most disliked nominees, John and Jessica respectively, do not make it onto the board as a result of a strategic allocation of votes:
Figure 3: Results of Negotiated Voting in a Cumulative Voting Scheme
Cumulative Voting: It’s the law!
In California, cumulative voting is a statutory right for shareholders of non-publicly traded corporations. By default, cumulative voting is available to shareholder elections of directors and it need not be specified in the articles or bylaws. Further, cumulative voting cannot be denied in the articles or bylaws as a matter of public policy (Corp. Code §708(a)). Only publicly traded corporations may opt out of the requirement (Corp. Code §301.5(a)).
The rationale behind cumulative voting is that the process translates into more proportional representation of the shareholders on the board of directors, giving minority shareholders the opportunity to exert influence on management through the election of directors who support their interests and priorities.
No Opt-Out Provision
You might think about incorporating in a different state to avoid the cumulative voting requreiment altogether. Think again. California law prohibits an out of state corporation from opting out of cumulative voting by amending its articles or bylaws. (Corp. Code §708(a)). Cumulative voting even applies to certain foreign corporations if more than half of their shareholders live in California and they do most of their business here. (see Wilson v. Louisiana-Pacific Resources, Inc. 138 CA3d 216 (1982); Corp. Code Section 2115). For an explanation of what constitutes a “pseudo-foreign” corporation, see http://www.eminutesonline.com/what-is-a-pseudo-foreign-corporation/.