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.

Administrative Law, Corporate Governance, Forum: Proxy Access, Securities | Bookmark

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