Corporate Governance (aka, CorpGov.Net)
9295 Yorkship Court, Elk Grove, CA 95758
May 26, 2003
Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Re: S7-10-03 Possible Changes to Proxy Rules
Dear Mr. Katz:
This is in response to your request for public views with regard to possible changes in proxy rules. I am the editor of CorpGov.Net and PERSWatch.Net, two Internet publications that are primarily concerned with enhancing the sustainable wealth generating capacity of corporations. CorpGov.Net is aimed at both individual and institutional shareholders. PERSWatch.Net is aimed at members of California Public Employees Retirements System (CalPERS). I am also an individual investor. My comments primarily address the director election and nomination process. I may submit comments on other aspects of proxy rules at a later date.
Les Greenberg, of the Committee of Concerned Shareholders (Committee), and I petitioned the Securities and Exchange Commission (SEC) last August for a change to Rule 14-a(8)(i)(8) to allow use of the shareholder proposal procedure to nominate candidates. The proposal (File No. 4-461) would require the names of such nominees and their supporting statements to be included in company proxy materials.
The $3 trillion Council of Institutional Investors (CII), which primarily represents large pension funds, indicated that our petition "re-energized" the "debate over shareholder access to management proxy cards to nominate directors and raise other issues."1 Sarah Teslik, their executive director has called the SEC's announcement "the biggest thing that has come out of the commission in my 20-year career." Patrick McGurn, vice president of proxy advisor Institutional Shareholder Services (ISS), said the movement for an open ballot the "Holy Grail of corporate governance." Obviously, this topic holds great potential.
I am delighted the Commission has indicated a desire to investigate the nomination and election process and sincerely hope Ms. Teslik's pronouncement is not premature. As discussed below, the Commission proposed giving shareholders access to the proxy to nominate directors in 1942.2 In 1978 SEC staff recommended that if sufficient progress wasn't made by companies in considering shareholder nominations during the 1980 proxy season, the Commission should grant shareholders "access to issuer proxy material for the purpose of making shareholder nominations."3 However, neither proposal was enacted.
In fact, the SEC has moved in the opposite direction. For years the SEC held that companies could not exclude shareholder resolutions pertaining to the director nomination process. Then in 1990, just when it seemed shareholders would begin winning majority votes on such resolutions, Commission staff began issuing "no action" letters on any proposals advancing shareholder influence over elections for directors.4
Had such resolutions not been excluded, we might have avoided the recent crisis in corporate governance typified by Enron, WorldCom, Global Crossing and so many others. The Commission should now move quickly to guarantee the right of every shareholder to meaningfully participate in the most critical aspect of corporate governance, the process of nominating and electing directors
Shareholder's Magna Carta
Although S7-10-03, Possible Changes to Proxy Rules, has received little attention from the media, its implications could be dramatic, something akin to a corporate governance equivalent of the Magna Carta, which eventually led to democracy in English civil societies. While the Magna Carta was drafted in response to the excessive use of royal power, a major factor in the resurrection of the movement for an open corporate ballot is the perceived abuses of power by chief executive officers (CEOs) at Enron, WorldCom, Tyco and others.
The first clause of the Magna Carta guarantees "freedom of elections" to clerical offices of the English church. This was designed to prevent the king from making appointments and siphoning off church revenues. A shareholder's Magna Carta by the SEC would prevent managers from having what often amounts to a lock on who sits on corporate boards and will substantially reduce their opportunities for using corporate coffers as their personal bank accounts.
At the turn of the twentieth century, "captains of industry" dominated corporations. Carnegie, du Pont, Mellon, Morgan, Rockefeller, and others owned large blocks of stock and exercised direct control over their investments. Ownership and control were embodied in the same individuals. Corporations were accountable to their owners who also managed them.
By 1932, however, Adolph Berle and Gardiner Means documented a significant shift in their classic book, The Modern Corporation and Private Property. Ownership had become so dispersed that control shifted from owners to managers. Berle and Means commented directly on the practice of proxy voting. "Since the proxy committee (was) appointed by the existing management, the later virtually dictate(d) their own successors."
The framework of corporate law, much of which developed in reaction to the stock market crash of 1929, restored public confidence by separating or limiting the power of bankers, insurance companies and mutual funds. They also gave broad powers to the SEC to develop rules "under which proxies may be solicited with a view to preventing the recurrence of abuses which have frustrated the free exercise of the voting rights of stockholders." 5
Although the framework subsequently developed has the appearance of being democratic (one share, one vote), it lacks the basic mechanisms to provide anything more than a mere illusion. Shareholders are nominally empowered to elect directors to oversee management but lack any right to participate in the nomination of candidates. While the corporation laws of every state solemnly recite that shareholders elect the board of directors, each year shareholders are asked to participate in an exercise which bears little resemblance to the word "election" as commonly used in any democratic country.
