Georgeson Shareholder Communications Inc.
VIA ELECTRONIC DELIVERY
December 12, 2003
Re: File No. S7-19-03
To the Commission:
The Securities and Exchange Commission (the "Commission") has proposed new rules that would establish requirements for companies to include shareholder nominees for director in company proxy statements. This letter is submitted on behalf of Georgeson Shareholder Communications Inc. in response to the Commission's request for comment.
Georgeson is the oldest and largest firm specializing in services relating to shareholder meetings, corporate governance, proxy solicitation, mergers and acquisitions, corporate control and a broad range of shareholder response transactions. Founded in 1935, Georgeson currently has offices in nine countries and works on engagements involving more than 1,000 companies annually. In addition to providing strategic advice and services to listed companies, the firm works with investors, directors, regulators, stock exchanges, professional associations and various financial, legal and communications advisors. We also provide expertise in the operations and back-office procedures that support U.S. and global systems of disclosure, governance and share voting.
Georgeson supports the Commission's stated objective to "enhance the transparency of the operations of boards of directors," and to enhance shareholders' ability to "participate meaningfully in the proxy process for the nomination and election of directors." We are sympathetic to shareholder complaints that the election process is not an effective accountability mechanism. Short of waging a proxy contest, shareholders lack the power to directly remove directors by voting against them. A campaign to withhold votes from directors, even when a majority is achieved, does not prevent their reelection or increase the likelihood of their removal. These are serious problems that engender skepticism about the election process and undermine good corporate governance.
We wholeheartedly endorse, as a first step in addressing these problems, the Commission's final rules on Disclosure Regarding Nominating Committee Functions and Communications Between Security Holders and Boards of Directors, Release No. 33-8340, adopted November 24, 2003. We agree that boards need more access to shareholders and more information about shareholder concerns, policies and voting practices. At the same time, shareholders need access to boards and more information about how boards make decisions and how those decisions take into account shareholder interests. These new rules should facilitate dialogue, increase understanding on both sides, encourage constructive problem solving and increase trust between shareholders and the directors who represent them.
Despite our agreement with the Commission's goals and our support for the new disclosure and communication rules, we have serious reservations about the radically different approach taken by the Commission in proposed Rule 14a-11 establishing new procedures for "Security Holder Director Nominations." This letter does not comment on the legal issues raised by the proposal. Instead, it outlines our concerns with respect to policy (part I), our assessment of the practical problems that would result from the proposed rule (part II) and our recommendations (part III).
I. Policy Concerns
(1) Despite the care and skill with which proposed Rule 14a-11 has been drafted, we believe it establishes procedures that would polarize issuers and shareholders and interfere with constructive dispute resolution. The rule promotes public confrontation rather than private engagement. It sets up an adversarial process, modeled on Rule 14a-8, that would promote combative tactics favored by the special interest groups that are currently the main users of Rule 14a-8. In so doing the rule overlooks the quiet but effective strategies perfected by organizations such as TIAA-CREF, CalPERS, Relational Investors, certain mutual fund management companies and other prominent investors after the 1992 proxy rule amendments liberalized shareholder communications. Indeed, during the 2003 proxy season only 2% of governance proposals under Rule 14a-8 were sponsored by pension funds.1 This statistic confirms that Rule 14a-8 has evolved into a forum for special interests. The threat of a shareholder proposal is still an important negotiating tool for responsible shareholder activists, but their goals are best achieved through direct negotiation. They recognize that talking is usually more productive than fighting and favor tactics described by TIAA-CREF Senior Vice President and Chief Counsel Peter Clapman as "quiet diplomacy." Unfortunately, proposed rule 14a-11 takes the opposite approach.
(2) We are concerned that Rule 14a-11 increases the procedural complexity and cost of the proxy process instead of pursuing simplification and cost reduction. The rule is highly complex and mechanistic. It prescribes a detailed set of procedures that, while clearly designed to balance competing interests, create a highly inflexible structure that promotes election contests over other forms of dispute resolution. It encourages activist shareholders to undertake complicated proxy fights rather than giving them the means to directly remove targeted directors.
