America's Community Bankers
December 18, 2003
Jonathan G. Katz
Re: Security Holder Director Nominations
Dear Mr. Katz:
America's Community Bankers ("ACB")1 is pleased to comment on the proposed rule issued by the Securities and Exchange Commission ("SEC") that would require companies to include in their proxy materials shareholder nominees for election as director.2
The proposal would establish a two-step process for allowing shareholders to list director nominees in a company's proxy material. The first step would be the occurrence of an event that would trigger a requirement to allow shareholder access to the company's proxy process ("shareholder triggering event"). Once a shareholder triggering event occurs, certain shareholders would be able to include a director nominee on the company's proxy during the calendar year in which the event occurs, anytime during the subsequent calendar year, and the portion of the next calendar year up to and including the annual meeting. The rule identifies the shareholders that could nominate a director once a shareholder triggering event occurs and establishes eligibility criteria for a nominee. The proposed rule also contains detailed notice and timing provisions.
ACB opposes this proposal. We urge the SEC to withdraw this rule at this time and monitor the impact of the new corporate governance-related rules issued by the SEC and the stock exchanges over the past two years, including new disclosure requirements addressing the director nomination process and shareholder communications with directors. These rules and passage of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley")3 have helped achieve a better appreciation for the needs and interests of investors and should be given time to work before implementation of a rule whose benefits are far from clear. If the SEC feels it is necessary to give some shareholders access to a company's proxy, we support the suggestion that the proposal be applied initially only to "accelerated filers" so that the SEC can examine the impact of the rule on larger companies before applying it more broadly.
While we appreciate the SEC's efforts in trying to balance the interests of shareholders and public companies in this proposed rule, the result is a very complex and probably unworkable scheme that will not serve the investor community or public companies very well. The two-step process and the detailed notice and timing provisions will make the rule burdensome and unmanageable if the process is triggered frequently, yet most shareholders will not receive any benefit from the rule at all. In fact, with the potential for creating disruptive election campaigns initiated by a minority of shareholders every year, the majority of shareholders could be harmed by the board's preoccupation with director elections rather than focusing on company business. The controversial aspects of the rule and the broad range of procedural and substantive issues that must be dealt with are reflected in the over 300 questions that have been submitted for public comment.
Smaller companies, like community banks, tend to be more responsive to shareholders and are less able to deal with the burden imposed by this rule if it is abused by shareholders with an agenda adverse to the interests of all shareholders. We are particularly concerned about the proposal's effect on mutual institutions that are considering conversion or have recently converted to stock form. This rule could give investors with narrow self-interests additional leverage to force a sale of these institutions.
The establishment of a two-step process complicates the rule and will lead to endless debate over what constitutes an appropriate shareholder triggering event. We also believe that the proposed thresholds for the shareholder triggering events will be more easily achieved for shareholders of our community bank members than shareholders of larger companies. If triggering events are to be used, they should be revised to more clearly evidence shareholder displeasure with the board's oversight of the company. We also suggest that the SEC consider eliminating the shareholder triggering events and instead raise the level of shareholder interest that would be required to place a shareholder nominee on the company proxy.
We strongly disagree with the SEC's suggestion in the preamble that public companies make certain disclosures about the proposed shareholder triggering events prior to adoption of a final rule. The SEC also has implied that there could be liability under the proxy rules for failure to make the disclosures. This is entirely inappropriate in the case of such a controversial proposal with over 300 questions for comment. It is not clear that the shareholder triggering events will remain as proposed, so premature disclosure will only cause shareholder confusion.
The SEC Should Withdraw the Rule
ACB does not believe that now is the appropriate time to adopt a rule giving shareholders access to the company's proxy. We have just witnessed the adoption of over twelve corporate governance-related rules under Sarbanes Oxley and additional rules adopted through the SEC's own initiative. We also have seen the stock exchanges and associations react to the recent corporate scandals by revising and updating listing requirements.4 The listing requirements mandate that a majority of directors be independent, using very stringent independence standards, and that they meet in executive session. The New York Stock Exchange will require listed companies to disclose a method for interested parties to communicate directly with the presiding director of executive sessions. Listed companies will have to have independent nominating and compensation committees or decisions involving director nominations and management compensation will have to be approved by a majority of independent directors. Under SEC rules, companies will have to disclose more information about the director nomination process and how shareholders can communicate with directors.5
In the past, shareholders have complained that they must undertake a proxy contest if they are dissatisfied with the leadership of a company.6 However, these recent corporate governance changes should expand the opportunities for shareholders to have their interests and needs considered and result in more independent and effective boards. All of these changes are new. In fact, some are not even effective yet. In light of all the issues surrounding the SEC's proposal, it would seem prudent to wait and see the impact of these changes before moving ahead on this new rule. The rule, with all its complexities and conditions, will serve neither the shareholders nor the companies particularly well. The proposal could open up the company proxy to a few chosen shareholders, but it is not clear that those shareholders will be acting in the best interests of the company and all of its constituents despite the SEC's admirable attempts to establish conditions to prevent abuse of the process. The proposal could turn every board election into an adversarial process pitting shareholders against the board and against each other.
