The Lack of Impartiality in the Proxy Process

The vote is in on the contest over whether position of chair and CEO should be divided at JP Morgan Chase.  But a fundamental shift in the traditional dynamics of a proxy contest occurred during the voting process.  Shareholders were denied an important piece of data.  Unlike management, shareholders were at least temporarily denied data on the running vote totals obtained by Broadridge.  As the WSJ noted:

• in the midst of one of the most closely watched investor votes in years — over whether to separate the roles of chairman and chief executive at JPMorgan Chase — that protocol has changed. The firm that is providing tabulations of the JPMorgan vote stopped giving voting snapshots to the proposal’s sponsors last week.

According to the article, Broadridge received a call from SIFMA, described as Wall Street's "main lobby group" and was told to "cut off access to organizations that are sponsoring proposals".  As the WSJ described: 

• Lyell Dampeer, a senior executive at Broadridge, said his firm was required to give real-time results to companies, and for years Broadridge gave that same information to proposal sponsors. But late last week, he received a call from an employee of the Securities Industry and Financial Markets Association, Wall Street’s main lobby group, requesting that Broadridge cut off access to organizations that are sponsoring proposals, he said. Sifma represents JPMorgan and other big banks and brokerage firms.

The tallies apparently resumed following pressure placed on JP Morgan.  As the Dealbook reported:  "After a series of conference calls on Saturday between lawyers for JPMorgan and the attorney general’s office, JPMorgan agreed to direct a firm that provides early tabulations to restart the tallies."

The information matters.  In the case of close tallies, proponents and opponents may want to increase the resources devoted to a proxy contest.  Significant shifts in the tallies may indicate the success or failure of a particular strategy.  The information also typically becomes public and can help publicize the context, something that may benefit the side with the fewest resources.  Thus, the practice by Broadridge denies shareholders information that may well be useful in a proxy contest. 

There are several observations to make about this new policy.  First, it is hard to understate the role played by Broadridge in the proxy process.  As the SEC recently noted:  "almost all proxy processing in the U.S. is handled by a single intermediary, Broadridge Financial Solutions, Inc. ("Broadridge").  Broadridge reported that during the year ended April 30, 2012 it processed over 12,000 proxy distribution jobs involving over 638 billion shares. Broadridge has estimated that in recent years it handles distributions to some 90 million beneficial owners with accounts at over 900 custodian banks and brokers."  Exchange Act Release No. 68936 (Feb. 15, 2013). 

Second, it is unlikely that SIFMA intervened only in the case of tallies involving JP Morgan Chase.  The article suggests that SIFMA sought an end to the disclosure of ongoing tallies more systematically.  Thus, while the practice was apparent in the context of JP Morgan Chase, it may well apply to future proxy contests involving other companies. 

Third, while issuers may have a desire to retain a monopoly on the running tallies, they are not the ones that hired Broadridge.  Broadridge is fulfilling the legal obligations of the brokers (and some banks).  Thus, the instruction to terminate came not from an issuer organization but one that represents broker dealers.  As SIFMA describes on its web site, the organization "brings together the shared interests of hundreds of securities firms, banks and asset managers."  In other words, it is brokers, not issuers, that are instructing Broadridge to cut off the tallies to shareholders. 

Fourth, the circumstances are complicated by the fact that issuers, not brokers, pay Broadridge.  See Id.  ("Since 1937 the NYSE has specified the level of reimbursement which, if provided to the member broker-dealers, would obligate them to effect the distribution of proxy materials to street name holders").  The fees are not insignificant.  Id.  ("Based on information from Broadridge, the PFAC estimated that issuers spend approximately $ 200 million in aggregate on fees for proxy distribution to street name shareholders during a year.").  Moreover, JP Morgan Chase is likely a member of SIFMA because of its role as an investment bank.  Nonetheless, Broadridge as a legal matters fulfills obligations of brokers.  It is an agent for those intermediaries. 

The bottom line is that brokers are effectively instructing Broadridge to provide information to one side but not the other in a proxy contest.  Yet the proxy system is designed to ensure that the intermediaries not directly involved in the contest remain impartial.  Thus, brokers are exempt from the proxy rules for forwarding materials to beneficial owners so long as they remain impartial in doing so.  See Rule 14a-2(a)(1), 17 CFR 240.14a-2(a)(1).  Similarly, brokers cannot vote uninstructed shares held by street name owners for controversial matters.  In other words, they are not allowed to use these shares to influence the outcome of the final tally of a controversial matters, something that includes the election of directors. 

Impartiality would mean that both sides (or neither side) received the data.  Although the flow of information to shareholders was resumed, The Council of Institutional Investors has raised the issue with the Commission.  To the extent the Securities and Exchange Commission views impartiality by intermediaries as an important element of the proxy process, this may be an instance where regulatory intervention is necessary.   

The Flawed System for the Election and Nomination of Directors (The SEC Disclosure Regime)

We are discussing the failure of a director at Sirius XM Radio who failed to receive majority support from shareholders.  Despite the negative vote, he was nonetheless reelected to the board. 

There are suggestions in the WSJ articles that this director may not have attended any meetings in 2011.  This contention, however, was speculation and attributed to "chatter."  In fact, his actual attendance was not known.  The uncertainty about the precise number of meetings attended demonstrates a gap in the SEC's disclosure obligations with respect to meeting attendance.  

The SEC requires disclosure in the proxy statement of any director that does not attend at least 75% of the board and committee meetings.  See Item 407 of Regulation S-K ("State the total number of meetings of the board of directors (including regularly scheduled and special meetings) which were held during the last full fiscal year. Name each incumbent director who during the last full fiscal year attended fewer than 75 percent of the aggregate of: The total number of meetings of the board of directors (held during the period for which he has been a director); and the total number of meetings held by all committees of the board on which he served (during the periods that he served)."). 

The SEC put this requirement in place in 1978.  See Exchange Act Release No. 15384 (Dec. 6, 1978).  For a discussion of the requirement go here.  See also Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure.  In proposing the requirement, the Commission considered but disregarded a more quantitative approach to disclosure.  See Exchange Act Release No. 14970 (July 18, 1978) (total time spent by directors "difficult to calculate and also could require substantial additional recordkeeping.  Moreover, a bare statement of the amount of time spent on corporate affairs would not convey the substance of a director's contribution to the company."). 

As an alternative, the Commission favored the use of a threshold. 

While the Commission believes that, as a general matter, disclosure of attendance records would be of limited usefulness, it has tentatively concluded that disclosure of a director's failure to achieve a certain minimum level of attendance could provide information which would facilitate shareholder assessment of his performance as well as the effectiveness of an issuer's board and committee system generally.

Exchange Act Release No. 14970 (July 18, 1978).  This was the approach taken in the final rule. 

