In June 2009, the Securities and Exchange Commission proposed to require public companies, under certain circumstances, to include in the company proxy statement and proxy card the names of director nominees submitted by substantial long-term shareholders (generally referred to as “access to the proxy” or “proxy access”). At the same time, the SEC proposed to amend Rule 14a-8(i)(8), the shareholder proposal rule’s “Election Exclusion”, to reverse a 2007 amendment and allow shareholders to submit proposals seeking the adoption of a proxy access regime. The comment period for the rulemaking expired on August 17, 2009, and the SEC received hundreds of comment letters.

Among commenters opposed to the adoption of Rule 14a-11, a common theme was that the SEC should refrain from imposing a uniform federal access procedure. Instead, these commenters urged, the SEC should facilitate private ordering to permit shareholders at each individual company to decide whether proxy access is desirable and to establish its precise contours. To that end, these commenters generally supported the SEC’s proposal to amend the Election Exclusion.

Two distinct types of private ordering were promoted in comment letters:

• Opting in: The default rule would be no proxy access. A company could opt in to a proxy access regime through (a) a bylaw adopted by the board, either in response to a non-binding shareholder proposal seeking access or on its own initiative; or (b) a bylaw adopted by shareholders. A proposal promoting proxy access, including a shareholder-initiated bylaw amendment, could be included in the company proxy statement—provided the SEC adopts the proposed amendment to the Election Exclusion—or it could be the subject of an independent solicitation. Advocates of an opt-in approach pointed out that Delaware recently enacted changes to its corporate law clarifying that bylaws establishing a proxy access regime are permissible under Delaware law.
• Opting out: The default rule would be proxy access established by SEC rule. A company could opt out of the access procedure if (a) its shareholders approved a management proposal to opt out or (b) its shareholders adopted a bylaw providing that the proxy access procedure would not apply.

In some discussions, the opt-out approach has been framed as including both opt-out and opt-in elements. In this conception, a company would be permitted to opt out of the access procedure established in Rule 14a-11; either at that time or a later time, the company could opt into a proxy access procedure of some kind, at the behest of shareholders using the shareholder proposal process or on the board’s own initiative.

Thus far, the proxy access debate has centered on the legitimacy of federal regulation on this subject, with supporters urging that the proposed access procedure is a logical extension of the SEC’s power over the proxy solicitation process and opponents arguing that the proposed rule represents too much of an incursion on states’ traditional jurisdiction over corporations’ internal affairs. Some attention has been paid to whether the virtues of an enabling approach—allowing companies to adopt a different rule from the default and thus to tailor practices to company circumstances—justify a departure from the mandatory approach seen in all other areas of U.S. securities regulation.

Missing from the discussion, however, is a systematic analysis of the feasibility of private ordering at U.S. public companies. A primary selling point of private ordering in the proxy access context is that it would ensure that the arrangement at a given company reflects the preferences of its shareholders, preferences that are informed by those shareholders’ views on whether proxy access would be value enhancing (and if it would be, the ideal terms of the procedure). Implicit in many of the comments supportive of private ordering are assumptions that shareholders can easily propose appropriate proxy access procedures at individual companies and that the shareholder voting process is free from significant distortions.

To test those assumptions, this study analyzes the prevalence of two governance arrangements—limitations on shareholders’ ability to amend the bylaws and capital structures involving multiple classes of stock with disparate voting rights—in three different market indices: the S&P 500, the Russell 1000 and the Russell 3000. [1] If shareholders cannot amend the bylaws, both opting into and out of proxy access through a shareholder-adopted bylaw amendment are impossible. Supermajority voting requirements to amend the bylaws create similar, though less severe, challenges. Multiple class stock structures with unequal voting rights can prevent voting outcomes from reflecting the views of holders of a majority of a company’s shares. Each of these arrangements is discussed in more detail below.

Overall Findings

Just under half the companies analyzed had either a restriction on shareholders’ ability to amend the bylaws or multiple classes of stock with disparate voting rights, or both. Among Russell 3000 companies, 48.5% of companies have at least one of these two governance arrangements in place.

Of Russell 1000 companies, 46.4% limit shareholders’ power to amend the bylaws or use a capital structure with disparate voting rights for multiple classes stock, or both.

Finally, 44.2% of S&P 500 companies restrict shareholders’ ability to amend the bylaws or have multiple classes of stock with disparate voting rights, or both.

Initiating Governance Change

Both the opt-in and opt-out regimes suggested by various commenters contemplate shareholders initiating changes to companies’ governance arrangements using the shareholder proposal process. A board can adopt an access procedure without prompting from company shareholders, but the current paucity of such arrangements suggests that shareholders will need to initiate the process at many companies.

Shareholder proposals may be made in binding or precatory form. A precatory proposal asks the company to take the desired action and leaves implementation to the board of directors. In other words, even if passed by shareholders, it does not bind the board. A binding proposal takes the form of an amendment to the company’s bylaws; it takes effect without further board action upon approval by the requisite percentage of shares.

For opt-in proposals, it is likely that shareholders will wish to submit binding proposals in some cases in order to retain control over key terms of proxy access, such as the amount of stock a shareholder must own in order to use the access procedure, the length of the holding period, the maximum number of candidates who can be nominated and the method of resolving conflicts between competing nominating shareholders or groups. A binding proposal may be viewed as preferable at a company whose board has already adopted an access procedure bylaw with terms seen as too onerous, or at a company where shareholders are skeptical that the board would implement a precatory proposal in a manner acceptable to shareholders.

In the case of opt-out proposals, it is less clear how shareholders would initiate the change because there is no precedent for a shareholder opt-out from a federal securities regulation. Under the law of some states, companies can opt out of the operation of certain anti-takeover statutes in a number of ways, including a statement to that effect in a bylaw. It is possible, then, that an opt-out procedure might involve shareholders adopting a bylaw opting out in whole or in part from a uniform federal access procedure. (Another possibility, not involving shareholder initiation, is that shareholders might ratify a board-adopted bylaw amendment.)

State Law and Proxy Access Proposals

Under the shareholder proposal rule, a company may exclude a proposal from its proxy statement if, among other things, (a) it is not a proper subject for shareholder action under the law of the state in which the company is incorporated or (b) implementing the proposal would cause the company to violate state law. Although a precatory proposal will not generally be subject to exclusion on this ground, a shareholder cannot submit a binding bylaw amendment on proxy access if the amendment would be invalid under the law of the state where the company is incorporated.

Supporters of private ordering point to recent statutory changes in Delaware-where the Delaware General Corporation Law now makes it clear that a bylaw establishing a proxy access regime is permissible–as evidence that there are few barriers to company-by-company reform on the issue. [2] Although “[a]ctive consideration” [3] is being given to amending the Model Business Corporation Act to follow Delaware’s lead, any changes to the MBCA must be adopted by individual state legislatures.

Among Russell 3000 companies, 1,713, or 57.1%, are incorporated in Delaware. Among larger capitalization companies, the proportion is slightly higher; 57.8% of Russell 1000 companies and 60.8% of S&P 500 companies are incorporated in Delaware. Thus, at 40% or more of companies analyzed for this study, there is no assurance that a shareholder-initiated bylaw amendment on proxy access would be valid. [4]

Limitations on Shareholders’ Ability to Amend the Bylaws

In addition to state law, companies’ own governance arrangements affect the ability of shareholders to initiate governance reforms using the bylaw amendment process. Shareholders cannot submit a binding proposal establishing or opting out of a proxy access procedure at companies where shareholders do not have the power to amend the bylaws. Although Delaware law does not permit the elimination of this right, the corporate law of some states either (a) supplies a default rule of no shareholder ability to amend the bylaws (thus requiring companies to provide a different rule in their charter or bylaws) or (b) supplies a default rule empowering shareholders to amend the bylaws but allows companies to eliminate the right entirely.

Approximately 4% of companies in the Russell 3000 and Russell 1000 indices do not allow shareholders to amend the bylaws. Among S&P 500 companies, about 3% prohibit shareholder bylaw amendments altogether.

Larger proportions of companies have supermajority voting requirements (a proportion larger than a simple majority or 50% plus one share) for shareholders to amend bylaws. A supermajority vote threshold is not the same as a prohibition, to be sure. But the way a supermajority vote threshold is calculated makes it a significant barrier to shareholder action. With many items on which shareholders vote—the election of directors, for example, or the approval of an equity compensation plan—the denominator is votes cast. For a bylaw amendment, by contrast, the denominator is shares outstanding, so an 80% requirement to amend the bylaws requires the sponsor of the bylaw amendment to ensure both that its case is persuasive to a very large proportion of shares voting (in other words, that they vote “for” instead of “against”) and also that turnout is sufficiently high for support among shares voting to translate into approval.

Data relating to board declassification suggest that supermajority vote requirements make passage of a ballot item significantly less likely, though circumstances vary from company to company. An analysis of shareholder voting on management proposals to declassify the board from 2004 through 2009, submitted at companies where shareholders had previously approved one or more shareholder proposals urging declassification, illustrates this phenomenon. (Most companies classify their boards in the charter, so companies seeking to declassify the board must seek shareholder approval for a charter amendment.)

The data show a lower approval rate for management declassification proposals requiring a supermajority vote than for those requiring only a simple majority vote, with both thresholds calculated out of outstanding shares. All of the proposals requiring a simple majority were approved, compared with 85% of those needing a supermajority vote. This difference is even more meaningful considering that these declassification proposals would have carried a “for” vote recommendation from the board and that brokers could vote uninstructed shares in favor of these proposals under New York Stock Exchange Rule 452. (Broker votes are typically cast in accordance with management’s recommendation; for a fuller discussion of broker voting, see “Distortions in the Shareholder Voting Process”.)

A supermajority vote requirement to amend bylaws is present at 39.1% of companies in the Russell 3000 index. This figure is a bit lower among Russell 1000 companies, 36.1% of which use a supermajority threshold, and S&P 500 companies, where 35.4% employ a supermajority vote standard.

Between outright prohibition and supermajority voting requirements, shareholders at approximately 40% of companies in the three indices face meaningful barriers to adopting a bylaw amendment opting into or out of a proxy access regime. A standard other than a simple majority is in place at 43.2% of Russell 3000 companies, 40.2% of Russell 1000 companies and 38.5% of S&P 500 companies.

