Thank you to our guests Christopher Bruner (Washington & Lee), Brett McDonnell (Minnesota), Nell Minow (the Corporate Library), Eric Talley (U.C. Berkeley), and J.W. Verret (George Mason) for joining Lisa and Usha in offering insights on the SEC's new proxy access rules. You can access all the posts here.
There is lots to talk about with the new proxy access rule, but one thing I have been trying to sort out is how I feel about the impact of proxy access on issues of director independence. There is of course considerable debate about whether proxy access will improve corporate governance. In its final rule, after "considering the costs and benefits identified by commenters," the SEC had this to say about that debate. "[W]e believe that the totality of the evidence and economic theory supports the view that facilitating shareholders' ability to include their director nominees in a company's proxy materials has the potential of creating the benefit of improved board performance and enhanced shareholder value. . ." In this regard, the SEC also indicated that "new shareholder-nominated directors may be more inclined to exercise judgment independent of the company's incumbent directors and management."
To be sure, there is also considerable debate about whether shareholder-nominated directors can be viewed as independent. But then one must ask the familiar question, "independent from whom?" As the SEC suggest, such directors are likely to be "independent" from current management and directors. On the one hand, some proxy access opponents contend that this kind of "independence" could result in the election of disruptive board members who undermine good board governance. On the other hand, studies regarding structural bias suggest that the process of being part of a board may mean that even directors with no prior connection to an incumbent board and management may develop ties that make them biased towards their fellow board members, which is no less than one would expect from people who work closely together. Nevertheless, given the current state of a board/management-dominated election process, it is hard to argue with the premise that proxy access may result in the election of directors more independent from incumbent directors and management than the existing process.
But then, proxy access opponents are not concerned about new directors' independence from management, but rather their independence from the shareholders who nominate them. With regard to this issue, the SEC did seek comment on whether shareholder-nominated candidates should be required to be independent from their nominating shareholder or group. While many commenters supported some limitation on the affiliation between the two, the SEC concluded that such limitations were "not appropriate or necessary." In its view, disclosure requirements and state fiduciary duty rules should help limit concerns that shareholder-nominated directors will advance shareholder-specific issues to the detriment of the broader shareholder class or otherwise feel beholden to the shareholders who nominate them. Hmmmm...
On the one hand, it may be possible that the fact that candidates must disclose their relationships with their nominating group will prove sufficient to weed-out candidates likely to advance special interests, particularly because corporations will have the opportunity to highlight such candidate's propensity in their proxy materials. Although there is also reason to be skeptical about this point.
And what about state fiduciary duty law? In several places the SEC noted that shareholder-nominated directors, once elected, would be subject to the same fiduciary duty as other directors. Perhaps this is enough. However, one can certainly be skeptical about the ability of fiduciary duty law to shape directors' behavior. Indeed, as we are all aware, that law generally contains a very high threshold for holding directors liable for breaching their fiduciary duty outside of the conflict of interest realm. Then too, while economic ties may raise different concerns, it is very hard for any social ties of the kind that may exist between shareholders and their nominees to be viewed as compromising a director's independence. From this perspective, it is not clear how far fiduciary duty law will get us.
Of course, in many ways, the concern regarding the influence of shareholders over their director-nominees reflects a recognition that nominees may feel beholden to those who nominate them--whether other shareholders or management. Then perhaps the question becomes, which type of potential beholdenness poses the greatest risk for good corporate governance?
I have a paper cooking about post-crisis corporate governance reform that makes a pretty simple point.
1. The corporate governance reformist view of the crisis is: managers ran amok, enriching themselves by sacrificing their companies' long-term health--and with it, the well-being of the economy--in order to cash in on flawed compensation models.
2. Solution: reform compensation schemes and give shareholders more say...on pay, on golden parachutes, on director nominations.
3. Result: accountability and less of that pernicious short-termism that got us into this mess in the first place.
4. The fly in step 2's shareholder-empowerment ointment is that the actual shareholders of public companies are overwhelmingly short-term players. As I blogged last year, Vice-Chancellor Strine has aptly observed:
Most Americans invest with a rational time horizon consistent with sound corporate planning. They invest with the hope of putting a child through college or providing for themselves in retirement. But individual Americans don’t wield control over who sits on the boards of public companies. The financial intermediaries who invest their capital do.
5. Those financial intermediaries--hedge funds and mutual funds--turn over their portfolios at a dizzying clip, buying and selling stakes in companies willy-nilly. Even pension fund managers feel the pressure to have their portfolios perform well each year. And forget about the flash traders, which according to the popular press accounts for about 60% of exchange trading volume these days. Holding shares for over a year is so 20th century.
