North Dakota, as we have written about on this Blog, has taken a unique approach to the corporate governance race.  Rather than following Delaware in the downward spiral (the so called race to the bottom), it has tried to go in the other direction.  The state has essentially provided expanded rights for shareholders in companies that register under the Act.  The impetus for the law apparently came from a group of activists, including Carl Icahn. The group hired William H. Clark from Philadelphia (who, by the way, has commented on this Blog) to draft the law.

The effort contains some good ideas but they will only become operative if companies reincorporate in North Dakota and elect to come under the Act.   Since the decision to reincorporate must first be approved by management and this lessens management's authority, the prospects look dim.

Nonetheless, shareholder proposals at four companies are seeking to force management's hands.  According to the WSJ, several companies are about to be subjected to shareholder votes on whether they should reincorporate in North Dakota.  Shareholders have submitted reincorporation proposals at:  Oshkosh, Hain Celestial Group, Whole Foods and PG&E. 

It can be expected that some or all of these companies will try to get the SEC's permission to exclude them from the proxy statement.  Unless there is some kind of technical violation, the likelihood of this occurring is slim.  The SEC has a relatively consistent history of not allowing reincorporation provisions to be excluded.  A waive of provisions arose ironically to encourage companies to move to Delaware to avoid states that prohibited the election of directors by majority vote.  The Commission staff has already denied Hain Celestial's request to omit the reincorporation proposal. 

Nonetheless, the provisions are unlikely to have much impact.  The shareholder proposals are non-binding.  As the Hain Celestial proposal reads:

• Resolved: That the stockholders of The Hain Celestial Group, Inc. ("Company") hereby request that the board of directors initiate the appropriate process to change the Company's jurisdiction of incorporation from Delaware to North Dakota and to elect that the Company be subject to the North Dakota Publicly Traded Corporations Act.

Thus, the board is free to ignore the provision even if it passes.

The focus on the North Dakota law is an interesting exercise.  The North Dakota Law Review is working on a symposium on the law and will have a conference on the subject in the Spring (I'll be there).  As my paper, Returning Fairness to Executive Compensation, notes, the problem with the North Dakota law is not in what it does but in what it does not do.  As we have written often on this Blog, corporate governance is weakened by the fiduciary standards (or lack of standards) set by the Delaware courts.  It is this lack of standards that is resulting in the current waive of nausea over the system of executive compensation.  Yet the North Dakota law does little to alter these fiduciary duty standards.

We are talking about a recent book written by Jon Macey at Yale titled Corporate Governance, Promises Kept, Promises Broken.  Ultimately Macey believes that the solution to the corporate governance problems in the United States is a more vigorous market for corporate control.  In other words, the inefficient company can be taken over and inefficient management replaced.  Thus, the acquisition of General Motors would likely result in a wholesale purge of top management, including the CEO, Rick Wagoner, and the board of directors who only seemed to take an active role in the crisis after a public relations disaster when the CEO went to Washington asking for a bailout without a plan and returning in a private jet.

There may well be a need for a more active market for corporate control.  The market has been shut down by the Delaware courts, leaving to management almost unlimited authority to rely on poison pills to stop unwanted ventures.  Thus, even the worst managers can remain in office, behind the poison pill shield.  Once again, the explanation rests with the Delaware courts.

But those who push an active market for corporate control as a solution often ignore the negative consequences of the approach.  One of them is that it discourages risk taking.  Companies wanting to enter a new market generally have two choices.  They can acquire an existing participant, purchasing market share and income streams, or develop their own capacity.  The risk of failure (and, presumably a hostile takeover), is greater with the development of capacity.  There is a chance that the entire venture will fail (smokeless cigarettes by RJR back in the 1980s for example), result in damage to profitability and a fall in share prices.  Buying an existing participant entails less risk of failure (and, concomitantly, a takeover).  But is this the best approach?  Let's take a look at the auto industry in the US.

Back in the 1980s, when hostile acquisitions raged, many car companies decided to go up market, to distribute a premium brand.  In the US, GM bought Saab (acquiring a 50% stake in 1990 and now for sale), Ford bought Jaguer, Aston Martin, Land Rover (all three subsequently sold), and Volvo (Ford is currently exploring "strategic alternatives" for Volvo, "including divestiture").  The Japanese auto makers, where hostile acquisitions were almost impossible, approached the same issue from an entirely different perspective.  They developed their own premium brand, with Toyota developing the Lexus, Honda the Acura, and Nissan the Infiniti.  A ranking of the luxory brands by customer loyalty in 2008 showed Lexus at the top with Land Rover, Jaguar and Saab at the bottom. 

In other words, an active market for corporate control could easily have been one factor in US companies uniformly expanding into a market through the least risky method, buying existing brands rather than starting their own.  In other words, it is no panacea to say that takeovers result in the removal of inefficient management.  They also arguably result in a risk averse strategy in business, something that has real and long term costs.

The entire SEC approach under Rule 14a-8 needs revision, a task that should be taken up quickly by the new Chairman.  On Friday, the staff of the Division of Corporation Finance issued Legal Bulletin No. 14D, informing market participants of, among other things, a new email address for submitting no action requests under the rule.  In addition, however, the bulletin also set out some of the staff's positions on assorted shareholder proposals.  Essentially, the staff indicated that proposals calling for the elimination of classified boards and the reduction in the size of the board from 21 to 14 directors could be deleted unless the proponent revised the proposal "to urge" the board to take the steps necessary to effect the proposals.  In other words, they would only be permitted if precatory.

The effect of the staff action is to essentially force shareholders to use precatory proposals.  There are a number of problems with the approach.  First, even the SEC has noted concern over an excessive use of precatory proposals without having acknowledged that it is the principal culprit for their use. 

Second the emphasis on precatory proposals severely weakens shareholder leverage.  Even if they pass, companies can and often do ignore them.  Thus, they falsely create the appearance of shareholder involvement in the governance process.

