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June 13, 2003

Jonathan G. Katz
Securities & Exchange Commission
450 Fifth Street N.W.
Washington, DC 20549-0609

Re:  S7-10-03 Possible Changes to Proxy Rules

Dear Mr. Katz:

I have been a shareholder activist since 1997 when I submitted my first shareholder proposal pursuant to rule 14a-8. Since then, I have conducted sixteen full-fledged proxy contests, i.e., where I actually sought proxy authority from shareholders. Other than the first two such contests, I have not used a lawyer (except for related litigation) or a proxy solicitor. I have also submitted many rule 14a-8 proposals and conducted a few "just vote `No'" solicitation campaigns pursuant to rule 14a-2(b) where I did not seek proxy authority. I have threatened a number of other proxy contests that did not take place because an accommodation was reached with management to take action to enhance shareholder value.

I have sued the managements of a few companies that abridged the franchise rights of shareholders and I have been countersued in return for alleged violations of section 13D and rule 14a-9.1 In each of these lawsuits, my goal was to allow shareholders to freely vote their shares and management's goal was to make me "go away."

I have dealt with many SEC staff members in the Division of Corporation Finance and the Division of Investment Management with respect to (1) requests by lawyers for management seeking no action assurance if they were to exclude a rule 14-8 proposal I submitted from the company's proxy card and (2) the filing/review/comment/response process when I sought to solicit proxies. My sense is that some staffers respect me for taking principled positions and others think I am a pain in the neck because I give them a hard time or refuse to comply with their "comments" when I think they are wrong.

Over the past six years, I have read many legal opinions, SEC releases and no action letters and scholarly articles on corporate governance and proxy contests and as a result, have become a pretty good amateur lawyer in this area. My "hands on" experience with contested proxy solicitations combined with my extensive "book knowledge" has given me a unique perspective about what in the proxy rules is broken and how to fix it.

Do the Proxy Rules Stifle Shareholder Democracy?

On October 16, 1992, after "an extensive three-year examination by the Commission of the effectiveness of the proxy-voting process and its effect on the corporate governance system in this country," it issued Release No. 34-31326 (the "Release"). The Release refreshingly admitted that "the demonstrated effect" of the proxy and disclosure rules was "contrary to Congress' intent that the rules assure fair and effective corporate suffrage." A number of amendments and new rules were adopted "to reduce [the] burdens [of] unnecessary regulatory impediments to communication among shareholders and others and to the effective use of shareholder voting rights."

The Release called for a lighter regulatory hand with regard to shareholder communication:

A regulatory scheme that inserted the Commission staff and corporate management into every exchange and conversation among shareholders, their advisors and other parties in matters subject to a vote certainly would raise serious questions under the free speech clause of the First Amendment particularly where no proxy authority is being solicited by such persons. This is especially true where such intrusion is not necessary to achieve the goals of the federal securities laws.

The purposes of the proxy rules themselves are better served by promoting free discussion, debate and learning among shareholders and interested persons, than by placing restraints on that process to ensure that management has the ability to address every point raised in the exchange of views.

With respect to "corporate performance, management capability or directorial qualifications," the Release asserted, "much commentary . . . is by its nature judgmental. As to such opinions, there is typically not a 'correct' viewpoint." The Release specifically urged a "hands off" approach in contested situations:

The Commission believes that the most cost-effective means to address hyperbole and other claims and opinions viewed as objectionable is not government screening or resort to the courts. Rather, the parties should be free to reply to the statements in a timely and cost-effective manner, challenging the basis of the claims and countering with their own views on the subject matter through the dissemination of additional soliciting material. The amendments adopted today applicable to regulated solicitations are intended to promote that goal.

Unfortunately, the Release's goal of easier shareholder communication and more shareholder democracy has not been entirely realized. The proxy rules as they exist today continue to impose heavy "burdens [of] unnecessary regulatory impediments to communication among shareholders and others and to the effective use of shareholder voting rights" and "the demonstrated effect" of the proxy and disclosure rules remains today "contrary to Congress' intent that the rules assure fair and effective corporate suffrage."

