Shareholder Rights, the 2008 Proxy Season, and the Impact of Shareholder Activism
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
U.S. Chamber of Commerce
July 22, 2008
Thank you, Steve [Law of the U.S. Chamber of Commerce], for that wonderful introduction. As you mentioned, this will be my last formal speech to an outside group before I leave the Commission. So this will be one of the last times that I must say the views I express here today are my own and not necessarily those of the Commission or my fellow commissioners.
It has been nearly six years since President Bush appointed me to be a member of the Commission. Next week, I will step down from the SEC and will find myself, for the first time in quite awhile, with no professional obligations to attend to. Nevertheless, I think my wife has prepared a very long "to do" list of neglected tasks that have accumulated since 2002!
It has been a privilege to serve the public as an SEC commissioner. The SEC is proud agency with a long and distinguished tradition. Next June, the SEC will celebrate its 75th anniversary, and it has been an honor to have played a small role in its history.
I appreciate the discussion that occurred earlier this morning and the publication of the Chamber's study on the impact of shareholder proposals on the market value of public companies. The analysis by Mr. Dos Santos and Dr. Song found no evidence of any significant improvement in short-term or long-term market value as a result of shareholder proposals. Their empirical observations were consistent with prior academic literature. Not surprisingly, Mr. Dos Santos and Dr. Song also found that shareholder proposals impose real costs on companies and proponents alike.
While the Dos Santos and Song analysis will surely have its critics, I applaud the effort to undertake a cost-benefit study. Critical thinking about costs and benefits ought to be at the center of the Commission's regulatory philosophy. As I have stated frequently before, the benefits of rules should outweigh the costs. If we make the regulatory costs of being a public company too high, there are alternatives: capital can flee abroad or migrate to private equity. In either case, it will be the investors who suffer from less choice or higher transaction costs.
Federal Securities Law and State Corporate Governance Laws
Today's topic — shareholder rights and the impact of shareholder activism — is one with which the SEC has wrestled since the Commission was formed. What is the appropriate role for a federal regulator, with limited jurisdiction, to play in governing the relationship between corporations and their shareholders? For the most part, our response has been to create a procedural framework that permits shareholders to vindicate the substantive rights granted under state laws.
The SEC has been criticized, from time to time, for straying from that path and deviating into the creation of substantive rights. In 2003 under former Chairman Bill Donaldson, we proposed an SEC rule granting so-called "proxy access," which would have created a federally-mandated right for shareholders to nominate candidates for director on corporate proxy statements. It was quite a controversial proposal, charitably described by a former SEC chairman as a "Rube Goldberg" contraption.1 Fortunately, the SEC did not adopt that proposal, but this issue re-surfaced in late 2006 due to litigation arising from a shareholder proposal submitted by the AFSCME union to amend a company's bylaws to provide proxy access.
Some would argue — and perhaps correctly — that the SEC's Rule 14a-8 on shareholder proposals inappropriately infringes upon state laws that govern the relationships among shareholders and between shareholders and the corporations that they own. It is state law, after all, that allows limited liability corporations to be formed. The federal government generally does not charter corporations, unless you count those incorporated in the District of Columbia. The state laws set up the menu of basic contractual rights that shareholders have; the duties that are imposed on their representatives, the board; and the obligations and parameters that are placed on the operations of their employees, management.
Nonetheless, the predecessors to Rule 14a-8 date back over sixty-five years to 1942, and the principles set forth in that rule have become firmly embedded in our application of the proxy rules.2 Despite the presence of Rule 14a-8, the Commission would be wise to continue to respect the principles of federalism and avoid the temptation to exceed the limitations on its authority delegated by the Congress.
One key opinion in this debate is the 1990 decision of the U.S. Court of Appeals for the District of Columbia in Business Roundtable v. SEC.3 In that decision, the court carefully reviewed the scope of SEC authority under Section 14(a) of the Securities Exchange Act. As some of you may recall, in the Business Roundtable case, the SEC was challenged — and lost — on a rule that asserted the principle of one-share-one-vote, prohibiting national securities exchanges from listing any class of stock that reduced the voting rights of shareholders.
So, to determine whether the SEC had authority under Section 19(c) of the Exchange Act to promulgate a rule affecting shareholder voting, the court undertook an examination of Section 14 of the Exchange Act. The Commission argued that it had broad authority because the purpose of Section 14 was "to ensure fair shareholder suffrage." The court rejected this broad interpretation. While it acknowledged that Congress stated that "fair corporate suffrage is an important right" in the Exchange Act's legislative history, the court pointed out that one needed to match this intent with the mechanisms that were provided in the actual statute.
