Another View: Recent SEC Proposals on Proxy Access

(Re)Enter the SEC

The SEC has tried on three occasions in the last six years to address the issue of shareholder access to company proxy statements. On each occasion, including the most recent, the SEC Commissioners have failed to achieve a consensus, in part because a single, federally mandated solution to shareholder access is virtually irreconcilable with a permissive, let-each-company-fashion-its-own-rules approach. The SEC's most recent attempt involves the unusual approach of proposing two conflicting rules'one enabling proxy access and the other precluding it.

The SEC's proposal, issued on June 10, 2009, contains two separate parts. The first and arguably less controversial part would require companies to include in their proxy materials shareholder proposals seeking to amend the company's governing documents as they relate to director nomination procedures or disclosures related to shareholder nominations. The second, more controversial part would require companies to include in their proxy materials directors nominated by certain shareholders or groups of shareholders.

Director Nomination Procedures

The first part of the SEC proposal reverses the so-called “election exclusion,” enshrined in current Rule 14a-8(i)(8), which permits a company to exclude from its proxy materials any proposal that “relates to a nomination or an election for membership on the company's board of directors ' or a procedure for such nomination or election” (emphasis added). Demonstrating how quickly the tide can turn, the SEC had reaffirmed this exclusion as recently as 2007 following a decision by the U.S. Court of Appeals for the Second Circuit. In that case, the Court found that the “ election exclusion” applied only to solicitations contesting an identified board seat, and that it did not apply to shareholder proposals asking companies to institute procedures (such as proxy access) that might make contested elections more likely in the future.

In the proposed proxy access rules, the SEC seeks to reverse its 2007 reaffirmation and to open up company proxy statements to shareholder proposals regarding procedures for director elections. This would allow shareholders to submit proposals to amend a company's bylaws, for example, to permit them to include shareholder nominees in the company's proxy statement. While a few years ago this concept was contrary to a well-established and generally supported SEC position, it now appears that even the two Commissioners who opposed the current proxy access proposal support the ability of shareholders ' on a company-by-company basis ' to propose bylaw amendments seeking access to a company's proxy statement for shareholder nominations.

Proxy Access

The second part of the SEC proposal'and by far the more controversial'is the proposal to give shareholders the right to include their director nominees in a company's proxy statement. An SEC rule to that effect might well be open to attack for encroaching on an area that is the province of state corporate law. Possibly in anticipation of such an attack, Sen. Charles Schumer (D-NY) included a provision in his recently proposed Shareholder Bill of Rights Act of 2009 requiring the SEC to promulgate such rules. The Bill would allow a shareholder who has held at least 1% of the voting securities of a company for at least two years preceding the date of the next scheduled annual stockholders meeting to include director nominees in the company's proxy statement. Despite the disconnect between Senator Schumer's 1% threshold and the thresholds proposed by the SEC, the principle still stands. Congressional authorization would go a long way toward insulating SEC rule-making in this area from attack.

Under the proposed proxy access rules, a 1% shareholder of a large accelerated filer, a 3% shareholder of an accelerated filer, and a 5% shareholder of a non-accelerated filer would be permitted to include their director nominees in a company's proxy statement. Multiple shareholders would be permitted to aggregate their holdings in order to meet these thresholds, although each member of a nominating group must still meet the requirement of having beneficially owned its securities for at least one year and must intend to own the securities through the date of the shareholder meeting. It should be noted that these thresholds are relatively low. In fact, 99% of large accelerated filers have at least one shareholder that beneficially owns at least 1% of the company's shares. These thresholds present an even lower bar when one considers that shareholders can meet them by aggregating their holdings

The SEC does not view proxy access as a means by which a shareholder or group should be able to acquire control of a company. To that end, it has attempted to incorporate various safeguards. First, the shareholder or group would be required to certify that they were not holding their shares for the purpose, nor with the effect of, changing the control of the subject company. This certification would be made in a new Schedule 14N, required to be filed with the SEC and which would also contain information about the nominating shareholder or group, and the director nominee or nominees. Second, a company would be allowed to exclude shareholder nominees representing more than 25% of the company's board of directors, subject to a minimum of one director. The first shareholder or group to provide its Schedule 14N to the company would have the right to nominate one or more directors up to the 25% limit, and any remaining spaces would pass to the shareholder or group that submitted each subsequent Schedule 14N in the order it was received.

As proposed, the rules create a number of dilemmas for shareholders. Some of these might be resolved through amendments to the proposed rules. Others, however, are a feature of proxy access itself, and they call into question its benefits to shareholders. For example, the SEC's method of allocating the 25% of board seats available to shareholder nominees on a first-come, first-served basis creates a situation where a smaller shareholder can capture all available nominee slots from a larger shareholder simply by submitting notice a single day (or a single hour) before the larger shareholder. A different method of apportionment is preferable; for example, one based on size of shareholding.