Third, and most importantly, the staff is acting as a gatekeeper for state law issues, mostly by interfering with governance by limiting shareholder rights.  To the extent that the proposals mentioned in the bulletin raise legal concerns, the better way to handle them is to allow them into the proxy statement as mandatory requirements and then let the parties sort out the legal issues themselves in court.  Indeed, VC Strine in the Delaware Chancery Court has encouraged the SEC to take this approach.

Shareholders may sometimes opt for precatory proposals as a matter of strategy, an approach designed to win over additional shareholders.   But the staff's decision to make precatory proposals mandatory for certain types of provision is simply an interference with state law rights and ought to be stopped.

 

Company	Proposal	Date of our response	Our response
SBC Communications Inc.	Resolved that as of December 31, 2005 the number of SBC Board of Director seats will be reduced from twenty one (21) to fourteen (14).	Jan. 11, 2004	We concurred in the company’s view that the proposal could be excluded under rules 14a-8(i)(2) and 14a-8(i)(6), unless the proponent revised the proposal as a recommendation or request that the board of directors take the steps necessary to implement the proposal.
Gyrodyne Co. of America, Inc.	It is proposed that the classified board be abolished and all Directors, effective after the election of Directors in 1999, be elected annually.	Aug. 18, 1999	We concurred in the company’s view that the proposal could be excluded under rule 14a-8(i)(1), unless the proponent revised the proposal as a recommendation or request that the board of directors take the steps necessary to implement the proposal.
Sears, Roebuck and Co.	Resolved: That the stockholders . . . urge the Board of Directors to amend the Company’s Restated Certificate of Incorporation to declassify the Board of Directors for the purpose of Director elections.	Feb. 17, 1989	We concurred in the company’s view that the proposal could be excluded under rules 14a-8(c)(2) and 14a-8(c)(6) [now rules 14a-8(i)(2) and 14a-8(i)(6)], unless the proponent revised the proposal to urge that the board of directors take the steps necessary to effect the proposed amendment to the certificate of incorporation.

We are pleased to note the entry of the Shareholder Communications Coalition to the blogosphere.  The Coalition is an advocacy organization "dedicated to improving the ability of individual investors to vote their shares and communicate with the publicly traded companies in which they invest."  The Coalition is seeking, among other things, reform of the Shareholder Communication Rules and supports the petition submitted by the Business Roundtable on the topic. 

This aspect of the Coalition's task is wholly supported by The Race to the Bottom.  The Shareholder Communication Rules, particularly those that deal with communications between issuers and beneficial owners, are unnecessarily complex and do more to impede rather than improve the communication process.  For more, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?  The article is listed on the Coalition's web site.  We are sure to follow the Coalition's efforts in this area.

Hedge funds have been taking a pounding, both in the market turmoil and with the SEC's decision to ban short selling.  They often been demonized and viewed as damaging to the markets.  A good example occurred a month or so ago, when Lynn Stout, a professor at UCLA, wrote an editorial in the WSJ titled "Why Carl Icahn Is Bad for Investors."  We penned a response and slated it for publication on another blog, but alas, it was never published.  So we take a moment or two to provide the comments here.

The editorial largely attacked hedge funds (in general and Carl Icahn in particular).  She characterized the funds as short term investors and views their investment strategies as inherently destructive. As the editorial observes:

• Hedge funds want to make money, quick. They push for strategies that raise the stock price of the few companies they own but may lower the stocks of other companies, or that raise prices in the short term while harming companies’ long-term prospects.

What did it mean to be short term? She cited a study showing that hedge funds had a median holding period of twelve months. In other words, at least half of all hedge funds stayed in a company over a year, hardly ringing proof of a short term investment horizon.

What about the harmful tactics? A “favorite” hedge fund tactic, according to the editorial, was to urge the sale of the company. But when a company is sold, the shareholders typically receive a premium. So what’s the harm? That the share prices of the acquiring company would drop. In other words, the hedge funds were harming the market because the acquirer overpaid.  The problem was not with hedge funds but with management.  To the extent there was an overpayment problem, the solution was not to penalize hedge funds but to tighten fiduciary obligations of the acquirer’s board. In other words, the best way to prevent overpayment is to make the acquirer more careful, not to prevent the seller from selling.

But there is another problem with the contention. Professor Stout referenced a 2005 study in the Journal of Finance. Presumably she is talking about an article titled “Wealth Destruction on a Massive Scale?” The article’s conclusion that there was a $240 billion loss to shareholders of acquiring companies was based upon data from 1998 through 2001. In other words, the data comes from a period that predates hedge fund activism. In fact, the study examined acquisitions in general, not those involving hedge funds. The data, therefore, shows at most that acquirers overpay, irrespective of the involvement of hedge funds. Said another way, she tagged hedge funds for a potential problem that is not of their making.

Potential because the evidence cited does not in fact show that acquirers routinely see their share prices drop. The study in fact showed that the “massive loss” occurred because of a small number of very large acquisitions.  As the study notes:

• The losses result from relatively few acquisition announcements, as can be seen from the fact that from 1998 through 2001, the equally weighted average abnormal return associated with acquisition announcements is positive. Without the acquisition announcements with shareholder wealth losses of $1 billion or more in our sample, that is excluding just over 2% of the observations, shareholder wealth would have increased with acquisition announcements. Looking at the aggregate performance of acquisitions, the economic importance of acquisitions with large announcement losses overwhelms that of thousands of other acquisitions.

In other words, she didn't cite convincing evidence that most acquisitions result in losses to the acquirer as a general matter much less show that any losses that did occur can be blamed on the seller.