(3) We believe the rule misinterprets the meaning and significance of votes cast by shareholders in favor of Rule 14a-8 proposals. The Commission appears to assume (particularly in the discussion of the third trigger) that a majority vote in favor of any shareholder proposal is a sign of general dissatisfaction with a company's board, governance or performance. In fact, Rule 14a-8 provides nothing more nor less than a referendum on the specific issue voted upon. For many years the highest levels of shareholder support have been achieved by a narrow group of policy questions - classified boards, poison pills, supermajority vote requirements and golden parachutes. Our analysis of voting practices on these proposals indicates that shareholders vote with lockstep consistency, pursuant to standardized voting policies, without regard to differences in company performance, governance ratings or other variables. These automatic voting practices suggest that, contrary to the Commission's assumption, voting results on shareholder proposals reveal little about shareholder attitudes toward company fundamentals. It is a mistake to think that these votes can be used to distinguish "bad" from "good" companies.
(4) We believe the proposed rule will perpetuate standardized voting practices both on trigger proposals and on the mini-election contests that will follow. We have no doubt that a trigger proposal by a 1%/one year holder seeking the nomination privilege will quickly be recognized as a shareholder benefit in all cases. Why would any shareholder vote against a grant of reserve power? Even though proxy advisory service Institutional Shareholder Services (ISS) has preliminarily indicated that it will take a case-by-case approach, we are convinced that investors' voting policies will quickly become standardized and favorable votes will be cast automatically, as they are for many policy questions under Rule 14a-8.
(5) We are concerned that the second trigger mechanism (when more than 35% of votes are withheld from a director) could distort the voting process and ultimately the governance process. If withholding votes from directors is the means to achieve nominating rights, shareholders may decide to act for that reason alone rather than because of a director's performance. The second trigger, when combined with the ISS policy of withholding votes from directors who do not implement shareholder resolutions approved by majority vote, could encourage more resolutions from special interests. Shareholders in turn might be more inclined to vote in favor of such resolutions to help achieve the majority that would then lead to more withhold votes needed for the trigger. Tactical voting of this type seems an unavoidable, though unintended, consequence of the trigger mechanism. Further, directors might be inclined to capitulate and implement shareholder resolutions simply to avoid the threat of the second trigger even when they disagree with the resolution on the merits. We are concerned that decisions based on gaming strategies and pressure, rather than on the merits, could degrade the proxy system and undermine the independence of directors.
(6) We disagree with the argument that the relatively small number of election contests that occur annually is evidence of deficiencies in the U.S. proxy system.2 Proxy contests should not be regarded as an everyday accountability mechanism. They are a last resort, to be used when all else fails. Election contests are the corporate equivalent of impeachment. Like impeachment, they are understood to be extremely disruptive and are intentionally designed to be procedurally difficult so that they will not be used carelessly, excessively or abusively. Election contests should occur only in extreme cases, after other checks and balances and accountability mechanisms have been exhausted. To argue that a high number of proxy contests is a measure of the corporate proxy system's health is illogical. No one would measure the health of our political system by the frequency of impeachment.
(7) Because of the rule's adversarial structure, we are concerned that it could have the unintended and unwanted effect of further uniting corporate directors and managers in a defensive alliance against a perceived common enemy, the shareholders. Such a result would directly contradict efforts by the Commission, the Congress and SROs to establish the board's independence and strengthen its ability to understand and represent shareholder interests. Another unintended consequence might be to reinforce public skepticism and mistrust, already heightened by corporate scandals and conflicts of interest in the financial services industry, at a time when companies and investors should be seeking common ground.
(8) We do not believe the proposed rule will achieve the goal of making the election process more meaningful. It does not address the underlying problem that shareholders lack the ability to selectively remove directors without a proxy contest. Giving shareholders a procedure to force their own candidates onto the proxy makes an end run around this problem without tackling it directly. Furthermore, we believe that shareholders would prefer a grant of power enabling them to remove directors rather than taking responsibility for finding candidates to replace them. Shareholders are skilled at evaluating corporate performance and governance, but it is highly questionable whether they have the resources or expertise, or even the desire, to become involved in director selection. As suggested in our earlier comment letter, we recommend that once given the power to remove directors, shareholders should also exercise a meaningful role in the process of selecting their successors.3 The appointment of a qualified shareholder representative to work directly with the nominating committee would be more effective and less disruptive than unilateral nominations by shareholders in cases where a full election contest is not warranted.