The Proxy Rules and the First Amendment

Some of the proxy rules and procedures are almost certainly unconstitutional when applied to proxy contests because they purport to proscribe speech or have the effect of chilling it. For example, there is little doubt that a court would find that the requirement to pre-file contested proxy materials2along with the staff's review/comment/response procedure constitutes a scheme of "prior restraint," i.e., the censorship or chilling of protected speech prior to a full, adversarial, and final adjudication of the legality of the speech. As the Supreme Court has repeatedly made clear, "[a]ny system of prior restraints of expression comes to this Court bearing a heavy presumption against its constitutional validity."3 Generally, a government agency may not engage in prior restraint of speech absent "a clear and present danger,"4a standard that would be virtually impossible to meet in the context of a contested proxy solicitation. Much of what staff reviewers do conflicts with what the Supreme Court said in New York Times v. Sullivan, 376 U.S. 254 (1964): "Authoritative interpretations of the First Amendment guarantees have consistently refused to recognize an exception for any test of truth - whether administered by judges, juries, or administrative officials - and especially one that puts the burden of proving truth on the speaker."

The obvious -- and only -- solution is to abandon the review/comment/response procedure for contested solicitations.

In addition to being at odds with First Amendment jurisprudence, staff review of contested solicitation materials is a poor use of the Commission's (and proxy contestants'5 resources. Too many staff comments deal with minutiae or demand the basis for the soliciting person's opinions rather than, as the Release advocated, allowing the opposing party to counter opinions it deems objectionable. Comments asserting real fraud are rare. It seems as if staffers are expected to produce many comments and they do that by demanding a factual basis for almost every opinion. This may be partly a result of the silly examples of "misleading" statements in the note to rule 14a-9. In the Release, the Commission explained why rule 14a-9 is needed, i.e. "to deal with the problem that would arise if a shareholder was advised that his or her shares were going to be voted on the election of directors and auditors, and instead the proxy was used to vote, for example, in favor of a merger with another company owned by insiders on unfavorable terms." Compare that sort of outright fraud with the trivial examples of misleading statements in the note to rule 14a-9:

  1. Predictions as to specific future market values.6Material which directly or indirectly impugns character, integrity or personal reputation, or directly or indirectly makes charges concerning improper, illegal or immoral conduct or associations, without factual foundation.

  2. Failure to so identify a proxy statement, form of proxy and other soliciting material as to clearly distinguish it from the soliciting material of any other person or persons soliciting for the same meeting or subject matter.

  3. Claims made prior to a meeting regarding the results of a solicitation.7

Certainly, none of these things rise to the level of advising "a shareholder . . . that his or her shares [are] going to be voted on the election of directors and auditors, and instead [using] the proxy . . . to vote . . . in favor of a merger with another company owned by insiders on unfavorable terms." Staffers should be reassigned from unproductive (and illegal) censorship duty to more useful tasks.

Another proxy rule that is almost certainly unconstitutional is rule 14a-4(d) because it proscribes a soliciting person from disclosing the names of the persons for whom the proxy holder will vote. Moreover, such forced nondisclosure of material information may be inherently misleading and sets up a "Catch 22" between compliance with rule 14a-4(d) and compliance with rule 14a-9. There is little doubt that rule 14a-4(d) would be invalidated by a court to the extent it proscribes someone from providing truthful information to shareholders. On a number of occasions, the Supreme Court has invalidated laws that purport to bar truthful speech. Recently, in Thomson v. Western States Medical Center (2002), the Court invalidated an FDA regulation that barred pharmacists from providing truthful information about a certain class of drugs, stating: "We have previously rejected the notion that the Government has an interest in preventing the dissemination of truthful commercial information in order to prevent members of the public from making bad decisions with the information."

There are other provisions of the proxy rules that violate the First Amendment when applied to a contested solicitation. In general, any rule for proxy solicitations that would be unconstitutional if applied to an election for political office is unconstitutional and should be abandoned. As the Release stated: "A regulatory scheme that inserted the Commission staff and corporate management into every exchange and conversation among shareholders, their advisors and other parties in matters subject to a vote certainly would raise serious questions under the free speech clause of the First Amendment particularly where no proxy authority is being solicited by such persons. (Emphasis added) There is no apparent legal basis to support a lower degree of First Amendment protection for the speech of persons that do solicit proxy authority. Therefore, the Commission should direct the staff to thoroughly review the proxy rules and related Commission practices and promptly rescind any ones that conflict with the First Amendment.