After 34 years of experience, changes to the requirement ought to be considered.  The situation at Siruis XM suggests that more precise information would be useful to investors. 

While it may not be necessary to disclose precise attendance records in all circumstances, the SEC should mandate disclosure of specific attendance records when they fall to abysmally low levels.  This could be required, for example, when a director attends less than 25% of the total number of meetings.  Such an attendance record suggests that a director is not playing a meaningful role in the governance of the corporation.  This is material information shareholders would want to know. 

That is not all.  Shareholders would likely want to know how the board considered this information in the nomination process.  With directors having a fiduciary obligation to act in the best interests of shareholders, the board ought to provide insight into the reasons why it was appropriate to renominate directors who had poor attendance records. 

The Flawed System for the Election and Nomination of Directors (The Weakness in Plurality Voting)

The WSJ reported on the "reelection" of one of the directors to the board of directors at Sirius XM Radio.  As the artcile described:  "Sirius XM Radio Inc. held seven meetings for its 13-person board during 2011. Leon Black, a well-known private-equity player, attended none of them."  The response by shareholders was direct and unequivocal.  In a Form 8-K Sirius disclosed that Black received 512,411,779 votes in favor and 955,186,887 votes against.  In other words, by any reasonable standard, he was overwhelminingly defeated for election to the board.

But reasonableness does not, for the most part, apply to the system for electing directors.  In something that would have intrigued Lewis Carroll and befuddled Alice in Wonderland, shareholders of public companis for the most part cannot defeat candidates for the board, no matter how many shares are voted against these directors.

This is the case because most states (including Delaware) rely on the plurality system for electing directors.  Under this system, directors who receive the most votes win.  When the number of candidates and number of vacancies are the same, the nominees presented by management always win.  In effect, the "no" votes cast against directors are irrelevant.  So Sirius had eight openings on the board and eight nominees.  All of them won, including the one director who did not receive a majority of the votes cast. 

Some companies have put in place "majority vote" provisions.  These generally provide that directors who do not receive a majority of the votes cast must submit a letter of resignation.  As we have discussed on this Blog, however, majority vote provisions provide no meaningful authority to shareholders. 

To the extent a candidate does not receive a majority of the votes cast, removal authority is not with shareholders but in the hands of the remaining directors.  In effect, therefore, a majority vote provision merely transfers to directors the power to decide on board membership.  Moreover, in a number of notable circumstances, the board has declined to accept the resignations of directors who did not receive majority support of shareholders. For examples, go here. 

Had a majority vote provision at Sirius been in place, the outcome would likely have been no different.  The board presumably knew about the poor attendance record when they renominated him.  Having decided this was not a disqualification for board membership, the remaining directors also presumably would have declined to accept a letter of resignation on that basis.  

Should anything be done about this?  Shareholders can only ensure the defeat of management nominated directors if they nominate their own candidates.  Doing so, however, is an expensive proposition.  Shareholder access was designed to make this easier by by requiring the company to include shareholder nominees in its proxy statement.  In certain, likely rare, circumstances, shareholders would have been in a position to opt for a non-management candidate.   

When would that occur?  Perhaps in the case of management nominating a director with a weak attendance record.  By striking the rule down in Business Roundtable, therefore, the DC Circuit effectively took away from shareholders a check on management.  The board can renominate directors with poor attendance records without having to worry that the decision would be second guessed at the ballot box.       

We will have some more thoughts on this approach to governance in the next few posts.

Narrowing the Scope of Inspection Rights: Espinoza v. HP (Part 6)

So where does Espinoza leave us? 

The lower court decision more or less conceded that the Report could be "helpful to plaintiff ("It might be helpful to the plaintiff in that it is something the board considered in making its decision") but ultimately concluded that plaintiff had not made a sufficient showing to justify setting aside privilege.  The Chancery Court specifically found that “[b]ecause I find that the interim report is protected by the attorney-client privilege and work product doctrine, it’s not necessary for me to reach the [statutory] issue of whether it also would be necessary and essential to the plaintiff’s stated purpose.”

While the decision can be criticized (and we have done so on this Blog), it was in some respect narrow.  It imposed a high burden on plaintiffs seeking to invoke their inspection rights but only when privilege was implicated. 

The Supreme Court, however, took the "opposite approach", see note 23.  Unlike the Chancery Court, the Court did not "reach or address the separate question of whether inspection of the Report is precluded under the attorney-client privilege or the work product immunity doctrine."  Instead, the very issue that the Chancery Court did not reach, whether the Report was "essential to the plaintiff's stated purpose," was the basis for the Supreme Court's decision.   

In so doing, the Court issued a decision that is likely to have a much broader impact on the ability of shareholders to enforce their inspection rights.  Espinoza provides companies with an expanded ability to resist inspection requests.  Companies already could argue that shareholders had not set out a proper purpose or lacked a credible basis.  Espinoza allows companies to assert that the sought after documents are not "essential" or "central" to the stated purpose, a standard that will often be difficult to meet at the pleading stage.  Moreover, since shareholders have the burden, companies can argue that shareholders have not met the burden even when they know that the documents are in fact essential or central.  They also have expanded ability to successfully argue that "essential" documents need not be disclosed since plaintiffs were informed of any "critical findings." 

The decision, therefore, discourages transparency and will, at least in some cases, make it more difficult for shareholders to acquire information about board activity, even when they have presented a credible basis for misconduct.  Moreover, this will likely force shareholders to litigate inspection rights more often.  Because they are not automatically entitled to fees when they win, only those who can afford to absorb the costs of a legal action will be in a position to vindicate their rights. 

The decision will likely contribute toward the trend in the federalization of corporate governance.  SOX preempted state law by adopting clawback provisions, regulating audit committees, and prohibiting loans to executive officers.  It was, however, an initial and tentative intrusion into the governance area.  Dodd Frank went much further.  It regulated compensation committees, strengthened clawbacks, allowed the SEC to define factors in determining director independence, provided for shareholder access, and gave shareholders an advisory vote on executive compensation.  The boards of large banks must have risk committees and financial regulators have the substantive authority to prohibit compensation practices that result in excessive risk.  

All of this shows that Congress no longer considers the role of states in the governance process as a significant barrier to intervention.  To the extent that the law in Delaware is not sufficiently balanced, further appeal to Congress and federal regulators will result.  Espinoza provides shareholders with an argument that inspection rights are not adequate to provide them with the information they need to monitor management and that this type of information ought to be mandated as part of the federal disclosure regime.  

Primary materials for the case at the trial level can be found at the DU Corporate Governance web site.

Disclosure of Internal Investigative Reports and A Predictable Response: Espinoza v. HP (Part 4B)

The Court's application of the "essential" standard shows the degree to which the element will be available in restricting access to relevant material even after shareholders have established a proper purpose and a credible basis. 