The other strategies she points to? A “second favored” transaction is to demand the payment of a “massive dividend” that drains cash and results in an over-leveraged company. Put aside that boards have fiduciary obligations and presumably would violate them if they paid out so much money the company was harmed. More importantly, her objection would apply to any transaction that drains cash, whether or not instigated at the request of a hedge fund. Thus, she presumably opposes leveraged (including management) buyouts since they usually leave companies highly leveraged with cash reserves drained.

Finally, she contends that “shareholder activism hurts average investors by making entrepreneurs and managers more reluctant to operate as public companies.” This is an unproven assertion but a popular one to raise about any development that somehow threatens the status quo. In fact, the argument is belied by the fact that private equity funds are now going public, with KKR having recently announced that it would do so.

Professor Stout, therefore, hasn’t made the case. It is instead an attempt to demonize hedge funds. In that regard, she is not alone. The Chairman of the SEC used hedge funds as the excuse to deny access and amici in the CSX case contended that the Second Circuit should give the trial courts the tools needed to battle hedge funds. There are likely some hedge funds that are destructive, a quality not limited to those funds. One wonders whether the real objection is the existence of shareholders willing to promote strategies that management doesn't like. It would, for example, explain the scorn sometimes heaped on unions, a view apparently shared by one former commissioner at the SEC.

There are legitimate issues about the relative balance between shareholders and managers in the corporate governance process. Likewise there are legitimate legal issues surrounding hedge funds that require resolution. Reporting obligations should be increased and, as we have been discussing on the Race to the Bottom in connection with the CSX case, there needs to be stricter beneficial ownership reporting obligations that would affect some hedge funds. But branding entire categories of shareholders as somehow destructive does not significantly advance the analysis.

With the current financial meltdown, Washington is overrun with calls for increased regulation, a far cry from a few years ago when the city seemed to be awash in efforts to repeal SOX.

The SEC has largely remained on the sidelines but it has been trying to get in the game.  Mostly it has done so through the effort to increase the regulation of short sales.  The agency imposed some emergency restrictions on short sales in connection with 19 financial institutions, restrictions that eventually lapsed.  With the latest turmoil, the SEC has rushed out new rules that would regulate short selling.   

But while some suspect that short selling has contributed to the current crisis, it is an unproven assumption.  The efforts are little more than an attempt to demonstrate the relevancy of the agency primarily responsible for overseeing the securities markets.

There is, however, an area that could actually contribute to fixing this problem.  One major source of the current problem has to be attributed to the board of directors.  The boards of these failed firms are often well paid.  They have not, however, played a significant role in reducing risk taking by the company.  Why?  Because they don't have to.  State law (read Delaware) does not impose meaningful standards on board behavior.  They can attend the six or eight meetings, deal with the issues that the CEO has put on the agenda and receive, in the case of Goldman Sachs, something in the neighborhood of $700,000. 

Boards are largely self perpetuating.  They are nominated by management and almost always elected without opposition.  Shareholders really have no effective say in the membership of the board.  As a result, boards have an economic incentive to act in the best interests of management rather than shareholders.  Moreover, state law shows no sign of increasing director duties or making shareholder elections easier.  The dismal, anti-shareholder decision in CA v. AFSCME illustrates the point clearly. 

It is time for a meaningful access proposal from the SEC, one that would give shareholders the right to insert their nominees in management's proxy statement.  The threat of a contest would likely focus the attention of directors on the interests of shareholders, improving management.  Moreover, the access proposals previously debated (one where shareholders can adopt a bylaw that allows them in the future to insert nominees in management's proxy statement) is not the right one.  The SEC should instead propose and adopt a rule that would allow certain shareholders to directly insert thier nominees into management's proxy statement. 

This is the reform that needs to occur.  Congress took the proxy process away from states in the 1930s because of the lack of effective regulation and the race to the bottom.  It is time for the SEC to finish the job and take away from Delaware control over the nomination process.  CA v. AFSCME and the current financial crisis shows that the issue is too important to be left to a pro-managment, non-diverse court in an otherwise unimportant state. 

As we have been discussing, Secretary of the Treasury Paulson has spearheaded the government's effective acquisition of AIG, the largest insurance company in the world.  The deal involved an $85 billion loan and the acquisition by the federal government in return for a 79.9% ownership interest in the form of warrants called equity participation notes.  

We got to thinking whether the acquisition effectively meant that the US government has becoming a sovereign wealth fund, those pools of money maintained by foreign governments that have caused so much teeth gnashing in the United States.  In that regard, we note that Paulson, the negotiator of the AIG buyout (along with his Fed counterpart) has been pushing sovereign wealth funds to adhere to a series of voluntary principles.  Thus, under Paulson's tutelage, Treasury has called for adherence to a number of principles, including:   

• Greater information disclosure by SWFs, in areas such as purpose, investment objectives, institutional arrangements, and financial information – particularly asset allocation, benchmarks, and rates of return over appropriate historical periods – can help reduce uncertainty in financial markets and build trust in recipient countries.

Treasury has also called for "strong governance structures" on the part of these investors.   Finally, the Department has indicated the need for transparency and called on the funds to comply "with all applicable regulatory and disclosure requirements of the countries in which they invest." 

While we have only seen the news reports of the acquisition of AIG, we have seen nothing indicating that Paulson has put in place a system that will ensure proper governance with respect to the government's interests or adequate transparency, including improved disclosure.  We await indications that Paulson intends to comply with the standards that he has urged on other governments.  

We are discussing the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” published by the Institute for Legal Reform of the Chamber of Commerce.

Perhaps the greatest irony in the report is the shots it takes at institutional investors.  Recall that Congress, with the support of the Chamber, adopted the PSLRA in an attempt to cut back on securities litigation.  One of the central pieces to the litigation was the effort to diminish the role of professional plaintiffs.  The PLSRA did so by replacing the race to the courthouse with a presumption that the shareholder (or shareholders) with the largest loss would serve as plaintiff.  It was expected that this would transfer control of the litigation to institutional investors who could exercise greater control over the case and over counsel. 