The new proxy access rule neatly addresses the short-termist shareholder problem by imposing a 3-year holding period and a 3% ownership hurdle before you get to nominate a director. Does that solve the short-termist problem? Yeah, but...
My intuition is that the 3%/3 year holders will mostly be 1) company founders or their descendants, and 2) funds like Calpers. Now, empowering these shareholders might be a good thing. The financial intermediaries certainly lack the motivation to invest any resources about director nominations, and the 3%/3 yearers have demonstrated a vanishingly rare commitment to a particular public company. The SEC's own data, cited by Lisa in her helpful post, show that only a minority of firms have even 1 of these shareholders. But if we have reason to think that the interests of the 3%/3 yearers are too idiosyncratic--they want to push a pro-labor agenda or preserve the status quo for the sake of the family name--(i.e. are, in Eric Talley's memorable words, "agenda-driven tinfoil-hat-wearing zealots") then shareholder empowerment is distinctly not a good thing.
Like Eric, in the end I think the sensible response is: "Let's see how this thing plays out." Fun stuff.
I am privileged to be back at the Conglomerate, a distinguished group who graciously let a green academic like myself visit when I first started teaching two years ago (which helped me get a full time gig blogging over at Truth on the Market). I appreciate the opportunity to talk about one of my favorite topics, shareholder voting. The debates over proxy access in the literature have been a fascinating exercise in scholarly engagement with the policy world, particularly the epic clash of the titans between Professor Bainbridge and Professor Bebchuk, but at long last the debates over whether we should give shareholders access to the proxy have come to a close with the SEC's new proxy access rule. So, now what? As it turns out, I have a few ideas.
I have joined the forum today with one purpose in mind: to hawk my new paper, Defending Against Shareholder Proxy Access: Delaware's Future Reviewing Company Defenses in the Era of Dodd-Frank, currently in submission. It hasn't yet found a law review home, but the expedite process is heating up.
In the paper I present 16 defenses companies might consider implementing to thwart shareholders from using their new federal proxy access right. I first describe the defenses I've invented and how they might offer strategic benefit. I then consider how they will fare under the scrutiny of the Blasius line of cases in Delaware protecting the shareholder franchise. (For those non-Delaware companies looking to defend against proxy access, many of the defenses can still apply. But if not, then I recommend...re-incorporating to Delaware).
The more important defenses I present are entirely legal under Delaware law and can be implemented immediately. Indeed, this summer I have been assisting a number of Fortune 50 company GCs in designing bylaw amendments to that end. A few of my defenses would, however, require amendment to the DGCL. Part of my thesis centers on my prediction that the Delaware Courts will recognize a distinction between defenses intended to thwart exercise of the shareholder franchise and defenses intended to thwart exercise of a shareholder's federal nomination right.
I also consider whether federal law pre-empts or prohibits my defenses, and I conclude that they are not pre-empted. To give readers a taste of my work, I'll move to a brief summary of what I believe are the best four defenses, both in terms of their strategic value and in terms of their ability to withstand scrutiny under Blasius and Schnell.
Though all of the Conglomerate's guests offer well considered insights, I find my take on this issue most in agreement with Professor Brett McDonnell's critique of the SEC's rule. Professor McDonnell urges that companies should be able to opt-out of the SEC's rule. In a fascinating back-and-forth in The Business Lawyer recently, Professor Bebchuk and Scott Hirst expressed agreement with a fairly constricted opt-out rule, and Professor Grundfest countered in favor of an opt-in rule. What I hope my paper offers is an effective opt-out, a clean slate onto which companies and their shareholders can then draw a new agreement by which shareholders can, if they would like, nominate candidates. This could be facilitated by exemptions in the Board defenses for nominations outside of the SEC mandated process.
The Corporate Federalism debate, so central to corporate law theory, is now getting on in years. President Kennedy's SEC Chairman, William Cary, urged that the SEC should pre-empt Delaware Corporate Law entirely to stop this "pygmy among the 50 states" that "denigrates national policy." Despite countless SEC Commissioners and Chairmen who shared his view, and have tried to pre-empt state corporation law as much as they could, Delaware continues to not only survive...but truly thrive and grow as a source of corporation law.