First, the Court found that the Report was not "essential" because it did not discuss "the 'for cause' termination issue." In other words, the Court did not rely on the content of the Report but on the absence one specific discussion.  Even without this discussion, however, the contents likely played a role in the Board's decision making process.  The Report was designed to provide the Board with information on the allegations of wrongdoing.  See Complaint, at P. 5 (investigation was initiated "to investigate the allegations contained in the Allred letter").  Since the Report was presented to the Board, it presumably helped inform directors with respect to any decision taken concerning the CEO.   

Second, the Court suggested that "essential" also meant "central" to the Board's deliberations.  The Court cited no precedent for this requirement.  Moreover, the Court acknowledged that the Board may have "consulted" the Report.  In other words, it wasn't enough to show board awareness.  Shareholders instead had to be able to describe the particular role played by the Report in the decision making process.  The Court did not explain how plaintiffs, at the pleading stage, would be able to make this showing.  

Finally, even if "essential" or "central," the Report did not have to be disclosed were the "essential elements" had already been revealed.  Plaintiff was made aware of the process used in the investigation as a result of receiving "board minutes describing what materials were considered and when meetings took place"  Plaintiff was also made aware of the "critical findings" in the Report, particularly that the CEO "violated HP's business conduct rules, but not its sexual harassment policy". 

The investigation that resulted in the Report, however, apparently involved an analysis, as an article in the WSJ suggested, of "phone calls . . . and PC usage" and interviews with relevant parties.  In other words, it looks to have been thorough.  The Report, therefore, probably included information that went to the strength of the allegations and the credibility of the persons involved.  Such information could impact the Board's analysis.  Nonetheless, the Court apparently did not consider this type of evidence "essential." 

The Court's analysis, therefore, provides a roadmap for avoiding disclosure of sensitive material.  The materials should avoid mentioning the ultimate issue at the center of the alleged wrongdoing.  To the extent that analysis of the specific matter at issue is necessary, it should be included in a separate document.  The sensitive material should be only part of the information given to the Board, requiring shareholders to establish the centrality of the documents.  And, finally, disclosure can at least sometimes be avoided if the conclusions in the senstive document are disclosed. 

Narrowing the Scope of Inspection Rights: Espinoza v. HP (Part 4A)

In construing the scope requirement for inspection rights, the Supreme Court in Espinoza stretched the boundaries of an existing doctrine far beyond what it had previously been.  Limitations on scope are permitted under the language in Section 220.  The provision allows a court to, "in its discretion, prescribe any limitations or conditions with reference to the inspection, or award such other or further relief as the Court may deem just and proper." 8 Del. C. § 220 (2011). 

The language does not impose substantive standards on document requests.  Instead, the language suggests that courts have the discretion to impose prophylactic limitations such as mandating the use of a confidentiality agreement.  Espinoza, however, read the language to impose an additional substantive obligation that was applicable to all inspection requests.  Shareholders with a proper purpose and credible basis could only inspect documents that were "essential" or "central" to the stated purpose. 

The Court relied for support on language from Thomas & Betts Corp. v. Leviton Mfg. Co., 681 A.2d 1026 (Del. 1996) but the language does not support the Court's position.  In that case, the plaintiff asserted a purpose that, according to the Court, was "antithetical to the interests of the corporation."  Although rejecting the "antithetical" purpose, the Court did allow access to documents that would permit plaintiff to value its holdings in the company.  This required the court to limit the scope so that only documents relevant to valuation would be made available.  As the Court reasoned, without citation to any authority: 

• "Here, the trial court has found that Thomas & Betts' primary purpose for inspection is at odds with the interests of the corporation. In this posture, it was entirely appropriate for the Court of Chancery to limit plaintiff's inspection to those documents which are essential and sufficient to its valuation purpose."

In other words, the term "essential" was intended as a boundary that separated the scope of inspection in cases involving both proper and improper purposes.  In cases only involving a proper purpose, it was not intended as a substantive limitation on the documents available to shareholders. 

Nonetheless, that is how the Court in Espinoza interpreted "essential."  Shareholders with a proper purpose were only entitled to documents that were "essential" to the purpose.  Presumably this means that "relevant" documents are not available unless also "essential."  Or, in the words of the Chancery Court, "helpful" documents are not available unless essential.   Moreover, the Court in Thomas & Betts combined "essential" with "sufficient."  The latter term, however, made no appearance in the Espinoza opinion. 

The need to establish that a document was "essential" wasn't the only requirement imposed by the Court.  Even if essential, the requested information must be "unavailable from another source."  The Court also made clear that a determination of "essential" was "fact specific and will necessarily depend on the context in which the shareholder's inspection demand arises."  In other words, it is an issue that can be raised in every inspection request.

We will look at the Court's application of this newly created standard in the next post.  Primary materials for the case at the trial level can be found at the DU Corporate Governance web site.

The Implications of Say on Pay: The Solution (Part 5)

Executive compensation remains an issue of considerable importance to shareholders, if not, as the High Pay Commission noted, society as a whole.  The introduction of an advisory vote on compensation represents a massive preemption of state law.  For the first time, federal law accedes to shareholders of public companies the right to vote on a particular matter. 

As with most sea changes, this reform was modest.  Shareholders were given only the right to an advisory vote.  Moreover, companies could limit the advisory vote to an every three year event.  As an advisory vote, directors were in theory free to ignore any shareholder "advice" on compensation issues. Of course, the spate of lawsuits that followed some of the negative advisory votes likely caused directors to give the "advice" greater weight than what the statute required.  

Britain and Australia show, however, that, to the extent say on pay fails, calls arise for greater shareholder authority.  While reforms in those two countries so far are mostly procedural, they are significant.  In Australia, continued shareholder opposition can lead to a recall election for the board.  In Britain, the High Pay Commission recommended that shareholders receive additional voting rights and that employees be brought into the compensation process. 

So what does it mean to "fail?".  In both Australia and Britain, the problem was the failure of say on pay (and other requirements) to reduce the rapid increase in executive compensation.  In other words, other benefits such as the increase in communication between shareholders and boards were not enough to alleviate the conclusion that the approach had failed.  To the extent that say on pay likewise does not slow the increase in executive compensation in the US, pressure on politicians will remain strong to take additional steps.  Proposals for second generation statutes will arise in the US.

Is there anything that can be done to head off this inevitability?  Actually, there is.  In the end, politicians, shareholders and directors are uncomfortable with limits on compensation that potentially interfere with the payment of adequate remuneration to those who deserve it.  Remuneration is best left as a case by case determination by those who know the company the best.  The problem is the process lacks sufficient integrity.  That CEO compensation is determined by a neutral and independent group of directors is, as we have often discussed (and the High Pay Commission more or less noted), a myth.  For a discussion of this issue, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty. 