We understand the concern of the SEC that prior actions, including new disclosure requirements about nominating committees adopted in 1977, did not lead to more meaningful participation by shareholders in the proxy process for the nomination and election of directors. However, the concern appears to be most pronounced with the larger companies. Community banks tend to have more frequent and open dialogue with shareholders. We are concerned about how the proposal will affect our community bank members, particularly institutions that recently have converted from mutual to stock form and those that are considering conversion.
Community banks have a strong interest in serving all members of their community, which includes their shareholders, employees and customers. Many of their long-term shareholders reside in the community. Many of the directors also reside in the community and are listed in the local telephone book. Since a focus on the community is what community banking is all about, community bank governing documents may require that the directors be from the local community. Shareholders and directors often know each other and communicate frequently. Long-term shareholders are often customers of the bank and care not only about the bank's financial performance, but also about how well the bank serves the community.
On the other hand, community banks also have a large percentage of institutional investors. Because these investors provide needed capital to the banks, the banks tend to be more responsive to their investors than larger companies with wider investor interest and easier access to the capital markets. However, some institutional investors have short-term interests and stake out a position in a community bank with the purpose of forcing a sale. This is particularly a concern for community banks that convert from mutual to stock form or that are considering conversion.
Some depositors in mutual institutions or shareholders in recently converted mutuals care only about reaping a return on their investment through the sale or merger of the bank after conversion.7 This proposal could allow short-term investors to get representation on the board to force their narrow interests. While the proposal would require that shareholders own their shares for a period of time and intend to continue to own them through the annual meeting where directors are elected, this will not solve the problem. Professional investors in recently converted mutual institutions are willing to wait several years while they continue to put pressure on management and the board to sell. To discourage this behavior, the Office of Thrift Supervision ("OTS") prohibits the acquisition of more than 10 percent of the stock of a converted institution without agency approval during the first three years after conversion.8 This regulation also provides that if a person violates the prohibition, the institution may not permit the person to vote shares in excess of 10 percent and may not count the shares in excess of 10 percent in any shareholder vote. We assume that the banking regulation would override the SEC rule. Otherwise, the goals of the OTS could be thwarted if the vote of shares over the 10 percent limit was allowed to be counted in determining whether a shareholder triggering event occurred. Clarification on this point would be appreciated.
We also question whether shareholder access to the company's proxy is wise in a regulated field such as banking. First of all, banking laws and regulations have their own standards of eligibility for directors of depository institutions and their holding companies, and some institutions must file an application or notice with a banking agency before adding a director to the board.9 Furthermore, individuals that are considered for election as directors of regulated financial institutions need to possess certain expertise and skills that are unique to the business of banking and must understand the significant responsibility imposed on directors in a regulated industry. Not only do the directors have to answer to shareholders, but they also have to answer to federal and state regulators. A shareholder nominee may not be fully aware of these responsibilities and duties or have the credentials necessary to perform in a satisfactory manner. Also, cooperation among board members is more critical in a regulated industry. Therefore, the potential negative effects of the proposal, including significant disruption from annual election contests, elections of directors representing special interests, disruption in the boardroom, and creation of adversarial relationships, could have a much greater impact on a bank or thrift than on a company in an unregulated industry.
Unless the potential for abuse can be dealt with more effectively and the benefits of the rule established with more certainty, it does not seem prudent to adopt this rule at this time. If it is adopted, the SEC needs to discuss the conflicts between this rule and the banking laws and regulations and clarify how those conflicts are to be resolved.