Shareholders are free to vote but generally have no real choice in the election of directors. Even if an overwhelming majority opposes a corporate sponsored nominee, that person will serve as director, unless an expensive proxy contest is undertaken. The real election for directors occurs within the boardroom, with shareholders relegated to a rubber-stamp process of affirmation.
It is well known that until recently the vast majority of board vacancies have been filled via recommendations from CEOs who also are typically chairmen of the boards. The result is that management of America's corporations are not accountable to their owners but only to an increasingly burdensome labyrinth of laws and regulations that governments are too understaffed to enforce. Recent requirements for an "independent" nominating committee provide little assurance against continued management domination. These "independent" board members serve at the pleasure of the CEOs and the other board members; they have no independent base of power.
CEOs and board members, who are only minimally accountable to shareholders, continue to have conflicts of interest resulting in the following:
- Overpaying CEOs
- Delaying in replacing underperforming CEOs and directors
- Concealing poor performance
- Discouraging potential acquirers
- Corporations managed for the benefit of CEOs, rather than shareholders, employees and society.
The current open ballot movement in corporate elections seeks to address the human tendency toward unchecked greed, not by initiating additional burdensome layers of government oversight, but by empowering shareholders with the most fundamental rights, which they have too long been denied; the right to nominate and elect their own representatives to the board of directors.
Other potential means to achieve accountability of directors are ineffective. The threat of potential litigation, through class-action lawsuits and/or derivative actions brought by shareholders, is highly overrated as a deterrent to corporate malfeasance. Corporations themselves and/or the SEC generally reveal corporate improper acts before civil litigation is commenced. Shareholder lawsuits rarely result in the perpetrators, themselves, paying damages. If damages are recovered, it is paid out of insurance policies and out of corporate assets. In the end, shareholders bear the cost of both sides and must cover the expenses of both plaintiff and defense attorneys, diluting the value of their shares.
Proxy contests to force change are hardly ideal. Often they are initiated only after a great many shareholders sell the stock and depress the price. Of course, sale of the stock does nothing to directly remove assets from management control. It simply passes the stock to another buyer who must suffer the same management abuses. In the process, shareholders can see considerable wealth destroyed by inept management and defensive measures. There are often also very heavy transaction costs for employees in the form of layoffs, lost wages, increased divorce and suicide rates, as well as to communities in the form of lost taxes and charitable contributions. Even after much of the wealth has been destroyed, the takeover and transition back to profitability is also expensive. Patrick McGurn, of ISS, estimated that, whereas professional fees and expenses from buyouts and takeovers averaged between 2 and 4% of transaction value, charges for proxy driven changeovers have run "considerably below" 1%.
In civil society, democratic transitions have long been recognized as preferable to war or armed revolution. The same principles should apply to corporate governance transitions. Current SEC rules are an impediment to peaceful transitions in corporate governance and encourage short-term speculators, rather than committed long-term investors.
Two Examples of Shareholder Struggles
In 1991 business leaders surveyed by Fortune magazine rated Sears at 487th out of 500 companies for the reputation of its management. Dale Hanson, then chief of the California Public Employees Retirement System (CalPERS) said, "from 1984 on, Sears went to hell in a handbag."
In May of 1991, Robert A. G. Monks indicated he would engage in a proxy contest for a single seat on the board, something no one had ever done before at any company. Sears hired renowned takeover lawyer Marty Lipton, brought a lawsuit to stop Monks and budgeted $5.5 million dollars over and above Sears' usual solicitation expenses to ensure his defeat. That allocation represented one out of every seven dollars made by the retail operation during the previous year. Sears also assigned 30 employees to spend their time working to defeat Mr. Monks.
With cumulative voting and five Directors up for election, Monks might have won a seat. But Sears shrunk its board by eliminating three director seats, which meant that he needed a higher proportion of the vote to win. About 25 percent of the vote was held by Sears employees (and voted by Sears trustees); much of the rest was held by individuals, who were impossible to solicit without spending millions of dollars.
In 1992, Sears shrunk their board again. Instead of running again, Monks supported shareholder proposals submitted by others and ran his now famous full-page ad in the Wall Street Journal declaring the board "non-performing assets." Two of the resolutions he supported, confidential voting and annual election of directors, got over 40 percent of the vote. The proposal to separate the CEO and chairman positions got 27 percent. Sears went on to implement several of the reforms that Monks had advocated, including restructuring its operations, which helped it rebound financially but it was clear that management retained full control.6
The Committee of Concerned Luby's Shareholders, predecessor to the Committee of Concerned Shareholders, met on an Internet Yahoo! finance message board and became the first grass-roots shareholders to conduct a formal proxy contest using that medium.
Luby's Inc., headquartered in San Antonio, Texas, was a 230-unit cafeteria chain with annual sales of approximately $500 million. The company had traded over $25 a share but dipped below $4 was trading in the $8 to $4 range in the months when shareholders rallied around a plan by Les Greenberg to try and win four seats on the company's 11-member board of directors at its annual meeting in January 2001.