Indeed, management typically has a significant role in the selection of directors.  Management has an incentive to nominate directors not because they will protect the interests of shareholders but because they will "reliably" support the policies of management.  See Essay: Neutralizing the Board of Directors and the Impact on Diversity. 

To the extent that compensation (even high compensation) emerges out of a process that is viewed as rigorous and independent, shareholders and other groups will likely have less concern with the results.  The best way to restore integrity to the compensation approval process, therefore, is to allow shareholder nominated directors to participate.  In other words, the solution is shareholder access.  

The decision of the DC Circuit to strike down the shareholder access rule in Business Roundtable v. SEC, therefore, is likely to have long term negative effects.  Without assurance that the compensation process has sufficient integrity, shareholders will continue to apply pressure on compensation issues and, ultimately, may apply pressure for stricter, second generation say on pay statutes in the US.

Primary materials from some of the "say on pay" derivative suits can be found at the DU Corporate Governance web site.

The ABA has just published its list of 100 law blogs, a list that includes the Race to the Bottom.  Please register and vote for the RTTB.

The Implications of Say on Pay: The Next Generation Statutes (Part 4)

The US implemented say on pay in TARP companies in 2010 and in public companies in 2011.  In that regard, the US has been behind other countries, particularly Britain and Australia.  Both gave shareholders an advisory vote on compensation earlier in the decade (Britain did so in 2002).

As a result, these countries have had more experience with the consequences of the practice.  It is safe to say that both countries remain frustrated with the continued trends in executive compensation.  A recent report in Britain by the High Pay Commission noted the harms caused by escalating executive compensation and challenged the holy grail of CEO compensation:  The need for it to be performance based.  As the report observed:  

• The question of whether pay for performance works is a controversial one. Popular common sense suggests that people can and will work within a range of effort and through pay we can encourage them to work harder and towards certain defined goals. However, this is increasingly questioned and the interaction between financial incentives and performance is not simple.

What seems clear is that both countries (and presumably shareholders) have become concerned with the amount paid rather than the metrics used to determine the amount.  

Both countries have either adopted or are considering changes to the say on pay approach.  Australia has adopted a second generation say on pay statute, with the changes having become effective on July 1, 2011.  The draft of the statute is here; an explanatory memorandum here.  The provision has generated considerable commnetary,  some of it critical.  For the debate on the legislation, go here.  The law prohibited certain shareholders from voting (directors and executive officers) and imposed a two strike requirement. 

Under the provision, the first strike occurs when at least 25% of shareholders oppose the compensation report.  This triggers a duty by the company to explain any response (or non response).  Following the receipt of one strike, companies must include on the ballot for the next meeting a "spill" motion.  To the extent 25% of the shareholders again vote against the compensation report and the spill motion passes, all directors except the managing director must stand for reelection.  

As ISS has reported, twelve Australian companies have received first strike votes.  These companies have a year to address shareholder concerns.  Otherwise, they may face a recall election for the members of their board. 

Britain has not yet acted but has suggested that it may adopt a say on pay provision that makes shareholder approval mandatory. Reform proposals in Britain have recognized the closed nature of the compensation approval process.  The proposed reforms, therefore, include employee representation on the remuneration committee.  As the High Pay Commission explained: 

• The High Pay Commission has found remuneration committees to be a closed shop, made up largely of current and recently retired executives. This model has failed, leading to spiralling pay. We believe that greater engagement with employees may help restrain executive pay and help mitigate negative impacts on morale as well as encourage a greater engagement with the workforce. We therefore call for employees to be represented on remuneration committees as a first step to better engagement and accountability. 

In addition, the High Pay Commission recommended the strengthening of the shareholder vote on compensation.  Rather than provide shareholders with a veto over compensation already determined, the Commission indicated that shareholders should have the right to help shape compensation in the future.  As the Report recommended: 

• Shareholders should cast forward-looking advisory votes on remuneration reports  The High Pay Commission has considered recommending making shareholders’ advisory votes on remuneration reports binding, but it was felt that a preferred option at this stage would be to make the vote forward looking. We therefore recommend that shareholder votes on remuneration are cast on remuneration arrangements for three years following the date of the vote and that these arrangements include future salary increases, bonus packages and all hidden benefits, giving shareholders a genuine say in the remuneration of executives.

The government has indicated that it will make specific proposals next month.  They may include eliminating the advisory portion of the vote, allowing shareholders to veto compensation packages.

Whatever one thinks of these reforms, they have one thing in common.  They are what occurs when "say on pay" ultimately fails to adequately address concerns about executive compensation.  To the extent that say on pay likewise does not work in the US, similar pressure will build.

Primary materials from some the "say on pay" derivative suits can be found at the DU Corporate Governance web site.

The ABA has just published its list of 100 law blogs, a list that includes the Race to the Bottom.  Please register and vote for the RTTB.

The Implications of Say on Pay: Relations with Shareholders (Part 2)

One of the promises of say on pay has been the hope that it will encourage greater dialogue between companies and shareholders. To some degree, this looks like it occurred. 

As the ISS Study noted, a number of companies sought to head off controversy by altering their compensation practices or issuing supplementary proxy materials.  As the Study noted:

• Notably, dozens of companies released supplemental proxy materials to address investor concerns or made late changes to their pay practices to win shareholder support, in most cases, after engaging with large shareholders.  For example, subsequent to tis proxy filing, General Electric filed additional proxy materials disclosing that, as a result of discussion with certain shareholders, the company agreed to attach performance conditions to stock options awarded to CEO Jeffrey Immelt.

Discussion will get additional impetus following the disclosure by public companies about the impact of the shareholder vote on compensation.  The SEC has required companies to disclose consideration of the advisory vote "in determining compensation policies and decisions".  Specifically, Item 402(b) requires disclosure in the Compensation Discussion and Analysis of:

• Whether and, if so, how the registrant has considered the results of the most recent shareholder advisory vote on executive compensation required by section 14A of the Exchange Act (15 U.S.C. 78n-1) or Rule 204.14a-20 of this chapter in determining compensation policies and decisions and, if so, how that consideration has affected the registrant's executive compensation decisions and policies. 

This provision was put in place specifically to spur discussion.  Commentators argued that the information "would provide shareholders a better understanding of how the board of directors considered the results of shareholder advisory votes and encourage a dialogue between issuers and shareholders on the topic of compensation."  As the Commission explained in the adopting release:

• This modification reflects that, in making voting and investment decisions, shareholders will benefit from understanding what consideration the issuer has given to the most recent say-on- pay vote.  Limiting the mandatory topic to the most recent shareholder vote should also focus the disclosure so there should not be lengthy boilerplate discussions of all previous votes.  Although we have added issuer consideration of the most recent say-on-pay vote to the mandatory topics, we believe that, consistent with the principles-based nature of CD&A, issuers should address their consideration of the results of earlier say-on-pay votes to the extent such consideration is material to the compensation policies and decisions discussed.