The court observed that "it is not seriously disputed that Congress's central concern was with disclosure," citing a 1964 decision by the U.S. Supreme Court in J.I. Case Co. v. Borak.4 In that case, the Supreme Court stated that "the purpose of Section 14(a) is to prevent management or others from obtaining authorization for corporate action by means of deceptive or inadequate disclosure in proxy solicitation."5 The Court held that, far from being a broad mandate to replace or supplement state corporate governance laws, Section 14 of the Exchange Act was tailored primarily to focus on disclosure and to improve communications and voting procedures, so that shareholders could exercise their rights as effectively as they might have by attending a shareholder meeting in person.
Shareholder Proposals and the 2008 Proxy Season
So how does Rule 14a-8 work? Rule 14a-8 provides an opportunity for a shareholder owning a relatively small amount of a company's securities — the lesser of $2000 or 1% of the outstanding shares — to have his proposal placed alongside management's proposals in that company's proxy materials for an annual or special meeting of shareholders. Thus, the cost for a shareholder proposal generally falls on the company — and indirectly on all of the other shareholders — rather than the shareholder proponent. Rule 14a-8 requires the company to include the proposal unless the shareholder has not complied with certain procedural requirements or the proposal falls within one of the rule's 13 substantive grounds for exclusion.
Procedural requirements include providing proof of ownership of shares for at least one year and a written statement that the proponent intends to hold the shares through the date of the annual meeting. Some substantive bases for exclusion include not being a proper subject for action at a shareholder meeting, violating state law, dealing with ordinary business, relating to an election of directors, and already substantially implemented by the company. If a company decides that a shareholder has failed to satisfy the procedural requirements or believes that it falls within one of the bases for exclusion, the company must notify the SEC of its decision in writing.
Our staff in the Division of Corporation Finance generally responds to the company with either a no-action letter or a letter indicating that it disagrees with the company's decision to exclude. Sometimes, the staff will support exclusion unless the proponent makes certain modifications. On other occasions, the matter may be subject to on-going litigation between the shareholder and the company; in these cases, the SEC will express "no view" on the matter.
Now, this system was arranged in the 1940s, when there were far fewer public companies than the more than 10,000 that we have today. Each year during proxy season, the staff of the Division of Corporation Finance forms a large task force of attorneys to review incoming notifications from public companies. Each request and response is reviewed by at least two persons. For novel or more complex issues, higher level staff members of the Division are involved. The goal of the task force is to be timely in issuing a response for the benefit of both the company and the shareholder proponent.
During the 2007-2008 proxy season, our staff was incredibly busy. We have received 426 no-action requests through July 15, an increase from the 367 received during the prior year.6 Of this number, 53 were withdrawn before the staff could respond. Unsurprisingly, the staff agreed with the company approximately 75.7% of the time. I say that it is "unsurprising," because companies generally do not try to exclude shareholder proposals under circumstances in which they know that they have little chance of success before the SEC staff. When the staff permitted exclusion, it did so for procedural reasons in 26% of the cases and on substantive grounds in the remaining cases.
Last month, the SEC utilized a new method to resolve an issue of state law. As I mentioned before, Rule 14a-8 allows a company to exclude a shareholder proposal if it is not a proper subject for action by shareholders under the laws of the state of incorporation or if it would cause the company to violate any state, federal, or foreign law to which it is subject. Ordinarily, the SEC staff relies upon opinions of legal counsel as to whether a proposal is a proper subject or will violate state law. In some cases, the SEC receives a well-reasoned legal opinion from the company, but also receives an equally well-reasoned legal opinion from the shareholder reaching the opposite conclusion. Since Rule 14a-8(g) places the burden on the company of demonstrating that exclusion is warranted, the SEC staff has previously not permitted exclusion when there are dueling legal opinions.
In 2007, the state of Delaware amended its constitution to permit the Delaware Supreme Court to accept questions of law directly from the Commission. On June 27th of this year, the SEC certified questions to the Delaware Supreme Court for the first time. The particular matter involved a proposal submitted by a union pension plan to CA, Inc., the company formerly known as Computer Associates. The union proposed a by-law amendment that mandated reimbursement of expenses in the event an outside shareholder challenged the management-nominated director candidates with its own short slate.
This proposal raised interesting questions under the Delaware General Corporations Law — specifically, whether this particular shareholder proposal submitted under Section 109(a) of the Delaware code would infringe upon management's ability to direct the affairs of the corporation under Section 141(a) of the Delaware code. The SEC staff received conflicting opinions from two well-known law firms who practice Delaware corporate law. So rather than, as we have done in years past, acceding to the proponent's position — to use a baseball analogy — with "tie goes to the runner" approach, this year we used our new ability to certify questions to the Delaware Supreme Court and it accepted.