Their efforts were given a boost when former Luby's executives joined the dissidents. They didn't want the firm they had spent decades building to crumble further. The daughter of a co-founder also signed on. The four candidates nominated by shareholders held a grand total of 0.3% of Luby's stock. Greenberg, a semi-retired attorney drafted the documents, allowing the Committee to wage its battle on the cheap.
Patrick McGurn, of ISS, indicated his belief that the efforts of the Committee influenced several positive company reforms. After a new CEO at Luby's recruited a retiree for the board, the Committee's support began to slip. ISS didn't support them, convinced that Luby's was "back on track."
The dissidents received 25% of the vote, an astonishing turnout for such a low cost effort. Two of their shareholder proposals (removal of all anti-takeover defenses and annual election of all directors) did even better, receiving approximately 60% of votes cast. Share price rebounded, briefly hitting $10. However, management didn't implement the measures that won a majority vote and never explained their inaction. Shares have now fallen to around $2.7
Near Insurmountable Hurdles
SEC regulations denying shareholders the right to place the names of director-nominees, or even resolutions concerning the election process on the corporate ballot, have become the largest impediment to democratic change in corporate governance. The assets of all shareholders are expended by management to distribute those ballots and to campaign for the company's candidates. Dissident shareholders can expect to expend at least $250,000 to run even a single candidate. Shareholders must: locate nominees, conduct related due diligence, draft a committee charter for a committee; and obtain and digest corporate bylaws and articles of incorporation, applicable state and federal laws and regulations.
Since corporations and their transfer agents will often stall and request thousands of dollars for a copy of the shareholders list, shareholders must be willing to file court actions. They must also be prepared to use the complex EDGAR filing system, to defend against frivolous legal actions and to lobby proxy advisors and institutional investors. Then, they need to verify that proxy statements have actually been mailed to "beneficial holders" of the stock and that votes have been counted properly.
Today, the only way shareholders can access management's proxy card is by filing a shareholder resolution. The shareholder proposal rule, which has been in place since 1942, sets eligibility requirements ($2,000 in stock or 1% of stock held continuously for at least a year), limits the length of resolutions (500 words, including supporting statement), restricts subject matter (13 grounds for omission) and stipulates resubmission requirements (minimum 3% vote in year one, 6% in year two and 10% in year three).
As you well know, not all resolutions make it on the corporate proxy. The SEC allows companies to omit resolutions that would let shareholders list candidates for directors, change the way elections are held or even set up a system where shareholders hire an independent monitor to advise them on elections. For example, SEC staff issued a no-action letter on a shareholder proposal I submitted in 1999, stating that allowing shareholder to vote on a proxy monitor firm to be hired by the company to advise shareholders on the election of future directors was a violation of section 14a-8(i)(8).
When Mark Latham8 and I modified it a year later to exclude advice on director elections, it won 18% of the vote at Equus II. I have no doubt the vote would have been higher if the proposal would have allowed the proxy monitoring firm to provide advice on the future election of directors, since board elections are the most critical issue on the ballot and shareholders are given little useful information concerning how nominees will vote on issues facing the company.
Shareholder resolutions are unlikely to bring fundamental management change because they are nearly all "precatory," or nonbonding under SEC rules. However, because they are a highly public way for shareholders to register frustration and have the potential of shaming management in the press, more that 1,000 resolutions have appeared on corporate ballots this year alone.
Rather than provoking shareholders to shame directors, SEC regulations should facilitate their ability to replace directors. Once shareholders know they can replace underperforming directors, they will spend more time and effort monitoring directors and providing them with valuable feedback.
Although the issue of facilitating equal access to the corporate ballot has been discussed several times during the last sixty years, nothing has been done to provide shareholders with this most fundamental democratic right. In fact, the SEC has moved in the opposite direction.
The issue of shareholder access has been around since at least 1942, when the SEC proposed giving shareholders proxy access to nominate directors. However, if you will kindly review that proposal I'm sure you will agree the language they proposed was confusing and poorly drafted. Additionally, the country was going to war and was not focused on corporate governance. The SEC said they dropped the proposal because "unqualified persons might be nominated, that too many candidates might be nominated, and that the shareholders would become confused and improperly mark their proxies."9
By 1947, the SEC enacted regulations providing director elections as a basis for exclusion for shareholder resolutions. Apparently, the Commission believed that dissidents seeking access to the board should be forced to run their own slates.
After the war Mortimer M. Caplin, of the University of Virginia Law School, set forth several alternatives for shareholder nomination of directors, ranging from all directors, to a proportion determined by company, to one position reserved for shareholder candidates.
The idea emerged again in a 1976 book, The Structure of the Corporation, by Melvin Eisenberg. He argued that companies should be able to set bylaw provisions imposing a standing requirement of a minimum ownership percentage for the right of shareholders to nominate. Since management routinely used the proxy to argue support for their candidates, fairness and fiduciary principles dictated similar access for shareholder candidates.