Thus, while the vote on executive compensation is advisory, shareholders presumably expect the company to take the advice into consideration.  During the proxy cycle beginning this winter, shareholders will learn what impact the advice had on compensation policies.

One interesting consequence of say on pay noted by the ISS Study had been the impact shareholder opposition to directors on the compensation committee.  Until say on pay, shareholders had no meaningful way of protesting compensation except through a no vote on directors on the committee.  With the advent of say on pay, shareholders can now express concern over compensation without using their vote on directors as a proxy.  As the ISS observed:  "The number of directors at Russell 3000 firms that failed to garner majority support fell by nearly half as say on pay votes presented shareholders with an alternative to votes against compensation committee members."

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The Implications of Say on Pay (Part 1)

We have had one proxy cycle with public companies having to provide shareholders with an advisory vote on the company's executive compensation. So what were the results?  ISS conducted a study of the vote at 4290 public companies, including 2200 companies in the Russell 3000. 

The ISS identified 38 companies that did not receive majority support, including eight companies in the S&P 500.  These companies included: 

Hewlett-Packard Company (48.25)
Freeport-McMoRan Copper & Gold Inc. (45.46)
Jacobs Engineering Group Inc. (44.82)
Masco Corporation (44.61)
Nabors Industries Ltd. (42.5)
Janus Capital Group Inc. (40.12)
Constellation Energy Group, Inc. (38.04)
Stanley Black & Decker, Inc. (37.95)

Cincinnati Bell, according to the ISS Study, received only 29.8%, the lowest percentage of any public company.  In addition to these companies, a study conducted by GMI noted a significant number of "maybe pay" companies.  As the study revealed: 

• In addition to the 38 failures, another 157 companies in the Russell 3000 failed to garner at least 70% shareholder support for compensation plans. Forty-two of these ‘maybe pay’ companies are in the S&P 500.

The study includes the list of these companies and their percentage.

The ISS identified as the "primary driver" for failed votes concern over the relationship between pay and performance.  In addition to excessive pay, shareholders apparently objected to specific pay practices such as "tax gross-ups" and "discretionary bonuses."  They were also concerned with "inappropriate benchmarking" and the "failure to address significant opposition to compensation committee members in the past." 

So what are the consequences of these votes?  We will examine several.  There is the impact of the vote on relations with shareholders.  There is the impact on fiduciary obligations.  And there is the development of second generation say on pay statutes in Australia and the UK, countries that have had more experience than in the United States.  While this is not currently on the table in the US, it may portend a future direction for regulation in the US. 

The ABA has just published its list of 100 law blogs, a list that includes the Race to the Bottom.  Please register and vote for the RTTB.

Business Roundtable v. SEC: The Battle for Proxy Access Continues

In Business Roundtable v. SEC, No. 10-1305 (D.C. Cir. 2011), the United States Court of Appeals for the District of Columbia vacated rule 14a-11 under the Administrative Procedure Act (“APA”), 5 U.S.C. §551.  The court found that the Securities Exchange Commission (“SEC”) acted in an arbitrary and capricious manner by failing to fully assess the rule’s economic effect.

Rule 14a-11 required companies to include in their proxy statement and card certain nominees for the board submitted by shareholders.   To qualify, the proposing shareholder, or group of shareholders, must have owned at least 3% of the company’s voting rights for at least 3 years and the shareholder(s) must have held that power through the company’s annual meeting.

Business Roundtable, a group of publically traded companies, brought suit against the SEC to vacate rule 14a-11.  The plaintiff alleged that the SEC did not consider the financial burdens the rule would place on publically traded companies.  The SEC claimed it created the rule to improve the board and thus shareholder value, which it found outweighed the potential costs associated with the rule.

The DC Circuit agreed with Business Roundtable and found that SEC Rule 14a-11 was arbitrary and capricious.  It found the SEC’s analysis of the economic consequences of the rule was deficient.  Specifically, the court found that “the Commission inconsistently and opportunistically framed the costs and benefits of the rule…” and “failed to respond to substantial problems raised by commenters.”  The court held that the SEC predicted benefits that it could not quantify and predicted costs that were too low given the evidence submitted by commentators.

The court also addressed concerns raised by petitioners relating to special investment companies where the rule could be utilized by subsections of shareholders for their benefit, but to the detriment of others.  It stated that the SEC did not sufficiently analyze these potential costs.

Because the court found the SEC acted arbitrarily and capriciously in promulgating SEC Rule 14a-11, it vacated the rule.

This case has been discussed in previous posts beginning here.

The primary materials for this case may be found on the DU Corporate Governance website.

Accounting Firms and Tenure

There is radical talk in the EU that auditors for public companies will be subjected to mandatory rotation.   That is, mandatory rotation of the firm, not just the lead partner.  

So what sort of tenure for auditors is typical in the United States?  Hat tip to Lynn Turner for this information.  It turns out that the average tenure for the 500 largest companies is 21 years.  Moreover, 59% of the Fortune 1000 have had the same auditor for more than 10 years, 37% for more than 20.  Mandatory rotation were it to be applied in the US would, therefore, result in a significant change.

With all of this concern over accounting firm tenure, we note that the staff of the SEC has taken the position under Rule 14a-8 that proposals can be excluded if they seek shareholder approval of the outside auditors.  While most companies voluntarily submit this matter to shareholders, some do not and when shareholders have tried to overturn the omission, the staff has intervened and allowed the shareholder proposals to be excluded.  That issue is developed in Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors

Union Leverage and Access: An Assertion in Search of Proof (part 3)

So what has happened since 1994?

As far as we can tell, there have been no proposals submitted by unions, union pension plans, or their supporters under Rule 14a-8(i)(4).  It has not, however, been from a lack of trying.  Companies occasionally seek to omit proposals submitted by shareholders that coincide with ongoing disputes or negotiations with unions.  The companies have not, however, been able, for the most part, to successfully tie the proposal to the negotiations.

The most recent effort by a company to exclude a proposal on this basis was in Penn National Gaming, Inc. (March 30, 2011).  There, the company asserted that a majority vote proposal was part of a plan designed to induce the company to implement a "card check" policy sought by the union.  As the company's letter described:

• the Proposal represents the latest attempt by the Proponent to pressure the Company into agreeing to the Proponent's card check demand. Although the Proposal purports to focus on the Company's corporate governance in a general manner, the Proponent's recent conduct, almost immaterial number of shares owned, and long history of attacks on the Company demonstrate that the Proposal is designed solely for the benefit of the Proponent and is part and parcel to its long-standing and well-documented campaign against the Company. Collectively, these actions demonstrate that the Proponent's campaign represents a national attack against the Company with the purpose of gaining leverage in its efforts  to institute the card check arrangement with the Company.