This result is a function of the vibrancy of Delaware's rule-making approach. The Delaware philosophy is largely one oriented under freedom-of-contract principles. (Though the Delaware General Corporation Law is certainly more rigid than the LLP or LLC code, when compared to the federal approach to company regulation it is clearly the winner in terms of facilitating private ordering.) The federal approach, on the other hand, is by its very nature constrictive. It seeks to affirmatively control market participants rather than enable them. As such, I think such a constrictive federal code will always find it difficult to fully pre-empt Delaware precisely because Delaware's abiding approach to lawmaking is more nimble and responsive to the preferences of market participants.
Viewed through the lens of editorial pages, Wednesday’s rule change was a watershed event. Shareholder activists have been calling for beefed up proxy access rules since at least the early 1990s. Critics have spent at least as much time (and probably more money) resisting the reform. It is therefore unremarkable that the SEC’s action was also highly politicized. Indeed, if it were itself a publicly traded company, the SEC’s stock price would not have changed much on the partisan, 3-2 party-line vote by the Commission. While such ideologically charged votes are historically rare, they have now become so commonplace at the SEC to border on the banal.
But beyond political remonstration, what does this actually mean for investors? That’s the exciting $60-trillion dollar question. My candid answer is a little less titillating: Given the stock of empirical knowledge we have today, I submit that the only responsible answer to this question is a cautious combination of “it depends,” or “we don’t fully know.” And that’s why I think – a bit ironically – that proxy access may have been the right move for the SEC to take.
The polar endpoints of the debate are well trodden terrain. One can very credibly argue (and many have) that proxy access portends a significant and unprecedented sea change in corporate governance -- for better or worse. After all, under the new rule dissident shareholders are no longer required to underwrite the administrative costs of proxy challenges personally, with only the speculative hope of being compensated should they win. Advocates contend that this enhanced credible threat of rival slates will effectuate greater accountability among board members, who have historically been able to use the governance process as a protective bunker, insulating them from any significant shareholder oversight and criticism. Critics contend that the new rule’s ownership thresholds are sufficiently low to invite commandeering opportunism by self-important shareholders whose interests diverge from the (putatively) most responsible goal of corporations: maximizing long term shareholder value. Moreover, some critics contend, the rule change may cause ordinary shareholders to be confused by a dizzying array of candidate choices, unable to discern sensible candidates from agenda-driven, tinfoil-hat-wearing zealots.
An equally plausible (though admittedly less scintillating) prediction is that the sound and fury attending Wednesday’s reform will ultimately prove to be mere fingerling potatoes in a stew combining the myriad forces at play in corporate governance. Shareholders tend, by and large, to defer to incumbent management unless they have good reason to jump ship (their confidence in management is what caused many of them to buy in the first place, after all). It is unlikely that such loyalists will become snowed or confused simply by having additional (but unproven) choices. In fact, public shareholders have long had to screen and evaluate qualifying proposals (including bylaw amendments) made by other shareholders, which under federal law must be included in proxy materials at company expense. Moreover, even prior to this rule change, dissident shareholders could wage a self-financed proxy contest, utilizing their inspection rights to locate other shareholders and disseminate to them a rival proxy solicitation for alternative candidates. While the new rule certainly makes some elements of a proxy challenge less expensive for such dissident shareholders (in the form of reduced postage and some administrative costs), it won’t save them many of the significant costs that attend a proxy challenge – they will still, for example, frequently want to influence other shareholders about their competing slate, and may still find it most effective to make their case(s) personally. In addition, many states (including Delaware, the incorporation home of most public corporations) had already authorized companies to implement a version of the rule in their own bylaws, and numerous companies were already on their way to a similar governance structure.
Finally, one must realize that the proxy access reform debate has not occurred in a complete statutory, regulatory and jurisprudential vacuum. Other concurrent developments in corporate and securities law may have effects that may tend to counteract (or at least inject considerable noise to) the proxy access debate. For example, Delaware’s Chancery Court has recently approved the maintenance of a dilutive shareholder rights plan triggered at an ownership threshold of 4.99% (see Selecteca v. Versata, a threshold far lower than conventional poison pills have historically prescribed (usually in the 15-20% range). If the Delaware Supreme Court affirms this holding – and many believe it will – the effect will be to remove a proverbial arrow from the quiver of dissident shareholders, just as Rule 14a-11 inserts another one. Similarly, Delaware courts have recently manifested a renewed willingness to whittle away at governance-related fiduciary duties (sometimes known as Blasius duties) that are a favorite and oft-utilized weapon of hedge funds and pension funds alike (see, e.g., the recent Barnes and Noble decision from Vice Chancellor Strine – Yucaipa v. Riggio). In short, proxy access is but a single eddy in a swirling endogenous sea of other corporate governance developments, many of which may tend to complicate or neutralize its effects.
