November 22, 2003
Mr. Jonathan G. Katz
Re: File No. S7-19-03 Security Holder Director Nominations
Dear Mr. Katz:
The Independent Corporate Directors Association ("ICDA") is a Virginia nonstock corporation formed as a tax-exempt professional association. ICDA Professional Members, who are thoroughly experienced as corporate directors, officers or advisors, are pledged to uphold a Code of Ethics and a set of progressive Corporate Governance Principles, copies of which may be viewed on the ICDA web site. The Code of Ethics includes the requirement, among others, that the director agree to:
We believe that shareholder nomination and election of directors thus vetted will eliminate charges that they are disruptive captives of the nominating shareholder group or other special interests. Thus, we encourage you to consider a similar pledge for all shareholder nominees eligible to be included in the company's proxy materials under new Rule 14a-11.
The balance of these comments address ICDA's recommendations of changes in the proposed proxy rules. First, however, we offer a rebuttal to certain comments filed in this matter November 14, 2003 by Wachtell, Lipton, Rosen & Katz, and on October 3, 2003 on behalf ofConocoPhillips by its Senior Vice President and General Counsel, Stephen F. Gates. Both sets of comments are in opposition to any change in the proxy rules.
The opposition arguments are artfully and persuasively presented and they are fairly representative of the positions previously taken in filings and public statements by other opponents of reform. Therefore, these arguments deserve to be examined and we feel it might be helpful in your deliberations to consider whether they should be accepted without question.
Each of the ConocoPhillips comments is presented below, followed by our rebuttal:
"One of the responsibilities of directors under state law is the nomination of director candidates. This responsibility is based upon the understanding that the board is best positioned to assess the qualifications of nominees. In considering who the nominees should be, a company's nominating committee must consider many factors, such as the need to have at least a majority of independent board members, the need to insure that the board has at least one independent financial expert who is qualified to serve on the audit committee, the need to have sufficient international expertise on the board if the company has international issues, and the need to have a variety of strengths and expertise that will result in a well-rounded board of qualified individuals who will act in the best interest of the corporation and its shareholders as a whole. While boards may consider shareholder nominees, the board has the ultimate responsibility for the nominees included in a company's proxy materials"
State laws do NOT assign to directors the responsibility to nominate director candidates. No mention of the nomination process is made in the corporation codes of Delaware or California, and the New York code sets forth what is implicit in all the other codes surveyed, namely that this issue is to be dealt with in the Articles or more normally in the By-laws. Articles and By-laws are drafted by attorneys for the original incorporators, among whom the practice developed of assigning nominations for the board to the board itself.
Thus, no "understanding" regarding the practice of board self-nomination can or should be inferred from state laws. Quite to the contrary, where state law has been interpreted by the courts, the right of shareholders to both nominate and elect directors has been resoundingly confirmed. Note as an example the following quotes from the influential Delaware Court of Chancery:
"Those precedents reaffirm the fundamental nature of the shareholders' right to exercise their franchise, which includes the right to nominate candidates for the board of directors.
That those rights are fundamental does not mean that their exercise cannot be restricted for valid corporate purposes by board-created procedural rules. However, those restrictions must not infringe upon the exercise of those rights in an unreasonable way.
From these principles it may be inferred that an advance notice by-law will be validated where it operates as a reasonable limitation upon the shareholders' right to nominate candidates for director.
More specifically, such a by-law must, on its face and in the particular circumstances, afford the shareholders a fair opportunity to nominate candidates."
To the extent Mr. Gates' argument insinuates that jurisdiction of the SEC in this area is improper, the commentator should recall that the authority to regulate the proxy process is set forth in the Securities Act of 1934, the same act that created the SEC.
Further, the idealized "well rounded board of qualified individuals" advocated by the comment clearly has failed to prevent massive fraud and looting of corporate assets by management. Something better is needed, recognition of which is the very reason for the current proposals for change.
"In contrast to the duties imposed on directors, the shareholders of a large public corporation are allowed to act purely in their self-interests. They have no fiduciary duties to the company or other shareholders and corporate constituencies. They may nominate director candidates for any number of purposes, regardless of whether those purposes are self-interested or designed to promote other agendas. Direct shareholder access to company proxy statements would undercut the role of the board and its nominating committee in the important process of nominating director candidates. Moreover, bypassing the nominating committee, which must be composed solely of independent directors under the proposed NYSE listing standards, would diminish board accountability to shareholders."