Perhaps it is only in Delaware that the judicial system can provide a final decision in such a timely manner. To give you an idea of the speed in which this matter moved, the SEC certified its questions on Friday, June 27. The Delaware Supreme Court accepted the matter on Tuesday, July 1. Briefs were due on Monday, July 7, and oral argument was held on Wednesday, July 9. Eight days later, on July 17, the Delaware Supreme Court issued its opinion, finding that although the proposal was a proper matter for shareholder action, the lack of a "fiduciary out" in the proposed bylaw violates Delaware law. Thus, having the guidance of the Delaware decision, the SEC staff notified CA on the evening of July 17 that the proposal could be excluded on the basis of Rule 14a-8(i)(2).
This speed shows the seriousness with which the Delaware Supreme Court takes the issue of federalism and its role in guiding the federal government in its application of state law. I salute the court in helping us define our respective roles.
The CA case indirectly reflects the issue of proxy access. In the fall of 2006, the U.S. Court of Appeals for the Second Circuit held that the Commission had improperly changed its interpretation of Rule 14a-8(i)(8), which permits the exclusion of a proposal that relates to an election for the company's board. While I respectively disagree with the court's conclusion — I think the Commission and its staff have been generally consistent in its interpretation and application of the exclusion — last year the SEC sought to respond to the ruling.
In July 2007, the SEC issued two separate releases. One release sought to modify the Rule 14a-8(i)(8) exclusion to permit shareholders to propose proxy access bylaw amendments under certain conditions, most notably if the shareholder — or group of shareholders — held at least 5% of the outstanding shares. The other release was an interpretative release that responded to the court's request for an explanation of the SEC's interpretation of Rule 14a-8(i)(8) and then proposed to make a minor clarifying change to the rule's language. Inside the SEC, we informally referred to the first one as the "long release" and the second one as the "short release."
As you are all aware, the Commissioners were split on the releases and eventually both were approved on 3-2 votes, with Chairman Cox voting both ways — in favor of each. After receiving extensive public comment — although the overwhelming majority of comments were form letters — the Commission voted 3-1 in December 2007 to stand on precedent and respond to the invitation of the Second Circuit by explaining the application of the rule and making the minor modifications set forth in the short release to clarify the rule.
Despite this action, Chairman Cox suggested earlier this year that he might seek to revisit the possibility of adopting rules to permit some form of proxy access shareholder proposals once a full complement of SEC commissioners is in office. The stated goal would be to have a rule in place prior to the 2009 proxy season. To the extent that some of you might have thought that consideration of the long release was finished, I am afraid that you may be mistaken.
My most significant concern is that the Commission could try to move to adopt a final rule based on the long release without additional public notice or comment. The long proposal was controversial with almost every group commenting on it — including procedural aspects as well as specific thresholds contained in the rule. Of course, it suffered from concerns as to the SEC's authority to do it, plus it undermines the proxy disclosure and solicitation regime. In addition, much has happened since the comment period closed on October 2, 2007.
For example, since January 1 of this year, all large accelerated filers have been subject to our mandatory e-proxy rules and all other companies have been permitted to use e-proxy on a voluntary basis. One interesting result of e-proxy, according to Broadridge Financial Solutions, Inc., is the significant decrease in retail shareholder participation. Using statistics compiled through May 31, 2008, the retail vote declined dramatically when e-proxy was used (based on 468 meeting results), the number of retail accounts voting dropped from 21.2% to 5.7% (over a 70% drop), and the number of retail shares voting dropped from 31.3% to 16.4% (a 48% drop). By the way, this result was predicted by many commenters who objected to the e-proxy rulemaking. The interesting question here is who are these shareholders that once voted and are not now voting and have we effectively disenfranchised them?
Given the turnover in Commission membership, the comments, and the passage of time, I do not see how the long proposal can even be reconsidered without substantial change. To serve the public interest, this would require re-proposal. The worst approach for the Commission would be to try to adopt a new rule along the lines of the long proposal with little warning, in the midst of a national election campaign, and with no additional public input. The Commission has not had a good track record recently of adopting controversial rules under dubious assertions of authority and with problematic procedural histories under the Administrative Procedure Act.
In recent years, shareholders have submitted proposals to companies on a multitude of issues, including executive compensation, employment policies, the environment, healthcare, and operations in certain countries where human rights abuses have been reported. Many shareholder proposals are characterized as "advisory," "precatory," or "non-binding" so as to not run afoul of state corporate laws that generally leave the tactical decisions of running a corporation to its management as overseen by its board of directors. These sorts of proposals often consume a significant amount of management time and attention.
Although SEC rules permit companies to exclude these proposals under certain circumstances, in many other instances they do not. In some cases, this results in a large number of shareholder proposals on a company's proxy statement. For example, at its 2008 annual meeting, Exxon Mobil Corp. had two management items — the approval of directors and ratification of auditors — and seventeen separate shareholder proposals. All of these shareholder proposals failed, despite the unprecedented press interest in some of them.