Ultimately, of course, this debate will likely boil down to an empirical question. And even as I write this, I conjecture, hundreds of financial economists and legal scholars are designing empirical studies of this rule change, looking for good control and treatment groups, identifying “clean” events, and cooking up game-theoretic corporate governance models (all the while remaining monastically quiet at the faculty lunch table, convinced – optimistically – that they are the only ones hot on the empirical trail). The better of these studies will likely be read by SEC staff economists and discussed (hopefully in an adult fashion) by the Commission. Perhaps some of them will even induce the Commission to adjust the rule, create extensions and/or carve outs, or maybe even rescind it in years hence.
But no matter how the ongoing policy skirmish shakes down, the legions of social scientists who will soon sweep into the debate are likely to bestow a subtle benefit on our future selves – one that is worth our deliberative consideration now: the benefit of empirical knowledge. Republican SEC appointee Kathleen Casey strongly criticized the new rule change, arguing that "the policy objectives underlying the rule are unsupported by serious analytical rigor." Casey, along with many critics of proxy access, appears to believe that the burden of proof about proxy access must rest squarely on the shoulders of advocates before any regulatory change is implemented. This claim is in many ways right – but perhaps only half right, or only some of the time. In at least some regulatory areas, the stock of empirical data for or against a proposed intervention is so impoverished or underdeveloped that it would be difficult to reject virtually any empirical hypothesis about outcomes; and here the burden of proof becomes insurmountable. Proxy access may well be one of those areas. Yet in such arenas, regulators are still charged with the unenviable task of making policy in an environment of sparse data, underdeveloped models, immense public scrutiny, and a resulting miasma of perfervid (and even quasi-religious) advocacy. Some rule changes – and particularly non-voluntary rule changes such as the new Rule 14a-11 – have the potential merit of creating natural experiments that add to the stock of information for future researchers, policy makers, regulators and investors. That dynamic value may justify their adoption in close cases, even if one’s knee-jerk judgment – based exclusively on currently available static information – would tilt ambivalently towards preserving the status quo. At the very least, if we’re genuinely interested in maximizing “long term shareholder value” (a topic that may be ripe for another debate, another time), the benefit of modest regulatory experimentation deserves a seat at the prescriptive table.
Here is another contribution to our forum on the SEC's new proxy access rules, this time from Christopher Bruner (Washington & Lee University School of Law). Professor Bruner writes the following:
Many thanks to Erik for organizing this forum, and for the invitation to share some initial reactions to the SEC’s new proxy access rule.
By now most everyone will be broadly aware of the general contours of the new rule (summarized by Lisa here). Rule 14a-11 will, under certain circumstances, permit shareholders or groups holding three percent voting power for three years to include in the company’s proxy their own nominees for up to 25 percent of the board (or a nominee for one seat, whichever is greater). At the same time the SEC amended Rule 14a-8(i)(8) in order to facilitate shareholder proposals relating to nomination procedures. Critically, the new proxy access framework is effectively mandatory, permitting states or companies to opt out only by literally prohibiting shareholder nominations.
In this post I’ll focus my comments on aspects of the purported rationale set out in the SEC’s adopting release that I find particularly noteworthy – and singularly unpersuasive. First, proxy access is presented as a response to corporate governance problems precipitating the financial crisis. Second, the specifics of Rule 14a-11 are styled as fully compatible with – and in fact facilitating – exercise of election-related shareholder rights under state law.
In its overview of the amendments (the opening paragraph, in fact), the Commission notes that when it proposed proxy access last year, it “recognized at that time that the financial crisis … heightened the serious concerns of many shareholders about the accountability and responsiveness of some companies and boards of directors to shareholder interests,” raising “questions about whether boards … were appropriately focused on shareholder interests, and whether boards need to be more accountable for their decisions regarding issues such as compensation structures and risk management” (at 7). Proxy access, it is suggested, “will significantly enhance the confidence of shareholders who link the recent financial crisis to a lack of responsiveness of some boards to shareholder interests” (p. 10).
Offering up proxy access and other forms of shareholder empowerment as a response to corporate governance problems precipitating the financial crisis is absurd. To the extent that excessive risk-taking led to the crisis, reforms like proxy access – aiming to empower the corporate constituency whose incentives are most skewed toward greater risk – simply don’t add up. As I discuss in a recent paper examining U.S. and U.K. corporate governance crisis responses, the fact that the far greater governance power of U.K. shareholders appears to have done little to mitigate the (very similar) crisis over there ought to give pause to those suggesting that augmenting shareholder powers will prevent future crises over here. Moreover, even if shareholder empowerment made sense in financial firms, it remains unclear why this would justify altering the balance of power between boards and shareholders across the universe of public companies. Perhaps recognizing the weakness of the crisis rationale, the SEC places it in the shareholders’ mouths by styling it a matter of investor confidence. But this doesn’t alter the flaws in the argument itself.
