The issue of allowing shareholders of public companies to include their nominees for director in the company’s proxy materials (“Proxy Access”) has been the subject of heated debate for years. In 2003, when there were no state law provisions addressing the issue, and in 2007 (when only the North Dakota statute addressed Proxy Access), the Securities and Exchange Commission proposed rules that would facilitate such inclusion, only to abandon the proposals. In March 2009, Delaware added Section 112 to its General Corporation Law, effective August 1, 2009, to allow for bylaws that permit Proxy Access. It has been widely expected that many other states would follow Delaware’s lead and adopt similar statutes. In May 2009, the SEC announced that it would propose a new rule, Rule 14a-11, dealing with Proxy Access that would preempt key parts (but not all) of Delaware Section 112. Proposed Rule 14a-11 would differ in three important respects from the Delaware provision:
In its release announcing that it would propose Rule 14a-11, the Commission focused on enhancing director accountability. According to the Commission, the current economic crisis has created widespread concern about “whether boards are exercising appropriate oversight of management, whether boards are appropriately focused on shareholder interests, and whether boards need to be held more responsible for their decisions regarding such issues as compensation structures and risk management.” The Commission’s solution to the above problems is Proxy Access:
Because of these concerns, the Commission has decided to revisit whether and how the federal proxy rules may be impeding the ability of shareholders to exercise their fundamental right under state law to nominate and elect members to company boards of directors.
But the connection between effective director accountability and Proxy Access for shareholders is not obvious and depends on the validity of several implicit and intermediate premises. We believe that the SEC should address and make a strong case on each of the following premises.
Proxy Access, as a component of corporate governance, is a matter more properly dealt with under state law. We believe that the SEC, as a federal agency, should make a strong case before regulating in an area traditionally regulated by states. This is especially true with respect to Proxy Access, where state legislation is only in its infancy. It is likely that the states will develop a significant body of experience in a relatively short time and it will not be long before more resolving evidence emerges whether or not Proxy Access initiatives at the state level are or are not an effective means of dealing with the issue of director accountability. (We do not address in this alert the issue of whether the SEC has the power to enact Rule 14a-11, an issue that others have dealt with.)
Accordingly, we believe that it would be appropriate for the SEC to adopt a rule consistent with Rule 14a-11, if, but only if, it can make a strong case that the proposed rule is likely to enhance director accountability; that state initiatives such as Delaware’s Section 112 are not likely to increase director accountability; and that the current problems with director accountability are severe enough that we cannot afford to wait to see whether state-level regulation proves out. In making that case, it should address each of the premises discussed below.
Premise #1. Reforms in recent years have not been sufficient to assure the appropriate level of director accountability
The first premise underlying the adoption of Rule 14a-11 is that recent reforms in listing standards and SEC rules, including those relating to:
• The substance and disclosure of the independence of a majority of the board of directors and of members on key committees, and
• Disclosures concerning the nominations process (including disclosures relating to consideration of any director candidates recommended by security holders),
have proven inadequate to assure the desired level of director accountability and that it is necessary for the Commission to take a different approach. But the question becomes whether Proxy Access, which, as we mention above, is only partially related to director accountability, will have any greater effect on making directors beholden to shareholders than current “reform” rules such as requirements for independent directors.
Premise #2. Proxy Access may contribute substantially to assuring the accountability of boards of directors
The second premise is that the election of directors nominated by shareholders or the appointment of such directors in lieu of a proxy contest may contribute substantially to assuring the accountability of boards of directors. Although this premise would appear fundamental to the Commission’s decision to propose Rule 14a-11, to our knowledge, the Commission has never directly addressed the issue.
A recent study entitled Effectiveness of Hybrid Boards (May 2009), prepared by Proxy Governance, Inc., deals indirectly with this issue, although it does not purport to prove that director nominated shareholders improve director accountability. The study addresses the impact of what it calls “hybrid boards,” which it defines as “boards formed when activist shareholders such as hedge funds, through actual or threatened proxy contests, were able elect dissident directors but did not win full control of a board.” The study evaluates “board effectiveness” in terms of “changes in corporate governance structures and strategy, as well as through increases or decreases in shareholder value, measured in both absolute returns and relative to peers.” The favorable changes in corporate governance and strategy appear to be significant. Favorable changes in shareholder value also appear to be significant, but such changes appear primarily to occur after the announcement of a proxy contest but before the hybrid board is seated. The study notes:
The single most significant contributor to overall share price performance for a company which seated a hybrid board was the “contest effect,” [that is] share price increase in the three months leading up to the resolution of a contest. Performance after a hybrid board was seated, therefore, might be only [be] on part (sic) with peers.
While the study is interesting, it is far from persuasive proof that the presence of shareholder nominees on the board is directly or meaningfully correlated to enhanced director accountability. The Commission needs to make its case on this issue.
Premise #3. The costs of mounting a proxy contest deter too many potentially beneficial proxy contests for minority representation on the board and the Commission’s proposed rule would encourage such proxy contests while reducing the costs substantially
The third premise addresses whether the costs of mounting a proxy contest deter minority representation that would lead to improved accountability and corporate governance. Whether this premise is true or not cannot be determined at this time. Certainly, inclusion of shareholder nominees in the company’s proxy statement would reduce the shareholder’s cost of mounting a proxy contest. But the likely restraints on disclosure by dissident shareholders in the company’s proxy statement raise two important questions. Would dissidents undertake the cost of mailing their own proxy materials in order to more effectively make their case? And if dissidents could avoid such costs, how effective would the challenge be if the dissident shareholder were severely limited in making its case in the company’s proxy materials?