This argument attempts to turn fiduciary duty on its head by asserting that board accountability to shareholders would be diminished by allowing the shareholders to select directors themselves. Following this chain of logic would lead to the absurd conclusion that Congressmen chosen by the voters are less accountable to the voters than would be Congressmen chosen by other Congressmen. The Founding Fathers were wiser than that and we should be too.
"If the nomination and election of directors would cause the company to violate federal law or fail to comply with SEC, NYSE or NASDAQ requirements, directors have the fiduciary duty to engage in an election contest, the result being an unfortunate disruption and diversion of company resources. The proposed new requirements regarding director qualifications would make it even more likely that the fiduciary duty of a board member will be triggered, thus settingup the potential for annual election contests. For example, shareholders could nominate and elect a director who may not be independent, which could make it difficult for a company to comply with the NYSE or NASDAQ proposed listing standards that generally require companies to have a majority of independent directors and prohibit non-independent directors from serving on certain board committees. Shareholders could nominate and elect a director who may be replacing a financial expert. If the new director does not qualify as a financial expert, the company's audit committee may no longer comply with the listing standards. In these situations, since directors cannot escape their obligation to consider nominees in the best interest of the corporation and its shareholders as a whole, providing shareholders direct access to company proxy material has the potential to turn every director election into a divisive proxy contest. The contentious and public nature of such proxy contests could substantially disrupt corporate affairs, result in significant costs to the company, and dissuade from board service well-qualified individuals who do not want to routinely stand for election in a contested situation."
What's so terrible about having director candidates be subjected to a genuine election in which they have to compete with other candidates?
The comment suggests that shareholder nominees might not be independent. Well then, let the proxy rules require independence of all shareholder nominees.
As for the possibility that a financially expert candidate put forward by the board might lose to a shareholder nominee, thus placing the audit committee in non-compliance, the commentator raises a genuine issue - but one for which the solution is not to bar shareholder nominations
Nominating shareholders are, after all, quite capable of putting forward financially capable nominees. The more interesting question is whether the board would be willing to put on the Audit Committee a thoroughly qualified financial expert elected by the shareholders, even if he or she were the only such qualified member of the board. Given the lengths to which companies have gone to combat any shareholder nominations, it seems doubtful.
We will recommend the new rules should require that the Audit Committee financial expert position be separately identified in the proxy materials and that if there is a contest between qualified expert nominees, the winner assumes the position.
"Direct shareholder access to company proxy statements to nominate directors is inconsistent with the proposed NYSE corporate governance listing standards (as well as similar NASDAQ proposed standards) and detracts from the role and independence of nominating committees. For instance, a nominating committee may determine to seek out a board candidate who has desired industry or financial expertise, based upon the belief that a nominee with such a skill-set will strengthen the overall functioning of the board of directors. However, as a result of shareholder access to the company proxy statement, such a candidate might fail to be elected because of theelection of a shareholder nominated director who does not possess such expertise."
Direct shareholder access to company proxy statements is NOT inconsistent with exchange standards, which define "independence" in terms of a lack of financial conflicts of interest- an issue that should always have been covered by the overall fiduciary standard.
Shareholders can accept these exchange standards as a basic minimum, remaining quite free to add to the definition of independence a requirement that independent directors (a) not be constrained by any special interest or agenda, even if advocated by the shareholder group that nominated them (other than principles of enlightened corporate governance on behalf of all the shareholders), (b) not be beholden to the CEO in any way (such as having been recommended for board membership by the CEO) and(c) not possess a mind-set that would condone CEO dominance or permit extravagant executive compensation at the expense of the shareholders.
As for the need to fill the board with special skills and expertise so they may advise each other and the CEO, this notion should be put to rest once and for all. Let's take commentator ConocoPhillips as an example. This is a huge company with assets and income in the billions of dollars. Management and the board can afford to, and surely do, engage the world's finest consultants on any conceivable subject. Board members are not there to act as consultants on special topics. Their job is to make sure the company is being run effectively and with integrity on behalf of the shareholders.
"The board of directors represents all shareholders, and meaningful shareholder involvement in director elections already is provided under existing proxy rules."
If this were true, we wouldn't be having these discussions.
"Permitting shareholders direct access to company proxy statements also may raise state law concerns. Two fundamental principles of state corporate law may be implicated by permitting shareholders direct access to company proxy statements. First, state corporate law generally vests with the board of directors the authority to manage the business and affairs of the company, including the process of considering and nominating qualified directors. Second, some state corporate laws, including Delaware and New York, prohibit shares of the same class from being treated disparately. The proposal to allow direct shareholder access to company proxy statements may provide a right to a single large shareholder or a block of shareholders that would not be available to all shareholders."