Distortions in the Shareholder Voting Process

Discussions about shareholder voting generally assume that a proposal’s approval or defeat reflects the preferences of holders of a majority of shares (or supermajority, as the case may be). Comments promoting private ordering exhibit this tendency. For example, Professor Grundfest stated in his comment, “Fully enabling rules would create shareholder referenda pursuant to which shareholders could propose, and a majority could adopt, proxy access standards for each individual corporation.” [5]

While that is the case at companies with one class of voting stock, it does not hold at companies with two or more classes of voting stock and disparate voting rights. This kind of capital structure assigns greater voting power to holders of one class of shares; these holders are often insiders or members of a company’s founding family or group and the supervoting shares are generally not available to the investing public. For example, holders of public Class A shares may have one vote per share while holders of Class B shares have 10 votes per share. Such arrangements distort the relationship between voting power and economic exposure and allow holders of what may be a very small number of shares to determine voting outcomes.

Of Russell 1000 companies, 8.8% have a multiple class capital structure with disparate voting rights. The proportion is a bit smaller among Russell 3000 companies, at 7.5%, and companies in the S&P 500, where 7.1% of companies have this governance arrangement.

There is very little overlap between companies that restrict shareholders’ ability to amend the bylaws and those that have multiple classes of stock with disparate voting rights. A very small fraction of companies—2.3% of Russell 3000, 2.4% of Russell 1000 and 1.4% of S&P 500 companies–has both of these governance arrangements.

In the case of management proposals to opt out of proxy access, the New York Stock Exchange’s broker-may-vote rule, Rule 452, may supply an additional distortion. Rule 452 allows a broker holding shares in “street name” for a customer to cast proxy votes on certain “routine” items if the broker does not receive voting instructions from the customer at least 10 days before the scheduled shareholder meeting. A management proposal is classified as routine, and thus eligible for broker voting, unless it is added to the list of non-routine items in the rule. (A shareholder proposal opposed by management, by contrast, is categorized as non-routine.) Broker votes are typically cast in accordance with management’s recommendation. [6]

Although the impact of broker voting varies from company to company, it can significantly bolster support for management initiatives. A study commissioned by the Council of Institutional Investors found that the elimination of broker voting would have increased the number of directors at companies with a majority vote standard who received “withhold” or “against” votes in 2007 of at least 25% from 68 to 98; similarly, the number of directors at plurality-vote companies receiving such votes would have increased from 384 to 514. [7]

Conclusion

The case for private ordering assumes that shareholders will be able to initiate proposals opting into or out of an access regime, as well as that voting outcomes reflect the will of the majority. Data on bylaw amendment limitations show that at between 38 and 43% of companies, depending on the index, shareholders are either unable to amend the bylaws or face significant challenges in the form of supermajority vote requirements. A lack of clarity regarding the validity of binding proxy access shareholder proposals in states other than Delaware further calls into question the feasibility of shareholder-initiated opt-in efforts at the nearly 40% of companies incorporated outside Delaware.

Moreover, at between seven and nine percent of companies, the capital structure varies from one share/one vote, giving disproportionate influence to holders of supervoting shares. Additional distortions could be introduced into the voting process for management proposals to opt out of proxy access as a result of the operation of the broker-may-vote rule.

Endnotes

[1] Because data were not available for all companies in the indices, the analysis was performed on 491 companies in the S&P 500, 924 companies in the Russell 1000 and 2,817 companies in the Russell 3000. Data were drawn from The Corporate Library’s database of North American governance information, and were current as of October 2009. The S&P 500 is a stock market index whose constituents have market capitalizations in excess of $3 billion and satisfy certain other criteria. The Russell 1000 index is made up of the 1000 largest U.S. public companies by market capitalization; similarly, the Russell 3000 constituents are the 3000 largest U.S. public companies by market capitalization.
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[2] See section 112, Delaware General Corporation Law.
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[3] Troy A. Paredes, Commissioner, Securities and Exchange Commission, Remarks at Conference on “Shareholder Rights, the 2009 Proxy Season and the Impact of Shareholder Activism,” at the Center for Capital Markets Competitiveness, U.S. Chamber of Commerce, June 23, 2009 (available at http://www.sec.gov/news/speech/2009/spch062309tap.htm).
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[4] North Dakota has a statutory proxy access right but no statute addressing the validity of a proxy access bylaw. In any event, no companies in the S&P 500 or Russell 1000, and only two companies in the Russell 3000, are incorporated in North Dakota.
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[5] Joseph A. Grundfest, “Internal Contradictions in the S.E.C.’s Proposed Proxy Access Rules,” working paper dated July 24, 2009, at 3 (submitted as comment letter).
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[6] See Latham & Watkins LLP webcast, “Kicking Off the 2009-10 Executive Compensation Season: A Real-Time Discussion of Critical Issues and Looming Legislative and Regulatory Changes,” at 1 (available at http://www.lw.com/upload/pubContent/_pdf/pub2841_1.pdf).
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[7] See Comment Letter of Council of Institutional Investors on “Proposal to Eliminate Broker Discretionary Voting for the Election of Directors” (SR-NYSE-2006-92), at 2 (Mar. 19, 2006) (available at www.cii.org).
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This week we bring you the second interview our “The Altman Interview” series where we speak with top experts and thought-leaders having an impact on corporate governance. Our interview with attorney Holly J. Gregory covers 10 questions on hot button issues for 2010.

Ms. Gregory is a well-known and highly respected figure in the world of corporate governance. As a partner at Weil, Gotshal & Manges, Ms. Gregory counsels corporate directors, executives and investors on the full range of governance issues and best practices. She played a key role in drafting the OECD Principles of Corporate Governance and advised the Internal Market Directorate of the European Commission on corporate governance regulation. Ms. Gregory has also served as an advisor to the World Bank and the joint OECD/World Bank Global Corporate Governance Forum on governance policy for developing and emerging markets.

In addition to her legal practice, Ms. Gregory has helped organize governance-related programs for the SEC, OECD, World Bank, Yale’s Millstein Center for Corporate Governance and Performance, Transparency International and Columbia University School of Law’s Institutional Investor Project.

Question 1

FH Byrd: Of all the proposed governance changes on the horizon which one, in your opinion, if adopted, will have the most impact on corporations?

Holly Gregory: This is difficult to predict given the number and range of governance reform proposals under discussion and the fact that if implemented the reforms will interact with recent rule changes concerning broker voting in the election of directors and new SEC rule interpretations that broaden shareholder power to bring advisory proposals on matters of CEO succession and risk oversight. But if I must identify one reform that threatens to work fundamental change, it is the grant to certain shareholders of direct access to the proxy for the nomination of competing candidates for director. Proxy access removes the gating mechanism of cost from a shareholder’s decision to put forward candidates to compete for board seats with the slate proposed by the board. Certain large shareholders or groups of shareholders who have held their stock for a year will be able to include their own candidates for up to 25% of the board in the company’s proxy at company expense. Greatly reducing the cost of mounting a campaign to elect a director outside of the board’s own proposed slate is designed to result in more contests for board seats. According to proponents, this is necessary to make directors more accountable to shareholders. What we will have to see play out is whether more frequent contests for board seats results in positive gains from heightened accountability. Some believe that boards are already under an unhealthy degree of shareholder pressure for immediate and ever rising share price gains. (See “Overcoming Short-termism”). Increasing the threat of election contests is not likely to reduce those pressures and improve board focus on the long-term performance that is essential to sustainable economic growth. This is especially so given the increasing number of elections that are held on an annual basis (and Senator Schumer has introduced a bill in Congress that would mandate annual elections for all directors by prohibiting staggered boards). Commentary to the SEC on the proxy access rule proposal has raised legitimate concerns about the impact of proxy access on the quality of board composition, the tenor of board deliberations and the board’s ability to reach consensus after full and constructive debate. The potential for more frequent director contests may discourage busy executives at the tops of their fields from serving on boards, and greater director turnover may undermine the quality of board decisions. New directors need time to develop the company-specific knowledge required for effective decision making. Time is also needed to develop the trust among directors that allows robust discussion, constructive debate and healthy disagreement to be followed by resolution and consensus. Greater director turnover may make it more challenging for boards to develop the appropriate culture of objectivity and constructive criticism that are the hallmarks of effective oversight of management. I hope that it will turn out that these concerns are overstated or unfounded.

Question 2

FH Byrd: Of the various stakeholders involved in U.S. corporate governance, who do you think will most likely benefit from proxy access, if adopted?

Holly Gregory: If the concerns that I’ve described are realized, proxy access will not be the panacea that the regulators intend, and shareholders as a whole will not be better off. In that scenario the primary beneficiaries will be shareholders who use proxy access to forward a specific objective or strategy that is not broadly shared by the entire shareholding body. Shareholders can no longer be thought of as powerless individuals with a common interest in corporate long-term performance that overrides other interests. The percentage of shares in the hands of institutional investors has grown considerably over the last 25 years, and these institutions and their interests are as diverse as the institutions are powerful. Public, private and union pension funds, mutual funds, private investment funds (including hedge funds), insurance companies, banks, endowments, and sovereign wealth funds are subject to varying levels of regulation, have distinct investment horizons and strategies, and exhibit varying levels of interest in the governance of portfolio companies. (What many institutions tend to have in common is their status as investment intermediaries who invest for the benefit of others and as a result face potential conflicts in managing fund assets.) Increasing diversity among shareholders brings with it heightened potential for divergent interests; this suggests a need for greater shareholder power to be accompanied with requirements for great transparency about the motives and interests of the shareholders who seek to exert the power.

Question 3

FH Byrd: With the likelihood of some form of Say on Pay, how do you think corporations should be preparing?

Holly Gregory: Corporations should be reassessing how they engage with their shareholders. It is important for boards and managers to understand who their shareholders are and what issues are important to them. In a say on pay and proxy access world, the ability to communicate clearly and effectively with shareholders about strategies and objectives — and specifically about how compensation plans are designed to create incentives for achieving strategic objectives — will differentiate companies and be associated with greater levels of “investor peace” and board and management stability. This is the time for boards and management teams to be gearing up and thinking about shareholder relations in new, more creative and more engaged ways. Improved engagement with shareholders is the best hope companies have of avoiding or mitigating the concerns addressed in my answers to the preceding questions.

Question 4

FH Byrd: With the loss of the broker vote, do you feel there will be more “vote no campaigns” in 2010?

Holly Gregory: Whether or not we see a rise in the number of “vote no campaigns” in 2010, it is a fair prediction that such campaigns will be more successful in a world in which brokers are not allowed to vote uninstructed shares in the election of directors.

Question 5

FH Byrd: Do you think HealthSouth’s decision to allow reimbursement of proxy contest expenses for dissidents (earning 40% or more of the vote) will lead other boards/companies to take similar action?

Holly Gregory: This kind of “private ordering” has significant value because it reflects board judgment about how to accommodate legitimate shareholder concerns in a company specific manner. Encouraging companies and shareholders to reach their own solutions is far preferable to the imposition of strict mandates. Recent approaches to say on pay by Microsoft (which will now give shareholders an advisory vote on executive compensation every three years) and Prudential ( say on pay every two years) further reflect the private ordering approach, and provide examples of how these concepts can be distinctly tailored. If companies believed that adopting reimbursement provisions would satisfy the SEC as a replacement for mandated proxy access, I predict many companies would seriously consider adopting it.