Premise #4. Bylaws adopted under the Delaware statute and similar statutes permitting the adoption of a bylaw would not, but Rule 14a-11 would, meaningfully enhance the possibility that shareholder nominees would be elected or appointed to the board of directors, especially at larger companies
The fourth premise is that bylaws adopted under the Delaware statute and similar statutes permitting the adoption of a bylaw would not meaningfully enhance the possibility that shareholder nominees would be elected or appointed to the board of directors, especially with larger companies. In evaluating this premise, we looked at the Model Delaware Bylaw, here, proposed by Wachtell, Lipton, Rosen & Katz, perhaps the leading voice on corporate governance matters. That bylaw requires that an eligible shareholder may make nominations to be included in the company’s proxy statement. An eligible shareholder is defined as a shareholder, together with his affiliates, who beneficially owns 5% of the voting securities. No provision is made for a group of unaffiliated shareholders acting as a group to satisfy the 5% threshold.
One way to evaluate whether shareholder use of Proxy Access would be meaningful if it were limited to 5% shareholders and did not allow shareholders to aggregate to satisfy that 5% threshold is to look at the number of 5% shareholders.
In 2007, the Commission proposed an amendment to Rule 14a-8(i)(8) similar to the Wachtell Model Delaware Bylaw. Under the proposed amendment, a 5% shareholder could use Rule 14a-8 to force the company to include a proposal for a bylaw relating to Proxy Access in the company’s proxy materials. In its proposing release, the Commission addressed the issue of the likely number of such 14a-8 proposals by 5% shareholders and the answer was that it would be modest. “[B]y establishing procedures for submission of these types of proposals, we are likely to encourage more bylaw amendment proposals than we currently receive . . . and estimate the number would be 30 per year.”
At the time of the Commission’s 2007 proposal, we looked at the then Dow 30 companies in order to determine how large the universe of 5% holders was. At that time there were a total of twenty 13(d) filers among the Dow 30 (excluding the two that acted as trustees for company employee benefit plans). One half of the Dow 30 companies did not have even one 13(d) filer listed in their most recent proxy statements. The twenty 13(d) filers were actually ten discrete entities, all of which were investment funds or investment advisors. According to the Georgeson US Annual Corporate Governance Reviews for 2004, 2005, and 2006, not one proposal had been submitted by any of those ten entities.
We also looked at a significant percentage of the Nasdaq 100, which represent a mix of large accelerated filers and accelerated filers. All of those companies had at least one 13(d) filer and the average was 2.56. In addition, we sampled portfolio companies of investment companies specializing in small- and micro-cap companies. Small-cap companies had an average of 2.48 13(d) filers and micro cap had an average of nearly 6.00 13(d) filers. The samples for small- and micro-cap companies were probably not representative, since these companies had attracted investment companies as investors.
These results suggest the 5% ownership threshold in the Wachtell Model Delaware Bylaw would substantially inhibit the use of Proxy Access and that the scaled ownership thresholds in proposed Rule 14a-11 would encourage use of Proxy Access. The results also suggest that the inability under the Wachtell Model Delaware Bylaw of unaffiliated shareholders to aggregate holdings to satisfy ownership thresholds would inhibit the use of Proxy Access and allowing unaffiliated shareholders under the proposed rules to aggregate their holdings to satisfy ownership thresholds would be very useful, indeed crucial, in encouraging shareholder nominations.
That said, it is clear that the SEC believes that the lack of director accountability is a widespread problem. It is by no means clear that Rule 14a-11’s scaled ownership thresholds and the aggregation of shareholdings would lead to utilization widespread enough so that Proxy Access could be meaningful as a means of enhancing director accountability.
Premise #5. The ability of shareholders, under Delaware Section 112, to override a board-adopted bylaw or to adopt a bylaw in the absence of board action would be ineffective in assuring director accountability
The fifth premise is that the ability of shareholders, under Delaware Section 112, to override a board-adopted bylaw (such as the Wachtell Model Delaware Bylaw) or to adopt a bylaw in the absence of board action would be ineffective in facilitating proxy contests that could assure director accountability. There are several possible reasons that Section 112 might be ineffective: shareholders might not seek a vote on a Proxy Access bylaw (whether or not the board of directors adopted one); a proposed bylaw with ownership thresholds (whether scaled or not) might be unlikely to pass in the face of management opposition; or the process of getting a shareholder sponsored bylaw passed would take too much time in light of the pressing need for director accountability. In any case, whatever the possible explanation, the underlying rationale of proposed Rule 14a-11 is that a two-step corporate democracy (the first step being the adoption of a shareholder-approved bylaw under Section 112) would be ineffective as a means of assuring director accountability. It is not clear what the basis is for this premise and the Commission needs to address the issue.
It is our view that before the Commission adopts a federal direct access rule and preempts state law, it must carefully address the premises above to ensure that a federal overlay of state proxy access laws is appropriate at this early stage of the game.