In other words, the Chamber got what it wanted.  But it doesn't seem to want this anymore.  The Chamber complains that the reliance on institutions has resulted in a "pay-to-play" mentality.

• As institutional investors like public pension funds play an increasingly important role as lead plaintiffs in securities class actions, a "pay-to-play" culture has emerged in which plaintiffs' law firms contribute to the political campaigns of officials who control the decisions of those funds.  

The evidence mostly comes from a single article in USA Today.  But even assuming this type of culture exists, it is ironic (and unmentioned) that it is a dynamic that the Chamber helped cause. 

Moreover, if anyone is harmed by this approach, it is shareholders.  But the fact that the Chamber of Commerce, an organization that represents the entities sued for securities fraud, is promoting the reforms suggests the contrary.  The fact that the Chamber doesn't like the system suggests that it is because institutional investors are too hard on public companies, perhaps seeking even higher settlements (a conclusion consistent with the data they rely on in the report).  In other words, hidden by the pejorative use of the words "pay to play" is an implicit criticism that institutional investors are, as a result, promoting the interests of shareholders, something the Chamber doesn't appreciate.   

We are discussing the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” published by the Institute for Legal Reform of the Chamber of Commerce. 

The report is a collection of arguments, not all consistent.  Some of them, if they became the basis for reform, would probably be opposed by the Chamber.  An example?  The report rightfully notes that "even if a [securities fraud] claim is legitimate, the "guilty individuals rarely make a significant contribution." 

In other words, the company pays (or more accurately the insurance carrier pays) but the persons responsible for the fraudulent disclosure do not.  In that case, isn't the solution obvious?  It's not to reduce litigation but to change the regulatory system to provide for increased likelihood that the responsible individuals will have to dig into their own pockets and pay a portion of any settlement. 

Yet in the list of reforms proposed by the Chamber, that particular one is noticeably absent.  In other words, there is nothing in the proposal designed to reduce fraud or bring to judgment the guilty individuals.  There are only proposals designed to make companies more litigation proof, irrespective of the merits.

In the veritable race to the bottom, Delaware controls the corporate law of most public companies.  The state, including the courts, has developed a law that is decidedly anti-shareholder in approach.  We will explore this topic later this week or early next with a discussion of a recent case out of Delaware. 

One of the interesting experiments to counter this trend has been the decision by North Dakota to adopt the Publicly Traded Corporations Act.  For companies that incorporate under the Act, shareholders have greater rights.  Moreover, the Act limits the discretion of the board in some circumstances, particularly those concerning poison pills.  We have posted on this law. 

As we have noted, shareholders benefit from incorporating under the law.  It is management, however, that ultimately must decide whether to reincorporate in a state and management has few if any incentives to reincorporate in a state that takes away some of its discretion and authority.  The only hope for shareholders is to adopt a shareholder proposal under Rule 14a-8 calling on management to reincorporate under the law.  We have noted this possibility before.  Moreover, the staff at the Commission have declined to authorize the omission of these proposals.

With that in mind, we note the report at RiskMetrics about the first shareholder proposal seeking reincorporation in North Dakota.  The proposal was submitted to The Hain Celestial Group.  As RiskMetrics notes, these types of proposals have received solid support in the past.  The most recent spate of reincorporation proposals, however, were designed to move a company to a jurisdiction where majority voting was permitted.  This is an entirely different matter.  It is not likely to pass but a strong showing will perhaps let management of public companies know that they should consider more seriously expanding shareholder rights. 

An issue that deserves far greater attention concerns the recent miscount of the votes in connection with the election of directors at Yahoo.  The commentary has been passing, although as usual Corporate Governance noticed and asked the right questions.

As was recently reported, there was a significant but not outcome determinative miscount in connection with the recent election of directors at Yahoo.  The original announced tally showed that Jerry Yang, the CEO, received 85% of the votes cast and Roy Bostock, the chairman, received 80%.  After complaints from institutional investors that the tally was inaccurate, Broadridge Financial Solutions went back and recalculated the tally finding that Yang received only 66% and Bostock only 60%.  A huge discrepency.  The explanation?  According to one source, Broadridge claimed the error arose from underreporting share numbers that exceeded eight digits.  Don't worry.   Chuck Callan from Broadridge, a Senior VP Regulatory Affairs said that "the problem was identified and fixed...the error did not change the outcome."

The error apparently came from Broadridge which was hired by Capital Research and Management, a large shareholder of Yahoo, to transmit its votes to the company.  While the published reports make it sound like Broadridge worked only for Capital Research, this is unlikely.  Broadridge (the successor to ADP Shareholder Services) is widely used by brokers and other investors to distribute proxy materials to beneficial owners and to tabulate and submit vote totals.  See Exchange Act Release No. 43487 (Oct. 27, 2000)("Nearly all large broker and many bank intermediaries currently outsource the proxy material distribution function for beneficial security holders to ADP Investor Communications Services.").   In other words, more than the inspector of elections under state law, it is Broadridge that tallies most of the votes in connection with shareholder meetings. 

The role of Broadridge represents a gap in the regulatory system.  Particularly with beneficial owners, the legal obligation to ensure that votes (voting instructions actually) are properly tallied and submitted rests with the brokers (and banks) under the rules of the stock exchange and the proxy rules (Rules 14b-1 and 14b-2).  It is a complicated and circuitous system laden with problems and little enforcement.  Brokers, however, typically contract out the responsibility to Broadridge, which has something approaching a monopoly over the services.  With the relationship contractual, Broadridge is free of any direct regulation of the Commission or the securities laws.  This is a problem.  See Marcel Kahan & Edward B. Rock, The Hanging Chads of Corporate Voting, August 13, 2007 ("The complexity of the custodial ownership system, combined with the pressure of numerous shareholder votes, creates a system that is far more complex and fragile than the one anticipated by the Delaware legal structure. There are somewhere around 17,000 reporting companies. Most of these companies are subject to the SEC proxy rules when they solicit proxies. Finally, annual meetings are seasonal, with most taking place during the second quarter of the calendar year. Broadridge delivers more than one billion communications to investors per year. It is an accident waiting to happen.").  

