December 5, 2003
Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street NW
Washington, DC 20549-0609
Re: File No. S7-19-03
Security Holder Director Nominations
Dear Mr. Katz:
I appreciate the opportunity to comment on the Commission's proposals to give stockholder-nominated director candidates access to company proxy statements in certain circumstances.
These comments reflect my first-hand knowledge of how the 3M Board of Directors operates and my observations of other successful and effective boards of directors.
The SEC's proposals are terrible public policy because they risk impairing the continued functioning of effective boards while failing to improve the operation of deficient boards. While the intent of the proposed "triggers" is sensible -- to permit easy ballot access for stockholders of companies whose directors are not appropriately aligned with the stockholders' interests while retaining the current system for those companies whose boards are performing conscientiously and competently -- the pending proposal is unfortunately not adequately tailored to achieve that objective. The proposed "triggers" are dangerously deficient because they fail to address the current realities of lock-step institutional voting and the insufficient resources available to institutions to assess the merits of stockholder proposals. As a result, the pending proposals will serve principally to permit groups with a narrow, specific focus to achieve board representation (with the attendant adverse consequences for the vast majority of stockholders described below), or to disrupt the company in the process of trying.
The pending proposals are far different from the positive reforms created by the Sarbanes-Oxley Act. While many companies arguably did not "need" that statute's new provisions, no company is significantly adversely impacted by them. Indeed, even the best managed companies benefit from the additional rigor and discipline provided by that Act. In contrast, for the reasons described below, the pending proposals risk palpable, adverse consequences for the functioning of the most effective boards. Because the proposed "triggers" fail to recognize the reality of contemporary institutional voting behavior, they make the risk of such unintended adverse consequences unacceptably substantial.
- The Overbroad Applicability of the Triggers
- The Proposal's "Triggers" are Unable to Distinguish Merited from Unmerited. The proposal attempts to confine the authority conferred on stockholders to only certain companies that have been "unresponsive" to shareholder concerns, presumably in recognition that the proposed remedy entails a risk of negative consequences (with which I agree as explained below) and is not appropriate for all companies. Unfortunately, the proposed "triggers" will eventually be satisfied by most companies. Currently a large majority of stockholders are institutional investors that typically cast their stockholder ballots in lock-step with the recommendation of a tiny number of associations, such as Institutional Shareholder Services (ISS). Approximately 55% of our top 50 institutional shareholders (representing about 50% of shares outstanding) follow ISS proxy voting guidelines. Neither the investors nor ISS or other such entities have the staff or resources to evaluate board-nominated director candidates on their individual merits. Instead they rely on a handful of litmus tests reflecting the policy decisions of ISS that are divorced from any one company's particular circumstances and, in most cases, have nothing to do with the company's "unresponsiveness" to shareholder concerns. The outcome of the elections that constitute the "trigger" mechanisms are controlled by these associations. The pending proposal is akin to having the U.S. Department of Education allocate federal education aid based on the suspect rankings of universities in U.S. News & World Report.
Conferring such power on a small group of associations with ranking systems is unwarranted. A recent experience at 3M provides a case in point: earlier this year a majority of our institutional holders approved a stockholder proposal related to "poison pills" that would have required the board to violate its fiduciary duties if it adopted the proposal as written.1 Notably, 3M has never had any poison pill. Nonetheless, ISS recommended approval.
In response to a similar stockholder proposal in the previous year, 3M's board resolved not to adopt a poison pill without stockholder approval, unless exigent circumstances led a majority of the independent directors to conclude that their fiduciary duties required them to act without the delay attendant on submission to stockholders. Despite this reasonable implementing resolution, which adopted the proposal to the extent permitted by the directors' fiduciary duties, ISS recommended that 3M stockholders approve this year's inapposite shareholder proposal, despite its inconsistency with fundamental notions of lawful corporate governance, and it won 58.9% of the vote. Many of the top 30 institutional shareholders we contacted in each of the past two years to discuss our position would not engage in any meaningful discussions, often citing adherence to ISS proxy voting guidelines that called for support of the shareholder proposal.