Also in 1976, Raph Nader and others advocated a stakeholder approach of control in their book, Taming the Giant Corporation. Consumers, citizens and shareholders would all have representatives on corporate boards under their scenario.
In 1977 the SEC responded to a series of corporate scandals and bankruptcies by issuing a release seeking public comment on corporate governance issues, including shareholder access to the proxy.10 More than 300 witnesses appeared before the Commission to testify. In August 1977 the influential Business Roundtable (BRT) recommended "amendments to Rule 14a-8 that would permit shareholders to propose amendments to corporate bylaws, which would provide for shareholder nominations of candidates for election to boards of directors."
The memo noted their amendments "would do no more than allow the establishment of machinery to enable shareholders to exercise rights acknowledged to exist under state law."
The BRT proposal limited shareholder access to those with an unspecified percentage of shares, placed a limit on the total number of nominees and by investor groups to avoid use as a takeover technique, and included a procedure to omit repeat nominees who did not receive a certain percentage of votes in prior elections. The BRT said shareholders making director nominations should be subject to the same qualification and disclosure requirements as other directors.11
Congress passed the Foreign Corrupt Practices Act that year and the stock exchanges' adopted rules requiring corporate boards to have "independent" audit committees. The SEC passed rules requiring board candidates to provide information in the proxy regarding conflict of interest transactions, required the corporation to disclose additional information regarding executive compensation, standing board committees, board member attendance records and resignations. However, nothing was done to facilitate equal access or an open ballot.
About two years later the SEC folded to pressure from the American Bar Association and others, proposing "further study" of the use of nominating committees to empower shareholders. Staff recommended that if there was not sufficient progress by companies in considering shareholder nominations, the Commission should then adopt a rule setting forth "procedures for shareholder access to issuer proxy material for the purpose of making shareholder nominations."12
Professor Jane W. Barnard indicates "no evidence exists that the Commission staff followed up on the Staff Report after its issuance or that it reviewed the 1980 proxy materials to measure the effectiveness of corporate nominating committees."13 She attributes the lack of follow-up to changing appointments under then newly elected President Ronald Reagan.
In 1980 a shareholder of Unicare Services was able to place a proposal on their ballot permitting any three shareholders to nominate board candidates and have them placed on the proxy. A similar proposal allowed a "reasonable number of stockholders" to place candidates on the proxy statement of Mobil. In 1981 Union Oil was forced to include a proposal permitting 500 or more shareholders to place nominees on the corporate ballot, with no threshold on the number of shares they held individually or collectively. Staff rejected management's argument that rule 14a-8(c)(8), the very rule that our August 2003 petition seeks to amend, allows exclusion. SEC staff held the proposal did not relate to "the election of directors at a particular meeting, but rather to the procedure to be followed to select nominees in general."14
Interestingly, during this period at least one corporation, Unocal, argued that placing a minimum threshold on access to the company's proxy would discriminate "in favor of large stockholder and to the detriment of small stockholders," causing the company to violate the equal treatment principle.15
In 1988, CalPERS submitted a shareholder proposal to Texaco providing for the establishment of a Stockholder's Advisory Committee made up of nine of the company's largest shareholders. CalPERS saw the Committee as an avenue to influence director nominations and withdrew the proposal when Texaco's management agreed to nominate a candidate recommended by CalPERS. Both CalPERS and CII began to express an interest in access to the proxy for the purpose of nominating directors but neither appears to have taken formal action to support open access until this year.
After years of allowing shareholder proposals concerning elections, the SEC suddenly issued a series of no-action letters in 1990 ruling that proposals concerning board nominations could be excluded under rule 14a-8(c)(8).16 Professor Barnard speculates the SEC probably changed their position because proposals being put forth by institutional investors were beginning to win majority votes. The SEC's failure to issue no-action letters to prohibit shareholder nominees on corporate ballots would soon have real consequences, noting that in 1990 more shareholder proposals passed than in the proceeding 40 years combined.
In prior years, the staff may have failed to consider the long-term implications of their decisions because they assumed that access proposals, like most shareholder proposals, would not command substantial shareholder support and could not win against management opposition. This assumption, however, was beginning to prove unsupportable. By 1990, an increasing number of shareholder proposals, particularly those initiated by institutional investors, were winning majority votes.17
Professor Barnard's opinion carries additional weight, considering that she was assisted in her research by Virginia Rosenbaum of Investor Responsibility Research Center, Jamie Heard, then with Analysis Group, Inc., Richard H. Koppes and Kayla Gillan, then with CalPERS, and Nell Minow, then at Institutional Shareholders Services, in addition to several others. These names are not unknown to shareholder activists or the SEC.
Most recently, the SEC refused to reverse staff's January 31, 2003, "no action" letter on a proposal submitted by the American Federation of State, County and Municipal Employees (AFSCME) to Citigroup. AFSCME had proposed a bylaw permitting a shareholder or group of shareholders holding at least 3 percent of the company's outstanding stock to nominate a candidate for election to the board and to have that candidate listed on the corporate ballot.