The claim that mandatory federal proxy access merely “facilitate[s] shareholders’ traditional state law rights to nominate and elect directors” – as the SEC states in the opening sentence of its overview and reiterates throughout – is equally difficult to accept. Observing that the two predominant models for state corporate law (Delaware, and the Model Business Corporation Act) already permit the adoption of proxy access procedures, the Commission proceeds to ground its mandatory rule in the perceived shortcomings of state law – for example, the lack of clarity regarding the competing bylaw authority of boards and shareholders (at 15, 326-27). The SEC seeks not to “facilitate” state law, but to improve it, as it subtly concedes in its cost-benefit analysis:
Because state law provides shareholders with the right to nominate and elect directors to ensure that boards remain accountable to shareholders and to mitigate the agency problems associated with the separation of ownership from control, facilitating shareholders’ exercise of these rights may have the potential of improving board accountability and efficiency and increasing shareholder value. (at 328-29)
In permitting states and companies to dissent from this view only through literal elimination of shareholder nominations, the SEC effectively says that shareholder nominations in public companies work our way, or not at all – a near-total federalization of a process pretty close to the heart of corporate governance, which cannot coherently be described as merely facilitating state law.
So what is actually going on here? Ironically, perhaps the most illuminating part of this 451-page release is a two-paragraph section titled “Our Role in the Proxy Process” (at 22-23), which can be succinctly paraphrased: Congress said so. See Dodd-Frank § 971. (Though stated permissively, it is not unreasonable for the SEC to have read “may” as “shall” given the political climate from which Dodd-Frank emerged.) Hence the question becomes why Congress said so – there being no doubt, of course, that Congress possesses ample constitutional authority to federalize corporate governance as and when it likes.
As I have argued at some length, U.S. corporate law – including in Delaware – has long been deeply ambivalent regarding the shareholders’ role in corporate governance and the degree to which corporate activity ought to prioritize their interests. This posture is evident, for example, in their inability to remove directors from a staggered board other than for cause; inability to initiate fundamental actions or to accept hostile tender offers without interference (not to mention board latitude to consider the interests of other constituencies); the lack of clarity regarding the shareholders’ bylaw authority; and even a somewhat murky statement of fiduciary duties owed simultaneously “to the corporation and its stockholders.” This ambivalence stands out quite starkly in contrast with U.K. company law, which by statute clearly defines the purpose of the corporation as being to promote the shareholders’ interests, and which favors shareholders with extraordinary governance powers.
The critical difference, in my view, lies in the fact that we in the United States have historically relied on public corporations to pull substantially more weight – notably including the provision of social welfare protections (such as health and retirement benefits) often provided directly by the state in other countries – which has resulted in far greater political pressure being brought to bear on U.S. corporate governance to accommodate non-shareholders’ interests (e.g. in hostile takeovers). The result has been two different forms of political equilibrium (in dispersed ownership systems, anyway) – one featuring stronger shareholder governance rights and stronger external social welfare protections (the U.K.), and the other featuring weaker shareholder governance rights and weaker external social welfare protections (the U.S.).
It is through this lens that U.S. shareholder empowerment initiatives following the crisis – including proxy access – truly start to come into focus. As I suggest in the recent paper noted above, post-crisis shareholder empowerment initiatives reflect a populist backlash against managers, fueled in part by middle-class anger and fear in an unstable social welfare environment.
While I do not claim that the two necessarily go hand-in-hand in all instances, it is quite telling that U.S. responses to the recent crisis have included both stronger shareholder governance rights, and stronger external social welfare protections (notably healthcare reform), suggesting a larger shift toward a different form of social welfare equilibrium. These seemingly unrelated initiatives similarly draw strength from the same constellation of middle-class social concerns – growing fears regarding the availability of healthcare and other benefits following job loss, and the safety of savings for education and retirement. This has tended to align “employee” and “shareholder” interests following the recent crisis, resulting in the defeat of “management” in popular politics, in much the same way that hostile takeovers in the 1980s tended to align “employee” and “management” interests, resulting in the defeat of “shareholders” in popular politics.
All of this suggests that what we’re seeing here is much bigger than the SEC’s rulemaking, and driven by factors considerably more wide-ranging and complex than debates about the merits of shareholder activism tend to suggest. The SEC has created a proxy access regime because Congress, responding to the national political climate, said so – and facilitating state corporate law most certainly did not loom large in that decision.