This recent experience at 3M, and others like it at other well-run companies, persuade me that the various "triggers" in the pending proposal, while intended to tailor the remedy to the perceived need, will in fact have broad application, including companies whose managements are properly aligned with the interests of investors. As our recent example illustrates, the "35% withheld" vote can be readily satisfied if one of the associations simply decides to recommend such withholding in the belief that it is useful to make the stockholder-nominating process "active," regardless of the merit of the directors at issue. Similarly, the 1% and 5% stock ownership requirements are far too low to constitute a reasonable test of significant stockholder dissatisfaction with existing management in light of two key factors: the absence of any meaningful transaction costs that might otherwise deter such holders from seeking access to the proxy; and the increase in narrowly-focused groups that seek board membership. In other words, the proposal will enable access not only to those boards that need a wake-up call, but also to any board where membership by a narrowly-focused group will be perceived by that group to advance its goals. For similar reasons, we believe the one-year holding period is too short to distinguish the casual holder seeking to advance a specific purpose from long-term investors concerned with the overall interests of the company and its other investors. While two years would appear reasonable for a test based on longevity of ownership, the stockholders comprising the group should be expected to commit to retain their holdings for a comparable period into the future, and any sale before then should be justified by clear changed circumstances.
In view of our strongly-held belief that the proposed triggers are not well aligned with the objective they are intended to serve, we advance alternative triggers for your consideration in the next section.
- Alternative Triggers. If the SEC concludes that it is necessary to experiment with risk, it should at most do so in a pilot program that targets those companies that have manifested objective earmarks of poor governance. This could be achieved by initially providing that the new election rules apply only to issuers with multiple management directors, or to those that have in recent periods been the subject of criminal prosecution.
In addition, the SEC's Enforcement Division could consider adding stockholder-nomination-of-director provisions, where appropriate, to the terms of consent decrees and administrative orders it enters into with companies that it has found have violated the securities laws. As you know, the SEC followed an analogous course for years in settling enforcement proceedings with individuals by barring them from serving in similar capacities with public issuers, despite the absence of explicit statutory authority for such relief.
Implementing the nomination proposal in a truly targeted manner would avoid risking the adverse consequences I foresee (and describe below) if the proposal is implemented with respect to all companies. It will also enable the SEC to develop empirical data concerning the operation of the proposed new procedures in actual practice, which it may then consider in determining whether to broaden the procedures' applicability in the future.
- The Foreseeable Harm
- Board Dynamics. The proposal appears to increase the election of stockholder-sponsored directors who have not been endorsed by a Board's nominating committee (if that is not the goal one would need to question the point of the exercise). The question is whether the resulting Board functions more effectively than a Board whose members are all approved by the Board's nominating committee. The potential for adversely impacting the Board is significant, and is not addressed by the comments I have reviewed to date.
Dean Sonnenfeld's seminal study of effective Board dynamics (Harvard Business Review, What Makes Great Boards Great, September 2002) correctly points out that:
What distinguishes exemplary boards is that they are robust, effective social systems. ... Team members develop mutual respect; because they respect one another, they develop trust; because they trust one another, they share difficult information; because they all have the same, reasonably complete information, they can challenge one another's conclusions coherently; because a spirited give-and-take becomes the norm, they learn to adjust their own interpretations in response to intelligent questions.
I agree with that observation. In discharging its oversight and supervisory functions, the Board acts best when it uses its collective insight and experience to test, question and challenge the plans of the CEO and senior management. It is important that Board dynamics promote a spirit of constructive challenge, which occurs when board members respect one another and are committed to working well together. Introducing one or more directors who may lack the respect of other board members, or who consider themselves accountable to the stockholder subgroup that nominated them, risks developing political factions within the board and disrupting the critically important goal of developing and sustaining effective board dynamics.
An effective board must also serve as a sounding board for and give trustworthy advice to the CEO. The position of CEO in a modern major publicly held American corporation is very demanding, and the dynamics of corporate management makes the CEO's position a lonely one. CEOs must have confidence in the wisdom of the board so that they can confide in and seek guidance from the group responsible for the business' direction. Including a director not approved by other board members will risk constricting the communication between board and CEO that is critical to effective oversight and management.