The Corporate Director Nomination Process

The question of whether the shareholder nomination process should to be broadened is a hot topic. Large and small shareholders generally support more shareholder involvement while management worries that that could lead a company becoming an asylum run by the inmates.

In a recent article8 two Chancellors of Delaware's Court of Chancery weighed in with their views on the corporate election process, calling it called "the forgotten element to reform." They write:

If [the philosophy that genuinely independent directors who owe their allegiances entirely to the corporation and its stockholders are valuable to investors] is so central to our system of corporate governance, one can rightly ask why the current incumbent-biased corporate election process should be perpetuated. As of now, incumbent slates are able to spend their companies' money in an almost unlimited way in order to get themselves re-elected. As a practical matter, 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. The aberrational cases in which shareholder activists have actually mounted proxy contests tend to prove the incumbent bias of the system, rather than cast doubt on it.

They conclude that "the rhetorical analogy of our system of corporate governance to republican democracy will ring hollow so long as the corporate election process is so tilted towards the self-perpetuation of incumbent directors." Despite the moaning of those in "the corporate community" who are rightfully concerned about their own security, there is no valid reason to allow directors of corporations to perpetuate themselves via elections more suitable to "banana republics" than western democracies. The SEC should be skeptical of any suggestion that pursuing an evenhanded corporate election process is a bad idea. To encourage shareholder democracy, it can start by considering whether rules like rule 14a-12 and rule 14a-8(i)(8) promote non-competitive "banana republic" elections.

Let me offer an example of what is wrong with the current system. Last week, Xerox announced that it would reimburse the bulk of some $22 million in penalties that six of its former executives agreed to pay to the SEC to settle a case alleging that they profited from improper accounting. The SEC announced the settlement in a June 5, 2003 press release that read in part:

"A public company's stock price should reflect economic reality, not a distortion of that reality," said Stephen M. Cutler, the SEC's Director of Enforcement. "As alleged in the complaint, Xerox's senior management substituted accounting devices for the company's true operational performance. The investing public pays an enormous price for such fraudulent conduct."

"Manipulation of revenue and earnings through accounting devices has no place in the executive suite," said Paul R. Berger, Associate Director of Enforcement. "The executive suite should be reserved for those who will tell the investing public the truth about the company's performance. That didn't happen here and Xerox's shareholders were deceived."

According to a report in The Rochester Democrat and Chronicle, Xerox's directors quickly decided that the deceived shareholders should bail out the very folks that deceived them:

But top officials at the Securities and Exchange Commission -- which brought the charges -- appear to be bristling at Xerox's decision to pay about $19 million of the $22 million in penalties imposed on the six, plus legal fees.

"The shareholder has a right to be upset and angry that the company -- and he or she as part owner of it -- has decided to indemnify individuals who are alleged to have participated in a massive financial fraud," said Paul Berger, associate director, Division of Enforcement at the SEC.

Now, if one of those "upset and angry" Xerox shareholders were to submit a rule 14a-8 proposal calling for the replacement of those directors responsible for indemnifying alleged fraudsters, he would quickly find himself stymied by the issuance of a letter from the SEC staff to Xerox agreeing not to recommend any action to the Commission if it omits his proposal on the ground that "the proposal may properly be excluded from the Company's proxy material pursuant to rule 14a-8(i)(8) because it relates to an election for membership on the company's board of directors." Indemnification for the misdeeds of those in control of corporate assets combined with a system that insulates them from any meaningful accountability is a recipe for further corporate waste and corruption.

There is no doubt that the current election process insulates even the worst directors from a meaningful challenge. In short, maintenance of the status quo is indefensible.

Whatever reforms are considered with respect to corporate elections should meet the standard for fairness set forth in Aprahamian v. HBO & Co., 531 A.2d 1204, 1206-07 (Del. Ch. 1987):

The corporate election process, if it is to have any validity, must be conducted with scrupulous fairness and without any advantage being conferred or denied to any candidate or slate of candidates. In the interests of corporate democracy, those in charge of the election machinery of a corporation must be held to the highest standards in providing for and conducting corporate elections.