I have mixed feelings about the new proxy access rules. The new rules change both the default rule and the altering rule for proxy access. Essentially, I like the default rules pretty well, but hate the altering rule.
Until yesterday, the default rule (except for North Dakota corporations) was no proxy access. Now the default rule is that shareholders who have owned 3% of a corporation's shares for at least 3 years can nominate candidates for up to 25% of the board seats using the corporate proxy. As I explain at length in my forthcoming article, it makes more sense to have some degree of access as the default. In part that's because access gives some real meaning to board elections as an accountability device, and board elections are one of the most plausible and easy to defend accountability devices available. In part it's because a pro-access default reduces the transaction costs for companies who want to tailor their own rules. So long as the altering rule is flexible (see next paragraph), if the default rule allows access but you want no access, that is an easy rule to write. Or, if you like the default rule in most respects but want to change one or two dimensions, that is easy to do as well. But if the default is no access, opting in to a pro-access rule is complicated. There are a lot of moving parts in an access rule--see the SEC's rules. Putting all that into the bylaws, and perhaps up for a shareholder vote, is complicated and hard to read. (Imagine a shareholder proposal creating a proxy access regime from scratch--how would you do that within the 500 word limit?) Best to have a detailed, well-known template as the default, and then let companies write around that if they so choose. I'm rather worried that the 3%/3 year combination rules out too many shareholders, but I think those levels are at least plausible guesses as to the best levels for most companies.
Where I disagree is the altering rule. Altering rules specify whether and how a company may opt out of the default rule. In the SEC's new system, companies may choose to adopt more generous proxy access rules, but they can't adopt less generous rules or opt out completely. That's too inflexible. I think the SEC's default rules are a good guess, but they may be wrong, either for most companies or at least for some. If a majority of shareholders think the rules should be more stingy, why not let them choose more stingy rules? If we trust shareholders to choose among competing slates of nominees, why not trust them to choose the best proxy access regime?
The SEC's response is that access is a right, and we shouldn't let a majority of shareholders vote to deny rights to all shareholders. That's not very persuasive. If this is an individual shareholder right, why limit it as strictly as the 3%/3 year rules do? The vast majority of shareholders are effectively denied this supposed right under the SEC's rule. The answer is that the rule balances competing considerations to arrive at a result that is likely to lead to the most efficient governance system. But that's not about rights at all, it's about effective governance. And the SEC may be wrong about that balance in general or for specific companies. If a company's shareholders think the SEC has got the balance wrong, they should be able to correct it.
Is this a step forward overall? I hope so, but I'm not sure. I suspect this is not the last word from the SEC on this subject. There's a lot right here, and what is wrong is pretty easy to fix. I hope that a future Commission will choose to fix it.
To start off our forum on the new SEC Proxy Access rules, we have Nell Minow of the Corporate Library. She writes the following:
The SEC's new proxy access rule is a modest and most welcome step forward. The post Enron reforms addressed many of the concerns that led to the avalanche of business failures almost ten years ago but did little to improve the ability of boards of directors to manage risk. And that led to the even bigger avalanche of business failures a few years later. One problem was the post-Enron reliance on board "independence," despite the fact that dozens of academic studies have failed to show any reduced risk or increased return correlating to the number of independent directors. That is not because independence is unimportant. It is because there is no such thing as independence as long as management controls who is -- and is not -- put on the ballot for election.
The very term "election" is absurd in this context. Edward J. Epstein has said that shareholder elections “are procedurally much more akin to the elections held by the Communist party of North Korea than those held in Western democracies.” Under the current system, management picks the slate of candidates, no one runs against them, and management counts the votes. Managers even know how shareholders vote. As soon as the votes come in, they can call and try to persuade (or pressure) those who vote against them. And, of course, management has access to the corporate treasury to finance its search for candidates and solicit support for their election, while anyone running against them must put up their own money. (Successful dissident slates often get reimbursed, however, once they are in office.) Management has access to the shareholder list; a dissident shareholder still faces significant obstacles, including millions of dollars for lawyers, ads, mailings, and more. As a result, CEO compensation has gone from being absurd to being offensive, to threatening the economy through perverse incentives. And shareholders have no way to respond. Panglossian free market acolytes will argue that objecting investors can sell the stock but that ignores the transaction costs and the fundamental contradiction that doing so is to sell at a low rather than a high. More important, it ignores the all-but universal adoption of shareholder-unfriendly management compensation due in large part to management control of the board.