No director selection mechanism can absolutely guarantee a thoughtful, responsible group of directors who feel empowered and obligated to perform the key Board tasks - asking hard questions when senior management may stray from sensible and ethical business decisions, providing support where senior management is on a path that is correct but challenging or uncertain, and advising the CEO on the myriad issues that must be resolved if the corporation is to prosper. The most effective selection process needs independent directors on the board's nominating committee who take their selection responsibility seriously, approach the task of director nominations with the same sense of fiduciary duty they apply to other significant board decisions, and devote the time necessary to assure that the new director(s) meet the board's current needs and enhance the diverse qualities that a board collectively requires.
It is equally appropriate for the nominating committee to consider nominees proposed by stockholders, as it is for the committee to consider nominees proposed by the CEO, search firms or others. A rule (whether promulgated by a state legislature, or if within its authority, the Commission) that mandates such consideration may be useful for those companies whose board members do not carefully and independently consider all potential nominees. A rule that overrides the role of the independent nominating committee in favor of ballot access for stockholder-nominated director candidates increases the chance for a dysfunctional board, and reduces the chance for a collegial board of thoughtful and challenging directors from whom the CEO seeks guidance.
The recent conduct of the United States Senate Judiciary Committee on judicial nominees shows why selecting members by individual constituency elections does not foster cooperation devoted to the good of the whole. The Senate's divisiveness may reflect a divided electorate, but it is a dysfunctional model for selecting members who oversee and supervise a profit-making enterprise.
- Director Selection Process. A basic tenet of Delaware corporate law is that the board of directors is ultimately responsible for managing the business and affairs of a corporation. Directors, as fiduciaries to the corporation and its shareholders, must diligently exercise their responsibilities as managers of the corporation, and are strictly forbidden from delegating their responsibilities to stockholders. The process for selecting directors is one of the most important tasks a board performs. At 3M, the Nominating and Governance Committee and 3M's Board devote substantial efforts to ensure that the Board is comprised of individuals with distinguished records of leadership and success who will contribute substantially to Board operations.
The 3M Board's Governance Guidelines address this important responsibility as follows:
The Nominating and Governance Committee periodically reviews with the Board the appropriate skills and characteristics required of Board members given the current Board composition. It is the intent of the Board that the Board, itself, will be a high performance organization creating competitive advantage for the Company. To perform as such, the Board will be comprised of individuals who have distinguished records of leadership and success in their arena of activity and who will make substantial contributions to Board operations. The Board's assessment of Board candidates includes, but is not limited to, consideration of:
(i) Roles and contributions valuable to the business community,
(ii) Personal qualities of leadership, character, judgment and whether the candidate possesses and maintains throughout service on the Board a reputation in the community at large of integrity, trust, respect, competence and adherence to the highest ethical standards,
(iii) Relevant knowledge and diversity of background and experience in such things as business, manufacturing, technology, finance and accounting, marketing, international business, government and the like; or
(iv) Whether the candidate is free of conflicts and has the time required for preparation, participation and attendance at all meetings.
A Director's qualifications in light of these criteria is considered at least each time the Director is re-nominated for Board membership.
The SEC's proposal is inadvisable because it (i) impermissibly delegates the board's responsibilities for director selection to certain shareholders for shareholder-nominated candidates, (ii) excludes consideration of the board's membership criteria for such candidates, and (iii) completely removes the Nominating and Governance committee and the full board from the process of ensuring "the Board will be comprised of individuals who have distinguished records of leadership and success in their arena of activity and who will make substantial contributions to Board operations."
- Availability of Superb Director Candidates. Also undesirable is the disincentive the proposals create for encouraging qualified director candidates to stand for election to corporate boards. Government policies ought to actively encourage eminently qualified candidates to serve on publicly held corporate boards. Instead, the proposals are a disincentive for that service at a critical time in the nation's business history. There are already too few attractive candidates for board service. This is due not so much to a fear of serving in the current climate, but to the added time board duties now plainly require. The added demands of time and attention limit the number of boards on which qualified people may serve. The proposals are another disincentive because qualified candidates are unlikely to agree to be nominated if they will risk becoming subject to a proxy contest that focuses on them personally. Many attractive candidates already facing many complicated demands will not participate in a process burdened by a significant risk of a contested election. As a result, actuating the stockholder nominating process can be expected to deter the willingness of qualified directors to serve.