With shareholder votes often becoming closer, particularly in an era of majority vote election requirements for directors, the system of counting votes needs to be accurate.  The example of Yahoo shows that Broadridge does not have a system in place sufficiently robust to catch mistakes that could amount to 20% of the total votes cast.  While in this case, the change did not affect the outcome, that will not always be the case.  Indeed, even much smaller mistakes can be outocme determinative.  Take a look, for example, at In re Transkaryotic where it was announced that a merger passed but evidence arising in litigation subsequently indicated that in fact it might have failed. 

Broadridge has been at the center of other complaints.  Some companies have professed disatisfaction with Broadridge over the implementation of the eproxy system recently approved by the Commission.  Certainly, return rates by retail investors have been low. And it is not a new problem.  It is discussed in my article, The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility

The system of shareholder voting cannot be sustained where those tabulating votes can make errors in the vicinity of 20%.  Moreover, without regulatory oversight, errors in vote tallies will rarely if ever become public.  In other words, we don't really know how often these kinds of mistakes occur.  It is an area that ought to be examined by the Commission.  

As a parting shot in departing from the SEC, now former commissioner Paul Atkins gave a speech on Rule 14a-8, the shareholder proposal rule.  Most of it was a warning about allowing shareholders access to the proxy statement and a self complementary discussion of the decision to refer the CA case to the Delaware Supreme Court.  That decision in fact may be Atkin's longest lasting legacy since the anti-shareholder decision will make it easier for companies to exclude categories of shareholder proposals under the rule.

The speech also devoted time to another anti-shareholder issue.  Atkins does not like precatory shareholder proposals.  His dislike, however, is not truly rooted in a desire to have a properly functioning system of shareholder proposals.  This can be seen from his refusal to acknowledge the role played by the Commission in encouraging these proposals.  See Note to paragraph (i)(1) of Rule 14a-8, 17 CFR 240.14a-8 (“some proposals are not considered proper under state law if they would be binding on the company if approved by shareholders. In our experience, most proposal that are cast a recommendations or requests that the board of directors take specific action are proper under state law. Accordingly we will assume that a proposal drafted as a recommendation or suggestion is proper unless the company demonstrates otherwise.”). 

In fact, the solution is to eliminate SEC encouragement of precatory proposals.  This was suggested by VC Strine.  Let shareholders include mandatory proposals and if they pass the companies can let the Delaware courts resolve their legality.  As he noted at a roundtable held by the Commission:

• "I think those of us from Delaware would say one of the things the Commission could do to facilitate this is to make clear that if it's uncertain under state law and it's a by-law proposal, then it shouldn't be excluded and they should be able to put it on absent some showing, and then leave it to us, hold us accountable, and if we make the wrong decisions, you can bet we are going to hear about it from the institutional investor community and from the management community."

Atkins quotes Strine but omits this portion of the testimony.  He uses Strine's testimony to suggest the need to eliminate precatory proposals but does not add the portion that instructs the Commission to stop excluding mandatory proposals. 

His real concern, therefore, is not precatory proposals per se but the use of Rule 14a-8 by activist shareholders.  Thus, his only evidence of an unnecessary burden imposed on companies is the singular example of Exxon-Mobile, which confronted 17 shareholder proposals in its proxy statement.  Atkins omitted to mention that Exxon was in many ways unique because of its obstinate resitance in addressing enviornmental issues and seeking to develop alternative energy sources.  Thus, most of the 17 proposals dealt with enviornmental/alternative energy issues.  He also failed to mention that many of the proposals received heavy shareholder support, with a proposal  to separate chairman and CEO receiving 39.5% and say on pay receiving 40.7%.  Nonetheless, Atkins would prefer to cut off this avenue of communication between shareholders and managers. 

The one example aside, his true objection can be seen from the data he uses.  Relying on an ICI study of the 2006-2007 proxy season, he notes that "there were 186 proposals sponsored by unions or affiliates of unions, but just three unions accounted for 94 of the proposals. So the data shows that a relatively small number of investors are responsible for a significant portion of the shareholder proposals."  He then notes that the "abusive use of the shareholder proposal process by some institutional investors is troubling."  In other words, the sole evidence of abuse is the number of proposals submitted by a small number of shareholders.  He makes no mention of the percentage that pass or the use of proposals to largely implement a system of majority voting among large public companies.

During his tenure, he was unable to accomplish the goal of restricting the scope of Rule 14a-8 and limiting the use of precatory proposals.  Attention hereafter will shift not to limiting Rule 14a-8 but expanding its reach to include access. 

Arthur Levitt, former Chairman of the SEC, writes in the WSJ today about the need for the Commission, now up to full complement, to turn back to shareholder access.  As he noted:

• All 40 of the largest markets outside of our own give shareholders the ability to nominate and remove directors. By reversing its decision from last year, this new SEC will make it very clear that it is not only at full strength, but strongly on the side of investors. It will show the world that the U.S. takes shareholder democracy seriously, strengthening our markets' standing as the world's best. More important, it will reinvigorate accountability, restoring trust in a system badly in need of support.

We couldn't agree more.  On this one, the US is an outlier.  Experience in the other markets shows that access will benefit, not harm corporate America.

We are revisiting the Commission's decision to amend Rule 14a-8 to permit the exclusion of shareholder proposals that would sometimes require management to include shareholder nominees in the company's proxy statement. All of this is explored in greater detail in my paper, The SEC, Corporate Governance, and Shareholder Access to the Board Room. Today we offer some final thoughts.

