Shareholders to Gain Access to Company Proxy Statements for Director Nominations

On May 20, 2009, the U.S. Securities and Exchange Commission (SEC) proposed amendments to the existing proxy rules that would, among other things, allow shareholders to nominate directors in a company's proxy materials. The SEC approved the publication of the proposed rules by a 3-2 vote, with Chairman Mary Schapiro voting in favor of the amendments. Chairman Schapiro, defending the new rules, stated that the current economic crisis “has led many to raise serious questions and concerns about the accountability and responsiveness of some companies and boards of directors, to the interest of the shareholders.” While the SEC hopes to be in a position to adopt rules that would be in place by the 2010 proxy season, Chairman Schapiro strongly encouraged interested parties to participate in the Commission's comment process that will end on Aug. 17, 2009.

Background

According to the SEC, the recent economic crisis has led to serious concerns regarding the accountability and responsiveness of some boards of directors to the interest of their shareholders, causing a drop in investor confidence. The Commission believes that shareholders' ability to hold boards accountable through their “fundamental right” to nominate and elect members to boards may be impeded by the current federal proxy rules.

When public companies hold annual elections for directors, the nominees for election are typically selected by the incumbent board, which sends information about the nominees to the shareholders through proxy materials. While shareholders have the ability to nominate candidates under state law, those laws do not require the company to include those nominees in the company's proxy materials. The current SEC rules also do not require inclusion of the shareholder's nominees in the proxy materials. Shareholders, however, can nominate their own candidates and mail out their own ballots, but this can be an extremely costly procedure. As a result, shareholders rarely have a significant input in the nominating process.

Many believe that allowing shareholders to effectively nominate directors would make boards more accountable, improve corporate governance, and make companies more responsive to those who own it. The SEC has adopted this view, believing that the most effective means of providing director accountability to shareholders is to “ensure that shareholders have a meaningful opportunity to effectuate the rights that they already have under state law to nominate directors.” The rule proposed thus allows shareholders who otherwise have the right to nominate directors at a shareholder meeting the ability to include nominees in the company proxy ballot that is sent to all voters. In a speech at the SEC open meeting, Chairman Schapiro stated that the proposed rules would turn “an illusory right to nominate into something that is real ' and has a real chance of holding boards of directors accountable to company owners.”

This is not the first time that the SEC has proposed amendments to the federal proxy rules. In 2003, the Commission proposed rules that would have required shareholder nominees for directors to be listed on the proxy materials provided that either one of the company's nominees received “withhold” votes from more than 35% of the votes cast or more than 50% of the shareholders voted to subject the company to the new proxy access rule. If either trigger was met, shareholders holding more than 5% of a company's shares would have been able to include up to three director nominees in the proxy materials. In 2007, the SEC proposed another rule that would have permitted shareholders to propose a binding proxy access bylaw for a company if the shareholder held at least 5% of a company's shares for at least one year. The SEC never adopted either rule, but activist investors were not quelled by the SEC's inactivity.

Proposed Ruled 14a-11 and 14a-8(i)(8)

The proposed rule would apply to all Exchange Act reporting companies, including investment companies, and would preempt any proxy access provisions set forth in state law or in a company's charter or bylaws. The rule would not, however, apply to companies that have only publically held debt securities. The rule proposes that unless prohibited by applicable state law, shareholders would be able to include their nominees for director in the company's proxy materials. The eligibility of a shareholder to nominate a director varies with the size of the company. Eligible shareholders include those who own at least 1% of the voting shares for large accelerated filers (i.e., companies with a market value of $700 million or more); those who own at least 3% of the voting shares of an accelerated filer (i.e., companies with a market value between $75 million and $700 million); and those who own at least 5% of the voting shares of a non-accelerated filer (i.e., companies with a market value of less than $75 million).

In addition, all shareholders would be required to have held their shares for at least one year. Shareholders could include no more than one shareholder nominee, or a number of nominees that represents up to 25% of the company's board of directors, whichever is greater, to include in the company proxy materials, which would allow qualifying shareholders to, for example, nominate up to two directors of a board of directors consisting of between eight and eleven directors. The nominating shareholder would also be required to file a new Schedule 14N, which would require that the shareholder disclose the amount and percentage of shares owned by the nominating shareholder, the amount of time the nominating shareholder has owned the securities, and a statement of intent to continue to hold the securities through the date of the company meeting. The nominating shareholder or group would also be required to disclose material relationships between the nominating shareholder or group and the company. The eligibility requirements are the same for registered investment companies except that the ownership thresholds would be based on the investment company's net assets.