In a letter to SEC Chairman William H. Donaldson, dated March 17, 2003, Sarah Teslik, Executive Director of the $3 trillion CII wrote:
At a time when legislation has directed the Securities and Exchange Commission to adopt a host of new regulations pertaining to corporate governance issues, the Council is surprised that the SEC staff would reverse position and reduce shareholders' rights to actively participate in one of the one of the most critical aspects of corporate governance - the director nomination process.
The letter further pointed to the inconsistency of "blessing shareholder resolutions calling on companies to nominate more than one candidate for board seats," but rejecting resolutions "providing a process for shareholders to nominate more than one candidate for a board seat." CII expressed its belief that "as the self-professed investors' advocate, the SEC should err on the side of inclusiveness by giving the benefit of the doubt to investors rather than companies."
In 1990 the United Shareholders Association (USA) submitted a rulemaking petition to the SEC that would have granted equal access to shareholders or groups of shareholders owning the lesser of at least 3 percent of outstanding shares or $1 million worth of stock. They sought to have companies give equal space, coverage and treatment to shareholder-nominated candidates for directors. Their petition requested the limit on supporting statements be 1,000 words and that expenses of qualifying candidates be reimbursed regardless of their success. The AFL-CIO petitioned for a similar rulemaking in May 1991, suggesting a "fair threshold level" for eligibility." As far as I know, neither petition received serious consideration.
On August 1, 2002, Greenberg and I, submitted petition, File #4-461, to the SEC to allow shareholders to place board nominees in corporate proxies under the same provisions that apply to the submission of shareholder resolutions discussed above. We also sought to disallow counting votes cast by brokers not directed by beneficial owners.
At the end of September 2002, e-Raider, an Internet confederation of investors where I have served as a moderator on corporate governance topics, submitted a similar petition to the SEC. Their petition additionally seeks to ban the use of corporate funds for campaigning and to strike down "unreasonable qualification tests" for director candidates.
The AFL-CIO also announced they would submit a rulemaking petition asking the SEC to create an absolute right to allow shareholders direct access to the proxy. In conversations with me, representatives explained they would wait until the SEC acted on their proposal to require mutual funds and investment advisors to report their voting policies and votes in corporate elections.
In March 2003, the movement got a boost when CalPERS voted to pursue an SEC rulemaking aimed at gaining greater shareholder access to management's proxy for the nomination of directors. As discussed at a board meeting, shareholders would have to hold an aggregate 5% of outstanding shares. Only shareholders of at least 1 year would be permitted to nominate candidates but second's would not be so limited. In an effort to minimize takeover concerns, they considered allowing shareholders to only nominate less than a majority of the entire board's occupied seats in any single year. They also discussed the need for reimbursement provisions in specific circumstances, a way to stem wasteful spending by companies and the need to keep the campaign expenditure process fair for shareholders.
Later that same month, CII voted to ask the SEC to enact similar rules that would allow shareholder nominees for directorships to be listed on corporate proxies. To my knowledge, none have recently filed a formal petition on open ballots or equal access. However, they are all submitting comments on S&-10-03 to support increased access.
Reaction to Open Ballot Concept
The following, from an investor in Germany, is typical in tone to the dozens of responses we have received to our petition: When I discovered that elections of directors of USA public companies are not democratic I was very surprised and disappointed. This is EXACTLY how voting in communist countries worked. Everyone could vote, but there was just NO CHOICE of candidates. The point was not how to be elected, but how to get on the election list. With this system no changes were possible, so there was no motivation to improve the governance.
The vast majority of those commenting on SEC Rulemaking Petition File No. 4-461 simply endorse its language outright. The few who made suggestions for improvement were all concerned with the possibility that some corporations may be inundated with petitions nominating board members.
For example, Carl Olson of the Fund for Stockowners Rights suggests that candidates be required to demonstrate support from 0.05% of shareholders or outstanding shares. Mark Latham, of the Corporate Monitoring Project suggests that nominators be required to either own at least 0.5% of outstanding stock or pay a fee of $20,000, to be refunded if the nominee gets at least 5% of the vote. A variation of this would be to require a refund of the deposit if the nominee meets the same threshold currently required for resubmission of proposals: minimum 3% vote in year one, 6% in year two and 10% in year three.
In January 2003 the Conference Board's blue-ribbon commission decried the process whereby "shareholders have no meaningful way to nominate or to elect candidates short of waging a costly proxy contest."