Question 6

FH Byrd: Excise tax gross-ups received a lot of attention in 2009, primarily due to RiskMetrics taking a harder stance on them. Do you think there are any other pay practices that corporations should be leery of?

Holly Gregory: Compensation committees and boards need to develop greater understanding of and sensitivity to the concerns about executive compensation that have resulted in such intense popular and political backlash. Many of these issues are not new, but at times boards and managements have exhibited tone-deafness or an unwillingness to set forth in plain and rational terms the legitimate justifications for certain pay practices. It is no longer enough to simply cite competition and retention concerns to justify large packages and grants.

Question 7

FH Byrd: Senator Schumer’s legislation proposes mandatory risk committees for U.S. corporations. Should boards be getting in front of this by establishing risk committees or reviewing their present risk mitigation and oversight structure?

Holly Gregory: The idea that independent risk committees of the board should be mandated for every public company is one reform idea that simply defies logic. Risk committees may provide efficient oversight structures for some boards but there is no reason to think that they are a universal solution. Only about 7% of public companies currently have risk committees — and the industry in which they are most prevalent is financial services. There is no evidence that I’m aware of to show that financial services companies are better than other companies with respect to risk management or the oversight of risk management. Indeed, the anecdotal evidence appears to draw into question the ability of the financial services industry to manage certain risks. So it is difficult to understand why the committee structure relied on in that industry should be mandated for all other public companies. Undoubtedly boards need to spend considerable energy and attention on understanding risk and the processes management has in place to identify and manage risk, since this is fundamental to the board’s ability to provide strategic guidance. The National Association of Corporate Directors’ recent Blue Ribbon Commission Report on Risk Governance: Balancing Risk and Reward, reflects a private sector effort to raise the level of understanding among directors about their responsibilities for risk oversight. In all of this, however, I think it is especially important that we recognize the growing gap between expectations about what boards can do and the reality of their limitations. Boards are neither positioned nor expected by the law to identify company-specific risks that executives have missed, let alone system-wide risks that regulators and central banks have missed.

Question 8

FH Byrd: In this environment of changing shareholder influence and pending reforms, do you have any concerns that companies considering adopting a majority voting standard may be voluntarily impeding the ability to have their directors elected?

Holly Gregory: The majority of S&P 500 companies have already adopted some form of majority voting, whether through actual charter or bylaw amendments or policies that require directors to tender their resignations if they fail to receive more “for” votes than “withhold” votes. There is a certain amount of nervousness about how all the reforms will play out in a majority vote system, and it appears that the momentum for companies to adopt majority voting has slowed. I think many companies are now adopting a “wait and see” posture given the high level of uncertainty in the current regulatory and legislative reform environment.

Question 9

FH Byrd: There has been a recent uptick in the amount of criticism leveled at proxy advisory firms, in particular RiskMetrics. Do you feel this criticism is well-founded?

Holly Gregory: There are legitimate concerns about the power of certain of the proxy advisory firms and about their capacity to provide the kind of nuanced company-specific analysis that will only become more important to our economic system as shareholders gain power. As shareholders gain influence on the actual composition of boards, the recommendations that proxy advisors make about voting in director elections gain importance. In particular, the propensity of certain proxy advisors to recommend against directors for any single item on a long list of one-size-fits-all governance no-no’s, rather than on a broader view of the director’s skills and qualifications and contributions, needs to be adjusted in the new world of heightened shareholder influence. Director elections will be too important to use as vehicles to protest what in the scheme of things are often relatively minor decisions the board makes about how it can best govern.

Question 10

FH Byrd: You recently chaired an ABA Task Force on the distinct shareholder and board roles. Will the reforms on the table change the roles of shareholders and boards in any meaningful way?

Holly Gregory: I think that the reform proposals if enacted in whole certainly will increase shareholder power, and will change the balance of shareholder and board power. Whether the roles change in meaningful ways will depend on how shareholders use their new power in the real world and how their use of their power interacts with other forces (such as the power of proxy advisors and their propensity to recommend protest votes against directors). At the extreme, we may see directors coerced to abandon their own judgment in certain circumstances to buy peace with a small but powerful and vocal set of shareholders. That would be unfortunate. As our Task Force Report emphasized, there is value to our economic system in allocating to boards the power and discretion to manage and direct the affairs of the corporation, while enabling shareholders to participate as passive investors with the benefit of limited liability for the actions of the corporation and the ability to freely enter and exit from their investments.

Francis H. Byrd is Managing Director and Corporate Governance Advisory Practice Co-Leader at The Altman Group

Mr. Monks began his talk by emphasizing the importance of shareholders. He noted that in the absence of having an informed, motivated and powerful counter force to management, the corporation will always have the problem of autocrat who is answerable to no-one. The capital markets generate tremendous wealth. The key issue is who is entitled to this wealth.

Mr. Monks discussed his past experience with Sears Roebuck, where he submitted himself as a nominee for director, and Exxon Mobil, where he filed proposals to separate the chairman and CEO roles. Throughout this discussion, he noted that the current system is in need of serious reform, in part because of the asymmetry of resources available to the company compared with the activist shareholder. Mr. Monks also discussed his proposal for a mandatory rule that gives 5% of the shareholders the right to call a special meeting at which a majority of the shareholders present can remove any or all of directors with or without cause.

The student questions covered a broad range of topics, from whether increased litigation would lead to more activism or more reliance on ISS voting guidelines, to the desirability of government versus private sector employment.

Background materials about Mr. Monks and his talk are available here. A video of the talk is available here (Quicktime .mov format).

As we now know all too well, the credit crisis and the global recession stemmed, in important part, from stark failures of boards of directors and operating business leadership in important financial institutions: the witch’s brew of leverage, poor risk management, creation of toxic products, lack of liquidity – all made more poisonous by compensation systems which rewarded short-term revenues/profits without regard to risk.

Buffeted by the recession and the seizing up of the credit markets, GM and Chrysler veered into bankruptcy, burdened by decades of questionable decisions.

As a result of these dramatic collapses in both the financial and industrial sectors, trust in corporate leaders – indeed in the ability of corporations to govern themselves – has eroded dramatically (even though there are, of course, well run corporations in both areas of the economy). This crisis in confidence, due to problems real or perceived, has spawned numerous public sector initiatives, both here and abroad, to impose new limits on private sector governance and self-determination.

In the financial sector, the regulatory debate is robust. It has focused on imposing direct, substantive government rules limiting private sector discretion: e.g. counter-cyclical capital requirements, liquidity protections, revised accounting standards, credit rating agency reform, regulatory review of executive compensation, regulatory approval of certain complex products, better consumer protection, assessment of systemic risk, and special oversight for large complex financial institutions.

But for all publicly held corporations, financial and industrial, a dominant, recurring theme has been to “improve” the process of corporate governance by mandating an enhanced role for shareholders as a check on boards of directors and business leadership.

But a fundamental, recurring question needs to be asked and answered: are “shareholders” part of the solution or part of the problem in this governance crisis of confidence?

• One public policy initiative is to give shareholders more “voice,” primarily through advisory votes at annual meetings on the executive compensation regimes approved by the boards of directors (”say on pay”). This would mandate uniform federal “process” in an area of the law historically governed by the states and by shareholder efforts, company-by-company, to secure the right have such “say on pay” votes.
• A second regulatory change would increase the ability of small groups of shareholders to nominate alternative candidates in the annual shareholder election of directors (”ballot access”). Today, shareholders customarily vote for slates of directors nominated by the directors themselves – and it is expensive and cumbersome for shareholders to field additional candidates. (Of course, powerful economic interests can buy large blocks of stock and force directors onto boards or launch a hostile takeover for the whole company.)

These are “hot” shareholder issues. Both the Obama Administration and the Congress support “say on pay” shareholder votes for all publicly held corporations in the U.S. . And the SEC, which has debated the subject for years, now has a Democratic majority to approve some version of a “ballot access” rule.

The problem: the easy assumption about “shareholder” as “solution” ignores some obvious issues which have gained force in recent years.

• There is no such animal as “the” shareholder. Instead there is an extraordinary menagerie: large and small individual investors; public and private pension funds; a wide array of mutual funds; endowment funds for educational, health and other non-profit institutions; and an equally wide array of hedge funds. Almost all these institutional shareholders are trying, in one way or another, to beat their “benchmarks” whether those are the Dow Jones or the NASDAQ or relevant S&P or MSCI indexes or to make annual, absolute profits for themselves to justify the fees charged clients (including the two percent fee and 20 percent of profits often required by hedge funds).
• Institutional investors now own approximately 60 percent of U.S. equities (using other people’s money). Many observers say, while there are some long-term value holders, many of these investors are driven by the goal of short-term performance in their portfolios, engage in relatively short-term trading strategies and have little interest in corporate creation of long-term economic value by the corporations whose securities they own and trade. (Shares of stock are now held, on average, for far shorter periods than was the case 10 or 20 years ago.)
• Indeed, important questions have been raised about the role institutional investors played in causing the melt-down by pressuring financial service entities to take undue risk for short-term profits., Did the short-term investors crowd out long-term value investors in influencing corporations, and, if so, is this likely to be the future pattern?
• Questions have have also been raised about what kinds of salary and bonus plans do the institutional investors provide to their fund managers – the people who drive the stock market and may be an important source of the short-term pressure on companies? And, how are powerful institutional investors–from pension to mutual to hedge funds – governed and what are their fiduciary duties to individuals whose money they “manage”?
• Ultimately, how imperfect are shareholders and the stock market in valuing companies given the widely divergent time frames and objectives of institutional investors and the irrationalities (e.g. herd mentality) and inefficiencies of the market at any moment in time?

As Henry Kaufman, a prominent Wall Street economist for decades has written in a recent book (The Road to Financial Reformation), most “investment relationships today are very fickle. Portfolio performance is measured over very short time horizons…Day trades and portfolio shifts based on the price momentum of the stock – rather than anything having to do with the underlying fundamentals – are commonplace.”

Or, as Ira Millstein, a godfather of the corporate governance movement and long-time advocate of more shareholder voice, has recently written (in Directorship magazine): “…the model of shareholder activism…envisioned in the 1980s and 1990s [is] under severe strain. Institutional investors were once presumed to share a common goal when exerting pressure on boards to monitor management and effectively guide firm strategy. That assumed homogeneity is long gone…The diversity of shareowners has brought a whole new host of agendas, strategies and values to the table. Some of these owners have limited investment horizons and are only interested in realizing a short-term profit, and others have hedged or shorted their positions and consequently have a financial interest in the failure of the enterprise.”