Earlier this month, the Investment Company Institute released a study on mutual fund proxy voting, which contained a number of interesting data points that are relevant to the larger discussion of shareholder proposals. For the 2006-2007 proxy season, the ICI reviewed all matters submitted to shareholders at companies composing the Russell 3000. Within this sample, there were 632 shareholder proposals. The ICI classified the largest category of shareholder proposals as "social/environmental" at 31%, followed by "compensation-related" proposals at 28%.
The ICI study found that 239 shareholder proposals were made by individuals, but that only five individuals were responsible for slightly more than half — 121 — of such proposals. Similarly, there were 186 proposals sponsored by unions or affiliates of unions, but just three unions accounted for 94 of the proposals. So the data shows that a relatively small number of investors are responsible for a significant portion of the shareholder proposals.
Equally important, however, is the fact that some proposals are never submitted to the shareholders, because management adopts the substance of the proposal, often through negotiation with the shareholder. Other times, the company adopts a significant portion of the shareholder's proposal and then seeks to exclude the proposal pursuant to Rule 14a-8(i)(10) on the grounds that it has been already "substantially implemented."
The abusive use of the shareholder proposal process by some institutional investors is troubling. At the SEC roundtable on the proxy process held on May 7, 2007, I was taken aback by the frank admissions from representatives of two institutional investors that they attempt to achieve their objectives behind closed doors and out of the public eye — and by using the shareholder proposal process as leverage. From an SEC perspective, this is particularly appalling because the fundamental principle underlying the federal securities laws is disclosure — we want to try to have openness and transparency — and here we have our own rules being abused to accomplish private objectives.
What we are seeing basically is large institutional investors, who have no duty to other shareholders, pushing behind the scenes particular measures that fail at company after company when actually put up for a shareholder vote. But, these shareholders admit that because of their behind-the-scenes maneuvering, they have been able to get the company to adopt those measures. Essentially, they are using their particular influence, the threat of shame or whatever, to try to get the company to acquiesce to their position.
Defenders of these sorts of actions by institutional investors probably will argue that although they have no fiduciary duty to shareholders, the board certainly does, and that at the end of the day, it is the board that agrees to implement the changes. I disagree; the board does have a fiduciary duty, but it also must decide whether it is in the best interests of the shareholders to use shareholder resources to contest the proposal and divert precious management time and attention to such efforts. It would not surprise me if, more often than not, the board simply applies a simple cost-benefit analysis and then takes the path of least resistance. So we must be vigilant that the shareholder proposal process does not result in the tyranny of the minority.
The SEC recognizes that the use of non-binding, advisory shareholder proposals is essentially a federal creation. As Vice Chancellor Leo Strine of the Delaware Court of Chancery stated at our proxy roundtable last year, Delaware corporate law does not recognize advisory proposals. He said "in Delaware, they vote on real things . . . we do not have imaginary voting."7 At a follow-on proxy roundtable, Vice Chancellor Strine further observed:
The shareholder vote on these nonbinding things is a result of federal action. . . . As a matter of the proxy rules, you have created something. And that was one of my points about your proposal. You're not vindicating a state law right.8
Vice Chancellor Strine's points about the lack of a state law right underlying non-binding shareholder proposals was ultimately recognized in the long release, in which the SEC issued some thoughtful interpretive guidance on the interaction of state corporate governance laws and the federal proxy rules with respect to advisory proposals.
Although I voted against the long release, I agreed with one section of that release in which the SEC acknowledged the ultimate role of state laws in deciding whether a matter could properly be brought before a shareholder meeting. The long release explained that because the proxy process is meant to serve, as nearly as possible, as a replacement for an actual, in-person meeting of shareholders, it should facilitate proposals concerning only those subjects that could properly be brought before a meeting under the corporation's charter or bylaws and under state law.
With respect to subjects and procedures for shareholder votes that are specified by the corporation's governing documents, most state corporation laws provide that a corporation's charter or bylaws can specify the types of binding or non-binding proposals that are permitted to be brought before the shareholders for a vote at an annual or special meeting. Rule 14a-8(i)(1) supports these determinations by providing that a proposal that is violative of the corporation's governing documents may be excluded from the corporation's proxy materials. Thus, to the extent a company adopts a proper bylaw under state law that limits or prohibits the consideration of a non-binding proposal at a shareholder meeting, those types of proposals may be excluded from the company's proxy statement. To date, I am not aware of any company that has sought to implement such a bylaw, but it would not come as a surprise if a company decides to do so in the future.
Thank you very much for listening. It has been an honor and a privilege to serve our country these last six years. I appreciate the opportunity to meet with you here today and would be delighted to answer any of your questions.