Another dilemma is the potential problem caused by the SEC's exclusion from the 25% cap of any director appointed pursuant to an agreement with a shareholder. A number of companies in the last two years agreed to appoint one or more of shareholder nominees to their boards of directors in order to settle or avoid a proxy fight. Those companies would face the prospect of having a further 25% of their board seats available for shareholder nominees if, as is commonplace, the settlement agreement extends for more than one year. As a result, the effect of the proposed rule would be to create incentives for companies not to reach agreement with activist shareholders for fear that other shareholders will simply propose additional nominees up to the 25% cap.

There is, however, potentially a more fundamental problem with proxy access. Shareholders have succeeded over the last two years in driving a significant change in the way directors are elected. Over 60% of companies in the S&P 500 now have majority voting policies for uncontested director elections rather than the plurality model that was previously used. Most shareholders perceive majority voting to be a significant weapon to unseat ineffective or inattentive directors. However, under the proposed proxy access rules, a 1% shareholder who proposes its nominee for the board of a company will effectively turn an uncontested election that was subject to majority voting into a contested election subject to a plurality voting standard. It is not clear that large, institutional shareholders would want to hand control over this issue to potentially smaller, more aggressive shareholders in every company in which such large shareholders might invest.

Therein lies the most significant challenge in the SEC's proposed shareholder access rules. They assume that a single, federally mandated solution is appropriate for every company, and that it reflects the will of most shareholders. In this way, however, shareholders are not really being given a say. For example, even though the SEC is proposing to overturn its “election exclusion” to give shareholders the right to make proposals regarding procedures for director elections, any such proposals could not alter the minimum thresholds that the SEC is proposing for shareholder access. In fact, the SEC rules would trump the shareholder access rules adopted by stockholders of a company even if they affirmatively voted to set higher thresholds or more stringent requirements than those contained in the proposed rules.

Giving Control to Shareholders or Taking It Away?

There is significant evidence that shareholders are already succeeding in effecting change in key areas affecting director accountability, and that the federal system of competing state corporate laws provides shareholders with further means to influence boards and nominate directors on a cost-effective basis. Indeed, recent proxy seasons have seen record numbers of activist campaigns by investors ' 506 in 2007, and 479 in 2008. These proxy fights and other campaigns resulted in activists gaining board seats at 84 companies in 2008 alone, more than any other recent year. Also, the corporate law marketplace has started offering new possibilities for activist shareholders. In 2007, North Dakota became the first and, to date, only state to adopt a mandatory proxy access law. So far, only one U.S. public company ' a company controlled by Carl Icahn ' voted to reincorporate in North Dakota. But others may follow. At the same time, Delaware recently amended its corporate law to explicitly permit companies to adopt provisions in their certificates of incorporation and bylaws allowing reimbursement of the expenses incurred by shareholders in director election contests. Delaware also amended its corporate law to explicitly permit (but not require) company bylaw amendments allowing shareholders to include director nominees in the company's proxy materials. Subsequently, the Corporate Laws Committee of the American Bar Association approved the first reading of amendments to the Model Business Corporation Act (the “MCBA”), which include provisions similar to the Delaware amendments. The MCBA has been adopted in whole or in part by more than 30 states, and so the potential impact of the change is broad. Finally, as noted above, the shift from plurality voting to majority voting has given teeth to a “no” vote, and has enhanced shareholders' ability to hold directors accountable.

These events give weight to the increasing ability of shareholders to influence boards and nominate directors on a cost-effective basis. This, in turn, calls into question the need for a single, federally mandated proxy access solution for all U.S. public companies. It would be preferable simply to open up company proxy statements to shareholder proposals regarding the director election process, as the first part of the SEC's proposed amendments seeks to do. Shareholders could then propose the rules they want for each particular company based on its particular circumstances.

In a world of angry, but rational, shareholders, it seems likely they would be better placed than the federal government to determine what those rules should be in each case.

Colin J. Diamond is a partner in the New York office of White & Case LLP. His practice is concentrated on securities transactions, public mergers and acquisitions, and general corporate representations. Diamond's work includes counseling the boards of public companies on their fiduciary duties, disclosure issues and corporate governance practices. He may be reached at [email protected]

The ongoing recession has led lawmakers and the SEC alike to focus on limiting perceived excessive risk-taking and improving the accountability of boards of directors to shareholders. Many believe these issues have contributed to the huge declines in shareholder value experienced during the downturn. This focus has yielded a range of ideas, although none more controversial than the SEC's recently proposed rules to permit shareholders to include their director nominees in a company's proxy statement.