Non-US regulatory bodies like the multinational Financial Stability Board or the UK’s Financial Services Authority in their lengthy post-mortems on the financial crisis have analyzed the harmful effects of investor short-termism. And when the Federal Reserve Board recently announced that it would supervise, and if necessary regulate, executive compensation at the nations banks, its proposed rule noted that a shareholder perspective was inadequate: “Thus a review of incentive compensation arrangements and related corporate governance practices [as through "say on pay" votes] to ensure that they are effective from the standpoint of shareholders is not sufficient to ensure they adequately protect the safety and soundness of the organization.”

In fact, there is now a growing movement to examine the institutional shareholders critically and systematically as a cause of the short-termism that drives bad corporate behavior (the Millstein Center for Corporate Governance and Performance at Yale’s School of Management and Aspen Institute Business and Society Program come to mind). The important issues noted above need systematic empirical and prescriptive exploration.

Seen through the lense of history, this is, in fact, just the latest chapter in an historic argument about the respective powers of shareholders, boards and management to control corporations (within the context of legal rules and regulations). Shareholders “own” the company and elect the directors, but often in the past there was no real electoral competition because the only candidates were those selected by the board itself, with heavy CEO influence, and management had a monopoly on important information. A famous book by Adolf Berle,Jr. and Gardiner Means in 1932 described this separation of “ownership” and “control” (The Modern Corporation and Private Property). Game on – for more than 75 years.

To be sure, those advocating a bigger role for shareholders are addressing real and important issues.

• Companies should consult shareholders, but not just on pay in a formal annual meeting vote. More importantly, corporate directors, CEO’s and senior business leaders need to give all stakeholders “voice”, not just shareholders: creditors, employees, customers, suppliers, communities. All are critical to the health of the corporation; all come in different shapes and sizes; all have important, but divergent interests. Company leadership must hear and balance all these concerns in reaching a decision about how to carry out the corporation’s fundamental mission. But how many listen well?
• Shareholders have also raised the profound issue of board and CEO “accountability.” The problem, as noted, is the self-perpetuating nature of corporate power, CEOs suggesting board members, board members nominating each other for routine shareholder election. If the company leadership is complacent or making bad decisions, how fix the problem. (GM?) The broad answers have their own issues. Regulation can be too heavy handed, have unintended consequences and stifle creativity and innovation (especially regulation about governance in contrast to laws protecting a social good like the environment). Turning corporations into political entities with blocs of shareholders fighting continuously about control and direction would sap precious time from providing great services. And the stock market may in the long run value companies correctly but in the short run be irrational and punish companies for taking actions for long term growth (investments, R&D) that depress profits in short term.

The ultimate question which underlies virtually all of the regulatory debates is: “voice” and “accountability” in the service of what mission? Many would argue that the dominant mission of the past two decades of creating shareholder value is too narrow and too prone to short-termism. Many market participants (and we need much more study to understand precisely) are not interested in what most would argue is the the basic task of corporations: to create sustainable economic value by providing great goods and services which customers want and which benefits all stakeholders using sound risk management and with high integrity (law, ethics, values).

Put a slightly different way, boards and CEOs must balance risk taking (innovation and creativity) with risk management (financial and operational discipline) and must fuse high performance with high integrity (to address legal, ethical, reputational, policy risk). Carrying out this mission by defining and attaining key operational goals in performance, risk and integrity dimensions – and compensating according to those goals– is the fundamental role of boards of directors and senior management. This what creates long-term shareholder value.

In light of the deleterious focus of many institutional shareholders on short-term results in their own, not the corporation’s interest, we need to understand in a much clearer way when shareholders can be part of the solution – and when they are a major part of the problem – in advancing that fundamental corporate mission. But the deeper problem is finding the right accountability mechanisms which allow the right measure of corporate self-determination at the board/CEO level but which also holds them to account.

Ben W. Heineman, Jr. is a Senior Fellow of the Harvard Law School Program on Corporate Governance.

The SEC rule proposal for proxy access drew more than 500 comment letters, many of which suggested significant and often conflicting revisions to the proposed rule and identified issues that were not addressed by the proposed rule.

Because of the complexity of the substantive issues and the importance of proxy access to corporate governance, the SEC has deferred action on proxy access until early 2010, with the result that a SEC proxy access regime will not be in place for the 2010 proxy season.

Additionally, three SEC commissioners have made clear that they are not prepared to adopt an amendment permitting shareholder proposals for proxy access as an interim or final outcome, and that they remain focused on adopting a prescriptive federal rule that mandates proxy access for public companies.

Accordingly, the key issues relating to proxy access are whether:

• The SEC’s prescriptive access rule will allow shareholders to adopt a different access regime for their company or, if they choose, no access regime (often referred to as a shareholder right of “opt-out”)
• The timing of implementation of the SEC rule, which is particularly important if the rule does permit shareholder opt-out
• The SEC rule will effectively preclude “misuse” of access for control purposes
• The rule will be workable in practice and sufficiently flexible to deal with the large number of different capital and board structures that are or could be put in place at all of the public companies that will be subject to the rule
• The rule will withstand the inevitable legal challenges to the SEC’s authority to adopt a prescriptive proxy access rule and to its adherence to applicable administrative law in the adoption process
• Congress will intervene with legislation and, if so, how extensively

Pending final SEC action on proxy access, we recommend that companies:

• Keep their senior management and boards current on the on-going proxy access debate
• Consider the strategy of preparing a bylaw setting forth a “reasonable” but tailored proxy access regime for proposal at the 2010 annual meeting to take advantage of any opt-out rights contained in the final rule prior to its effectiveness for the 2011 annual meeting cycle

Recap of SEC Comment Letters

We reviewed 135 letters sent by companies, domestic and foreign public employee pension funds, labor unions, traditional for-profit institutional investors, hedge funds, bar and trade associations, law firms, academics, proxy advisory firms and others in response to the SEC’s request for comments. The letters were selected to reflect a broad cross-section of the various constituencies that participated in the comment process and were limited to those that contained either a substantive discussion of proxy access issues or answered specific questions raised by the SEC in its proposing release.

As would be expected, the comment letters from corporate governance activists (consisting principally of public employee pension funds, labor unions and proxy advisory firms) and those from the corporate community (consisting principally of companies, company-sponsored trade associations and the private bar) sharply differed on the wisdom of adopting a prescriptive proxy access rule, the pros and cons of private ordering and a number of other key policy issues. However, these two philosophical groupings tended to break down on a number of subsidiary issues and actually achieved what could be characterized as a consensus on others.

The results of our review with respect to what we think are the more important issues are briefly described below. A more complete summary in tabular format is attached here.

• Private Ordering. The most basic policy issue addressed in the comment letters was the desirability and scope of private ordering that would be permitted under the new SEC proxy access regime. Of the letters we reviewed, 74 percent supported the SEC’s proposal to amend Rule 14a-8 to permit shareholder proposals on proxy access (either in conjunction with, or as an alternative to, adoption of Rule 14a-11), while only 33 percent supported the SEC’s proposal to adopt a prescriptive proxy access rule (either as proposed by the SEC or with suggested revisions). Predictably, the corporate community was a strong supporter of reliance exclusively or principally on private ordering (encouraged by the threat or actuality of shareholder proposed proxy access bylaws under an amended Rule 14a-8). The corporate governance activists, on the other hand (with only one arguable exception), were united behind adoption of a prescriptive proxy access rule, such as proposed Rule 14a-11. [1]
• Shareholder opt-out from Rule 14a-11. Private ordering was also at the heart of the debate regarding the desirability of allowing shareholders of a company to vary the SEC’s prescriptive rule in any way they determined. A significant majority (77 percent) of the 60 letters that addressed this issue was in favor of shareholders having the ability to adopt bylaws varying the SEC prescribed regime, without regard as to whether the end result made access easier, harder or even totally unavailable (“full” opt-out). Almost all letters supporting a full opt-out right were submitted by the corporate community. The other 14 letters addressing the issue (23 percent), almost all of which were from public employee pension funds and labor unions, urged the SEC not to grant any opt-out right to shareholders that would have the effect of making proxy access more difficult than the SEC regime. Many of the proponents of full opt-out rights cited the philosophical inconsistency of mandating an access regime to vindicate shareholder democracy, while at the same time denying the shareholders the right to vote on whether they wanted access and, if so, in what form. Opponents of full opt-out frequently relied on the premise that other SEC prescriptive rules do not permit any form of opt-out and the Securities Exchange Act of 1934 itself contains an anti-waiver provision.
• Minimum ownership under Rule 14a-11. Most commentators favored a flat ownership threshold (applicable to all categories of filers), and higher ownership percentages than those proposed by the SEC. Only a few commentators endorsed without reservation the tiered ownership percentages proposed by the SEC.
  • Threshold for nominating shareholder. One hundred and 10 letters made a recommendation regarding the threshold that should apply to large accelerated filers, 84 percent of which argued for a higher threshold than the 1 percent proposed by the SEC. Of these, 65 letters (59 percent) supported a threshold of 5 percent. Only 18 letters (16 percent), mostly from labor unions and public pension funds, as well as RiskMetrics, [2] supported the 1 percent SEC-proposed threshold. Notably, a number of the letters supporting a higher threshold came from the corporate governance activists and/or for-profit institutional investors including Calvert Group, Ltd. (3 percent), the Committee on Investment of Employee Benefit Assets (3 percent), several foreign public employee pension funds (3 percent), TIAA-CREF (5 percent), T. Rowe Price Associates, Inc. (5 percent), ValueAct Capital (10 percent), Capital Research and Management Company (10 percent), Vanguard Group, Inc. (10 percent), Pershing Square Capital Management, L.P (unspecified), Barclays Global Investors (5-15 percent). The Council of Institutional Investors, while supporting the SEC-proposed threshold, noted that its policy provides for a 3 percent threshold.
  • Threshold for nominating groups. With the exception of four letters from the corporate community, no commentators objected to allowing shareholders to aggregate their shares and form a nominating group. The commentators who endorsed the SEC proposed thresholds did not separately comment on the thresholds that should apply to nominating groups. Those who rejected the SEC-proposed thresholds as being too low overwhelmingly suggested a 10 percent threshold for nominating groups (at least for large accelerated filers).
• Minimum holding period for nomination under Rule 14a-11. Of the 77 letters that addressed the appropriate length for a required continuous holding period, 75 percent recommended two years, 21 percent recommended one year and 4 percent recommended three years.
  • The recommendation of a two-year holding period came not only from the corporate community, but also from the Committee on Investment of Employee Benefit Assets and from a number of labor unions and public employee pension funds (American Federation of Labor and Congress of Industrial Organizations, Central Pension Fund, International Association of Machinists and Aerospace Workers, International Brotherhood of Teamsters, Laborers’ International Union of North America, Ohio Public Employees Retirement System, Sheet Metal Workers’ National Pension Fund, TIAA-CREF).
  • The support for a one-year holding period came mostly from labor unions, public employee pension funds, hedge funds and for-profit institutional investors, as well as from proxy advisory firms.
  • Moreover, a number of commentators (including several public employee pension funds, RiskMetrics and the Council on Institutional Investors), while endorsing or not opposing the proposed one-year period, stated that they would not object to a longer period.
• Definition of beneficial ownership. This is one area in which the various constituencies achieved true consensus. [3] Many commentators noted that the SEC proposal lacked a definition of beneficial ownership, and a significant subset specifically suggested that beneficial ownership be defined by reference to “net long positions.” While most of the letters that contained comments on this issue came from the corporate community, it is interesting to note that a definition of beneficial ownership referring to “net long positions” was also supported by CalPERS, the Central Pension Fund, the Florida State Board of Administration, the American Federation of Labor and Congress of Industrial Organizations, T. Rowe Price Associates, Inc., ValueAct Capital, the Committee on Investment of Employee Benefits Assets, and several major bar and trade associations. It is also worth noting that 14 labor unions and public employee pension funds, and at least one bar association, urged the SEC to allow shares on loan to be counted for purposes of determining beneficial ownership.
• Independence of nominee from nominating shareholder. Of the 82 letters that took a position on the issue whether the nominee should be required to be independent from the nominating shareholder, a large majority (82 percent) was in favor of such a requirement (generally based on concern regarding special interest directors and control implications if there were no independence requirement), while only 18 percent rejected it (generally arguing that such a requirement is not applicable in traditional proxy contests). Those in favor of the independence requirement were virtually all from the corporate community, but did include five foreign public employee pension funds and The Corporate Library. Those opposed to such a requirement consisted principally of labor unions, public employee pension funds and other corporate governance activists.
• Maximum number of access directors (at any given time). There was great variety in the comments with respect to this issue. For example, different commentators defined the maximum as: (a) a percentage, (b) a number or (c) the greater/lower of a percentage and a number. Also, there was no consensus regarding whether the percentage / number should be fixed or should be dependent upon the size of the board.
  • The 71 letters that addressed this matter can be grouped as follows: 30 percent (from various categories of commentators) supported the SEC’s proposal of defining the maximum as the greater of 25 percent or one nominee, 30 percent (mostly from companies) either supported a 15 percent maximum or recommended that access be limited to one nominee, and 21 percent (comprised exclusively of public employee pension funds and unions) requested that the minimum number be raised to two nominees (instead of one) pointing out, for example, that a single director customarily would not be able to table motions at a board meeting without a second to the motion. The remaining letters included other formulas or did not contain specific recommendations.