The non-access amendment adopted by the Commission was done on partisan lines, with the lone Democrat voting against it. It contained language far broader than what was required to overturn the Second Circuit, creating plenty of opportunities for management to argue that other types of proposals should be excluded. In discussing the amendment, the Commission described the language as “clear and concise,” doing nothing more than codifying “the agency's longstanding interpretation.” Yet to explain the “clear and concise” language, the adopting release provided all manners of interpretive gloss.

The amendment also left in place the very problem that ostensibly led to its adoption. The Commission claimed as a central motivation concern that shareholders inserting their proposals in the company's proxy statements would sidestep the election contest rules. See Rule 14a-12(c), 17 CFR 240.14a-12(c). But of course prohibiting access proposals under Rule 14a-8 did not mean there would be no instances of shareholders including nominees in the company's proxy statement, leaving the election contest rules and, at least according to the Commission, the proxy antifraud provision inapplicable. In other words, the amendment did not fix the ostensible problem.

The actual language adopted in the non-access proposal was a Trojan horse. Instead of allowing the exclusion of proposals that “relate to an election,” the amendment expanded the exclusion to include any proposal relating “to a nomination or an election for membership on the company's board of directors . . . or a procedure for such nomination or election.”  In other words, the explicit language of the amendment put in play areas not at issue in AFSCME and that had traditionally not been subject to exclusion under Rule 14a-8.

The denial of shareholder access also undermined the goal of improving disclosure through the mechanism of independent directors. To be more than an expediency, the directors had to be genuinely independent. With the stock exchanges and state courts unwilling to adopt a definition that would accomplish this, access provided an alternative mechanism. By allowing shareholders to nominate and elect directors, access increased the likelihood of truly independent directors on the board.

Finally, the decision was inconsistent with the Commission’s mission to promoting full disclosure. Denying access left in place a structural problem with the proxy rules that meant shareholders could still avoid the election contest rules and, at least according to the Commission’s reasoning, the antifraud provision of the proxy rules.  In other words, the Commission left in place a set of rules that all but guaranteed that in some election contests, shareholders would not receive all relevant information.

What does the future hold?  The pressure from institutional investors will continue.  The Commission's absolutist approach and the weak underlying reasoning will do nothing to abate the pressure.  Moreover, the pressure will build not for attenuated access to the proxy statement but direct access, without having to first force shareholders to adopt an access bylaw.  This issue will be revisited and will be at the top of the agenda after the November 2008 elections.

We are revisiting the Commission's decision to amend Rule 14a-8 to permit the exclusion of shareholder proposals that would sometimes require management to include shareholder nominees in the company's proxy statement. All of this is explored in greater detail in my paper, The SEC, Corporate Governance, and Shareholder Access to the Board Room.

By the new millennium, the decision of the Commission to deny shareholders access to the proxy statement for their nominees had again bubbled to the surface. It took a direct challenge from institutional investors, fully active and no longer willing to wait for the Commission to overcome its inertia. In time for the 2003 proxy season, AFSCME submitted a proposal to several companies that, if adopted, would allow shareholders to include nominees in the company’s proxy statement. The proposals amounted to a direct challenge to the position of the staff adopted in 1990. The staff affirmed the existing position and allowed companies to exclude the proposals. Unsatisfied, AFSCME first took its case directly to the Commission but was rebuffed. The Commission did instruct the Division of Corporation Finance to reexamine the proxy rules for possible changes, including the director nomination process. The staff, predictably, recommended that shareholders be given access to the proxy statement for its nominees.

In response to the staff position, the Commission for the first time since 1942 proposed amendments to the proxy rules that would provide direct access to the proxy statement for shareholder nominees. Reflecting the inevitable controversy over the initiative, the proposal was filled with limitations.The proposal attracted approximately 500 comments, dividing along the usual lines, with institutions and ordinary shareholders favoring access, management opposing it.

There the proposal sat, the vociferous nature of the opposition and regime change (Chairman Donaldson replaced by Chairman Cox) explaining the inactivity. But for the Second Circuit's decision in AFSME, the issue probably would have remained unaddressed until the next administration. The Second Circuit, however, struck down the Commission's position that Rule 14a-8(i)(8) prohibited access proposals, providing shareholders with one proxy season to experiment with the proposals.

Experience in the 2007 proxy season suggested the modest impact of access. Only three companies inserted an access proposal in their proxy statement, with a fourth proposed but withdrawn. In addition, one company voluntarily adopted an access proposal. Of the three submitted to a vote, only one, the proposal at CRYO-CELL International, Inc., passed. The proposal provided that shareholders (or groups) owning 5% or more of the company’s voting shares could nominate a short slate of directors.

Despite the modest impact, the Commission proposed an amendment to Rule 14a-8 to overturn the Second Circuit decision and adopted the proposal in December 2007.  Tomorrow we provide some final thoughts on this process.

We are examining the decision by the Commission to deny shareholders access to the company's proxy statement for their nominees. As part of the process, we are examining the history of access. Much of what is written can be examined in greater detail in my paper, The SEC, Corporate Governance, and Shareholder Access to the Board Room.

The first official surfacing of concern over access since the efforts in 1942 occurred when the Commission decided to hold public hearings on the proxy rules in the aftermath of the corporate bribery scandals arising out of the Watergate investigations. The hearings planned to address, among other things, whether "shareholders [should] have access to management's proxy soliciting materials for the purpose of nominating persons of their choice to serve on the board of directors," a topic that included restrictions on the authority. The Commission acknowledged that nominations taking place at the meeting were “of little practical value, since at that point proxies have already been received by management for the nominees it has chosen, and the number of shareholders attending an annual meeting typically is insignificant.”