II. Practical Concerns
Despite its cost and complexity, the U.S. proxy system works well. It famously achieves the world's highest levels of shareholder participation at annual meetings. However, it is not a perfect system. The back office operations that produce these outstanding results have never been subject to careful monitoring because results were what mattered. Election contests have been the one exception to this laissez-faire, no-questions-asked attitude. During contests the proxy process shifts into a higher gear, with supplemental disclosure, special procedures and additional regulatory oversight. We are concerned that a proliferation of mini-proxy contests under Rule 14a-11 will substantially raise the stakes at many more annual meetings and will require more frequent and thorough monitoring of back-office mechanics. The SEC staff will have no choice but to establish procedures to meet these new demands. Overseeing these "high gear" Rule 14a-11 campaigns and mediating the disputes that are certain to arise will demand substantial additional resources and will engage the staff in matters of judgment even more complex than those they now face under Rule 14a-8.
In no particular order, here are some of the problems we foresee.
(1) Accuracy of share records. The total share positions on omnibus proxies issued by the Depository Trust Company invariably fail to reconcile with the Cede & Co. record date positions on companies' share registers. The discrepancy is usually small in percentage terms, and the problem has been ignored because no practical way has been found to reconcile share positions of actively traded securities with the same degree of accuracy required in financial accounts. The prevailing attitude has been that such inaccuracies are neutral, not favoring either party, and can therefore be disregarded. If Rule 14a-11 mini-contests become common, however, there will be pressure to eliminate any inaccuracies in the shareholder register that could possibly throw into question the outcome of a close election. Establishing the means to achieve accurate reconciliation would require a comprehensive review of record-keeping practices by all participants in stock clearing, settlement, registration and custody. Is the Commission prepared to take on such a project?
(2) The universal proxy card. Rule 14a-11 mandates an election contest with competing candidates carried on a single card or ballot. If there are 11 candidates for a nine-person board, how will the proxy card be designed to clearly distinguish the two shareholder candidates from the nine incumbents? The card format must strike the right balance, clearly segregating incumbents and shareholder candidates, while not isolating either group unfairly. The staff has always reviewed proxy card format in full-fledged election contests with a view to ensuring fairness and preventing bias or shareholder confusion. It will now have to mediate these design questions for 14a-11 campaigns as well. Furthermore, ADP's Investor Communication Services Division (ADP) uses its own Voting Instruction Form (VIF) to solicit instructions from broker and bank customers, which it tabulates internally before voting on a master ballot. Design disputes over ADP's VIF will also have to be mediated by the SEC staff.
(3) Voting in blank. Shareholders are accustomed to signing proxies in blank, relying on proxy card disclosures that in the absence of specific instructions their shares will be voted as management recommends. Will this arrangement work for the 14a-11 universal card? Activists and sponsors of shareholder candidates will certainly argue that the practice gives an unfair advantage to incumbent candidates. If voting in blank were prohibited by the SEC staff or by a court, a comprehensive informational campaign would be required to educate investors and prevent their inadvertent disenfranchisement.
(4) The 10-day rule. The availability of discretionary broker voting in Rule 14a-11 campaigns will also be in question. We foresee that it will be difficult for the New York Stock Exchange to permit brokers to vote in their discretion under NYSE Rule 452 when there are competing candidates for board seats. Rule 452 relies on a presumption that customers knowingly authorize their broker to vote as management recommends if they do not return the instruction form. Brokers do not make independent voting judgments under Rule 452 (although they may do so by separate agreement with their customers). In a Rule 14a-11 campaign it may not be clear which incumbent(s) will be unseated if one or more shareholder candidates are elected. This uncertainty could be seen as introducing an element of judgment into the broker's discretionary vote, thereby invalidating the arrangement under Rule 452. In any event, it is certain that shareholder activists would oppose discretionary broker voting in 14a-11 campaigns. If the practice were disallowed, a comprehensive effort by regulators to educate investors about the changes and their additional responsibilities would be necessary.4
(5) Back office tabulation. ADP uses proprietary electronic systems and the Internet to handle proxy processing for institutional accounts and increasingly for retail customers as well. In 14a-11 campaigns it is likely that issuers will insist that these electronic processes be carefully monitored for accuracy and to prevent fraud. There is no precedent for such oversight. Even in election contests, access to back office processing of beneficial owners' vote instructions has been granted only by court order in rare cases. The Inspectors of Election in a contest are allowed to look behind the voted proxies only when there is an overvote or other evidence to justify an inquiry. Trust in the reliability of back office procedures or faith that processing errors have neutral impact will not suffice if 14a-11 campaigns become commonplace.