The staff, however, declined to permit the the exclusion of the proposal.  In its typically cryptic manner, the staff concluded:

• We are unable to concur in your view that Penn National may exclude the proposal under rule 14a-8(i)(4). We are unable to conclude that the proposal relates to the redress of a personal claim or grievance against the company. We also are unable to conclude that the proposal is designed to result in a benefit to the proponent, or to further a personal interest, which is not shared by the other shareholders at large. Accordingly, we do not believe that Penn National may omit the proposal from its proxy materials in reliance upon rule 14a-8(i)(4)

In short, companies have rarely succeeded in showing, to the satisfaction of the SEC staff, that shareholder proposals submitted by unions (or their pension plans) were motivated by something other than the general interests of shareholders.

Union Leverage and Access: An Assertion in Search of Proof (part 2)

As we noted, the court in Business Roundtable cited no support for the contention that unions would use access as leverage in wage negotiations.

Since access doesn't really exist (only three companies have an access bylaw and shareholders have apparently never used any of them), any possibility that access will be used as leverage is, by definition, speculative.  But to the extent union pension plans are inclined to use governance as leverage in wage or other types of negotiations with employers, there are other places where evidence of this practice ought to exist.  Shareholder proposals under Rule 14a-8 is one of them. 

Union pension plans make extensive use of the rule, submitting something like 20% of all shareholder proposals.  Rule 14a-8 allows for the exclusion of proposals that arise from a "personal claim or grievance against the company . . . which is not shared by the other shareholders at large".  Rule 14a-8(i)(4), 17 C.F.R. 240.14a-8(i)(4).  To the extent, therefore, union pension plans tried to use shareholder proposals as leverage, companies would be able to publicly disclose the effort and have a basis for excluding an otherwise valid shareholder proposal from its proxy statement. 

This is particularly true since the SEC has indicated that it is willing to exclude shareholder proposals on this basis.  Back in 1994, the staff agreed to allow Dow Jones to exclude a shareholder proposal submitted during the pendency of collective bargaining negotiations.  Dow Jones & Company, Inc., (avail. Jan. 24, 1994).  The proposal, submitted not by the union but by two persons with connection to the union, called on the board to limit the increase in CEO compensation to not more than  "the average percentage increase in compensation paid to the non-officer employees of Dow Jones over the same period." The company sought to exclude the proposal and submitted evidence seeking to connect the union to the proposal.    

The staff agreed to allow for exclusion of the proposal under subsection (i)(4).  In doing so, the staff indicated agreement with the use of the subsection to exclude proposals that appeared designed to advance employee rather than shareholder goals.  The proposal did not come from a pension plan so there were no conflicting fiduciary duties.  Presumably any threat by a union to use shareholder proposals as leverage in wage or other negotiations would qualify for exclusion under subsection (i)(4).

The use of shareholder proposals as leverage by unions ought, therefore, to appear in the record in the form of proposals excluded under subsection (i)(4).  We will see if they do in the next post. 

Union Leverage and Access: An Assertion in Search of Proof (Part 1)

One of the grounds used by the DC Circuit to strike down Rule 14a-11 (the shareholder access rule) was the failure of the SEC to assess the costs associated with the threatened use of access by unions in connection with wage negotiations. 

The "cost" was speculative.  Moreover, the court cited no actual evidence that this sort of behavior had actually occurred.  Other than noting that the concern had been raised during the comment process, the court could only cite one inapposite quote from a law review article as a authority. 

Here is what the court actually said in toto, minus only the URLs for some of the material cited.  

• Notwithstanding the ownership and holding requirements, there is good reason to believe institutional investors with special interests will be able to use the rule and, as more than one commenter noted, "public and union pension funds" are the institutional investors "most likely to make use of proxy access." Letter from Jonathan D. Urick, Analyst, Council of Institutional Investors, to SEC 2 (January 14, 2010). Nonetheless, the Commission failed to respond to comments arguing that investors with a special interest, such as unions and state and local governments whose interests in jobs may well be greater than their interest in share value, can be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value, and will likely cause companies to incur costs even when their nominee is unlikely to be elected. See, e.g., Detailed Comments of Business Roundtable on the Proposed Election Contest Rules and the Proposed Amendment to the Shareholder Proposal Rules 102 (August 17, 2009), ("'state governments and labor unions ... often appear to be driven by concerns other than a desire to increase the economic performance of the companies in which they invest'" (quoting Leo E. Strine, Jr., Toward a True Corporate Republic: A Traditionalist Response to Bebchuk's Solution for Improving Corporate America, 119 Harv. L. Rev. 1759, 1765 (2006)).  By ducking serious evaluation of the costs that could be imposed upon companies from use of the rule by shareholders representing special interests, particularly union and government pension funds, we think the Commission acted arbitrarily.

In addition to the unsupported and speculative nature of the asserted costs, the court essentially assumed that unions would use access to benefit employees in wage negotiations and in so doing presumably violate their fiduciary obligations to plan beneficiaries. 

The absence of proof in the opinion that this dynamic is present is particularly striking given the logistical difficulties in using access as a threat.  In general, unions do not own 3% of most public companies.  As a result, they could not unilaterally threaten to submit access candidates if the company failed to meet their wage demands.  At most, they could threaten to seek support from other shareholders for an access challenge.  Given the uncertainty of any such effort, the likelihood that most shareholders would not favor an access challenge designed to influence wage negotiations, and the ability of management to publicize the real reason for the effort, it would seem to be mostly an empty threat.  

We will continue with this thread in the next two posts. 

State Law and the Myth of Private Ordering: Mandating Staggered Boards (Part 3)

All of this brings us to the latest state to mandate staggered boards, the scion of electoral politics, Iowa, an issue recently discussed by Ted Allen at the ISS Governance Blog. 

The Iowa Legislature recently passed a law mandating staggered boards for certain public companies.  The terms of the provision suggest that it was designed to benefit a specific company or companies, currently incorporated in Iowa.  The requirement applies only to public companies on the effective date (so not companies that become public afterwards) and is temporary (it expires in 2014).

The provision extends to public companies which is defined as any exchange traded company or one with "more than 2000 shareholders."  In counting the number of shareholders, the statute specifically references record rather than beneficial owners.  The provision does not, therefore, coincide with the definition of public company under the securities laws which requires only 500 shareholders of record.  See Section 12(g), 15 USC 78l(g).  As a result, it does not apply to smaller public companies unless they are also listed on an exchange.  