Those seeking to improve the governance process in the university setting may view the recent contested election for membership in the Yale Corporation (Yale University's supervisory body) as instructive. Apparently, neither Yale nor the diverse members of its Corporation found the experience to be positive.
- Distraction of Board and Management. When the inevitable occurs, the management and directors will likely try to defeat the actuating resolution or the election of the stockholder-appointed nominee. Any such effort requires extensive communications with stockholders, including travel to the locations of major institutional holders. Management has a finite amount of time and energy to operate the business; allocating a substantial portion of it to this pursuit necessarily detracts from managing the enterprise.
- Ineffectiveness of the Proposal. Risks to the functioning of currently successful boards might be worthwhile if the proposal clearly promised to enhance oversight and effectiveness of deficient boards. But it is hard to see how adding one or two stockholder-nominated directors is highly likely to make a positive material difference. Can the SEC identify the person who, if selected by stockholders to the Enron board, would have altered the course of Enron's misconduct? Without engaging in hindsight, does the Commission believe a single director who perceives ambiguous corporate wrongdoing can persuade other directors to act on that perception? Without a significant basis to conclude that the pending proposal, had it been enacted in 1997, would have prevented Enron's misdeeds, the potential benefits of the proposal do not outweigh its clear risks.
- A final note. There is at most an imperfect analogy between "stockholder democracy" and political democracy. Political democracy is premised on electing legislators and executive officers, not supervisory or oversight boards similar to a corporation's board of directors. The characteristics of a legislative body in a democracy are very different from those of a corporate board. Legislators must try to reach a compromise between political interests. Corporate boards are not in the business of achieving compromise but instead must set a clear, coherent, and productive agenda for the corporation and management to follow.
Democratic government limits people's right to vote on the theory that non-citizens do not have the same long-term stake in the polity. Corporation law does not make a long-term stake a prerequisite to voting, perhaps because economic investment is a surrogate for such a stake. Unlike citizens, however, dissatisfied stockholders can express their dissatisfaction with management by selling their stock. Citizens, in contrast, rarely can move to a different country and must use the democratic process to express their dissatisfaction with elected officials. If there is any useful analogy to draw, it is that citizens' access to the ballot for nominating candidates should be less restricted than that of stockholders'.
In short, theoretical notions of "stockholder democracy" should not drive changes in corporate governance that are likely to undermine the very objectives they seek.
The SEC's recent initiatives on the conduct of board nominating committees and improved transparency of board actions have not been in place long enough to be tested in practice. Such reforms are intended to improve materially the board composition in those companies where improvement is needed. It seems radical to adopt the pending proposals before evaluating the effectiveness of other recent initiatives. It would be prudent to defer consideration of such risk-laden experiments until the other recent initiatives are implemented and their effectiveness assessed.
I would be pleased to discuss these issues with the Commission or its representatives.
Very truly yours,
W. James McNerney, Jr.
cc: Hon. William H. Donaldson-Chairman, U.S. Securities and Exchange Commission
Hon. Paul Atkins-Commissioner
Hon. Roel Campos-Commissioner
Hon. Cynthia A. Glassman-Commissioner
Hon. Harvey Goldschmid-Commissioner
Alan L. Beller-Director, Division of Corporation Finance
|1|| This proposal, presented in boilerplate form applicable to any corporate entity, was in its entirety: "This is to recommend that the Board of Directors redeem any poison pill previously issued (if applicable) and not adopt or extend any poison pill unless such adoption or extension has been submitted to a shareholder vote." Notably, the Delaware courts shortly before our annual meeting this spring reaffirmed the potential desirability of a "poison pill" as a means for conscientious directors to protect important stockholder interests in certain circumstances. See Creo, Inc. v. Printcafe Software, Inc., C.A. No. 20164, Chandler, C (Del. Ch. Feb. 21, 2003)(TRANSCRIPT) (rejecting injunction against adoption of rights plan, as directors "were acting consistent with their obligations and fiduciary duties to achieve the highest and best value reasonably obtainable for the Printcafe shareholders if in fact the company is going to be sold.")