That same month, Delaware Chancery Court Chancellor William B. Chandler III and Vice-Chancellor Leo E. Strine Jr. described the election process as a "forgotten element of reform." They suggested that policy makers take up the issue of management-biased elections and require equal access to "the proxy machinery between incumbents and insurgents with significant nominating support." "As of now, incumbent slates are able to spend their companies' money in an almost unlimited way in order to get themselves reelected, they wrote. This renders the corporate election process an irrelevancy, unless a takeover proposal is on the table and a bidder is willing to fund an insurgent slate."18
American Federation of State, County and Municipal Employees (AFSCME) submitted binding and nonbinding proposals at several firms, including Citigroup to "in effect take a fake democratic process and make it real," according to Michael Zuker, director of corporate affairs. The SEC let stand a no-action letter on Citigroup, even as it announced ordering staff to review the rules to possibly "improve corporate democracy."
Impact on Boards and Corporations
If petition File No. 4-461 were enacted, management selected candidates would still retain a number of advantages over challengers such as incumbency, ballot position within management's slate and resources.
Yet, just the possibility of director contests will lead nominating committees to search out more diverse candidates with new ideas, including those recommended by their large investors. Outside directors who own or represent the ownership of substantial stock in companies have been found to be much more likely to ask discerning questions. This will allow a more realistic appraisal of alternative actions, especially during times of crisis. Such truly independent directors will challenge management, stimulating greater corporate performance.
Competition for board positions has traditionally stimulated share value. Researchers have found that "firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, lower capital expenditures, and fewer corporate acquisitions." Investors who bought firms with the strongest democratic rights and sold those with the weakest rights "would have earned abnormal returns of 8.5 percent per year during the sample period."19
Opening the corporate ballot will increase market mechanisms for corporate control through gradual takeovers, disarmament of poison pills and other management entrenchment devices. Yet, directors nominated by shareholder are likely to take a long-term view of the firm because the most active large shareholders have been those with the longest time horizon, pension funds.
Impact on Business and Society
The movement to more democratic forms of corporate governance by empowering owners is important not only for creating wealth; it cuts directly to our ability to maintain a free society. As Monks and Minow have noted, with the slight exaggeration suitable for book covers,
Corporations determine far more than any other institution the air we breathe, the quality of the water we drink, even where we live. Yet they are not accountable to anyone.20
Institutional investors hold more than 50% of all listed corporate stock in the United States (about 60% in the largest 1,000 corporations). As early as 1988 the Department of Labor (DOL) set forth their opinion that, since proxy voting can add value, pension fund voting rights are subject to the same fiduciary standards as other plan assets. Last year former SEC Chair Harvey Pitt clarified that the same standards of trust law also hold for mutual funds. On January 23, 2003, the SEC ruled that proxy votes made by mutual funds must be disclosed.
Pension and mutual funds will face increasing pressure from beneficial owners to ensure votes are cast in a manner they agree with. Opening the corporate ballot will further increase monitoring of management by shareholders. The most vigilant shareholders, especially with regard to submitting resolutions, have been those who profess to be "socially responsible." That includes several small mutual funds, as well as labor and public pension funds which seek to increase triple bottom line returns (adding economic, environmental and social value).
Public employees, for example, don't want to work during the day to protect the environment, only to find the corporations their pension funds have invested in are polluting it. Those trends will continue to accelerate, especially when investment advisors, such as Innovest find that the top half of firms ranked by environmental sensitivity outperformed the bottom half by up to 21.8% over a two-year period, depending on industry.
Another petition before the Commission is that of the Rose Foundation for Communities and the Environment and others "Request for Rulemaking for Clarification of Material Disclosures With Respect to Financially Significant Environmental Liabilities and Compliance with Existing Material Financial Disclosures: 4-463." That petition cites the need for reportable environmental liabilities to be aggregated to determine whether they exceed the SEC's materiality threshold. Such disclosures would better enable shareholders to determine the real value of their shares and would encourage companies to act responsibly, knowing that environmental liabilities must be reported. It have become clear that many corporate failings are linked to not to the desires of shareholders but the greed of unfettered management.
Experience with more democracy at the top, especially when found profitable, may lead companies to make better use of employees. A 1986 study by the National Center for Employee Ownership (NCEO) found that firms with significant employee ownership and participation in decision making grew 8 to 11% faster than their counterparts. A year later the General Accounting Office found that such firms experienced a 52% higher annual productivity growth rate.21
Scientists have known for years that such organizations would generate more wealth. For example, even back in the 1970s a panel of experts, after reviewing the extensive findings of 57 field experiments in job satisfaction and productivity for the National Science Foundation, concluded:
Human involvement at the work place in all facets of the work is a prerequisite for the enhancement of quality life as well as performance and satisfaction.... The organizational policy, therefore, should work towards enhancing such aspects of work which encourage people's ownership of the work place as well as the work itself, collaborative efforts among coworkers, and decision-making processes based on participate models.22
It is paradoxical that the standard justification for autocratic practice in industry is its alleged efficiency, since the empirical research results do not support that conclusion. In fact, increased rank-and-file responsibility, increased participation in decision-making and increased individual autonomy are associated with greater personal involvement and productive results.