Moreover, the importance of allowing shareholders to nominate candidates for director was considered in Durkin v. Nat'l Bank of Olyphant, 772 F.2d 55, 59 (1985::

We rest our holding . . . on the common sense notion that the unadorned right to cast a ballot in a contest for office, a vehicle for participatory decision-making and the exercise of choice, is meaningless without the right to participate in selecting the contestants. As the nominating process circumscribes the range of the choice to be made, it is a fundamental and outcome-determinative step in the election of office-holders. To allow for voting while maintaining a closed candidate selection process thus renders the former an empty exercise. This is as true in the corporate suffrage context as it is in civic elections . . . .

Here is the way I would propose the corporate election machinery should look like in order to make elections for directors of publicly traded companies more meaningful:

  1. Eliminate the use of the proxy statement and proxy card and replace them with an impartial information circular and absentee ballot. - The use of proxies is inherently unfair and confusing, especially in the context of a contest. This is because a proxy statement and proxy card constitute a hybrid of a disclosure document and partisan electioneering material. It is ironic that those who oppose granting shareholders access to management's proxy card express a feigned concern that doing so would create confusion for shareholders. The truth is just the opposite.

    First of all, many shareholders have no idea as to what is the effect of their checking the "Withhold" box on a proxy card. In the course of proxy contests I have conducted, shareholders that support my nominee have told me that "I already voted against management on its proxy card." (I then explain why a vote to "Withhold" for management's nominees on its proxy card is not the same as a vote "For" my nominees on my proxy card and that if a shareholder wishes to elect my nominees he must vote affirmatively for them on my proxy card.) As a result of such confusion, millions of shares are voted incorrectly each year. If one absentee ballot listing all the nominees were provided instead of two different proxy cards, a shareholder would know exactly who he was voting for, just as he does in a political or union election.

    Secondly, the rules about revoking proxies are confusing to many shareholders. In a proxy contest, shareholders may not understand that their latest dated proxy revokes all previous ones. Thus, a shareholder that already voted for the challenger's nominees may unwittingly void his earlier vote if he gets a subsequent proxy card from management and marks it "Withhold."

    Finally, the proxy rules permit, and it is not uncommon for management and a challenger to issue proxy cards that are different from one another. For example, a challenger may seek to elect a "short slate" of only one nominee while management's proxy card contains a full slate of three nominees. Trying to reconcile these two proxy cards is confusing to shareholders. Placing all four nominees on one ballot and simply stating that the three nominees receiving the greatest number of votes will be elected is much more understandable. Or, a challenger may include one or more proposals on his proxy card that are excluded from management's card pursuant to the complicated provisions of rule 14a-4(c). The upshot is that, as a result of the so called "discretionary authority" permitted by rule 14a-4(c), a shareholder who returns a proxy card to management can unknowingly have his shares vote against a proposal he would actually favor. An absentee ballot containing all proposals would be much less confusing for shareholders and allow them to vote on all proposals as they wish. Moreover, allowing a proxy holder to exercise unnecessary discretionary authority is inconsistent with democratic principles and fair elections.

    To summarize, it would be much less confusing to replace competing proxy cards with one official absentee ballot listing all nominees and all proposals to be presented at the meeting. No matter how many mailings a shareholder receives from the contesting parties, each would contain the very same ballot with the same boxes to check.

    Finally, in lieu of separate proxy statements, an information circular containing unbiased information about the matters to be voted on at the meeting would accompany the initial absentee ballot. The information statement might or might not permit each nominee to make a policy statement of a maximum length. Any written material beyond that would be considered soliciting material and would be the responsibility of the contestant that sends it, not the company.

  2. U> Each company should be required to adopt a bylaw establishing an equitable procedure for nominating candidates. -- Rather than have the SEC establish "one size fits all" eligibility requirements for making shareholder nominations pursuant to rule 14a-8, each company must establish its own requirements provided they do not confer or deny any advantage to any candidate or slate of candidates and are not preclusive, i.e., not have the effect of barring a contest. Incumbents and challengers would have to meet the same requirements and follow the procedures. For example, if a company requires the written support of shareholders owning 3% of the outstanding shares in order to nominate candidates, that requirement would apply to incumbents and challengers alike. To avoid nuisance candidates, a company may limit the number of nominees in any equitable way.