Market forces will operate far more efficiently if board members are subjected to even the very small market test of a very limited ability for shareholders to put alternate candidates to a vote. The complaints of those who see specters of "special interests" are hypocritical and disingenuous. No one will be elected to the board without the support of more than 50 percent of the shareholders. That means they will need to persuade not just "activist" funds but also staid institutions like foundations and mutual finds that their candidates are better than managements'. If the shareholders get more than 50 percent of the vote, it is their opponents who are "special interests." It is appalling that the very people who rhapsodize about the purity of the markets when it comes to their products (unless they can persuade the government to impose barriers to entry or limits to liability) get weak in the knees when it comes to their board members. Lehman Brothers had a board that included an actress, a theatrical producer, and a retired admiral -- and no one who understood the complex securities that lead to their implosion. The Wall Street Journal found more than 80 directors currently serving even though a majority of the votes cast by shareholders were against them. We have found some who serve despite only a third of the votes cast. Proxy access is important but majority vote requirements for service on a board are crucial.
The providers of capital should play a role in deciding who has the all-important fiduciary duty to minimize the inevitable agency costs of a capitalist system. The proxy access rule will establish the credibility of our markets and economy and encourage investment. As Thomas Paine might have said, if this be capitalism, make the most of it. (Updated: Aug. 26, 4:18 PM EDT).
Following on Lisa’s posts on the SEC’s new proxy access regulations (see here and here), we decided to ask a number of experts for their initial views on the rules. We will be featuring their responses over the next several days.
For a small sample of other views from law professors on the rulemaking, see
Update: Add to your list of sites to visit, Larry Ribstein over at Truth on the Market
On my first read through the new proxy access rules, at least five things occurred to me.
As an initial matter, although one can (and many likely will) object to the manner in which the SEC ultimately resolved the complex web of issues involved with forming a proxy access rule, reading the final rule not only left me with the impression that the SEC had seriously considered the multitude of comments it received (apparently totaling about 600 comment letters), but also left me with the impression that the SEC had made the effort to either incorporate those comments or respond to those comments as it deemed appropriate, which, from a rulemaking standpoint, is a favorable impression.
Second, given the emphasis by many on private ordering and the SEC's acknowledgement that support for changes to Rule 14a-8(i)(8) was relatively widespread, it seems noteworthy that the SEC did not take the relatively easier, and certainly less controversial, approach of only amending Rule 14a-8(i)(8) and either abandoning Rule 14a-11 or leaving that rule for another day. Though perhaps, in light of the specific authority to adopt a proxy access rule granted under the Dodd-Frank Act, which the SEC noted made any challenges to its statutory authority "now moot," the SEC felt it needed to strike while the iron was hot.
Third, it also seems noteworthy that while the SEC recognized and took note of state law changes aimed at facilitating proxy access, such as the Delaware and ABA amendments, those changes did not dissuade it from fashioning a federally mandated rule. Under the SEC's view, even if proxy access bylaw amendments were permissible in every state, the fact that shareholder proposals could face significant obstacles that could undermine shareholder efforts to obtain proxy access warranted a federal rule.
Fourth, the 3%/3 year requirement of course raises the question about whether such a requirement will prove too difficult to meet, rendering the proxy access rule inaccessible for most shareholders. On the one hand, there was a lot of push back when a 5% rule was proposed (and then abandoned) in connection with the Dodd-Frank Act, with opponents contending that such a rule would prevent all but the largest investors from taking advantage of proxy access. The SEC's final rule reflected its concern that a 5% threshold would be too high. On the other hand, there seemed to be a lot of agreement that 1% was too low--though there were those who advocate no ownership threshold. In the end, the SEC contends that the 3%/3 year requirement facilitates the ability of shareholders with "significant, long-term" stakes, to take advantage of the rule. In support of this contention, the SEC pinpointed data indicating that 33% of public companies "have at least one institutional investor owning at least 3% of their securities for at least three years," and that "31% of public companies have three or more holders with at least 1% share ownership each; and 29% have two or more holders with at least 2% share ownership each." In this regard, the data suggest that there are many companies at which a relatively small number of shareholders could form a nominating group. Of course the SEC recognized the limitations of its data, and hence the SEC recognized that there is no real way to know whether and to what extent the holding requirements will serve to hinder use of the proxy access rule. At the very least, the requirements make it likely that shareholders will need to form groups in order to take advantage of the proxy access rule, which the SEC suggested was a good outcome.