Key Issues For Prescriptive SEC Proxy Access Rule

The Fate of Private Ordering (Shareholder Opt-Out)

The SEC’s proposed access rule contained a very limited, “one-way” right for boards or shareholders to vary the SEC’s prescriptive proxy access regime—only bylaws that made access easier, not harder, would have been permitted. As noted above, 77 percent of the comments on this point advocated that the rule be revised to permit shareholders to engage freely in private ordering by adopting bylaws varying the SEC prescribed regime, with the majority of recommendations made by companies and the private bar. Notably, no labor unions or public employee pension funds favored private ordering in general, or a full shareholder opt-out in particular.

Opt-out is the most important of the issues confronting the SEC. If the final rule contains a full right to opt-out, companies would have the ability to tailor proxy access to their particular conditions and to the wishes of their particular investors. Flexibility would be provided to deal with widely varying situations confronting different companies. Workability and control issues could be dealt with in the context of specifics, not generalities. Investors could choose a proxy contest reimbursement regime in lieu of proxy access or in combination with a far more limited right of proxy access. [4] Complicated capital and board structures could be taken into account without doing damage to their purpose and effect. Finally, a full right to opt-out would eliminate the anomaly of adopting proxy access as a vindication of shareholder democracy, while in the very same rule precluding shareholders from exercising their franchise by denying them the right freely to vary the terms of proxy access.

In the run-up to the SEC vote on the proxy access proposal, two of the three Democratic Commissioners supporting proxy access were rumored to be leaning toward including an opt-out provision that would have allowed, at least under certain circumstances, shareholders to adopt a more restrictive, as well as a less restrictive, proxy access regime. Reportedly, the third Democratic Commissioner did not agree, and the two favoring some form of opt-out wound up supporting the proposed rule that, as noted, would only permit bylaws that made access less restrictive than the SEC regime. If this dynamic continues to prevail, the fate of a full opt-out provision seems to be in the hands of the Republican Commissioners. Presumably, if one of the Republicans were to join the two Democrats rumored to favor broader opt-out rights, a final rule might be adopted including a full opt-out provision.

The potential adoption of a full opt-out provision poses two additional issues:

• The first issue is whether the full opt-out right will be limited solely to shareholder-adopted bylaws or some provision will be made for boards to adopt or modify access bylaws between annual meetings. Given the controversy surrounding full opt-out and the policy justification that shareholders should have the ability to decide on their governance regime, it is reasonable to assume that any right given to boards to modify proxy access, as a minimum, will be subject to shareholder ratification at the next annual meeting. Indeed, it is not unlikely that any board right to modify a proxy access regime will be limited in scope so that it can be exercised only to “fix” so-called “workability” problems in an existing proxy access bylaw, not to adopt a proxy access bylaw ab initio.
• The second issue is how long a transition period will be provided in the final proxy access rule.
  • The importance of the length of a transition period is a factor of the natural desire of boards to wait until a final proxy access rule is adopted before considering whether they wish to propose an alternative access regime to their shareholders. Moreover, most companies considering this course would also want to consult with their larger shareholders in advance of going public with their alternative access proposal in their proxy statements.
  • However, if the rule is not adopted until sometime in 2010 and is effective for the 2011 proxy season, companies that take a wait-and-see approach until a final SEC rule is adopted would have to call special meetings of shareholders to vote on their alternative proxy access proposal to avoid being subject to the SEC rule for at least their 2011 annual meetings. It seems safe to predict that few, if any, companies would call special meetings of shareholders just to propose an alternative proxy access regime.
  • This consideration argues that in order to provide time for companies to consider the desirability of proposing an alternative access regime, the SEC should provide a long transition period, with the rule not taking effect until the 2012 proxy season. In this way, companies would be able to bring an alternative access regime to a shareholder vote at their 2011 annual meetings, without the need to design their alternative proposals in advance of adoption of a final SEC rule or to call special meetings.
  • However, 2012 seems a long way from now, and it is not likely that the SEC would wait that long to implement its mandatory proxy access rule. If the rule is effective for the 2011 proxy season, companies wishing to propose alternative proxy access regimes to their shareholders would have to do so, as a practical matter, at their 2010 annual meetings.
  • Proposing an alternative proxy access regime at 2010 annual meetings imposes a very short time frame for companies to design such alternative regimes and, if they wish, consult with their investors, particularly given that many companies would ordinarily be reluctant to act until the final rule is adopted and proxy access is a reality. However, it probably is the only alternative to becoming subject to the SEC proxy access regime, at least for the 2011 proxy season.

Control Issues

Although the SEC made clear in its proposing release that it did not intend proxy access to be used to change or affect control, a number of comment letters from the corporate community pointed out quite forcefully that additional safeguards are necessary in order to achieve that goal. Frequent suggestions included:

• A requirement that access nominees be independent of the nominating shareholder
• A limit to one on the number of nominations that a single shareholder or group could submit in any year
• A limit on the number of shareholders that could be solicited to create a nominating group or that could participate in a nominating group (for example, no more than 10)
• A limit to one on the number of nominating groups any single shareholder could join
• Elimination of any new exemption from existing proxy rules or solicitations to join a nominating group
• Preclusion of a proxy access election contest concurrently with a conventional election contest
• If there is no ban on concurrent proxy access and conventional election contests, a prohibition on the proponents in the conventional election contest from including proxy access nominees on the insurgents’ proxy card and a requirement that supporters of a proxy access candidate use only the “universal” proxy card mandated under the proxy access rule and that they not solicit for any insurgents in the concurrent conventional election contest
• A prohibition on nominations by shareholders who filed a Schedule 13D (thereby acknowledging a lack of passive investment intent) or lost a conventional election contest during preceding years

Many observers believe that the lack of such safeguards in a final proxy access rule would allow shareholders aspiring to affect company policy or otherwise exert control room to utilize proxy access to achieve at least some of their goals. Moreover, it is uncertain whether the SEC appreciates that the proposed rule contains so many holes in its anti-control protections. Unfortunately, relatively few of the comment letters identified the potential holes that would permit the rule to be used to change or affect control in practice. [5] For this reason, it may well be that the SEC will fail to plug enough of the control related holes in its final rule to preclude abuse. This concern is all the more reason why a full right of private ordering through an opt-out mechanism is the single most critical issue in the proxy access debate.