  3. Shareholders would send absentee ballots to a neutral third party. - It is a conflict of interest for management to be in charge of the election machinery if it is also a contestant. Therefore, all absentee ballots would be sent to a neutral third party such an independent inspector of election or the company's outside auditor. The neutral third party would have the power to take all measures necessary to insure that the election is conducted fairly.

  4. Each company should be required to adopt a bylaw establishing an equitable procedure for allocating electioneering costs among the contestants. - Any reforms regarding making nominations will be diluted if management has unlimited access to the corporate treasury to gain re-election while challengers must pay their own expenses. A fair method of allocating electioneering costs is necessary to insure a level playing field. For example, a company with ten million shares outstanding could allocate a maximum of $100,000 for soliciting expenses with each contestant receiving reimbursement for the lesser of his reasonable expenses or $0.01 per vote cast for his slate of nominees.

The above procedure is similar to that used for political elections. There is no reason to accept a less democratic standard for corporate elections. If, however, the Commission determines to retain the confusing system of separate proxies and allow shareholders to make nominations on management's proxy card via rule 14a-8, I recommend that it be guided by Aprahamian by establishing a procedure that does not result in "any advantage being conferred or denied to any candidate or slate of candidates."

Rule 14a-8 Reforms

The staff spends far too much time responding to no action requests from companies seeking to exclude shareholder proposals submitted pursuant to rule 14a-8. Furthermore, its responses have sometimes been inconsistent and not infrequently are based on shaky legal reasoning. I propose eliminating rule 14a-8, substituting an absentee ballot for management's proxy as described above and requiring each company to establish an equitable and reasonable procedure for submitting proposals to appear on the absentee ballot. There would be no basis for excluding any proposal other than a determination that the proponent failed to follow the procedure or did not meet the eligibility requirements. If management deems a proposal to be of questionable legality, its position can be stated in the information statement and the proponent can respond. If it is adopted, its legality can then be litigated. This is preferable to the staff predicting, based on scant evidence and tenuous legal support, that a court would determine that a proposal could not be implemented and thus, shareholders should not vote on it.

If rule 14a-8 is retained in substantially the same form, then to limit frivolous or abusive no action requests to exclude proposals, each request should be accompanied by an affidavit from the company certifying that: (1) management has made a reasonable effort to resolve its differences with the proponent and failed, and (2) the board has determined that (a) it is in the best interests of shareholders that the proposal in question be excluded from management's proxy card and (b) the cost of seeking no action relief is reasonable for the benefit to be gained.

Also, the staff often seems to grudgingly accept dubious legal arguments as to why a particular proposal is excludable. As a result, many no action letters say: "There is some basis for your position that . . . ." This phrase suggests that management has not met its burden under rule 14a-8(g) to "demonstrate that it is entitled to exclude a proposal." Neither the staff nor the Commission should issue a no action letter unless they are willing to include words to the effect that "you have clearly and convincingly demonstrated to us that you are entitled to exclude the proposal."

NYSE Rule 452 and "Discretionary Voting"

This rule is should be renamed the "rigged vote count" rule. Its purpose is ostensibly to aid companies to achieve a quorum. It would be hard to find an intelligent investor that believes that. The real purpose of Rule 452 is more likely to give an inflated picture of shareholder support for the management responsible for paying the NYSE's listing fees. In plain language, one hand washes the other.

How does rule 452 work. Let's use Xerox again as an example. If, at Xerox's next annual meeting, many of those justifiably "upset and angry" shareholders decide to vote to "Withhold" for the incumbent directors in order to send the board a message, the NYSE will nevertheless declare the election for directors to be "routine" (assuming there is no challenger soliciting proxies) with the result being that all uninstructed proxies for shares held in street name will be voted for management's nominees. Let's assume that holders of 25% of the shares actually vote for the nominees, holders of 30% of the shares vote to "Withhold" and holders of 45% of the shares don't vote. Of the 45% of shares not voting, assume 35% are held by in street name by stock brokers that "discretionarily" (What a euphemism!) vote for the nominees. Then, instead of 25% of the votes being cast for the nominees and 30% to "Withhold," the results are reported as 60% for their election and 30% to "Withhold," making it appear as if the shareholders support management by a margin of 2-to-1.