Fifth, my research suggests that the solicitation exemptions are critical for ensuring the viability of the proxy access rule. Indeed, in Canada, where there is a proxy access rule that goes virtually unused, corporate governance experts note that one of the reasons for the non-use is shareholders' inability to solicit on behalf of their nominees outside of the limited information printed in the corporation's proxy statement. In this regard, the fact that solicitation basically requires the filing of a separate proxy statement apparently makes the Canadian proxy access rule unattractive. By comparison, the fact that the new US rules enable shareholders to solicit without such a filing should make the US rules more attractive, and hence more likely to be utilized by shareholders.
To be sure, it is unclear how any of these issues will shake out. However, given that the new rules are scheduled to take effect 60 days after publication in the federal register, we won't have that long to wait.
Yesterday the SEC finally made proxy access a reality. Indeed, the SEC not only adopted a proxy access rule requiring that under certain circumstances, companies include in their proxy statement information about, and the ability to vote for, shareholder-nominated director candidates, but also amended Rule 14a-8 to require that under certain circumstances, companies include shareholder proposals seeking to establish procedures by which shareholders can include their nominees in company proxy materials.
For those who have not managed to get a look at the new rules, here are some highlights:
1. A Mandated Rule. The proxy access rule, new Rule 14a-11, does not provide for an opt-in or an opt-out. In other words, it is mandatory, except in that rare (if non-existent) circumstance where state law or a company's governing documents prohibit shareholders from nominating a candidate for election as a director.
2. New Ownership and Holding Periods. In order to utilize Rule 14a-11, a nominating shareholder or group must (a) own at least 3% of the voting power of the company's securities entitled to be voted at the meeting, (b) own such amount continuously for at least three years, and (c) continue to own such amount through the meeting date. Both the ownership threshold and holding period are different from the June 2009 Rule 14a-11 proposal, which only had a one year holding period and contained a threshold that varied depending on a filer's status or the net assets of an investment company.
3. No Control Intent. The nominating shareholder or group may not hold the securities with the purpose or effect of changing control of the company, or gaining seats that exceed the maximum number of nominees required to be included under Rule 14a-11.
4. Maximum Number of Nominees. Rule 14a-11 only requires that a company include one shareholder nominee, or that number of nominees that represents up to 25% of the company's board, whichever is greater.
5. Shareholder Proposals. Rule 14a-8(i)(8) was also amended to allow for shareholder proposals seeking to establish a procedure in the company's governing documents for including shareholder nominees in the company's proxy statement. Importantly, any procedure established pursuant to Rule 14a-8(i)(8) would represent an additional avenue for proxy access, and hence would not serve as a substitute for Rule 14a-11 or otherwise serve to restrict or eliminate Rule 14a-11.
6. Solicitation Exemptions. The new proxy rules also carve out exemptions from the solicitation rules for solicitation activities related to forming a nominating group, as well as activities related to supporting shareholder nominees so long as shareholders do not seek proxy authority.
7. Smaller Reporting Companies Delay. As a general matter, the new rules apply to companies that are subject to the Exchange Act proxy rules including investment companies. However, smaller reporting companies will not be subject to Rule 14a-11 until three years after the effective date for other companies.
The new rules repeatedly emphasize the importance of facilitating shareholders' exercise of their state law right to nominate and elect directors of their choice, while also discussing the importance of ensuring that the proxy access process functions "as nearly as possible, as a replacement for an actual in-person meeting of shareholders." To be sure, there is also discussion about the impact of the financial crisis, and shareholders' related concern about the "accountability and responsiveness of some companies and boards of directors to shareholder interests."
Interestingly, the SEC considered, but rejected, the notion that recent changes related to shareholder rights (such as increased adoption of majority voting or the recent amendment to Rule 452) obviated the need for a proxy access rule. Instead, the SEC noted that such changes do not negate the need for proxy access because they "bolster shareholders' ability to elect directors who are already on the company's proxy card, not their ability to affect who appears on that card."
As is clear from the mandated rule, the SEC also rejected the private ordering arguments that arose in several contexts, including as a rationale for only amending Rule 14a-8, or in support of allowing companies to opt-out of 14a-11. The SEC addressed the argument throughout the final rule, often noting the impropriety of allowing some shareholders--even a majority--to impair other shareholders' ability to exercise their nomination right. However, the following statement captures the thinking on private ordering.
"[Corporate governance is not merely a matter a private ordering. Rights, including shareholder rights, are artifacts of law, and in the realm of corporate governance some rights cannot be bargained away but rather are imposed by statute. There is nothing novel about mandated limitations on private ordering in corporate governance."
So. . . ready or not, proxy access has come.