Since the proposal would reflect a substantial change in the SEC's proxy rules, if the SEC intends to move forward with this rule, we support the suggestion that the rule initially apply only to "accelerated filers." "Accelerated filers" are those reporting companies with a common equity public float of at least $75 million that have been reporting companies for some time.10 This category of filers was created when the SEC accelerated the filing of periodic reports and applied the requirement only to the larger companies since the requirement would be extremely burdensome for smaller companies. The SEC also noted that the "accelerated filer" definition would cover the most actively followed companies and that the definition served as a reasonable measure of market interest.11 The information available to the SEC suggests that interest in the proxy process is concentrated within the universe of "accelerated filers."12
If the proposal is not limited to the larger companies, it could have a disproportionate effect on community banks. The SEC provides details on the number of companies that have one or two shareholders that could meet the proposed thresholds (discussed below) for initiating shareholder votes and for nominating director candidates.13 While we do not have specific evidence at hand, we do believe that community banks are more likely than larger companies to have shareholders that meet those thresholds because of the representation of institutional investors among community bank shareholders and the smaller trading market for community bank stock. If the SEC is correct in noting that there is more interest in the proxy process among the larger companies, it would be ironic and contrary to the SEC's goals if the proposal resulted in more disruption at community banks because the proxy process was opened to investors interested merely in forcing a sale of the bank.
Shareholder Triggering Events
A company will be required to open its proxy process to a shareholder or group of shareholders who meet certain conditions to nominate a director if applicable state law or the company's governing documents do not prohibit the shareholders from nominating a candidate for election as a director and one of the following events has occurred:
It is clear that the SEC has gone to great lengths to propose shareholder triggering events that balance the interests of shareholders with the need to have an orderly proxy process. Despite its best efforts, the establishment of shareholder triggering events complicates the proposal tremendously while not necessarily aiding the SEC's goal of greater input by shareholders. If triggering events are to be adopted, they should evidence shareholder displeasure with the current board and the operation of the company and should be reflected in the views of a substantial segment of shareholders.
We can make many arguments as to why the percentages chosen by the SEC are not appropriate, but the bottom line for community banks is that it may be easier for shareholders to meet those thresholds at a community bank for the reasons stated above. This would not achieve the SEC's goal of improving shareholder input where it is most needed. Interests on both sides of the issue can and will argue endlessly about what the proper thresholds should be. That is one of the many reasons that we believe the rule should not be adopted or, if adopted, should be limited to "accelerated filers." However, we do have the following suggestions for improvements if the rule is adopted.
If the SEC retains thresholds based on a percentage of votes cast rather than outstanding, we suggest a modification that would base thresholds on a percentage of votes cast only when shareholders owning a specified minimum percentage of outstanding shares vote on the issue. That will help better ensure that a shareholder triggering event represents the views of a significant number of shareholders.
The SEC has proposed an additional shareholder triggering event based on the failure of the board to implement a shareholder proposal that receives support from a majority of votes cast. We oppose this proposal because of the problems that the SEC, itself, has identified. In order to address all of the possible issues that could arise in connection with such a proposal, including situations where the shareholder proposal conflicts with federal or state law (particularly important for a regulated industry such as banking) and questions regarding how to determine whether implementation has occurred, the rule would have to be so detailed that it would be almost incomprehensible and unworkable.
We also suggest that the SEC revise the shareholder triggering events so they more clearly signal unresponsiveness by the directors or problems at the company. The events would include involuntary delisting of the stock, sanctions by the SEC, and other similar events that evidence a problem with board oversight. If certain shareholders want the ability generally to present director candidates for a vote by other shareholders, they should follow the well-established proxy contest rules that currently apply.
Another possibility that the SEC may want to explore is eliminating the shareholder triggering events altogether in order to avoid endless debate among various interests over the proper thresholds and appropriate triggering events. Instead, the SEC could increase the threshold for determining the shareholders that could propose a director nominee for inclusion on the company proxy, as discussed below. The SEC states that while the shareholder triggering events add complexity, they also would "evidence that the proxy process may otherwise have failed to permit security holder views to be adequately taken into account."14 That does not seem to be the case. They might evidence that a small percentage of shareholders did not like one of the director nominees or that a small percentage of shareholders would like the ability to present a director nominee for consideration by other shareholders. However, there already is a process available for shareholders to engage in a proxy contest. This complicated two-step process should be limited to those situations where directors are not doing their job. Otherwise, or as an alternative, the triggering events should be scrapped and a more simplified approach should be considered.