The provision also provides that in electing each class, the "shareholders’ meeting shall be conducted not less than eleven months following the last annual shareholders’ meeting conducted before the public corporation became subject to this subsection."  This is likely designed to (and in any event does) avoid the problem in Airgas where the insurgents took the position that an election for classes did not have to wait a temporal year of approximately 12 months but could occur in the next calendar year, even if the meetings were only a few months apart.  The management friendly decision by Delaware Supreme Court predictably provided that the reference to year in the staggered board provision referred to temporal rather than calendar years.  The Iowa provision makes the matter absolutely clear by adopting the Delaware approach.   

To ensure implementation of a staggered board without the need for shareholder approval (something that might not be given), the statute significantly changes the traditional balance of rights between management and shareholders.  The statute mandates that the staggered board provision be enshrined in the articles. Traditionally, amendments could only be adopted with shareholder approval (blank check stock provisions are a bit of an exception but at least the authority to adopt new classes of stock must be in the articles). 

The provision, however, gives the board unilateral authority to unilaterally amend the articles.  As the statute states:  "The board of directors of a public corporation subject to this subsection shall adopt an amendment to its articles of incorporation".  To make the import of this provision absolutely clear, the statute provides:  "Any amendment to the articles of incorporation as provided in subsection 1 of this section shall be made without shareholder approval."

The provision also deprives shareholders of the traditional authority to change the size of the board or to fill a vacancy.  As the statute notes:  "For a public corporation subject to section 490.806A, subsection 1, a vacancy on the board of directors, including but not limited to a vacancy resulting from an increase in the number of directors, shall be filled solely by the affirmative vote of a majority of the remaining directors, even though less than a quorum of the board.". 

The provision is likely to have modest impact.  According to ISS, Iowa has 13 public companies that fall with the parameters of the new provision.  In addition, ISS had this to say:

• It appears that this legislation was passed to help Casey's General Stores, an Iowa-incorporated firm that faced an unsuccessful proxy fight in 2010. Casey's, an S&P 600 small-cap firm, did not opt out of the law and since has adopted a staggered board structure. The company has strong state legislative connections. One Casey board member, Jeffrey M. Lamberti, is an attorney who served in the Iowa Legislature from 1995 to 2006, which included three years as president of the Iowa Senate. His father is Donald Lamberti, the company's founder.

The provision was opposed by some in Iowa.  The Iowa State Bar Association's Business Law Section Council objected.  Amusingly, the memorandum gave as one reason for opposition that "the bill sends a signal of management protectionism that may discourage other public companies from locating or incorporating" in Iowa.  In fact, the reverse is true.  Reincorporations can only be initiated by management.  Thus, management is only likely to go to states that are management friendly.  The Iowa provision is certainly that. 

The Iowa provision illustrates the practical weakness in the use of private ordering.  What ever the theoretical benefits, shareholders are for the most part disadvantaged under any system of private ordering in the governance context.  They cannot initiate amendments to the articles and incur significant limits on the subject matter that can be addressed in bylaws.

Despite these limits, shareholders sometimes succeed in pressuring management to reform its system of governance.  Yet when they succeed, states can intervene and cut off the avenue of influence.  With respect to staggered boards, that is what seems to be taking place.

State Law and the Myth of Private Ordering: Mandating Staggered Boards (Part 2)

Staggered boards show the weakness in the system of private ordering. 

Staggered boards typically appear in the articles or charter and divide the board into two, three or even four classes, with one class elected each year.  See N.Y. BUS. CORP. LAW § 704(a) (permitting staggered boards with four classes).  The effect of a staggered board is that shareholders cannot vote out a majority of directors in a single year.  This discourages takeovers and insulates poorly performing boards from removal.   Staggered boards are also negatively correlated with firm value.

Perhaps unsurprisingly, shareholders, as a general matter, do not like staggered boards.  This can be seen from voting patterns on provisions calling for the repeal of staggered boards.  As Ted Allen has noted on the ISS Corporate Governance Blog:

• When investors do have a chance to vote on this issue, they are overwhelmingly supportive of annual board elections for all directors. During the spring 2011 proxy season, shareholder-filed declassification proposals averaged 73.5 percent support, up more than 12 percentage points from 2010, and won majority support at 22 out of 23 large-cap firms, according to ISS data.

Yet in the so called universe of private ordering, shareholders have no actual authority to repeal staggered boards.  To the extent appearing in the articles, only directors may initiate an amendment.

Shareholders are, therefore, left with pressure and persuasion as a means of eliminating staggered boards.  In applying pressure, shareholders make considerable use of the bully pulpit provided by Rule 14a-8.  The rule allows shareholders to make precatory proposals calling for the repeal and include them in the company's proxy statement.  The mechanism provides management with some sense of the aggregate support among shareholders for repeal.  When these proposals pass overwhelmingly, which they often do, management is left trying to justify something that is unsupported by most shareholders. 

The result has been a decline in the use of staggered boards among larger public companies.  See Gregory T. Carrott, The Case For and Against Staggered Boards, Directorship, Sept. 22, 2009 (“So, perhaps not surprisingly, under pressure from institutional investors, there has been a tremendous decrease in the percentage of companies with staggered boards. Among the Standard & Poor’s 500, for example, only 34 percent have a classified board. According to RiskMetrics, 79 publicly traded companies themselves placed declassification resolutions on their ballots in 2008. There were 54 company-sponsored proposals in 2007 and 72 in 2006.”).

Yet two developments have made shareholder pressure increasingly unlikely to succeed.  For one thing, the poison pill cases out of Delaware have raised the value of staggered boards to management.  Delaware courts in Selectica and Yucaipa affirmed poison pills that, when used in conjunction with staggered boards, frequently bar insurgents from entering into agreements with other shareholders on a common strategy or the sharing of expenses associated with a proxy contest.  As Airgas showed, a poison pill combined with a staggered board can make a proxy contest almost impossible to win.  Given this new found benefit, management will likely be less likely to accede to shareholder pressure and propose the necessary amendments that will result in repeal. 

The other development has been under state law.  States have begun to adopt statutes that require staggered boards.  By requiring staggered boards, proposals under Rule 14a-8 calling for repeal can be excluded from the proxy statement.  Thus, these mandatory staggered board provisions eliminate the bully pulpit.

We have done posts on one of these statutes, the one adopted in Oklahoma.  Iowa has become the latest to adopt a mandatory staggered board provision.  We will discuss the statute in the next post. 

State Law and the Myth of Private Ordering: Mandating Staggered Boards (Part 1)

There is a sort of myth that in the shareholder governance area, companies are better off with a system that relies on private ordering.  The idea is that governance requirements ought to eschew the one size fits all, categorical approach.  Instead, companies can pick and choose the most efficient set of governance requirements that fit their specific needs.