The SEC is also proposing to amend Exchange Act Rule 14a-8(i)(8) to include proxy access shareholder proposals that would allow shareholders to amend, or request an amendment to, a company's governing documents regarding nomination procedures or director nomination disclosure provisions. This rule would reverse in part the SEC's 2007 rule that allowed proxy access bylaw amendments to be excluded. These shareholder proposals would be subject to the same eligibility requirements under 14a-8, namely, that a shareholder must hold the lesser of $2000 in market value or 1% of the company's shares for at least one year. The SEC would continue to permit companies to exclude a proxy proposal under Rule 14a-8(i)(8) if it would disqualify a nominee standing for election, remove a director before the expiration of his or her term, question the competence or business judgment of a nominated director, or otherwise affect the outcome of an upcoming election of directors.

Problems and Implications

The current proposal is timely and follows Sen. Charles E. Schumer's (D-NY) introduced legislation that would require the SEC to promulgate rules permitting shareholders who own at least 1% of a company's voting shares for at least two years to nominate members of the board using proxy materials. In addition, both the North Dakota and Delaware legislatures have adopted rules pertaining to rights of proxy access to shareholders. In 2007, North Dakota passed the North Dakota Publically Traded Corporations Act, providing a right of proxy access to shareholders who owned at least 5% of a company's voting shares continuously for at least two years. Following North Dakota's lead, in April 2009, the Delaware legislature amended the Delaware General Corporation Law (“DGCL”) to include two provisions that permit, but do not require, companies to adopt bylaws that would require a shareholder nomination process using its proxy materials.

The SEC proposals have not gone uncontested. The two commissioners who voted against the proposal, Commissioners Kathleen Casey and Troy Paredes took issue with the rules, noting that the rules would be imposed not only on large banks and Wall Street firms but also on thousands of smaller public companies who had nothing to do with the financial crisis that is the driving impetus behind the amendments. The two dissenters were also concerned that the proposals overly encroached on the primacy of state laws. Many have raised other potential concerns associated with shareholder nominated directors. For example, some commentators argue that shareholder nominated directors might be beholden to the nominating shareholder, allowing for a single shareholder to impose his or her view of the company on the rest of the shareholders and moving the company in a direction that does not reflect the interests of other shareholders.

The amendments also pose a number of potential practical problems. For example, if there are more nominations for directors by proxy access than there are slots for directors, priority would be determined by the date of submission. In effect, the first shareholders to file are the ones who will receive priority. Furthermore, the number of nominations by a shareholder is not limited, so the earliest nominating shareholder could potentially use all the available nomination slots. Unless amended after the comments process, there could be a shareholder rush to nominate as fast as possible.

There are a number of important implications that the proposed rules could have on existing corporate law. For example, most states allow companies to place reasonable limitations in their governing documents on the ways in which shareholders may go about nominating directors, but these limitations would effectively be preempted under Rule 14a-8 when a company's governing documents are more restrictive than the SEC's rule. The SEC stated that companies could not “opt out of Rule 14a-11 by adopting alternative requirements for inclusion of shareholder nominees for director in the company's proxy materials.” As a result, even the DGCL provisions recently adopted by the Delaware legislature could become preempted by the amendment. The SEC has, however, requested comment on whether the Rule should apply even when a company has a shareholder-approved proxy access provision different from Rule 14a-11.

Conclusion

The SEC has solicited comments on the proposals, due, as mentioned above, on Aug. 17, 2009. It appears that the SEC would like to adopt the final version of the proposals in time for the 2010 proxy season. Whatever the final result may be, boards will be forced to become attuned to the concerns of their significant shareholders more frequently.

Timothy M. Clark is a partner in the Corporate Group of the global law firm Proskauer Rose. His practice focuses on alternative investment funds, representing hedge funds, private equity and venture capital funds in fund formation, as well as structuring transactions such as mergers and acquisitions, private placements and equity offerings.