Rebuttal One above disposes of the "fundamental principle" argument that state laws vest the process of nominating directors with the directors. They don't. State laws relegate the issue to the by-laws, which are company internal documents not even filed with the state. Nothing either ICDA or the SEC proposes will interfere in any way with the authority of the board. In fact, we seek to strengthen it. As for disparate treatment, a nominating shareholder or shareholder group is permitted to act under the proposed SEC rules on behalf of all the shareholders, and all shareholders retain the right to vote on candidates. If the commentator still perceives a disparity, this could be eliminated by allowing any shareholder to nominate director candidates.
"Insider trading laws may be implicated if directors nominated by shareholders are viewed as having been "deputized" by those shareholders. The inside information the "deputized" director receives might limit the trading of other members of the group, and shareholders in the group may be viewed as affiliates of the company who must comply with various rules applicable to insiders trading in the company's stock."
These issues are dealt with by the SEC's proposed rules. See the discussion in the passage that refers to footnote 175, as follows:
We do not believe that a group formed solely for the purpose of nominating a director pursuant to proposed Exchange Act Rule 14a-11, soliciting in connection with the election of that nominee, or having that nominee elected as a director, would be the type of group that should be viewed as being aggregated together for purposes of Exchange Act Section 16. Their actions are fully disclosed and are not for a "control" purpose, and they clearly do not have presumed "insider" status.
Similarly, citing its earlier discussion of required director"independence", the proposed rules address the "deputization" issue in the passage following the reference to footnote 179, as follows:
"In the context of a newly adopted regulatory framework that is already designed to address the issues of board composition and director performance, the adoption of proposals to facilitate election contests is an unwarranted step that offers little apparent benefit while threatening significant harm. We encourage the SEC to weigh these costs against the absence of any clearbenefit and reject these proposals."
Neither Messrs. Sarbanes and Oxley nor the exchanges take the position that their good works are a complete cure for corporate governance ills. Indeed, perhaps the most experienced and involved advocate of governance reform, former SEC Chairman Richard C, Breeden, in his Report to the U.S. District Court judge overseeing MCI's bankruptcy entitled "Restoring Trust" proposes to implement 78 recommendations intended to prevent any reoccurrence of the governance abuses that were instrumental in the collapse of WorldCom. He observes: "Directors are the representatives of shareholders, yet the current system essentially freezes shareholders out of the selection process for their own representatives." The Report outlines a mechanism by which MCI shareholder nominations will be made in the future. The following additional quote from the Report is of particular relevance here:
"A broad theme of this Report is that in establishing the most healthy balance of authority and responsibility among the shareholders, the board and management over a long period of years, increased direct consultation with shareholders would be beneficial. Rather than more regulation by government to protect shareholders, this Report calls for more democracy for shareholders so that they can more effectively protect themselves. In large part this requires mechanisms to allow shareholders to make a board aware of their concerns quickly and forcefully. The more truly representative the board is of shareholder concerns, the more one can justify greater discretion in the board. (The Report assumes compliance with all federal and state laws, including every provision of Sarbanes- Oxley and its implementing regulations in addition to these recommendations.)
* * *
Increasing the power and voice of major shareholders in a carefully controlled manner will improve the operation of checks and balances against excessive executive power. Bringing the observations of the largest stakeholders more directly into the process of selecting directors will reinforce other recommendations in this Report that are designed to encourage greater vigilance and greater independence of thought and action among board members."
Let us take a brief look at the arguments of Wachtell, Lipton, Rosen & Katz.
Their parade of terrible consequences of shareholder nominations included:
Significant disruption from annual election contests
We believe our rebuttals to Mr. Gates' arguments have disposed of these arguments of Wachtel, Lipton as well. We concur also in the dispositive analysis of the Wachtel, Lipton argumentsoffered by the comments in this proceeding by Les Greenberg, Chairman, Committee of Concerned Shareholders on November 18, 2003.
Unfortunately, these spurious arguments find their way into other opposition comments, such as those of the Business Roundtable reported in the Memorandum by Patrick Von Bargen, Managing Executive for Policy and Staff filed as a comment in this proceeding.
One position taken in the Wachtel, Lipton comments cries out for special attention.