Workability Issues

An important theme that has been sounded by the SEC, and is reflected in a number of the comment letters, is the importance of ensuring that an SEC access rule be “workable” in practice (see, for example, the letters submitted by the Committee on Federal Regulation of Securities of the American Bar Association, the Council of Institutional Investors, the Business Roundtable, and the letters submitted collectively, and in several cases separately, by Latham & Watkins and six other prominent law firms). Workability encompasses many issues, some that go to the core of an access regime and others that are peripheral. The following are what we consider to be some of the more important workability issues flowing from the proposed rule:

• The rule should take into account the reality that the some 7,000 public companies that will be subject to a prescriptive access regime have a myriad of capital and board structures. While this concern is often dismissed on the grounds of “mere technicalities,” it is important that the final rule take into account application to companies with multiple classes of stock entitled to vote for directors (including, classes with disparate voting and/or economic interests) and to companies with classes of directors elected by different classes of stock or subject to contractual agreements regarding rights to designate directors. An access rule that does not make adequate provision for the variety of capital and board structures utilized by companies subject to the rule will inevitably lead not merely to an on-going need for interpretation, but also to incentives on the part of various constituencies to “game” the rule. [6]
• The rule should not create perverse incentives on the part either of shareholders or boards. For example, one troubling aspect of the proposed rule is its timeline that would require notice of access nominations in the late fall, well before most boards have made decisions regarding their director nominations for a spring election of directors. A possible consequence of this timing disparity, particularly with respect to directors elected by access in a prior year, is that shareholders may feel compelled to notice nomination of the sitting access director (or a replacement) to ensure a place on the ballot, not knowing whether the board would do so voluntarily. [7] This, in turn, might lead a board to react by not including the access nominee on the board’s slate. Such an outcome would run counter to an integration of access directors into the board room and tend to perpetuate an “us versus them” dynamic on the part both board-nominated directors and access directors.
• A related workability issue is sometimes referred to as “access-creep.” Because the proposed rule does not impose access status on access directors who are re-nominated by the board, access nominations in succeeding years could result in a board composed of far more directors elected through the access process than the cap set forth in the rule. Although this may not be an issue if the proxy access directors integrate well with their new boards, this will not always be the case. To avoid the latter outcome, some boards undoubtedly will deny re-nomination to access directors, a result that can only increase the divisiveness of the access process and is likely to lead to dysfunctional board dynamics.
• As proposed, the SEC’s rule would permit annual proxy access contests. Even if the final rule limited the rights of shareholders to propose access nominees in successive years by imposing a minimum vote requirement or the like, it is possible that some number of public companies will receive access nomination year after year unless and until access nominees are seated on the board. While many companies maintain successful “engagement” programs with their shareholders and by so doing may be able to avoid annual proxy access election contests, such “engagement” programs will not always be sufficient to avoid this result. The enervating effect of the threat or actuality of annual proxy access election contests could create significant leverage for shareholders seeking to place candidates on a company’s board, far beyond their ability actually to win a proxy access election contest. Add to this threat the ability (at least under the proposed rule) of shareholders to use nominating groups with different compositions to end-run limitations based on prior low votes for access candidates, to nominate multiple candidates (up to whatever cap is adopted in the final rule), and/or to align with other shareholders running traditional proxy contests. The result for some number of companies, particularly those which have been targeted by activists for whatever reason, could be to subject them to a “sword of Damocles” like environment. The time and resource demands of fighting repeated proxy access election contests cannot be good for those companies, nor is it what access is presumably about.

A Modest Proposal

A review of the comment letters makes clear that coming to grips with all of the workability and other issues in an access rule will not be an easy task. As so many commentators have observed, it is very difficult to get a “one size fits all” rule to work across the public company spectrum in a way that does not implicate significant control issues and that has sufficient flexibility to allow adaptation to a potentially endless variety of different corporate situations.

We do believe, however, that incorporation of three relatively simple provisions in a final access rule would solve, at least in large part, many of the workability, control and flexibility issues inherent in the access concept.

• First, permit unlimited private ordering by shareholder vote, with an additional limited right for directors to adopt or amend bylaws to correct mistakes, cure ambiguities and the like, subject to subsequent shareholder ratification at the next annual meeting. This is the only practical way in which flexibility can be achieved. Also, as noted above, it would vindicate the shareholder franchise and thus be totally consistent with the purpose and philosophy of an access rule.
• Second, limit the access nomination process to a triennial schedule by putting a moratorium on access nominations for the two-year period following an access nomination, so that companies are not faced with the prospect of annual access election contests and so that directors elected through access can be re-nominated by the board without fear of “access creep.” This limitation would also go a long way in preventing the abuse of proxy access for control-related purposes.
• Finally, require a continuous two-year “net long” holding period (excluding participation in share lending programs prior to the submission of a notice of an access nomination) to ensure that access nominations are available only to true long-term holders. As discussed above, a two-year holding period has been endorsed by prominent representatives of every constituency involved in the access debate: companies and the private bar, trade associations, traditional institutional investors, and labor unions and public employee pension funds. Moreover, both the proposed Shareholder Bill of Rights Act in the Senate and the proposed Shareholder Empowerment Act in the House contemplate a two-year holding period.

Conclusion

Proxy access is a complicated subject and one with potentially significant ramifications for any company that receives an access nomination. Moreover, the very existence of a right to make access nominations will inevitably change board and shareholder relationships in ways that are far from clear. If, as many of its supporters claim, proxy access is rarely used and reserved for only the most egregious circumstances, it may not matter very much. But if, as some observers fear, proxy access is used to promote special interest directors, divisive or inappropriate agendas of certain shareholder groups or directors with aspirations to affect a company’s policies or strategies materially, proxy access could become a very big deal, indeed.

At this point in time, the comment process is essentially completed and the staff and SEC are focused on fashioning a final proxy access rule. However, this does not mean that companies should passively stand by and await the outcome.

• First, the SEC and staff appear willing to continue to dialog with interested parties. Industry groups, bar associations and the like may still have an opportunity to communicate their views. As important, perhaps, Congress has yet to be heard from. Bills that contain provisions regarding proxy access are pending in both the House and the Senate. Lobbying on this front could be productive.
• Second, it seems clear that there will be a prescriptive proxy access rule. While its details are not known, its general scope is. Further, there may be developments in the proxy access debate on any number of fronts. Accordingly, it is important that senior managements and boards be educated, not only about the basics of proxy access, but also its evolution to the extent that can be determined.
• Finally, senior managements and boards should be prepared for the possibility that the SEC will adopt proxy access with a full opt-out right, but will not provide a lengthy transition period. In that case, as noted above, companies may only have their 2010 annual meetings at which to propose an alternative proxy access regime before the SEC’s version becomes operative for 2011. Companies should focus on the possibility that they may have only a very time-constrained opportunity to act and consider preparing a proxy access bylaw for proposal at their 2010 annual meeting. [8]

Charles M. Nathan is a corporate partner resident at Latham & Watkins LLP.

Endnotes

[1] The United Brotherhood of Carpenters supported the proposed amendment to Rule 14a-8 but did not support the adoption of Rule 14a-11.
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[2] RiskMetrics’ own company bylaws contain more restrictive conditions for shareholder access to the proxy: the nominating person must have owned at least 4 percent of the outstanding common stock continuously for at least two years.
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[3] A general consensus among the commentators applied to a number of other issues, including: (1) how to determine priority in case of multiple nominations, and (2) limitations on repeat access nominations by a shareholder or shareholder group whose candidate did not win a significant vote. With respect to priority, of the 105 letters that addressed this issue, only one endorsed the SEC’s proposed “first-in” approach, while 89 percent recommended that priority be based on largest ownership and/or longest holding period. With respect to re-submissions, 90 percent of the letters that addressed this point urged the SEC to provide that if a nominee fails to receive a minimum number of votes (most commonly 25 percent or 30 percent), the nominating shareholder would not be permitted to submit other nominees for a certain period of time (most commonly two or three years). This proposal came mostly from the corporate community but was also endorsed by for-profit institutional investors and by at least one public employee pension fund.
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[4] On October 26, 2009, HealthSouth Corp. announced that its Board of Directors had approved the general terms of a corporate bylaw that will provide for reimbursement of shareholder expenses in connection with a proxy solicitation campaign, subject to certain conditions. This is one of the first proxy contest reimbursement bylaws adopted under the recent amendments to the Delaware General Corporation Law.
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[5] See, for example, the letters submitted by Latham & Watkins and six other prominent law firms, the Committee on Federal Regulation of Securities of the American Bar Association, the Business Roundtable and the Society of Corporate Secretaries and Governance Professionals.
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[6] For example, companies with the right to issue preferred stock with terms designated by the board might be tempted to create new classes of voting stock with disproportionate voting rights. Or, aggressive investors might buy outstanding “super-voting” shares of stock to get more “access bang” for their bucks when trying to amass sufficient shares to comply with access thresholds. For more details on this topic, please see the comment letter submitted on August 31, 2009 by the Committee on Federal Regulation of Securities of the American Bar Association (in particular, section II.G.2 which discusses variations in board and capital structures).
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[7] Although companies could have discussions with their shareholders and sitting access directors to avoid such situations, in practice that may not always happen. Relying on the possibility of such a dialog to avoid the tension that could be created by an access nomination of the sitting director (or a replacement) ignores certain issues. For example, it presupposes that all nominating committees and boards will be able to fairly and fully evaluate the quality and performance of their access directors in the approximately six months between their election and the proxy access deadline for the following annual meeting. It also presupposes that no other shareholder(s) will submit notice of an access nomination creating the very dynamic of an access election contest that the board was seeking to avoid by agreeing to re-nominate the sitting access director.
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[8] A good starting point for a comprehensive proxy access bylaw can be found in the Exposure Draft of an Illustrative Access Bylaw with Commentary prepared by the Task Force on Shareholder Proposals of the Committee on Federal Regulation of Securities of the American Bar Association (click here to view).
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On October 27, 2009, the SEC’s Division of Corporation Finance issued a Staff Legal Bulletin changing prior guidance on the application of Rule 14a-8(i)(7), and expanding the scope of matters that the Division considers permissible subjects for shareholder proposals in company proxy statements. Rule 14a-8(i)(7) permits a company to exclude a shareholder proposal from the company’s proxy statement insofar as the proposal deals with a matter relating to the company’s ordinary business operations.

In the Staff Legal Bulletin, the Division reverses its prior positions that proposals relating to environmental, financial or health risks and proposals related to CEO succession planning may be excluded under Rule 14a-8(i)(7). The Division’s action met with approval from environmental activists who have long sought to include shareholder proposals related to climate change issues in corporate proxy statements.

The Division also clarified that both companies and shareholder proponents may alert the Division in advance of their intent to submit correspondence in connection with a no-action letter request under Rule 14a-8.

Analyzing Shareholder Proposals Related to Risk

Rule 14a-8 addresses when a company may exclude a shareholder proposal in the company’s proxy statement and form of proxy when the company holds an annual or special meeting of shareholders. Rule 14a-8(i)(7) states that a shareholder proposal may be excluded if it “deals with a matter relating to the company’s ordinary business operations.” -2- Shareholder Proposals November 9, 2009

The historic position of the SEC’s Division of Corporation Finance (the “Division”) has been that proposals that focus on a company engaging in an internal assessment of the risks and liabilities faced by it as a result of its operations and, specifically, proposals related to minimizing or eliminating operations that may adversely affect the environment or the public’s health, may properly be excluded under Rule 14a-8(i)(7). On October 27, 2009, the Division issued a Staff Legal Bulletin to provide guidance under Rule 14a- 8(i)(7) regarding the application of the Rule to risk.

In the Staff Legal Bulletin, the Division noted there recently has been an increase in the number of noaction letter requests from companies seeking to exclude shareholder proposals as relating to an evaluation of risk. The Division stated that companies have frequently argued that proposals that do not explicitly request an evaluation of risk are excludable under Rule 14a-8(i)(7) because those proposals would require the company to engage in risk assessment. In reversing its position on these types of questions, the Division stated it was concerned that Rule 14a-8(i)(7) might have been applied to exclude proposals that focus on significant policy issues.