Eligibility of Nominating Shareholder
In order to be eligible to submit a director nominee for inclusion in proxy materials, the shareholder or group of shareholders must meet the following conditions:
For the reasons stated above, we believe that shareholders of our community bank members will more easily be able to meet the five percent threshold than shareholders at larger companies. Therefore, community banks will be more exposed to the possibility of having disruptive election campaigns every year. This result will have a more negative impact on a regulated industry such as banking where the ability of directors to work together in a cooperative and productive fashion is so important. Therefore, we believe that the thresholds should be higher if the proposal is not limited to "accelerated filers." The individual limit should be raised to at least 10 percent and the aggregate should be raised to at least 15 percent. Those higher thresholds will further help avoid, but still will not eliminate, the election of a director that will serve the narrow interests of one minor shareholder. If the SEC decides to eliminate the shareholder triggering events, the thresholds should be raised to at least 15 percent for an individual shareholder and 25 percent when shareholders aggregate shares.
We do not believe it is appropriate to have the same threshold for both individual and aggregate shareholdings. If, as the SEC states, shareholders could have significant difficulty in aggregating their shares to meet a larger ownership threshold, then maybe that should be evidence that there is no real problem that needs to be addressed here. Shareholders that cannot persuade other investors to join in the effort to get a shareholder nominee elected will always have the option of using the SEC's proxy contest rules to present director nominees for election at an annual meeting.
The holding period for the shares should be revised to require that the nominating shareholders hold the shares for at least two years prior to the nomination and have the intent to hold the shares for as long as their director nominee would serve if elected. If shareholders are given the right to include a nominee on the company's proxy and actively promote the election of that nominee, those shareholders should be committed to the company for the longer-term. There is no justification for allowing the shareholders to dispose of their shares immediately after their nominee is elected to the board.
Eligibility of Shareholder Nominees
The proposal establishes eligibility standards for a shareholder nominee that attempt to establish the independence of the nominee from the nominating shareholder and the company that the nominee would serve as a director. In order to be eligible as a shareholder nominee for election as a director, the following conditions must be met:
We have several comments and concerns about the criteria. First, a shareholder nominee should have to meet both the objective and subjective standards of independence established for directors by the stock exchanges and associations. The board of a company covered by those requirements must make an independent judgment, based on a review of all material relationships with the company, that a director is independent in order to determine whether the company meets the requirements that a majority of directors are independent.15 The SEC is encouraging violations of listing requirements by requiring that boards ignore the subjective standards. Also, the SEC does not discuss the potential impact of this approach. If a shareholder nominee elected as a director meets the objective, but not subjective, standards to be considered independent, should that director attend executive sessions of independent directors or serve on the audit, nominating or compensation committee? Listing requirements would indicate that the individual cannot participate in that fashion. To avoid these issues, any shareholder nominee should have to fully qualify as independent under applicable listing requirements before appearing on the company's ballot. This still does not address the question of liability if the nominating shareholders provide misleading or incomplete information about a nominee and an elected nominee violates the independence standards. In that case, the director should have to resign from the board to avoid violation of a listing requirement.
We believe that changes need to be made to the standards for establishing the nominee's independence from the nominating shareholders. Rather than discuss each particular standard point-by-point, we suggest that the independence standards be revised to add standards closely mirroring those used by the stock exchanges and associations to establish the independence of a director and audit committee member. Nominating shareholders should have to certify in good faith that the nominee is independent based on objective standards as well as a full review of material relationships between the nominee and the nominating shareholders and all relevant facts and circumstances.
On a related matter, we note that a nominating shareholder would have to submit a notice to the company and the SEC when nominating a director candidate. The notice would have to include, among other things, a statement that, to the shareholder's knowledge, the candidate's nomination or service would not violate controlling state law, federal law, or listing standards. We believe that the knowledge qualifier should be eliminated. That change would encourage nominating shareholders to properly perform their due diligence and make clear that it is the nominating shareholder that should incur liability for violations if the statement is false.
As stated above, we also would appreciate clarification of how the rule would work in cases where banking law or regulation or a banking agency order or directive requires that a depository institution or its holding company get agency approval or file a notice before adding or replacing a member of the board.16 Also, clarification would be needed on how to handle a situation where the agency denied the request to add the particular director. We assume that in these situations, the shareholder director, if elected, would not be placed on the board until all regulatory requirements are met and that if a banking agency disapproved the service by the shareholder nominee, the nominee would never be placed on the board.