At the hearings, predictably, “most corporate commentators were opposed” to allowing shareholders the right to include their nominees in the company’s proxy statement. The objections were familiar, with some contending that shareholders really did not want the authority (shareholders “were apathetic” and not in a position “to evaluate the qualifications of nominees”), others that it would have a disruptive impact on the board (shareholder nominations would “politicize the board, thereby diluting its effectiveness and reducing the accountability of board members”) and still finally others contending that it would discourage good candidates from serving (“good candidates for the board would be discouraged if they had to ‘run’ for office.”).     

Although not fully agreeing with the objections, the Commission opted not to allow access but instead opted for a milder, less controversial, approach. Companies would be encouraged to set up nominating committees and implement procedures designed to encourage the submission of shareholder nominees. It was hoped that the approach would encourage communications and even negotiations between management and shareholders, arguably reducing the need to include nominees in the company’s proxy statement. But of course the right to submit nominees to nominating committees did not guarantee that they would be considered seriously. See Exchange Act Release No. 48626 (Oct. 14, 2003) (“While security holders can recommend a candidate to a company's nominating committee, security holder comments suggest that these recommendations rarely are effective”).

Predictably the approach did not work. For one thing, companies had little incentive to respond to bureaucratic prodding. For another, improved communications did not obviate at least the occasional need for shareholders to include their own nominees in the company’s proxy statement. As a result, public companies did not respond vigorously to the efforts. A study of the 1979 proxy season revealed that only 29% of companies had a nominating committee and only 78% of those considered shareholder nominations, results described by the staff as “disturbing.” 

A staff report called for another year of study but warned that a proposal to give shareholders greater involvement in the nomination process could still emerge. "If there is not a substantial increase in the percentage of companies with independent nominating committees who consider shareholder nominations, the Commission should authorize the staff to develop a rule to require companies to adopt a procedure for considering shareholder nominations."  The numbers improved, providing an excuse for further delay. The delay proved terminal, at least in part because of regime change at the Commission.

With the energies of the Commission spent, efforts shifted to self help, something aided by a sympathetic staff.  Although continuing to prohibit the use of Rule 14a-8 for the nomination of specific individuals, the staff took a more liberal approach towards proposals that, if adopted, required management to include a shareholder nominee in the company’s proxy statement. Through the 1980s, the staff declined to allow companies to exclude these proposals.  Shareholders, therefore, received a form of access, without having to undergo the formality of, and controversy surrounding, an amendment to Rule 14a-8.  

The approach generated little controversy. It provided access to the proxy statement for nominees but only if the requisite bylaw was first adopted by shareholders. Proposals made in the 1980s came from individuals, not large institutions. Moreover, they invariably failed. Thus, they posed little threat of actual election of shareholder nominated directors.  By the end of the 1980s, however, the calculus changed. The era of institutional activism had erupted. To the extent activist shareholders got behind access proposals, the odds of passage increased substantially. Perhaps aware of this possibility, the staff undertook a 180 degree shift and, without explanation, issued a no action letter in 1990 agreeing that access proposals could be excluded under Rule 14a-8.

The staff, therefore, cut off the mild form of access to the proxy statement for shareholder nominees.  As shareholder activism grew, however, pressure would build for increased access.  One wonders whether the administrative decision to eliminate access would prove to be another Pyrrhic victory.

We are examining the decision by the Commission to deny shareholders access to the company's proxy statement for their nominees. As part of the process, we are examining the history of access. Much of what is written can be examined in greater detail in my paper, The SEC, Corporate Governance, and Shareholder Access to the Board Room.

The aborted effort in 1942 to provide shareholders with access to the proxy statement for their nominees put an end to the efforts until the 1980s. Two things changed during the longer interlude. First, by the late 1980s, shareholder activism had risen to the fore. Shareholders wanted greater influence in the board room, with Rule 14a-8 ceasing to be the exclusive purview of the gadflies.

Second, the Commission began to realize that the efficacy of the disclosure process required some attention to the substantive behavior inside the board room. In assigning to the Commission responsibility for disclosure, Congress interjected the agency into the corporate governance process. With the traditional problems of self perpetuation and excessive compensation documented in the legislative history, Congress assumed that the disinfectant of sunlight coupled with extant shareholder authority would solve the worst abuses.

The authority was not paired with the right to regulate substantive behavior within the company. Typically treated as a matter of fiduciary obligations, it was left to the states. Over time, however, it became clear that the efficacy of the disclosure system depended upon the substantive obligations of the responsible officers and directors, something that emerged with a vengeance during the corporate bribery scandal of the 1970s. Uncovered as a byproduct of the Watergate scandals, the widespread nature of the problem demonstrated weaknesses in the process of formulating disclosure. Although the scandal resulted in amendments to the Exchange Act, none seriously addressed the issue of accountability.

The Commission tried to encourage the use of independent directors in part by exhortation. See Exchange Act Release No. 14970 (July 18, 1978) (“In this regard, the Commission believes that it is desirable that these three standing committees, which have responsibilities in areas where disinterested oversight is most needed, normally be composed entirely of persons independent of management.”). Alternatively, it sought to pressure the stock exchanges into requiring independent director requirements through the mechanism of listing standards, an approach weakened by the DC Circuit's decision in Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990).

Increased shareholder activism, the search for accountability, and the growing importance of independent directors, meant that attention would eventually return to the election process, including the limitation in Rule 14a-8 on shareholder nominations. At the same time, however, resistance from corporate America would remain stiff. Shareholder access raised the threat of directors not vetted by management, an anathema. More specifically, companies were concerned with “special interest” directors.  

The Commission, therefore, found itself in the middle of the two warring camps. The leanings of the staff and the interests of institutional investors sometimes resulted in access returning to the forefront.  The dynamics would cause access to resurface but would leave the Commission paralyzed from decisive action.  Tomorrow, we shall look at access revisited. 