The SEC's proxy rules ' Rule 14a-8 specifically ' currently permit shareholders to propose only a limited number of items for inclusion in a company's proxy statement. These do not include proposing nominees for the company's board of directors. As a result, in order to propose a director nominee, shareholders are forced to print and distribute their own proxy statement, and to solicit proxies in opposition to management. The cost of this exercise is often high ' far higher than it would be if a shareholder could include its nominees in the company's proxy statement.

Proponents of proxy access believe that lowering these barriers and eliminating these costs would enhance shareholder democracy. Detractors, on the other hand, believe that proxy access lowers the cost of nominating a director to such a point that it becomes something that can be done almost casually, including by a shareholder looking to advance its own selfish interests at almost no cost.

(Re)Enter the SEC

The SEC has tried on three occasions in the last six years to address the issue of shareholder access to company proxy statements. On each occasion, including the most recent, the SEC Commissioners have failed to achieve a consensus, in part because a single, federally mandated solution to shareholder access is virtually irreconcilable with a permissive, let-each-company-fashion-its-own-rules approach. The SEC's most recent attempt involves the unusual approach of proposing two conflicting rules'one enabling proxy access and the other precluding it.

The SEC's proposal, issued on June 10, 2009, contains two separate parts. The first and arguably less controversial part would require companies to include in their proxy materials shareholder proposals seeking to amend the company's governing documents as they relate to director nomination procedures or disclosures related to shareholder nominations. The second, more controversial part would require companies to include in their proxy materials directors nominated by certain shareholders or groups of shareholders.

Director Nomination Procedures

The first part of the SEC proposal reverses the so-called “election exclusion,” enshrined in current Rule 14a-8(i)(8), which permits a company to exclude from its proxy materials any proposal that “relates to a nomination or an election for membership on the company's board of directors ' or a procedure for such nomination or election” (emphasis added). Demonstrating how quickly the tide can turn, the SEC had reaffirmed this exclusion as recently as 2007 following a decision by the U.S. Court of Appeals for the Second Circuit. In that case, the Court found that the “ election exclusion” applied only to solicitations contesting an identified board seat, and that it did not apply to shareholder proposals asking companies to institute procedures (such as proxy access) that might make contested elections more likely in the future.

In the proposed proxy access rules, the SEC seeks to reverse its 2007 reaffirmation and to open up company proxy statements to shareholder proposals regarding procedures for director elections. This would allow shareholders to submit proposals to amend a company's bylaws, for example, to permit them to include shareholder nominees in the company's proxy statement. While a few years ago this concept was contrary to a well-established and generally supported SEC position, it now appears that even the two Commissioners who opposed the current proxy access proposal support the ability of shareholders ' on a company-by-company basis ' to propose bylaw amendments seeking access to a company's proxy statement for shareholder nominations.

Proxy Access

The second part of the SEC proposal'and by far the more controversial'is the proposal to give shareholders the right to include their director nominees in a company's proxy statement. An SEC rule to that effect might well be open to attack for encroaching on an area that is the province of state corporate law. Possibly in anticipation of such an attack, Sen. Charles Schumer (D-NY) included a provision in his recently proposed Shareholder Bill of Rights Act of 2009 requiring the SEC to promulgate such rules. The Bill would allow a shareholder who has held at least 1% of the voting securities of a company for at least two years preceding the date of the next scheduled annual stockholders meeting to include director nominees in the company's proxy statement. Despite the disconnect between Senator Schumer's 1% threshold and the thresholds proposed by the SEC, the principle still stands. Congressional authorization would go a long way toward insulating SEC rule-making in this area from attack.

Under the proposed proxy access rules, a 1% shareholder of a large accelerated filer, a 3% shareholder of an accelerated filer, and a 5% shareholder of a non-accelerated filer would be permitted to include their director nominees in a company's proxy statement. Multiple shareholders would be permitted to aggregate their holdings in order to meet these thresholds, although each member of a nominating group must still meet the requirement of having beneficially owned its securities for at least one year and must intend to own the securities through the date of the shareholder meeting. It should be noted that these thresholds are relatively low. In fact, 99% of large accelerated filers have at least one shareholder that beneficially owns at least 1% of the company's shares. These thresholds present an even lower bar when one considers that shareholders can meet them by aggregating their holdings

The SEC does not view proxy access as a means by which a shareholder or group should be able to acquire control of a company. To that end, it has attempted to incorporate various safeguards. First, the shareholder or group would be required to certify that they were not holding their shares for the purpose, nor with the effect of, changing the control of the subject company. This certification would be made in a new Schedule 14N, required to be filed with the SEC and which would also contain information about the nominating shareholder or group, and the director nominee or nominees. Second, a company would be allowed to exclude shareholder nominees representing more than 25% of the company's board of directors, subject to a minimum of one director. The first shareholder or group to provide its Schedule 14N to the company would have the right to nominate one or more directors up to the 25% limit, and any remaining spaces would pass to the shareholder or group that submitted each subsequent Schedule 14N in the order it was received.