Even with these suggested changes, the standards do not go far enough in ensuring that a shareholder nominee would not advance the special interests of the nominating shareholders rather than shareholders as a group. This is especially the case due to the nature of the shareholder triggering events. If they were more clearly tied to the performance of the board or the company, then it would be more likely that the desire to have a shareholder nominee elected to the board would be related to the interests of all shareholders. Since the shareholder triggering events are instead focused on the inability to get a shareholder representative elected to the board, there is more chance that the shareholder nominee will promote the narrow interests of the nominating shareholders.
Limitation on Shareholder Nominees
The proposal places limits on the number of shareholder nominees that can appear on a company proxy. The limit is one nominee if a board has less than nine members, two nominees if a board consists of nine to nineteen members, and three nominees if the board has twenty or more members. Community banks tend to have larger boards, partly as an outreach to the community. This proposal may encourage companies to have smaller boards even if that is not in the best interests of the shareholders or the company. By limiting the number of nominees by number, rather than percentage of board members, there can be a huge difference in the percentage of shareholder nominees on a board merely as a result of having one less board member. One shareholder nominee on an eight-member board would represent 13 percent of the board, while two shareholder nominees on a nine-member board would represent 22 percent.
Part of the problem with determining what the correct number or percentage should be is uncertainty about the purpose of the proposal. Again, the proposed shareholder triggering events do not evidence dissatisfaction with the board or the operations of the company. If the purpose is merely to give shareholders a better chance of getting a director nominee on the board, then the rule should only allow one shareholder nominee on a ballot. As a middle-ground, we would suggest that the rule adopt two limits: one shareholder nominee for a board with 20 or fewer members and two shareholder nominees for a board with more than 20 members.
The SEC asks whether it should allow an unlimited number of shareholder nominees to appear on the company proxy, but limit the number that can be elected. While this may sound appealing to address shareholder concerns, the proposal would most likely conflict with state corporate law and a company's governing documents that address the voting rights of shareholders and the election of directors.
The provisions addressing notice requirements and timing are complicated and unworkable. A nominating shareholder does not need to provide notice and the name of a nominee until 80 days prior to the mailing of proxy material. This leaves little time for the company to perform due diligence to determine whether the nominating shareholder is eligible to use the procedure and that the nominee would qualify as a director. Any hiccup during the process could cause severe problems for the company in getting proxy material out to its shareholders on a timely basis in accordance with state corporate law requirements and the company's governing documents. The number of questions asked about the procedure reveals the SEC's own concerns about how this will all work. If the SEC decides to move forward on this rule, we believe that it should issue another proposal for comment that establishes a more definitive procedure and addresses all of the issues and concerns raised in the SEC's questions.
ACB opposes the requirement that a company must include a statement about the shareholder nominee in its proxy material if the company includes statements supporting company nominees other than a recommendation to vote in favor of the nominees. A company should be able to say something more in support of its own candidates without then requiring the company to include endorsements of the shareholder's nominee. A statement from the nominating shareholder should be required only if the company says something in opposition to the shareholder's nominee other than a mere recommendation to withhold votes for the candidate.
We also oppose the prohibition on providing shareholders with the option to vote for or withhold votes for the company's nominees as a group when a shareholder nominee appears on the ballot. There is no justification for this prohibition. With the ability to vote for candidates as a group, shareholders still would be able to vote for individual candidates if they wished, but would have the convenience of checking only one box if they support all of the company's candidates.
Disclosures Prior to Adoption of Final Rule
We strongly oppose the guidance the SEC provides about disclosures that should be made prior to adoption of a final rule. This is not appropriate in light of the controversial nature of the proposal and the possibility that the shareholder triggering events could change.
The SEC should withdraw this rule and give all of the recent corporate governance initiatives time to have an impact. The complexity of the rule and the disruption it may cause will not serve the best interests of either shareholders or public companies. We also are concerned that this rule may conflict with the goals of OTS banking regulations. If the rule is adopted, the SEC should apply it only to "accelerated filers." The proposal should be reissued for comment once the SEC has addressed many of the issues raised by the hundreds of questions submitted for public comment, including concerns with notice requirements and timing.
ACB appreciates the opportunity to comment on this important matter. If you have any questions, please contact the undersigned at (202) 857-3121 or via e-mail at firstname.lastname@example.org, or Diane Koonjy at (202) 857-3144 or via e-mail at email@example.com.