Under the Division’s new analytical framework, on a going-forward basis, in evaluating registrant requests to exclude risk-related shareholder proposals under Rule 14a-8(i)(7), the Division will focus on the subject matter to which the risk pertains rather than simply on whether a proposal relates to a company engaging in an evaluation of risk. The Division will consider whether the underlying subject matter of the risk evaluation involves a matter of ordinary business to the company. “In those cases in which a proposal’s underlying subject matter transcends the day-to-day business matters of the company and raises policy issues so significant that it would be appropriate for a shareholder vote, the proposal generally will not be excludable under Rule 14a-8(i)(7) as long as a sufficient nexus exists between the nature of the proposal and the company.”

Although the language of the Staff Legal Bulletin is sufficiently broad to cover a range of underlying issues, environmental activists, in particular, are applauding the change in position by the Division as a major victory that will support their efforts to challenge the environmental policies and activities of public companies. As a consequence, all companies, and especially companies engaging in activities that could arguably be a factor in climate change such as energy and mining companies, should expect to see an increase in shareholder proposals relating to their policies and activities.

CEO Succession Planning

The Staff Legal Bulletin also reverses the Division’s prior position on whether a company may invoke Rule 14a-8(i)(7) to exclude a shareholder proposal related to CEO succession planning.

These proposals generally seek to compel a company to adopt and disclose written and detailed CEO succession planning policies. In the past, based on the SEC’s statements in Exchange Act Release No. 40018 (May 21, 1998), the Division supported excluding proposals related to CEO succession planning -3- Shareholder Proposals November 9, 2009 because those proposals relate to ordinary business matters involving the management of the workforce and the hiring, promotion and termination of employees. However, that same release also stated that ordinary business matters may transcend a company’s day-to-day business matters and raise policy issues so significant that it would be appropriate to submit those matters to a shareholder vote.

In reversing its prior position, the Division stated that CEO succession planning raises a significant policy issue regarding the governance of a company that transcends the day-to-day business matter of managing the workforce. Going forward, the Division will take the view that a company may not generally rely on Rule 14a-8(i)(7) to exclude a proposal that focuses on CEO succession planning.

Communications Concerning No-action Letter Requests

The Staff Legal Bulletin also encourages companies and shareholder proponents who intend to submit a no-action letter request under Rule 14a-8 to contact the Division in advance of making their submission so that, if possible, the Division can review the related correspondence prior to issuing its no-action response. Companies and shareholder proponents can call the Division at (202) 551-3500 or send an e-mail to  shareholderproposals at sec.gov, and are encouraged to provide the date by which they intend to submit their correspondence. The Division noted that, as stated previously in Staff Legal Bulletin No. 14, if a shareholder proponent intends to reply to a company’s no-action letter request, the shareholder should try to send the reply as soon as possible after the company submits its no-action letter request.

Concluding Thoughts

The expansion of matters that are considered permissible subjects for Rule 14a-8 shareholder proposals is consistent with trends in recent years and the particular areas of this interpretation—environmental risks and CEO succession address topics high on the agenda of social/governance activists. The inclusion of proposals on these topics creates the potential that RiskMetrics, in the future, will determine that a Board’s failure to take a requested action should result in a “withhold” recommendation for director nominees. In the many companies that have adopted majority voting for directors, such “withhold” recommendation can jeopardize the ability of incumbent directors to obtain a majority vote.

Given the timeframe required under SEC rules for the submission of shareholder proposals, an increased volume of these proposals may be arriving in the coming days.

James Morphy is a mergers & acquisitions partner at Sullivan & Cromwell LLP.

Effective January 1, 2010 brokerage firms will no longer be able to vote for non-responding clients with regard to uncontested elections of directors as a result of the SEC’s recent approval of Amended NYSE Rule 452. Also, for many years corporations have complained about a lack of access to the names of all of their beneficial owners. Finding ways to deal effectively with these issues is now of significant importance to public companies of all sizes.

Our proposal to the SEC suggests certain reforms to the proxy voting system. Among the key issues which we propose the SEC take action on are the following 5 points:

• 1. First and foremost, a new methodology called ABO (i.e., All Beneficial Owners) should replace the current NOBO/OBO mechanism which has existed for 25 years, at least with regard to record dates for annual or special meetings.
• 2. The SEC should seek to authorize the establishment of a second mail and tabulation methodology, one that would give companies the ability (using the names available under ABO) to choose a different vendor to take responsibility for the mailing and tabulation process, while retaining the option to use the current Broadridge system. This new option would be akin to the way most companies currently use their transfer agent to mail and tabulate the votes of registered owners.
• 3. The SEC should require the NYSE to implement as quickly as possible a robust investor education program to try and ameliorate at least some of the impact resulting from the loss of broker voting on non-contested director elections under Amended NYSE Rule 452.
• 4. The SEC should amend Rule 13(f) so that information reported by institutions reflects both shares owned and also voting rights after taking into account loans and other transactions that alter such rights. We also suggest shortening the reporting period for 13(f) information to 15 days from 45 days after the end of a calendar quarter and reducing from 20 to 10 business days the pre-notification of a company’s annual meeting record date.
• 5. The SEC should establish new procedures to deal with issues like “empty voting” and the use of derivative positions to alter voting rights.

The SEC recently announced that it would delay voting on the adoption of its mandatory proxy access regime to consider the comments and feedback it received in response to its proposed Rule 14a-11. Meanwhile, at the state level, corporate practitioners are closely following whether (and, if so, in what form) Delaware corporations will voluntarily adopt proxy access bylaws pursuant to the recent amendments to the DGCL. In a brief article appearing in the latest issue of The Review of Securities & Commodities Regulation, we compare Delaware’s approach of authorizing corporations to adopt narrowly tailored proxy access bylaws to the SEC’s approach of prescribing a generally applicable proxy access rule. We illustrate the differences between the two approaches by describing a model proxy access bylaw adopted under the DGCL and pointing out various ways in which that model bylaw could be modified to meet the needs of a particular corporation. Some highlights of the model bylaw are as follows:

• Granting the proxy access right to the stockholder or group with the greatest holdings (14a-11 grants the right based on a first-in-time system)
• Requiring the stockholder proponent (and each member of a group) to continue to hold shares through the date of the meeting
• Prohibiting the stockholder proponent (and each member of a group) from materially increasing its ownership stake for a specified period
• Excluding nominations from proponents whose nominees have failed to gain substantial support in prior elections
• Requiring a stockholder nominee to submit a conditional resignation that would become effective upon a finding that information included in the proponent’s nomination request, or information furnished by the proponent and included in the proxy statement, was false or misleading
• Requiring proponents to indemnify the corporation against any liability, loss or damage arising out of a stockholder nomination submitted pursuant to the bylaw

The article is available here and the model bylaw (with annotations explaining ways in which various provisions may be modified) is available here.

In a very interesting opinion on a matter of first impression, Vice Chancellor John Noble has indicated that the refusal of a board of directors to accept the resignation of a director who fails to obtain a majority vote under a “Pfizer-style” majority vote resignation policy is largely immune from judicial review.

The case – City of Westland Police & Fire Retirement System v. Axcelis Technologies, Inc., decided September 29, 2009 – involved something of a collateral issue: namely, whether to permit inspection of documents relating to the board’s decision to reject the proffered resignations of three directors.  In rejecting that demand, however, the court suggested that such a rejection would not ultimately be tested under standards of judicial review more demanding than the business judgment rule.  For reasons explained below, I question whether that degree of deference should prevail as a general rule, especially in the situation where the majority voting rule exists as a requirement in the bylaws, rather than only as a matter of board policy.

The three directors in question, while elected by the required plurality vote as specified in Axcelis’ bylaws, did not receive a majority of votes cast at Axcelis’ 2008 annual meeting.  (The opinion suggests that this shortfall resulted from an ISS recommendation based on the 7-member board’s refusal to support a proposal to dismantle the board’s classified structure).  As a result, and as mandated by a governance policy adopted by the board of directors (a so-called Pfizer type policy), those three individuals were required to submit their resignations.  Under the policy, however, the board of directors had the discretion to reject the resignations.  In announcing the board’s rejection of the three directors’ policy-mandated resignations, Axcelis referred to the experience of the directors, their membership on key committees, and the anticipated need to supervise negotiations with a potential bidder for the company.

Over six months after the annual meeting, and after a very disappointing outcome of the bidding negotiations, the stockholder plaintiff made a formal demand to inspect documents, mostly relating to the board’s dealings with and evaluation of a potential bidder’s acquisition proposals.  The demand also included the following two categories:

6. All minutes of agendas for meetings (including all draft minutes and exhibits to such minutes and agendas) of the Board at which the Board discussed, considered or was presented with information concerning or related to the Board’s decision not to accept the resignations of Directors Stephen R. Hardis, R. John Fletcher, and H. Brian Thompson.

7. All documents reviewed considered, or produced by the Board in connection with the Board’s decision not to accept the resignations of Directors Stephen R. Hardis, R. John Fletcher, and H. Brian Thompson.

The stated purpose for this inspection was apparently to investigate possible waste or mismanagement, a traditionally accepted basis for inspection under Section 220 of the Delaware General Corporation Law.  Under settled Delaware law, all the plaintiff had to proffer to become entitled to the inspection demanded was “some evidence to suggest a credible basis from which [this Court] can infer that mismanagement, waste, or wrongdoing may have occurred.” And as the Vice Chancellor acknowledged, this evidentiary requirement has accurately been described as “‘the lowest possible burden of proof’ in Delaware jurisprudence.”

And yet:  the Vice Chancellor found the facts as described above insufficient to justify the requested inspection, applying reasoning that calls into question whether judicial review of a board’s rejection of a resignation under a board majority vote policy will ever be substantive and substantial.  In essence, the opinion reasons that (i) the three directors were duly elected under the plurality standard prescribed in the bylaws, (ii) the majority vote policy explicitly affords the board discretion to reject a director’s resignation, (iii) the board in the present case simply exercised that discretion, and therefore there was no evidence of wrongdoing.

As the Vice Chancellor saw it, “the plaintiff’s position would require this Court to accept the theory that mere shareholder reliance upon a board-enacted governance policy could effectively rewrite the voting provisions contained in a corporation’s by-laws.”  In a similar vein, the court suggested that the stockholders had no reasonable expectation that a failure to obtain a majority vote would result in the removal of the directors; the court suggested, in fact, that anyone seeking such a result should have instead pursued it directly, by attempting to remove the directors and putting forward an alternative slate of directors.  As the court explained it, reliance on the majority vote policy in lieu of a removal vote was a “poor strategic choice” that “cannot be the basis” for inspection under Section 220.