As proposed, the rules create a number of dilemmas for shareholders. Some of these might be resolved through amendments to the proposed rules. Others, however, are a feature of proxy access itself, and they call into question its benefits to shareholders. For example, the SEC's method of allocating the 25% of board seats available to shareholder nominees on a first-come, first-served basis creates a situation where a smaller shareholder can capture all available nominee slots from a larger shareholder simply by submitting notice a single day (or a single hour) before the larger shareholder. A different method of apportionment is preferable; for example, one based on size of shareholding.

Another dilemma is the potential problem caused by the SEC's exclusion from the 25% cap of any director appointed pursuant to an agreement with a shareholder. A number of companies in the last two years agreed to appoint one or more of shareholder nominees to their boards of directors in order to settle or avoid a proxy fight. Those companies would face the prospect of having a further 25% of their board seats available for shareholder nominees if, as is commonplace, the settlement agreement extends for more than one year. As a result, the effect of the proposed rule would be to create incentives for companies not to reach agreement with activist shareholders for fear that other shareholders will simply propose additional nominees up to the 25% cap.

There is, however, potentially a more fundamental problem with proxy access. Shareholders have succeeded over the last two years in driving a significant change in the way directors are elected. Over 60% of companies in the S&P 500 now have majority voting policies for uncontested director elections rather than the plurality model that was previously used. Most shareholders perceive majority voting to be a significant weapon to unseat ineffective or inattentive directors. However, under the proposed proxy access rules, a 1% shareholder who proposes its nominee for the board of a company will effectively turn an uncontested election that was subject to majority voting into a contested election subject to a plurality voting standard. It is not clear that large, institutional shareholders would want to hand control over this issue to potentially smaller, more aggressive shareholders in every company in which such large shareholders might invest.

Therein lies the most significant challenge in the SEC's proposed shareholder access rules. They assume that a single, federally mandated solution is appropriate for every company, and that it reflects the will of most shareholders. In this way, however, shareholders are not really being given a say. For example, even though the SEC is proposing to overturn its “election exclusion” to give shareholders the right to make proposals regarding procedures for director elections, any such proposals could not alter the minimum thresholds that the SEC is proposing for shareholder access. In fact, the SEC rules would trump the shareholder access rules adopted by stockholders of a company even if they affirmatively voted to set higher thresholds or more stringent requirements than those contained in the proposed rules.

Giving Control to Shareholders or Taking It Away?

There is significant evidence that shareholders are already succeeding in effecting change in key areas affecting director accountability, and that the federal system of competing state corporate laws provides shareholders with further means to influence boards and nominate directors on a cost-effective basis. Indeed, recent proxy seasons have seen record numbers of activist campaigns by investors ' 506 in 2007, and 479 in 2008. These proxy fights and other campaigns resulted in activists gaining board seats at 84 companies in 2008 alone, more than any other recent year. Also, the corporate law marketplace has started offering new possibilities for activist shareholders. In 2007, North Dakota became the first and, to date, only state to adopt a mandatory proxy access law. So far, only one U.S. public company ' a company controlled by Carl Icahn ' voted to reincorporate in North Dakota. But others may follow. At the same time, Delaware recently amended its corporate law to explicitly permit companies to adopt provisions in their certificates of incorporation and bylaws allowing reimbursement of the expenses incurred by shareholders in director election contests. Delaware also amended its corporate law to explicitly permit (but not require) company bylaw amendments allowing shareholders to include director nominees in the company's proxy materials. Subsequently, the Corporate Laws Committee of the American Bar Association approved the first reading of amendments to the Model Business Corporation Act (the “MCBA”), which include provisions similar to the Delaware amendments. The MCBA has been adopted in whole or in part by more than 30 states, and so the potential impact of the change is broad. Finally, as noted above, the shift from plurality voting to majority voting has given teeth to a “no” vote, and has enhanced shareholders' ability to hold directors accountable.

These events give weight to the increasing ability of shareholders to influence boards and nominate directors on a cost-effective basis. This, in turn, calls into question the need for a single, federally mandated proxy access solution for all U.S. public companies. It would be preferable simply to open up company proxy statements to shareholder proposals regarding the director election process, as the first part of the SEC's proposed amendments seeks to do. Shareholders could then propose the rules they want for each particular company based on its particular circumstances.

In a world of angry, but rational, shareholders, it seems likely they would be better placed than the federal government to determine what those rules should be in each case.

Colin J. Diamond is a partner in the New York office of White & Case LLP. His practice is concentrated on securities transactions, public mergers and acquisitions, and general corporate representations. Diamond's work includes counseling the boards of public companies on their fiduciary duties, disclosure issues and corporate governance practices. He may be reached at [email protected]