The NYSE should not have the power to distort the results of an election for self-serving reasons. While lesser reforms to rule 452 such as requiring brokers to use mirror or proportional voting for uninstructed proxies are possible, the best solution is just to get rid of rule 452 completely. If obtaining a quorum is problematical for publicly traded companies, the respective state legislatures or the companies themselves can lower the quorum requirements. The SEC should outlaw any procedure like rule 452 that yields phony voting results. End of story!

Equal Access to Shareholder Lists

If an election is to be fair, a challenger must have access to the company's shareholder list and, if management obtains it, the NOBO list. In Release Nos. 34-20021 and 40-13408 (July 28, 1983), the Commission concurred with commentators asserting that "equal access to these lists is essential if the balance between issuers and proxy contestants or tender offerors is to be maintained" and stated that it "anticipates making any necessary changes in the proxy and tender offer rules . . . prior to the time Rule 14b-1(c) and the amendment to Rule 17a-3(a)(9) become effective." Somehow, the "necessary changes" were never made. I know things sometimes take longer than expected but twenty years is a pretty long time to wait.

Rule 14a-7 was last modified in Release No. 31326 and it contains several provisions that are used as loopholes that management can use to deny proxy contestants equal access to shareholder lists including NOBO lists. Rather than tinkering with rule 14a-7, it should be changed to require a company to promptly provide, at the company's expense, any and all shareholder lists reasonably obtainable by the company to any record or beneficial shareholder that asks for it provided he affirms that he will only use the lists for a proper purpose, e.g., to communicate with shareholders about the company. The company should not have the option of mailing the shareholder's soliciting material in lieu of providing the lists because that is by definition, not equal access. Because not every state guarantees equal access to shareholder lists, the Commission should adopt a rule to provide a level playing field.


The corporate scandals of recent years have demonstrated that power without real accountability is a recipe for corruption. Under corporation law, the only recourse for shareholders who do not approve of management is to vote the rascals out. Yet, even in companies where malfeasance has been egregious, that has been rare because management controls the election machinery. This is an opportune time for the Commission to make the process of electing directors more democratic. Hopefully, it will listen to investors, dismiss the self-serving arguments of management and propose some meaningful reforms.

Very truly yours,

Phillip Goldstein
Kimball & Winthrop, Inc.
General Partner

1 Almost by definition, a lawsuit brought by a company against a shareholder engaged in a proxy contest is abusive. I am familiar with dozens of such lawsuits alleging section 13D or rule 14a-9 violations and I have yet to see one that had any merit. Invariably, the sole purpose of such a lawsuit is to impose costs on a shareholder seeking to oust management in the hope of making him "go away."
2 Rule 14a-6
3 Bantam Books, Inc. v. Sullivan, 372 U.S. 58, 70 (1963)
4Schenck v. United States, 249 U.S. 47 (1919)
5 Since most proxy contestants engage a lawyer to deal with the SEC staff, the filing/review/comment/response process can impose significant legal costs on a challenger in a proxy contest. Management's lawyers are paid with the company's funds so the process tilts the playing field in management's favor.
6 This example may have been superseded by Congress when it adopted the Private Securities Litigation Reform Act of 1995 ("PSLRA"). The PSLRA established several safe harbors for certain "forward-looking statements." The Eleventh Circuit in Harris v. Ivax Corporation, 182 F.3d 799 (11th Cir. 1999), held that one such safe harbor applies to any statement about a company "whose truth or falsity is discernible only after it is made." As the court explained, Congress' intent was "to loosen the `muzzling effect' of potential liability for forward-looking statements, which often kept investors in the dark about what management foresaw for the company." Similarly, nothing in rule 14a-9 should encourage a "muzzling effect" on forward-looking statements made by proxy contestants.
7 Id.
8 William B. Chandler III and Leo E. Strine, Jr., The New Federalism of the American Corporate Governance System: Preliminary Reflections of Two Residents of One Small State, Working Paper To be Published at __ U. Pa. L. Rev. ___ (2003) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=367720