We are examining shareholder access to the proxy statement, with a brief exegesis into the history of the shareholder proposal. Much of what is written can be examined in greater detail in my paper, The SEC, Corporate Governance, and Shareholder Access to the Board Room.

The Commission adopted the shareholder proposal rule in 1942. The rule gave shareholders some access to the company's proxy statement for their proposals. What about shareholder nominees?

As we have noted, even before the adoption of the shareholder proposal rule, the Commission required companies to disclose information about upcoming proposals at the upcoming meeting and provide shareholders with some opportunity "to specify the action which he desires to be taken pursuant to the proxy on such matter." Exchange Act Release No. 2376 (Jan. 12, 1940). The authority did not, however, apply "to the matter of an election to any office which the persons making the solicitation are informed other persons intend to present for action at such meeting." Id.

Two years later, however, the Commission floated a proposal that would require companies to include shareholder nominees in their proxy materials. Management, however, had the right to limit the number of nominees “on some fair and equitable basis." See Securit[ies] and Exchange Commission Proxy Rules: Hearings on H.R. 1493, H.R. 1821, and H.R. 2019 Before the House Comm. on Interstate and Foreign Commerce , 78th Cong., 1st Sess., at 35 (1943). The circulated proposal would have allowed management to limit the number of nominees to “twice as many nominees as there are directors of the issuer.” Id. at 157. Shareholders would have been required to disclose “the information about such officers . . . required by the rules.”

The Commission never adopted the proposal. The release itself contained no explanation. It was clear, however, that the proposal to allow shareholders to insert their nominees into the proxy statement caused stiff resistance. Business interests opposed the right of shareholders to insert nominees in the company’s proxy materials, sentiments echoed in Congress.  Criticisms included concerns over the Commission’s authority to “change the proxy into a ballot,” the possibility that implementation would result in violations of state law, the vagueness in the grounds for excluding a nominee, the failure of the proposal to deal with staggered boards, and the risk of shareholder confusion. None of the criticisms challenged the right of shareholders to nominate directors under state law nor contested the impact of the proxy provisions on that right.

Most of the concerns could have been addressed through more adroit drafting. The Commission, however, chose not to go forward with the proposal, the controversy too great. Four years later, the shareholder proposal rule was amended to make the implicit explicit, barring its use for proposals relating to “elections to office.” See Exchange Act Release No. 3998 (Oct. 10, 1947) (proposing to add language that “This rule does not apply, however, to elections to office.”).

In fact, the proposal had no real prospect for success.  Not only was opposition vociferous, the beneficiaries were nowhere to be seen.  In an era predating the rise of activist investors and the institutionalization of the market, shareholders not only had little interest in the authority, generally opposing any increase in their role in the governance process. Aside from the Commission, therefore, no clear constituency favoring access had yet emerged.  Nor had the costs of a separate solicitation become prohibitive or the importance of independent directors on the board firmly established.

We are examining shareholder access, reminiscing over the Commission's decision to deny shareholders access to the company's proxy statement. Today we will look at some of the history of the approach. Greater detail on the topic can be found in my paper, The SEC, Corporate Governance, and Shareholder Access to the Board Room.

One of the interesting things about the history of Rule 14a-8 is that, contrary to common expectation, it was adopted in an effort largely to assist management, not shareholders.

Shortly after the adoption of the Exchange Act, the Commission put in place rudimentary proxy rules. One of the earliest disclosure problems concerned the failure by management to disclose shareholder proposals that it knew would be made at an upcoming meeting.

The issue arose in connection with a proxy solicitation by Bethlehem Steel in 1939. See Arthur H. Dean, Non-Compliance with Proxy Regulations, 24 CORNELL L. Q. 483, 503-04 (1938-1939). The company knew about a proposed bylaw that would give shareholders the authority to approve the auditors. The company solicited proxies but made no mention of the proposal. The Commission took the position that this rendered the proxy materials misleading and pressured the company into adjourning the meeting and sending out a revised notice informing shareholders of the proposed bylaw.

Non-disclosure was particularly acute when management sought discretionary voting authority in order to vote against the proposal. The Commission responded by amending the proxy rules. Management was required to reveal in the proxy materials any proposal that it knew would be submitted by shareholders at a meeting, at least where it intended to cast proxy votes against the proposal or “for purposes of a quorum supporting such a vote.” See Exchange Act Release No. 2376 (Jan. 12, 1940). In those circumstances, shareholders were to receive “means shall be provided whereby the person solicited is afforded an opportunity to specify the action which he desires to be taken pursuant to the proxy on such matter.”

But these disclosure requirements placed the onus on management to describe a shareholder's proposal. The shareholder proposal rule lifted this burden. It would be up to the shareholders to provide a statement concerning their proposal.

As an aside, the shareholder proposal rule caused some consternation in Congress, with some members viewing the effort as a communist plot.  At one point, Congressman Wolverton noted that the proxy rules adopted in 1942 had caused “turmoil” and insinuated that this may have been part of a communist plot. See Securi[ties] and Exchange Commission Proxy Rules: Hearings on H.R. 1493, H.R. 1821, and H.R. 2019 Before the House Comm. on Interstate and Foreign Commerce, 78th Cong., 1st Sess. at 289 (1943).

In fact, the Commission's ability to push through a shareholder proposal rule, despite the turmoil and purported communist roots, occurred in large part because it was a continuation of existing practices and couched in terms of disclosure.  Moreover, it had limited reach.  It applied only to stock exchange traded companies (Section 12(g) of the Exchange Act was still 22 years away) and only if they solicited proxies.  Indeed, in the first year of operation, a mere 13 statements were submitted by shareholders and most of them were by the same person, a number that remained small through much of the early decades of the rule.

Tomorrow we'll talk about the early efforts to provide shareholders with access to the proxy statement for their nominees, something proposed in 1942 but not adopted.