They attack the fundamental ownership rights of shareholders, citing an article by Martin Lipton and Steven A Rosenblum written for publication in the American Bar Association publication, The Business Lawyer. That article contains the following altogether remarkable passage:
"Shareholders have no more claim to intrinsic ownership and control of the corporation's assets than do other stakeholders".
We submit this statement as the best proof of the need for basic reform. When the leading advocates engaged by senior corporate executives are willing to submit to the Commission an argument that ignores the clear import of state corporation codes, rewrites the history of the joint stock company and warps the fundamental concept of corporate structure to such an extent that they maintain that NOBODY owns the company, simply to justify the CEO-dominant paradigm, something very basic is awry.
This is the sort of insular, Olympian group-think that tends to validate the following generalization of German sociologist Roberto Michels, characterized as the Iron Law of Oligarchy:
"The technical specialization that inevitably results from all extensive organization renders necessary what is called expert leadership. Consequently the power of determination comes to be considered one of the specific attributes of leadership, and is gradually withdrawn from the masses to be concentrated in the hands of the leaders alone.
Thus the leaders, who were at first no more than the executive organs of the collective w ill, soon emancipate themselves from the mass and become independent of its control.
* * *
With the institution of leadership there simultaneously begins, owing to the long tenure of office, the transformation of the leaders into a closed caste."
FINAL ICDA COMMENTS:
Cataclysmic economic crises are "triggering events" that give rise to major reforms. One such triggering event, the harmful concentration of economic power in large corporations and in combinations of them, led Congress to pass the Sherman Act in 1890, the Clayton Act and to the formation of the Federal Trade Commission.
In 1934 the Securities Exchange Commission (SEC) was created in the wake of another such triggering event, the 1929 stock market crash, to protect investors and to add the stability needed to restore investors' confidence.
Sarbanes-Oxley, new rules of the exchanges and a myriad of similarly-directed efforts now attempt to remedy a third triggering event, the calamitous collapse of confidence in corporate governance following Enron, Tyco, WorldCom and other disclosures of fraud and misdeeds at the highest levels of many of our most trusted corporations, accounting firms and mutual funds. These remedies are excellent, but whether they will suffice to fully cure epidemic corporate ills remains an open question.
Arguably, the fundamental illnesses of current corporate governance are too systemic for such external remedies to reach. The board of directors may still be hand-picked by the CEO. A director who raises too many questions may still not find his or her name on the next slate of board candidates. After decades of lawyerly advice that they may avoid liability by passively relying on whatever representations are made to them by senior corporate officers, can we expect these same board members (typically like-minded CEO's of other companies) suddenly to become and remain active, independent, objective and shareholder-focused?
Access to the proxy process is still effectively denied to shareholders, so the process of electing directors remains completely undemocratic. There are still no realistic limits to executive compensation.
Who will manage the managers in the long term interest of the shareholders and other significant stakeholders?
We believe that the final push to complete the needed reforms in corporate democracy and accountability must come from within the boardroom. A new infusion of directors, not beholden to the executive, but committed to a code of ethics and principles of enlightened corporate governance can gradually bring about the necessary changes.
The question presented now is whether, without the impetus of new legislation, the SEC will bring about an across-the-board restoration of the ability of investors to play a central role in choosing those who represent them. The presently proposed rules will not achieve that and thus do not, we believe, fulfil the Congressional injunction that the SEC address this issue with rules "necessary or appropriate in the public interest or for the protection of investors".
We hope the Commissioners remain open to a simpler, more direct approach.
Here are our substantive comments regarding the presently proposed rules:
We are unaware of any state law that prohibits nominations by shareholders. However, if this condition remains in the final rules, it is predictable that a race to state legislatures by incumbent executives will ensue in an effort to have just such prohibitory laws passed to protect them from change. To avoid this unseemly result, we recommend that the SEC eliminate this condition on the ground that the proxy rules pre-empt any such state laws, relying upon massive interstate commerce in securities and the strength of the federal interest involved as compared with the lack of any legitimate state interest in foreclosing shareholders from protecting their investments.
The members of ICDA have made lifetime commitments to free enterprise and the corporate structure, which, at its best, allows investors and employees to work so effectively toward common economic goals. We are not anti-management.
However, each member, based on his or her own experience, has reached the conclusion that to function properly and to serve the public good, the corporate system needs to reestablish the lost authority of the board to act as the stewards of shareholder interest. The system should not have to rely solely on the integrity and benevolence of senior management, or their fear of liability. Thus, support by the SEC of a more open nomination process such as we recommend is critically important.
Thank you for your attention and for the opportunity to address this most important issue.