On May 20, 2009, the U.S. Securities and Exchange Commission (SEC) proposed amendments to the existing proxy rules that would, among other things, allow shareholders to nominate directors in a company's proxy materials. The SEC approved the publication of the proposed rules by a 3-2 vote, with Chairman Mary Schapiro voting in favor of the amendments. Chairman Schapiro, defending the new rules, stated that the current economic crisis “has led many to raise serious questions and concerns about the accountability and responsiveness of some companies and boards of directors, to the interest of the shareholders.” While the SEC hopes to be in a position to adopt rules that would be in place by the 2010 proxy season, Chairman Schapiro strongly encouraged interested parties to participate in the Commission's comment process that will end on Aug. 17, 2009.

Background

According to the SEC, the recent economic crisis has led to serious concerns regarding the accountability and responsiveness of some boards of directors to the interest of their shareholders, causing a drop in investor confidence. The Commission believes that shareholders' ability to hold boards accountable through their “fundamental right” to nominate and elect members to boards may be impeded by the current federal proxy rules.

When public companies hold annual elections for directors, the nominees for election are typically selected by the incumbent board, which sends information about the nominees to the shareholders through proxy materials. While shareholders have the ability to nominate candidates under state law, those laws do not require the company to include those nominees in the company's proxy materials. The current SEC rules also do not require inclusion of the shareholder's nominees in the proxy materials. Shareholders, however, can nominate their own candidates and mail out their own ballots, but this can be an extremely costly procedure. As a result, shareholders rarely have a significant input in the nominating process.

Many believe that allowing shareholders to effectively nominate directors would make boards more accountable, improve corporate governance, and make companies more responsive to those who own it. The SEC has adopted this view, believing that the most effective means of providing director accountability to shareholders is to “ensure that shareholders have a meaningful opportunity to effectuate the rights that they already have under state law to nominate directors.” The rule proposed thus allows shareholders who otherwise have the right to nominate directors at a shareholder meeting the ability to include nominees in the company proxy ballot that is sent to all voters. In a speech at the SEC open meeting, Chairman Schapiro stated that the proposed rules would turn “an illusory right to nominate into something that is real ' and has a real chance of holding boards of directors accountable to company owners.”

This is not the first time that the SEC has proposed amendments to the federal proxy rules. In 2003, the Commission proposed rules that would have required shareholder nominees for directors to be listed on the proxy materials provided that either one of the company's nominees received “withhold” votes from more than 35% of the votes cast or more than 50% of the shareholders voted to subject the company to the new proxy access rule. If either trigger was met, shareholders holding more than 5% of a company's shares would have been able to include up to three director nominees in the proxy materials. In 2007, the SEC proposed another rule that would have permitted shareholders to propose a binding proxy access bylaw for a company if the shareholder held at least 5% of a company's shares for at least one year. The SEC never adopted either rule, but activist investors were not quelled by the SEC's inactivity.

Proposed Ruled 14a-11 and 14a-8(i)(8)

The proposed rule would apply to all Exchange Act reporting companies, including investment companies, and would preempt any proxy access provisions set forth in state law or in a company's charter or bylaws. The rule would not, however, apply to companies that have only publically held debt securities. The rule proposes that unless prohibited by applicable state law, shareholders would be able to include their nominees for director in the company's proxy materials. The eligibility of a shareholder to nominate a director varies with the size of the company. Eligible shareholders include those who own at least 1% of the voting shares for large accelerated filers (i.e., companies with a market value of $700 million or more); those who own at least 3% of the voting shares of an accelerated filer (i.e., companies with a market value between $75 million and $700 million); and those who own at least 5% of the voting shares of a non-accelerated filer (i.e., companies with a market value of less than $75 million).

In addition, all shareholders would be required to have held their shares for at least one year. Shareholders could include no more than one shareholder nominee, or a number of nominees that represents up to 25% of the company's board of directors, whichever is greater, to include in the company proxy materials, which would allow qualifying shareholders to, for example, nominate up to two directors of a board of directors consisting of between eight and eleven directors. The nominating shareholder would also be required to file a new Schedule 14N, which would require that the shareholder disclose the amount and percentage of shares owned by the nominating shareholder, the amount of time the nominating shareholder has owned the securities, and a statement of intent to continue to hold the securities through the date of the company meeting. The nominating shareholder or group would also be required to disclose material relationships between the nominating shareholder or group and the company. The eligibility requirements are the same for registered investment companies except that the ownership thresholds would be based on the investment company's net assets.

