February 3, 2004
Mr. Jonathan G. Katz
Re: File No. S7-19-03 Security Holder Director Nominations
Dear Mr. Katz:
Please accept and consider these late-filed comments as a response to comments filed by the Section of Business Law of the American Bar Association and others after the December 22, 2003 deadline .
Shareholder Sovereignty - The Sword in the Stone
The SEC possesses a sword called "Shareholder Sovereignty" forged by the broad power to regulate the corporate proxy process granted by Section 14a of the Exchange Act of 1934. The sword could be wielded on behalf of investors - the very class the SEC is enjoined to protect. But, unlike Excalibur of the King Arthur legend, the Shareholder Sovereignty sword appears lodged firmly in a stone created by a loss in a D.C. Circuit Court case (The Business Roundtable v. SEC, 905 F.2d 406, 1990), and the consequent atrophy of the SEC's will to take the field..
Today, instead of graping the sword and championing the full exercise of shareholder voting rights, the SEC has screwed up its will just enough to yank the sword out a little way. It has proposed Rule 14a-11 -- a new regulation that would require listed companies to include, in listed companies' proxy materials, candidates for the board of directors that are nominated by one or a group of shareholders alongside those candidates nominated by the existing board.
This proposed right to nominate is, however, hedged about with so many conditions, and is so fundamentally limited that it will accomplish little on behalf of shareholders or the public.
A firestorm of comments have been filed with the SEC regarding this proposal, of which more than 10,000 are fiercely in favor shareholder voting that is less restricted than that proposed by the SEC. Most want the SEC to allow shareholders to engage in self-help by freely electing directors pledged to vigorously support their interests.
Yet, in addition to the limits and conditions previously noted, the SEC has said that Rule 14a-11 will be ineffective if it conflicts with any state law. What is the source of this timidity?
Opposition Jurisdictional Arguments
Those making the most fundamental arguments in opposition to the entire SEC proposal are the America Bar Association ("ABA") and the Business Roundtable, an association of CEO's.
In comments dated January 7, 2004, the Section of Business Law of the ABA attacks the SEC's jurisdiction in the matter, calling it an"intrusion in significant governance matters regulated by state corporate law", asserting that:
The Business Roundtables comments, dated December 22, 2003, state that:
The legal arguments of both the Business Roundtable and the ABA rely almost entirely on the Business Roundtable case, which invalidated Rule 19c-4 of the SEC, saying:
The State Law Vacuum
The first major problem with these arguments of the ABA and the Business Roundtable is that the field of corporate governance is not, in fact, occupied by, or "reserved" or "left" to the states. With respect to the internal affairs of companies incorporated in any state, corporation codes are merely "enabling" - that is, they leave most internal corporate governance to be determined by the language of the corporate charter and the bylaws.
This is exemplified by the Delaware corporations code and confirmed by the most authoritative sources:
Consequences of the Vacuum
Management, like nature, abhors a vacuum and has expanded its power to fill it. Management-focused boards have constructed governance structures within which shareholder participation is largely illusory:
Federalism and the SEC
Let us go right to the heart of the matter. How do we determine the proper allocation of authority between federal and state rules in these matters? Does a state law that leaves the details of shareholder voting rights to be determined by the company's charter and bylaws trump the provisions of Exchange Act Article 14?
In the leading case of SEC v. Transamerica,(163 F2d 511, 3d Cir. 1947), the court determined that it does not. In that case, a shareholder sought to have a proposal to amend the bylaws included in Transamerica's proxy materials,to be voted on by the shareholders The shareholder relied on SEC Rule 14a-8, which addresses when, and the procedures by which, a company must include a shareholder's proposal in its proxy statement. Transamerica's board refused to include the shareholder's proposal, saying that Delaware state law should prevail.
Transamerica's charter stated that all the powers of the corporation were vested in the board of directors, which had passed a bylaw that allowed the board to bar any attempt by shareholders to amend the bylaws simply by not including in the notice of the annual meeting that such an amendment was proposed.
A section of Delaware's General Corporation Law provided that the company's certificate of incorporation may set forth provisions which limit, regulate and define the powers and functions of the directors and stockholders. So, Transamerica took the position that the power to control corporate acts rested in the board of directors and not in the stockholders, that the board had not given notice of the shareholder's proposal, and that therefore the proposed amendment was not, in the language of SEC Rule 14a-8, "a proper subject for action by security holders".
The court flatly disagreed, stating that:
State laws, either by code or case law, recognize that shareholders have a right to nominate directors. Nothing in proposed Rule 14(a)(11) is at odds with that right, except as the right is limited by the Rule.
The opposition goes to great lengths to try to distinguish Rule 14a-8 from proposed Rule 14a-11,but their position is untenable. Both rules address procedural aspects of the proxy process.
The error of the opposition's federalism argument lies in its attempt to exalt the states' abstention doctrine into positive law that could not be challenged by federal rules - the very issue decided by the Transamerica case.
.The Scope of SEC Authority under Section 14
The second major problem with the arguments of the ABA and the Business Roundtable is that they slide over the following passages in the opinion of the court in the Business Roundtable case:
Taken together, these passages show the court carefully conceding that the SEC may have procedural as distinct from substantive authority under Section 14. The case didn't really decide this question under Section 14, since it found that the one-share one-vote thrust of Rule 19c-4 was clearly substantive.
Thus, no case, and certainly not the Business Roundtable case, has ruled out the authority of the SEC over procedural aspects of corporate governance. Including the nominating process.
Supporting the view that the SEC possesses such procedural authority, please note the following passage by the distinguished academic observer, Professor Stephen Bainbridge of U.C.L.A. in his comments in the present proceeding dated December19, 2003:
Self-Help is the Most Effective Policy
Provided protective measures are in place to prevent the nomination and election process from subverted by other companies seeking to acquire the corporation, the best thing the SEC could doin this proceeding would be to free shareholders to nominate the directors that represent them. All of them.
Aside from being an approach that is in accord with our democratic principles, this is a free-market solution. It would allow shareholders to correct problems of governance at the source through board members dedicated to their interests without having to rely on after-the-fact remedies such as derivative actions.
So, we encourage the SEC to pull out that sword and wield it proudly on behalf of Shareholder Sovereignty!
Thank you for allowing us to comment on these important matters.
C. Harley Booth