The court also suggested that the board’s rejection of the resignations did not implicate any standard of judicial review more demanding than the business judgment rule.  A Unocal standard would not apply, the court indicated, because “there was no present threat to control at the time of the May 2008 election.”  Not surprisingly, then, the court also declined to treat the rejection of the resignations as an act of entrenchment requiring a compelling justification under Blasius.  Given that these more demanding standards of judicial review were found not to apply, the Vice Chancellor found insufficient evidence of wrongdoing to justify the requested inspection.

Thus, there is little in the opinion to suggest that the question of evidence of wrongdoing, and the choice of standard of judicial review of the rejection of the resignation, would be treated any differently if the rejection followed a failure to achieve a majority vote required by a bylaw, under which the director would nonetheless continue in office as a holdover director, rather than under a Pfizer type policy, under which the director is actually formally elected.

If the same deference suggested in the Axcelis opinion were to control in the case of a majority vote  bylaw requirement, the directors’ decision to reject a resignation would be essentially immune from judicial review, and even a majority vote bylaw would have little in the way of judicial enforcement to back it up.

That seems unlikely to have been the result anticipated by those who adopted majority vote bylaws.  Undoubtedly, the board needs to retain some discretion to reject a resignation.  The official comment to the Model Business Corporation Act (Section 10.22) discusses some of the reasons why the board’s discretion could plausibly be exercised in favor of rejecting a resignation.

But it would surprise me if rejection of a resignation submitted by a director who was not elected were to be considered the norm, let alone an act effectively beyond judicial review.  As the Model Act comment notes, “given the directors’ consideration of their duties, boards are likely to be hesitant to select [ ] a director” who has failed to achieve a majority vote.  If the Axcelis opinion were read to state the law generally applicable where a director fails to achieve a majority vote required by a bylaw, there would be little reason for directors to “be hesitant” to keep him or her in office based on “consideration of their duties.”

Perhaps a new doctrinal structure is needed to deal with the situation:  perhaps when a director fails to be reelected by a majority of the shares voting, and a previously submitted resignation thereby becomes effective, the remaining directors ought to be charged with carrying some burden (similar to enhanced scrutiny under Unocal) that their decision has been made in good faith and for a proper purpose.  After all, choosing who should stay on as a director despite having failed to be reelected is not, as Blasius has pointed out, purely a matter of business judgment; rather, the matter is one at least partly within the domain of the stockholders’ legal power.

And when it comes to a request for inspection of resignation rejection-related documents, maybe we need a new category of proper purpose:  investigating possible waste or mismanagement doesn’t really describe the problem at issue.  Perhaps seeking the documents simply to evaluate the board’s decision to reject the resignation ought to be viewed as a proper enough purpose to justify at least a limited scope of inspection.

The Vice Chancellor’s opinion expresses concern that allowing the inspection of resignation-related documents would subject the company to an inappropriate “burden.” This burden seems somewhat overrated to me, however:  the matter involves a single, discrete decision by the board, and any request for documents related to that decision ought to be relatively easy to respond to, or a response could at least be limited if the burden truly were excessive.

It may well be that the Vice Chancellor reached the right result in Axcelis.  Perhaps it was significant that the demand for rejection-related documents was merely an appendage to a more extensive demand relating to the board’s strategy for dealing with an acquisition proposal.  Perhaps it was significant that the demand for inspection, which fairly promptly followed an unhappy resolution of that strategy, was not presented until over six months had elapsed following the resignation rejection. Perhaps the doctrine of laches should have informed the question of proper purpose for inspection:  given long-standing policy in favor of prompt resolution of board composition issues, any demand for inspection of documents with a view to judicial review of the decision should be made and pursued promptly after announcement of the rejection, rather than waiting over six months while the directors at issue have continued in office and engaged in significant decision making processes.  Or perhaps most importantly, perhaps a resignation by a duly elected director is qualitatively less compelling or entitled to deference than a resignation by a director who has failed to be reelected in accordance with a majority vote bylaw.

In any event, the Axcelis ruling is now on appeal.  It will be interesting to see how the Delaware Supreme Court handles the highly nuanced, but important, legal issues implicit in the case.

The SEC has proposed to amend the Internet proxy delivery rules in order to increase retail shareholder participation in the proxy voting process and to improve the notice and access model. The proposed amendments would:

• provide flexibility regarding the format and content of the Notice of Internet Availability of Proxy Materials;
• permit issuers and other soliciting persons to accompany the Notice of Internet Availability of Proxy Materials with an explanation of the process of receiving and reviewing proxy materials and voting; and
• permit a soliciting person other than the issuer to use the notice and access model and send its Notice of Internet Availability for Proxy Materials by the later of
  • 40 days before the shareholders meeting, or
  • the date on which the soliciting person files its definitive proxy statement if the soliciting person’s preliminary proxy statement is filed within 10 days of the issuer’s filing of its definitive proxy statement.

The SEC is providing an abbreviated comment period with comments due by November 20, 2009.

Background

In 2006, the SEC adopted rules permitting issuers and other soliciting persons to distribute proxy materials through the Internet on a voluntary basis. In 2007, the SEC adopted rules that mandated all proxy materials to be made available through the Internet. These rules established the notice and access model for the distribution of proxy materials, under which issuers and other soliciting persons may elect to deliver proxy materials to shareholders through either the “notice-only option” or the “full set delivery option.” [1]

Since the effectiveness of the Internet proxy delivery rules, the SEC has noted confusion among shareholders regarding the instructions contained in the required Notice of Internet Availability of Proxy Materials (the “Notice”) with respect to the proxy solicitation process. In particular, the SEC is concerned about a decline in the percentage of “retail shares” [2] voting at meetings when the notice-only option is utilized, as indicated by statistical data recently published by Broadridge Financial Solutions, Inc. [3] The SEC indicates that the data may reflect shareholder confusion due to the strict requirements regarding the content and format of the Notice and the inability of issuers under the current rules to accompany the Notice with other explanatory materials. The proposed amendments to Rule 14a-16 are designed to mitigate shareholder confusion and facilitate shareholder participation by creating flexibility in the content and format of the Notice and permitting explanatory materials to accompany the Notice. [4]

In addition, existing Rule 14a-16 requires that, in order for a soliciting person other than the issuer to use the notice-only option, the person must send its Notice to shareholders by the later of 40 days prior to the shareholders meeting or 10 days after the issuer first sends its Notice or proxy statement to shareholders. Such a soliciting person, however, cannot send its Notice to shareholders until it files its definitive proxy statement. Because a soliciting person may miss the 10-day deadline due to SEC staff review of its preliminary proxy materials, the SEC proposes to amend the rule to allow sufficient time for the completion of SEC staff review of the preliminary proxy materials.

Proposal to Facilitate Shareholder Voting

Under the proposed amendments, issuers and other soliciting persons would have more flexibility to choose the format and language in the Notice used to provide the information currently contained in the prescribed legend. The Notice would still be required to contain a legend, in bold font, that the Notice provides information regarding the availability of proxy materials for a specific shareholders meeting. However, as proposed, issuers and other soliciting persons would be able to describe in the language and format of their choice other information required in the Notice under current rules, including:

• an indication that the Notice presents only an overview of the proxy materials, and that shareholders should review the proxy materials before voting;
• the address of the website containing the proxy materials; and
• the instructions on how to request a paper or email copy of the proxy materials.

The SEC believes that the proposed amendments will allow issuers and other soliciting persons to communicate with shareholders more effectively and provide clearer instructions to shareholders regarding the proxy voting process.

In addition, the SEC proposes to permit issuers and other soliciting persons to include in the Notice an explanation of the notice and access model, which is prohibited under current rules. As proposed, such explanation would be limited to the process of receiving or reviewing the proxy materials and voting. Materials designed to persuade shareholders to vote in a particular manner, change the method of delivery or explain the basis for sending only the Notice would not be permitted as part of such explanation. The SEC expects that the explanation will be brief (one or two paragraphs of text) and that standardized language will be developed through practice. [5]

Proposal to Facilitate Third-Party Solicitations

The SEC has also proposed an amendment to Rule 14a-16 that would allow a soliciting person other than the issuer to use the notice-only option by sending its Notice by the later of:

• 40 days before the shareholders meeting, or
• the filing date of the soliciting person’s definitive proxy statement, so long as the soliciting person files a preliminary proxy statement within 10 days of the issuer’s filing of its definitive proxy statement.

The current rule requires the soliciting person to send its Notice by the later of 40 days before the shareholders meeting or 10 days after the issuer first sends its Notice or proxy statement to shareholders. The SEC notes that, under its current practice, the SEC staff reviews preliminary proxy materials filed in the case of contested solicitations and that completion of these reviews may exceed 10 calendar days. As a result, due to unresolved SEC staff comments, a soliciting person may not be able to meet the current 10-day deadline for sending the Notice and thereby be excluded from relying on the notice-only option. Under the proposed amendment, the soliciting person would have sufficient time to respond to SEC staff comments and still use the notice-only option. The proposed rule does not provide a specific deadline for a soliciting person to send its Notice to shareholders, but the proposing release indicates that it should be sent early enough to provide shareholders with “sufficient time” to review the proxy materials and make an informed voting decision.

Solicitation of Public Comments

The SEC has solicited comments on all aspects of its notice and access model, including:

Comments are due by November 20, 2009.

Endnotes

[1] The previously adopted Internet proxy delivery rules are discussed in previous Sullivan & Cromwell LLP memos to clients, “SEC Adopts Final Rules Permitting the Internet-based Distribution of Proxy Materials and Proposed Rules to Require Internet Delivery of Proxy Materials,” dated February 13, 2007, and “SEC Mandates that Large Accelerated Filers Use the Internet to Distribute Materials for 2008 Proxy Season,” dated June 21, 2007.
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[2] Broadridge defines “retail shares” as any shares that are not either managed by an advisor or subject to a consent to electronic delivery of proxy materials.
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[3] Broadridge Notice and Access, Statistical Overview of Use with Beneficial Shareholders (as of June 30, 2009) is available at http://www.broadridge.com/notice-and-access/NAStatsStory.pdf.
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[4] The SEC’s new proposed changes are in Rel. Nos. 33-9073, 34-60825, IC-28946, Amendments to Rules Requiring Internet Availability of Proxy Materials (Oct. 14, 2009), available at http://www.sec.gov/rules/proposed/2009/33-9073.pdf.
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[5] In the case of registered open-end investment companies, the SEC has proposed to amend Rule 14a- 16(f)(2)(iii) to permit the delivery of a summary prospectus with the Notice. This change is intended to permit registered open-end investment companies to utilize the SEC’s recent rule change to permit the use of a summary prospectus. See Rel. Nos. 33-8998, IC-28584, Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies (Jan. 13, 2009), available at http://www.sec.gov/rules/final/2009/33-8998.pdf.
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