(6) Shareholder confusion. There is a likelihood that the type of hybrid mini-contests contemplated by Rule 14a-11 will generate substantial confusion among shareholders. Initially, it will take time for shareholders to become comfortable with the complex mechanical alterations the rule will engender, such as the loss of the group voting privilege and the potential loss of discretionary broker voting and voting in blank. Even more serious, however, is the concern that in 14a-11 campaigns shareholders will have difficulty deciding which candidates deserve their vote on the merits. Will there be enough disclosure for shareholders to judge an individual candidate's character, expertise and credentials? ISS and others making voting recommendations to institutional clients will face the same problem. Will ISS routinely support shareholder candidates, or will it attempt to decide case-by-case? Will ISS be conflicted when one of its institutional clients sponsors or supports shareholder candidates? If the issuer decides to conduct an aggressive communication campaign in support of its candidates but the shareholder proponent lacks resources to do so, will the outcome be subject to challenge on the grounds of fairness? The perception of lopsided or politicized campaigns, unequal financing and other fairness issues can confuse and alienate shareholders and undermine the credibility of the election process generally. These concerns arise in election contests currently, and must be dealt with strategically by the participants in the conduct of each campaign. SEC staff oversight plays an important role in ensuring the conduct of election contests is fair. If mini-contests under Rule 14a-11 were to proliferate, the wholesale challenge of monitoring these issues would have to be met by regulators. Failure to do so could undermine the integrity of the proxy system.
(7) Tabulation. Tabulation procedures will present the most intractable problems, requiring a substantial commitment by the SEC staff to mediate disputes. How will tabulators determine the intent of shareholders who mistakenly or carelessly vote in favor of all l1candidates for a nine-person board? Will it be possible for management to disclose in the proxy statement or on the card how such votes will be relegated? Will agreement be needed with the sponsors of shareholder candidates to make such a determination? When customers of shares in street name make voting errors, how will brokers or ADP decide how to vote the shares? Will issuers insist on the right to review street-name tabulation records? Will shareholder proponents object to the independence of Inspectors of Election appointed by issuers? Will shareholders be given equal access to the review process, as is common in election contests? Will procedures be available to cure voting errors? A well-known tabulation enigma arises with respect to the voting of loaned stock. Brokers commonly are entitled to lend shares in margin accounts without the customer's knowledge or consent. At proxy time these shares are sometimes double-voted, with instructions coming both from the lending customer (who does not have voting rights) and from the borrower (who does). This practice has largely escaped regulatory scrutiny. In Rule 14a-11 campaigns it is doubtful that a hands-off attitude toward this arrangement could continue. The SEC staff and the SROs would be called upon to develop a solution.
(8) Cost. It is impossible to predict the cost of dealing with the issues outlined above as well as the many other complexities and expenses that will undoubtedly arise under Rule 14a-11. However, the types of costs are clear - greater SEC staff time and resources; issuers' increased legal and advisory fees, executive time and out-of-pocket expenses; brokers', banks' and intermediaries' outlays in time, money and resources for new technology and procedures; shareholders'costs for preparing and conducting 14a-11 campaigns.
The Commission's proposed Rule 14a-11 calls attention to the inner workings of the proxy process. Whether or not the proposal is implemented, amended or withdrawn, it offers an opportunity to simplify the proxy system, encourage better use of technology, reduce costs and make the election process more responsive and accurate. The recommendations that follow are designed to achieve these goals.