Why, against the findings of so many studies, do organizations continue to allow workers so little control over their jobs? Our best guess is that most decision-making structures, including those now governing corporations, are designed around status needs related to dominance and control over others; they are not designed to maximize the creation of wealth for shareholders or for society at large. In order to gain higher status, individuals seek to dominate more and more people. This dynamic moves the locus of control inappropriately upward. In order to generate more wealth, we need to take advantage of all the brains in our companies, as well those of concerned shareholders. We can do so by making corporations more democratic, top to bottom.
The keys to creating wealth and maintaining a free society lie primarily in the same direction. Both require that broad based systems of accountability be built into the governance structures of corporations themselves. By accepting the responsibilities that come with ownership, pension funds and other institutional investors have the potential to act as important mediating structures between the individual and the dominant institutions of our time, the modern corporation.
Amendments to Petition File No. 4-461
Based on the above, I would propose a few amendments to my prior petition. Provisions should include the following:
- Minimum Ownership Threshold (included in 4-461): The threshold should be kept low, the same as for resolutions...a minimum holding of $2,000.
A higher threshold is likely to lock out most individual shareholders and even small institutional investors. Shareholder scrutiny would almost entirely focus on large companies, where the majority of stock is held by large institutional investors. Shareholders in the other 8,500+ companies would be left with the current system, which denies them any significant access to representation.
Additionally, we do not want to move from management domination to domination by majority shareholders, as exists in much of Continental Europe. Such markets are not as robust because minority shareholders and prospective shareholders fear that dominant shareholders will divert value from the firm to themselves. Although strong fiduciary duties, laws against unfair interested party transactions, and other enforcement mechanisms can reduce these kinds of private benefits of control, the least costly mechanism is to allow all shareholders to have a voice in corporate governance. Active monitoring by investors of all sizes will ensure diverse ownership, proper valuation of stocks and robust markets.
- Minimum Holding Period (included in 4-461): Shares held by the nominating shareholder must have been held for a minimum holding period in excess of one year. This helps to prevent use by short-term speculators.
- Good Faith Deposit: Nominations should be accompanied by a deposit of $3,000 per candidate nominated, which is to be refunded if each nominee meets the same threshold currently required for resubmission of proposals: minimum 3% vote in year one, 6% in year two and 10% in year three. This would discourage frivolous filings.
- Competing Shareholders: In the even that multiple shareholders compete for access to the proxy for their director nominees, the SEC should employee a process similar to the "lead plaintiff" provisions of the Private Securities Litigation Act of 1995. Only candidates from the largest two shareholder blocks should be required to be placed on the corporation's proxy ballot. This is the fairest way to reduce the number of potential candidates to a manageable size. Any rulemaking should allow for at least two shareholders or groups of shareholders to have their director nominees included in order to ensure against domination by a single shareholder, as discussed above.
- Instant Run-off Voting (IRV): Since there may be up to three candidates for a given board seat and we want to ensure board members receive majority support, while minimizing the expense of elections, IRV should be required whenever there are three candidates. Under this procedure, voters rank the three candidates by preference. If no candidate wins a majority of first choices, then the last-place candidate is eliminated. Ballots of that candidate's supporters are then reallocated to their next-choice candidate and the winner is determined. For more information on IRV, see "Voting System Reform" at http://www.corpmon.com/VotingReform.htm.
- Exemption from Regulation 13-D: Communication among shareholders together holding more than 5% should be exempted from burdensome requirements under Regulation 13-D so long as that communication is limited to efforts to nominate director candidates. Shareholders should be able to openly discuss the merits of candidates without the need to file burdensome paperwork.
- Maximum Permissible Slate: Qualifying shareholders should have the right to nominate a maximum of half the board minus one at each shareholder meeting. This will discourage short-term speculators from using the process. Existing methodologies for shareholders to run an entire slate would remain in tact and provide an alternative, if more expensive one, for shareholders to seek a change in control.
- Director Statement: Each shareholder-nominated director candidate should have the opportunity to include a background statement (e.g. 500 word maximum) in the proxy statement in support of his or her candidacy. The word limit should include the ability to reference an Internet address where additional information can be obtained. Management-nominated candidates should be afforded the same opportunity with the same word limit.
- Provisions to Prevent Management from Gaming the System: If current rules are insufficient, new rules should contain appropriate provisions to prevent management or the incumbent board from seeking to pre-empt an independent shareholder effort to nominate directors by, for example, colluding with a friendly shareholder group to nominate directors who are in effect their own nominees.
- Broker voting (included in 4-461): When not directed by beneficial owners in each specific election, broker voting should not be allowed in the election of directors. Management should not gain an advantage from shareholders who are too lazy or busy to vote.
For example, the New York Stock Exchange's "10-day rule," adopted in 1937, allows brokers to vote on certain proposals if the beneficial owner hasn't provided voting instructions at least 10 days before a scheduled meeting. These broker votes are always cast in favor of management. The exchange justifies this unfair system by claiming that these proxy items are "routine." However, it is clear that even ratification of the auditor cannot be taken for granted as a "routine" matter.
