New rules would allow shareholders to include in the company’s proxy statement their nominees for board elections and proposals to amend a company’s charter or bylaws related to director nomination procedures.
The Securities and Exchange Commission (SEC) has debated the merits of revamping the proxy process to increase shareholder access for most of a decade, and even waged two ultimately unsuccessful campaigns to accomplish such change in 2003 and 2007. Now the third time may be the charm, as the SEC renews its efforts to demonstrate that it remains a potent regulator of the financial markets and their participants, in response to the public’s perception that the SEC’s failure to detect and prevent recent financial scandals contributed to the economic crisis.
On June 10, 2009, the SEC released proposed rules that enable shareholders, subject to certain eligibility requirements, to submit a proposal nominating a minority slate of directors that must be included in the registrant’s proxy statement. If these proposed rules are adopted, they will have a major effect on the director nomination process, the relationship between companies and their shareholders and the interplay between federal securities and state corporate laws. While the SEC posits this effect will be beneficial, it is unclear that increased shareholder access will improve the long-term bottom line of corporate America, nor is it clear that the federalization of proxy access (and the concomitant demotion of state law) will result in an optimal legal regime.
Historically, the SEC has staked out a regulatory position limited to requiring disclosure of material information to shareholders, adopting the philosophy that “sunshine is the best disinfectant.” This approach has translated into the promulgation of disclosure requirements that have expanded over the years in line with shifts in investor and political prerogatives. In the 1960s, in conjunction with the enactment of the Williams Act, the SEC promulgated extensive new rules requiring specific disclosures by shareholders in connection with their acquisition of significant ownership positions in public company securities, as well as by both acquirers and target companies in connection with tender offers to acquire public company securities. In the early 1980s, the SEC harmonized its disclosure requirements between securities offering documents and periodic reports. The SEC promulgated new executive compensation disclosure rules in the early 1990s that significantly expanded the nature of disclosures concerning a public company’s executive and director compensation; these rules were tweaked over the following decade until they were substantially overhauled and expanded in 2006. In 1999, the SEC adopted new rules expanding the types of disclosures required in connection with the acquisition of public companies, and in 2005, the rules concerning substantive and procedural requirements in connection with disclosures provided to investors in public securities offerings were revamped.
But before these new proposed proxy rules, the SEC delved infrequently and cautiously into substantive corporate governance matters, preferring to leave such issues to be addressed in state law or stock exchange listing requirements, or to be fought out between activist shareholders and corporate boards, with corporate governance watchdog groups as referees. One recent exception to this tendency was the enactment of the Sarbanes-Oxley Act in 2002, under which the SEC was mandated by statute to adopt rules designed to require the independence of public company audit committees.
The Current Framework for Electing Directors
Historically, a public company annually elects its directors by putting forth its nominees in its proxy statement, which is disseminated to all shareholders either on paper or online. The company’s proxy statement has and continues to be well-guarded territory, with access reserved almost exclusively for matters that the company desires to present to its shareholders, and granted only grudgingly for shareholder proposals meeting the stringent procedural and substantive limitations imposed by SEC rules. And since the earliest SEC regulation of the proxy solicitation process, notwithstanding multiple attempts to change the system through the SEC no-action letter process, litigation, and SEC-proposed rule changes, shareholders have been blocked from requiring companies to include in their proxy statements shareholder nominees for board elections or any shareholder proposals relating to the director election process.
Shareholders who wish to have their own nominees elected to the board therefore have had limited options available to them. While their right under applicable corporate law to nominate one or more proposed directors for election has been and continues to be inviolate, and may not be infringed by a company except through procedures that require reasonable advance notice, shareholders’ practical ability to garner the votes necessary to elect their nominees has been undermined by the complex and expensive process entailed by the SEC proxy rules.
A shareholder may propose to have a nominee added to the board by contacting the nominating committee of the company’s board of directors and requesting that the committee voluntarily include the shareholder’s nominee on the company’s own slate of nominees to be set forth in the company’s proxy statement. Except in cases in which the shareholder and the board have a strong relationship, or in which the shareholder poses a sufficient threat to the continuity of the board, such an approach is rarely successful.
Alternatively, a shareholder wishing to have one or more of her own nominees elected to a public company’s board of directors may engage in a proxy solicitation that competes with the company’s. This means engaging in an expensive process that includes hiring lawyers, proxy solicitation firms and investor relations consultants to conduct a likely lengthy and frequently unsuccessful proxy contest against the company’s board. The deck is typically stacked against the insurgent in such situations because the board is permitted to use company funds to defend against the insurgent’s campaign.