As a theoretical idea, private ordering has much to offer.  The theory, however, often fails when translated into practice.  Private ordering is often a synonym for a categorical rule that favors management. 

Thus, waiver of liability provisions are supposed to be an example of private ordering.  Companies can, in their articles, decide to waive liability by directors for breach of the duty of care.  Private ordering would suggest that some companies will opt for full waiver of liability, some for partial waiver and some for no waiver at all.  The choice will depend upon efficiency. 

In fact, nothing of the sort has happened.  Empirical evidence indicates that all large companies (Pepsi the inexplicable exception) waive liability to the fullest extent possible.  In other words, private ordering with respect to waiver of liability for breach of the duty of care is not private ordering at all.  It has resulted in a categorical rule in favor of waiver.  This is all discussed at length in Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom. 

The other side of the issue is that sometimes shareholders succeed in pressuring management to change its governance structure.  Under a private ordering system, this is how things ought to work.  But where private ordering seems to work, states at least sometimes step in and eliminate the possibility by imposing a categorical rule that favors management.  This is taking place in some states with respect to staggered boards.  Shareholders have pressured management of some companies into removing staggered boards.  The result is that three states have, by statute, mandated their use.  Iowa has become the third entrant into the market for categorical rules concerning staggered boards.  We will discuss this new statute in the next few posts. 

Shareholder Access and the Uneconomic Economic Analysis: Business Roundtable v. SEC (Part 11)

There is little question that the decision discourages rulemaking.  To the extent the SEC wants to adopt any rule in the governance area, it knows that at least some judges on the DC Circuit are prepared to stretch the law to find a basis to strike it down.

One way to try to address this concern is to employ an outside economic analysis.  In other words, the SEC can contract out the economic analysis.  Some have suggested that this is the appropriate solution.  As one set of commentators have observed:  "Better regulation, able to survive review by the D.C. Circuit Court, will likely require incorporating substantive and independent economic analysis into the development of every rule as standard operating procedure."

This is inconsistent with the legislative history to Section 3(f), adds considerable cost to the rulemaking process, and does not provide any guarantee that a court dissatisfied with the substance of the rule will uphold it.  

The tough standard used by the DC Circuit may ultimately prove harmful to the interests of public companies.  The DC Circuit struck down efforts by the SEC to impose governance requirements through the use of listing standards back in the 1990s (in a case brought by the Business Roundtable).  It was a short term victory for public companies but a long term loss.  Depriving the SEC of the authority to act meant that the problems could only be solved through congressional intervention.  SOX and Dodd-Frank are to a large degree a legacy of that decision.  Opposition to access has already resulted in one example of congressional intervention.  Section 971 of Dodd-Frank clarified that the Commission has very broad authority to adopt an access rule. 

The approach may also push the Commission to use a regulatory approach less prone to legal challenge.  The Commission could for example use its informal authority to impose similar requirements.  Thus, for example, the Commission could use the antifraud provisions to require companies to disclose information about shareholder nominees.  The Commission has brought these kind of claims before.  See The SEC, Corporate Governance, and Shareholder Access to the Board Room. 

To the extent companies are seeking proxies for their candidates, shareholders likely have a need to know that in fact there are other candidates that may be nominated at the meeting.  To the extent using this type of informal authority, there is no need to conduct an economic analysis of any kind. 

For more thoughts on the court's opinion in Business Roundtable, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC.  Primary materials on the case, including the relevant briefs, can be found at the DU Corporate Governance web site.

Shareholder Access and the Uneconomic Economic Analysis: Business Roundtable v. SEC (Part 10)

The analysis was also deemed arbitrary because the discussion of the frequency of access was “internally inconsistent.” 

As a benefit, the Commission listed the printing costs avoided through the use of access.  The savings would remove a “disincentive” to election contests.  In assessing these "benefits," according to the court, the Commission assumed “frequent use” of shareholder access.  At the same time, in assessing the costs, the Commission assumed “infrequent use,” thereby demonstrating an internally inconsistent approach. 

In fact, the Commission did not state that shareholders would use access on a "frequent" basis, thereby creating the inconsistency that the court concluded was present.  Here is what the Commission actually said in the adopting release about the benefits of the cost savings:

• We also recognize that the direct printing and mailing cost savings of $ 18,000, on their own, may not be viewed by some to be significant enough to drive the behavior of large shareholders of public companies. The comments that we received regarding the likely increase in the number of election contests resulting from the new rules, however, seem to undercut this view and suggest instead that shareholders' behavior may indeed be influenced by the rules. The extent to which election contests are predicted to increase as a result of shareholders nominating their own director candidates for inclusion in the company's proxy materials strongly indicates that the benefits of the new rules cannot be fairly characterized as a "mere $ 18,000 in estimated savings" -- a characterization that we believe obfuscates the significance of this benefit of our new rules.

In other words, the Commission at most stated that there could be some increase in the number of election contests as a result of shareholder access, a seemingly unassailable proposition. 

The court's characterization that access would be used frequently came from the fact that, in making the statement that removal of costs would increase the use of access, the Commission cited a letter written by a commentator.  The letter suggested frequent use of access and calculated a frequency.  Here is the footnote:

• n872 See, e.g., letters from Altman (stating that participants in its survey predicted that, on average, 15% of companies listed on U.S. exchanges could expect to face a shareholder director nomination submitted under Rule 14a-11 in 2011, based on the eligibility criteria of the Proposal); BRT (stating that the new rules "will increase the frequency of contested elections * * *"); Chamber of Commerce/CCMC (noting that if the new rules are adopted, "it is likely that proxy contests (in which the company is required to solicit proxies on behalf of shareholders) will increase greatly and may become customary.").

But the conclusions as to the frequency of access suggested by the commentators in the footnote were never adopted by the Commission.  Indeed, the SEC actually disagreed with the conclusions.  In precisely quantifying the number of access challenges, the SEC came up with a number substantially below what was suggested by the commentators.  Id.  (“For purposes of this analysis, we estimate that 45 companies other than registered investment companies will receive nominees from shareholders for inclusion in their proxy materials.  We further estimate that six registered investment companies will receive nominees from shareholders pursuant to Rule 14a-11 annually.”). The calculation was substantially less than what was described in the footnote. 

In other words, in 70 plus pages of economic analysis consisting of 40,000 words, the court found as proof of irrationality the citation to a single commentator in a footnote.  To view this as arbitrary, the court first had to assume that the SEC adopted the data in the footnote then had to assume that the SEC did so despite other determinations elsewhere in the release that directly contradicted the data in the footnote.  Neither of those assumptions were warranted.

For more thoughts on the court's opinion in Business Roundtable, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC.  Primary materials on the case, including the relevant briefs, can be found at the DU Corporate Governance web site.