The SEC is also proposing to amend Exchange Act Rule 14a-8(i)(8) to include proxy access shareholder proposals that would allow shareholders to amend, or request an amendment to, a company's governing documents regarding nomination procedures or director nomination disclosure provisions. This rule would reverse in part the SEC's 2007 rule that allowed proxy access bylaw amendments to be excluded. These shareholder proposals would be subject to the same eligibility requirements under 14a-8, namely, that a shareholder must hold the lesser of $2000 in market value or 1% of the company's shares for at least one year. The SEC would continue to permit companies to exclude a proxy proposal under Rule 14a-8(i)(8) if it would disqualify a nominee standing for election, remove a director before the expiration of his or her term, question the competence or business judgment of a nominated director, or otherwise affect the outcome of an upcoming election of directors.

Problems and Implications

The current proposal is timely and follows Sen. Charles E. Schumer's (D-NY) introduced legislation that would require the SEC to promulgate rules permitting shareholders who own at least 1% of a company's voting shares for at least two years to nominate members of the board using proxy materials. In addition, both the North Dakota and Delaware legislatures have adopted rules pertaining to rights of proxy access to shareholders. In 2007, North Dakota passed the North Dakota Publically Traded Corporations Act, providing a right of proxy access to shareholders who owned at least 5% of a company's voting shares continuously for at least two years. Following North Dakota's lead, in April 2009, the Delaware legislature amended the Delaware General Corporation Law (“DGCL”) to include two provisions that permit, but do not require, companies to adopt bylaws that would require a shareholder nomination process using its proxy materials.

The SEC proposals have not gone uncontested. The two commissioners who voted against the proposal, Commissioners Kathleen Casey and Troy Paredes took issue with the rules, noting that the rules would be imposed not only on large banks and Wall Street firms but also on thousands of smaller public companies who had nothing to do with the financial crisis that is the driving impetus behind the amendments. The two dissenters were also concerned that the proposals overly encroached on the primacy of state laws. Many have raised other potential concerns associated with shareholder nominated directors. For example, some commentators argue that shareholder nominated directors might be beholden to the nominating shareholder, allowing for a single shareholder to impose his or her view of the company on the rest of the shareholders and moving the company in a direction that does not reflect the interests of other shareholders.

The amendments also pose a number of potential practical problems. For example, if there are more nominations for directors by proxy access than there are slots for directors, priority would be determined by the date of submission. In effect, the first shareholders to file are the ones who will receive priority. Furthermore, the number of nominations by a shareholder is not limited, so the earliest nominating shareholder could potentially use all the available nomination slots. Unless amended after the comments process, there could be a shareholder rush to nominate as fast as possible.

There are a number of important implications that the proposed rules could have on existing corporate law. For example, most states allow companies to place reasonable limitations in their governing documents on the ways in which shareholders may go about nominating directors, but these limitations would effectively be preempted under Rule 14a-8 when a company's governing documents are more restrictive than the SEC's rule. The SEC stated that companies could not “opt out of Rule 14a-11 by adopting alternative requirements for inclusion of shareholder nominees for director in the company's proxy materials.” As a result, even the DGCL provisions recently adopted by the Delaware legislature could become preempted by the amendment. The SEC has, however, requested comment on whether the Rule should apply even when a company has a shareholder-approved proxy access provision different from Rule 14a-11.

Conclusion

The SEC has solicited comments on the proposals, due, as mentioned above, on Aug. 17, 2009. It appears that the SEC would like to adopt the final version of the proposals in time for the 2010 proxy season. Whatever the final result may be, boards will be forced to become attuned to the concerns of their significant shareholders more frequently.

Timothy M. Clark is a partner in the Corporate Group of the global law firm Proskauer Rose. His practice focuses on alternative investment funds, representing hedge funds, private equity and venture capital funds in fund formation, as well as structuring transactions such as mergers and acquisitions, private placements and equity offerings.