A shareholder seeking to elect a competing slate of directors at a shareholders meeting without soliciting proxies in advance could simply arrive at a shareholders meeting with her shares in hand and nominees in tow, having provided any necessary advance notice to the company. However, in the case of a public company of any meaningful size, this would almost always be a futile effort because the shareholder would find that when it comes time to count the votes, the insurgent’s votes would be overwhelmed by the public shareholders’ proxies that have been collected by the company through its own proxy solicitation process.
The Proposed Rules
The balance of power in electing directors has been heavily in favor of a company’s existing board of directors. The ability of eligible shareholders to include a director nominee or a proposal concerning the election of directors in a company’s proxy statement, as proposed, would swing the pendulum strongly in favor of shareholders, because the proposed changes would allow the shareholder’s nominees equal visibility compared with board nominees when shareholders review the company’s proxy statement and vote for directors. Also, it would cost the insurgent substantially less to present her nominees to all of the company’s shareholders for a proxy vote.
According to the proposed rules, a shareholder’s ability to include a proposal or nomination in a company’s proxy statement would be subject to the following guidelines:
If the board of directors already includes one or more shareholder-nominated directors who will continue to hold office following the upcoming election, shareholders may nominate only that number of directors that, if elected, would cause the shareholder-nominated directors on the board of directors to constitute 25 percent or less of the board of directors. For example, if the board is composed of 12 incumbent directors, two of whom are shareholder-nominated and whose terms will continue after the upcoming election, a shareholder may nominate one additional director to the board under the terms of the proposed rules.
In addition to the new rule permitting shareholder nominees to be included in a company’s proxy statement, the SEC has proposed amendments to narrow the restrictions on shareholder proposals that “relate to an election” – a reversal of current rules under which a company is permitted to exclude such shareholder proposals from the company’s proxy statement. The proposed new rule would permit companies to exclude only proposals that would disqualify a nominee standing for election; terminate a director’s tenure prior to the expiration of his or her term; question the competence, business judgment, or character of one or more nominees or directors; nominate a specific individual for election to the board other than pursuant to the proposed new rule governing shareholder nominations of director candidates, discussed above; or otherwise could affect the outcome of the upcoming election of directors.
The proposed amendment not only accommodates the shareholder nominating procedure provided under the proposed shareholder nomination rule but also enables shareholders to submit proposals to amend a company’s charter or bylaws to remove any prohibitions to a shareholder nomination process as envisioned by the proposed new shareholder nomination rule.
The SEC’s decision to move forward with these proposed rules effectively short-circuits recent legislative changes in Delaware, the state where most Fortune 500 companies are incorporated. Only last year, the Delaware constitution was amended to permit the Delaware Supreme Court, one of the most influential determinants of U.S. corporate law, to accept and rule on questions of Delaware law certified to it by the SEC. Indeed, the 2008 proxy season gave rise to such a certification with respect to the inclusion of a shareholder proposal submitted by AFSCME in the proxy materials of CA, Inc.
Delaware recently amended its corporate law, to become effective in August 2009, in response to the CA v. AFSCME controversy, and with the intent to clarify the distinction between procedural matters (which are appropriate matters for shareholder proposals) and substantive management functions (which are not). The Delaware corporate law amendments will, among other things, permit a Delaware corporation’s bylaws to enable shareholders to include their nominees for election to the board of directors in the company’s proxy statement, as well as to provide for reimbursement of proxy solicitation expenses of victorious dissident shareholders.
Under Delaware’s approach, either a board of directors of a Delaware corporation on its own motion, or shareholders gaining sufficient support in a shareholder vote, could implement changes to a company’s governing documents granting shareholders access to a company’s proxy statement just as the SEC’s proposed rules would do. But the precise contours of such provisions are not dictated by the Delaware statute; rather, they are left to the board of directors and shareholders to define.
The SEC has thrown its hat into the substantive corporate governance ring with its proposed rules, which, if adopted, will effectively eclipse the flexible approach represented by the latest changes to Delaware law in favor of a single, federal approach that is mandatory rather than permissive. If adopted, the proposed rules would cause a shift in the relative power of boards of directors and shareholders - at the very least with respect to director nominations. To the extent this unprecedented proxy access by shareholders results in the election of shareholder nominees to the board, then shareholders can have more power over corporate affairs generally. Moreover, the proposed rules represent a shift in the SEC’s own approach to regulation, signaling that it no longer believes that sunshine alone is an adequate disinfectant.
1 See Proposed Rule 14a-11(b). A “large accelerated filer” is a company that has a public float (i.e., value of publicly held equity securities) of at least $700 million and an “accelerated filer” is a company with a public float of at least $75 million.
2 In the event that one-fourth of the total number of directors is not a whole number, shareholders may nominate the number of directors equal to the nearest whole number below 25 percent of the total.
Robert A. Friedel and Shirley R. Kuhlmann
The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.