- Improve disclosure requirements, not just for shareholder nominated directors, but for all nominees and directors: The SEC should require nominees to disclosure professional, financial and family relationships between themselves, other directors, top management and the corporation itself. Shareholders cannot properly assess the independence of potential directors unless potential conflicts of interest are properly disclosed.
- Reimbursement of expenses: Although SEC amendments should not provide reimbursement of campaign expenses for shareholder director nominees, the rules should include potential reimbursement if the company takes legal action to block shareholders using the open access process from their right to nominate and run candidates. Additionally, I would favor some overall limitation on campaign expenditures to prevent companies from overspending shareholder assets to protect the status quo.
- Diluting the board: Companies should be prohibited from increasing the number of board seats to dilute the impact of cumulative voting or the influence of shareholder nominated board members, as Sears did in one of the examples cited above.
Providing shareholders the ability to place the names of director nominees on the corporate ballot is the most significant step the SEC can take to restore investor confidence, avoid the need for overly detailed prescriptive regulations to prevent Enron type abuses and to release the wealth generating powers of the modern corporation. Shareholders can do much of their own monitoring and policing, if given this most significant tool.
It is vitally important that this right extend to individual small shareholders, as well as large institutional investors. Otherwise the positive effects will only be felt among Fortune 500 companies, instead of the 9,000+ public companies that make our economy so innovative and dynamic. Additionally, we don't want to move from management-dominated corporations to corporations dominated by a single shareholder. Both suffer access agency costs and are to be avoided. I urge the SEC to keep thresholds low so that all shareholders will see that they have an important voice in corporate governance and will be encouraged to use that voice to improve its value, rather than selling at the first sign of disappointment.
Request for Website Postings of All Written Comments
I respectfully request the SEC to post all written comments on S7-10-03, Possible Changes to Proxy Rules. It should be a relatively simple matter to scan documents received in hardcopy and post them to the Internet. This would facilitate greater public access to the information being considered by the SEC. Given the nature of this topic, possibly increasing democracy in corporate governance, I would hope that you would be especially sensitive to this possibility. This could save interested parties a significant expense, since we would avoid the need travel to the SEC's Public Reference Room in Washington, D.C. or to hire an agent to copy submissions.
I would welcome the opportunity to discuss my comments with staff. Please contact me at the phone number below.
James McRitchie, Editor
|1|| CII, "Equal Access - What is It?" undated copy, California Public Employees Retirement System (CalPERS), Investment Committee, Agenda Item 8d, March 17, 2003.
|2|| SEC Exchange Act Release No. 3347, December 18, 1942.
|3|| SEC Exchange Act Release No. 15,384, December 6, 1978.
|4|| Bank of Boston, Unocal, Amoco, and Thermo Electron, issued in January, February and March, 1990.
|5|| Section 14(a) of the Securities Exchange Act of 1934, 15 U.S.C. 78n(a)
|6|| See Robert A. G. Monks and Nell Minow, Corporate Governance (1995), pages 399-412.
|7|| Based on correspondence with Les Greenberg, May 2003.
|8|| See Corporate Monitoring site on the Internet at http://www.corpmon.com.
|9|| Jane W. Barnard, "Shareholder Access to the Proxy Revisited," Catholic University Law Review, Volume 40, Fall 1990, Number 1, page 54. Much of the subsequent historical material presented here is drawn from that article.
|10|| Id. at page 63, Re-examination of Proxy Rules, SEC Exchange Act Release No. 13,482.
|11|| BRT references from previously cited CII paper, "Equal Access - What is It?"
|12|| SEC Exchange Act Release No. 15,384, December 6, 1978, cited by Barnard, page 65.
|13|| Barnard, page 65.
|14|| Barnard, page 70.
|15|| Barnard, page 69.
|16|| Barnard, page 72. Bank of Boston, SEC No-Action Letter of January 26, 1990; Unocal, SEC No-Action Letter of February 6, 1990; Amoco, SEC No-Action Letter of February 14, 1990; and Thermo Electron, March 22, 1990.
|17|| Barnard, page 74.
|18|| The New Federalism of the American Corporate Governance System: Preliminary Reflections of Two Residents of One Small State, NYU, Ctr for Law and Business Research Paper No. 03-01; U of Penn, Inst for Law & Econ Research Paper 03-03, see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=367720
|19|| Paul A. Gompers, Joy L. Ishii, and Andrew Metrick, "Corporate Governance And Equity Prices," Quarterly Journal Of Economics, February 2003. See http://finance.wharton.upenn.edu/~metrick/gov.pdf
|20|| Robert A.G. Monks and Nell Minow, Power and Accountability, 1991. See http://www.ragm.com/library/books/poweracc/index.html
|21|| For these and more up to date studies, see http://www.nceo.org/library/corpperf.html
|22|| Suresh Srivastva and others, Job Satisfaction and Productivity, Kent, Ohio: Kent State University Press, 1977, p. xix.