(1) Implement Direct Access and revoke the NOBO-OBO rules. The Commission should rescind the NOBO-OBO rules and establish procedures permitting issuers to identify and communicate directly with all their shareholders, including all beneficial owners who hold in "street name." Direct access could readily be accomplished by mandating the issuance of a second tier of omnibus proxies by DTC participants. DTC's current practice is to pass Cede & Co.'s voting rights to participant banks and brokers by issuing on the record date an "omnibus proxy" and participant listing. Under a new direct access program, banks and brokers in DTC would in turn issue their own omnibus proxies passing voting rights to the customers for whom they hold shares on the record date. Issuers would receive these lists of record date customers and would be entitled to distribute proxy material directly to them and to communicate with them by telephone, mail or electronically. The customers would be fully empowered to sign and vote proxies. Direct access has been debated for decades, but advances in technology and changing shareholder attitudes have increased support for the idea. In the context of new NYSE listing requirements we have suggested that direct access could help prevent quorum problems in the event that discretionary broker voting under Rule 452 were further cut back or eliminated altogether.5 In the context of proposed Rule 14a-11, the benefits of direct access would be greater than simply protecting quorum. Direct access would bring transparency to proxy mechanics and would eliminate the delays, confusion and additional costs that are now serious obstacles to communication between issuers and shareholders. It would give beneficial owners increased recognition and standing to act directly with respect to the companies they own. It would facilitate the creation of an audit trail, which is an essential first step in establishing end-to-end vote confirmation - a goal sought by both issuers and shareholders. The sole cost of direct access would be the loss of customer anonymity, primarily a competitive concern of brokers. However, brokers' objections to customer identification could be eliminated by not disclosing broker affiliation on the record date customer lists. The information would not be needed because brokers would no longer participate in the voting process. Beneficial owners who persisted in choosing to conceal their identity from issuers could do so by continuing to maintain private nominee accounts. However, expenses related to such accounts, including postage and handling charges of intermediaries, could be paid by beneficial owners, not by issuers. Direct access could eliminate the current burdensome arrangement that requires issuers (and therefore all shareholders) to underwrite the expenses associated with street name ownership. Direct registration and equal treatment of registered and beneficial owners make sense both economically and from a policy perspective.
(2) Dematerialize equity securities and accelerate the development of electronic disclosure and share voting with a goal of achieving end-to-end vote confirmation electronically. The United States lags other industrialized nations in not having fully dematerialized equity securities. The persistence of physical stock certificates is a costly and anachronistic impediment to development of efficient equity trading, electronic communication and share voting. The Commission should work with state governments and the NYSE to eliminate rules requiring certificates. Mandatory book-entry record keeping would facilitate the creation of direct electronic links between issuers and beneficial owners. This would in turn permit the use of electronic tags to track the voting instructions of specific beneficial ownership positions even as they move through pooled accounts and custodial layers, thereby providing an effective means of vote confirmation.
(3) Require the calculation of voting results to be based on outstanding shares. Proposed Rule 14a-11 follows the Rule 14a-8 practice of calculating results as a percentage of votes cast rather than as a percentage of outstanding shares. The Commission should eliminate the "votes cast" measurement standard entirely and replace it with a uniform standard based on outstanding shares. There are obvious advantages. Calculating votes as a percentage of outstanding shares provides greater certainty by utilizing a number that is disclosed in the proxy statement that cannot be manipulated. It avoids the disputes and questions of fairness that arise from differing treatment of abstains and discretionary broker votes. It allows statistical comparability from year to year and from company to company.
(4) Implement, at least as a temporary measure, the Grundfest proposal to handicap directors from whom votes are withheld and, over the long term, seek changes in state law to increase shareholder power to remove directors. Former SEC Commissioner Joseph Grundfest has submitted a comment letter dated October 22, 2003, with an ingenious proposal to penalize directors from whom a majority of votes are withheld.6 His approach, which could be implemented through exchange listing requirements, is a straightforward and low-cost method of making "withhold" have real impact on targeted directors. The Grundfest proposal directly addresses the underlying problem - that shareholders lack the power to remove individual directors without a contest - by means of an approach that makes it impractical for targeted directors to continue serving on the board. This suggestion deserves more study and discussion. It is certainly far less disruptive and costly than proposed Rule 14a-11, and could serve as a temporary expedient until state laws could be amended to provide shareholders the right to remove directors.
(5) Encourage new approaches and creative ideas such as MCI's proposed electronic "town meeting." Recommendation 6.04 of "Restoring Trust," the report on corporate governance for the future of MCI Corp. authored by former SEC Chairman Richard C. Breeden7, calls for the establishment of an "electronic town meeting" for shareholder proposals. The mechanics of the Breeden plan are still unclear. However, the concept is forward-looking. It would have the benefit of giving shareholders greater control over the resolution process, permitting proponents to conduct informal straw votes to determine which issues attract substantial shareholder support and therefore merit inclusion in the company's proxy statement. Properly organized, this approach could be used to screen out and eliminate low-scoring proposals before they reach Rule 14a-8. Elimination of less important matters from Rule 14a-8 would reduce costs and make the shareholder proposal process more meaningful.
Georgeson endorses the Commission's goal of maintaining a fair and efficient proxy system that protects the investing public, provides an effective means of dispute resolution and fairly distributes power among management, directors and shareholders. For the reasons outlined in this letter we are concerned that proposed Rule 14a-11 would not achieve this goal, and we urge the Commission to reconsider its proposal.