Mr. Jonathan G. Katz, Secretary
Re: File No. S7-19-03
Dear Secretary Katz,
Edward Jay Epstein once wrote that what we call corporate elections are more like what goes on in a totalitarian state than a democracy. Incumbent management picks the candidates, who run unopposed, and then management counts the votes. The current options for shareholders who are not satisfied with management's candidates are prohibitively expensive. Shareholders can sell the stock at what they perceive to be a substantial discount. Or they can run their own slate of candidates, paying 100 percent of the costs, which may come to hundreds of thousands or even millions of dollars, for only a pro rata share of any increase in shareholder value as a result of the contested election. Meanwhile, management will spend the shareholders' money to fight them. This is not a level playing field. It is close to perpendicular.
The current system for selecting directors is a self-perpetuating closed loop. And thus it is not surprising that the corporate scandals of the last few years revealed a systemic failure of boards of directors to provide meaningful or effective independent oversight of the corporate managers who select and compensate them, and who determine the agenda, the timing, quality, and quantity of information they receive, and even select the advisors they rely on.
The stunning failures of board after board at companies like Enron, Global Crossing, Adelphia, WorldCom, and the others, all with directors who were distinguished people with records of achievement and integrity, shows that the problem is pervasive and systemic. Even non-scandal companies had failures at the board level, as with the embarrassing executive compensation disclosures at GE and the public exchange of criticism by the departing directors at Disney. As Peter Drucker has said, "Whenever an institution malfunctions as consistently as boards of directors have in nearly every major fiasco of the last forty or fifty years it is futile to blame men. It is the institution that malfunctions."
Post-Enron reforms like Sarbanes-Oxley and the NYSE and NASDAQ listing standards emphasized and strengthened the role of the "independent" director, a notion that has a great deal of intuitive appeal. But that is not the answer, at least not enough of an answer, for three reasons.
First, there are no disclosures, currently required or possible to impose that would reveal all relationships that might cause conflicts of interest or otherwise compromise the independence of a board candidate. Our predecessor firm, The LENS Fund, once invested in a public company whose board consisted of the company's CEO, another executive who reported to the CEO, the company's investment banker, the company's lawyer, and another director who, according to company filings, was independent. It turned out that he and the CEO performed in the same musical group. Now this relationship does not have to be disclosed under current SEC rules. And even if it did, like any other relationship, it is only an indicator of a potential problem, not a definitive impediment to board service. But it demonstrates the absurdity of trying to determine independence from disclosed relationships. In another recent case, a very independent-minded director had to leave a public company's audit committee because a firm controlled by her brother had become one of the company's suppliers. Again, it is not clear what, if any, impact this "related transaction" could have on the director's ability to serve.
The second reason that this reliance on "independence" is not sufficient is that there is no evidence to suggest that directors who are "independent" do a better job. There have been several attempts at empirical studies, but none have been able to document any reduced risk or enhanced value from the number of "independent" directors. This underscores the inability of any disclosures to reveal the kind of independence of spirit or courage that are necessary for performing the duties of care and loyalty required of board members. Almost all of the companies involved in scandals had boards made up of "independent" directors (with Adelphia as one significant exception). They did not prevent catastrophe.
Finally, the most important reason that reliance on what we call "resume independence" will not make a difference is that as long as the CEO plays the defining role in determining who serves on the board, the people he selects cannot be truly independent. There is a strong human impulse to "dance with the one who brought you to the party" and if CEOs are the ones who pick (and un-pick) the directors, they will dance with him.
Even the legendary Warren Buffett admits he found it more difficult to provide independent oversight on such matters as excessive compensation when he had been invited onto a board by management. In that environment, he says, "collegiality trumped independence." But when Buffett came to then-troubled Salomon on behalf of shareholders as its largest investor, he had no trouble delivering the message that every fund director (and corporate director) should make every executive write 1,000 times on the blackboard like Bart Simpson: "Lose money for the firm and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless."
We commend the SEC for recognizing that it is absolutely necessary for the integrity and credibility of the corporate governance process that there be some mechanism for shareholder access to the proxy cards of the companies they own. The remaining questions are the specifics of the proposed mechanism, in particular whether it achieves the balance that is appropriate, and responses to some of the arguments made by those who are opposing this rule.
The proposal attempts to strike a balance that affords shareholders who are unhappy with the performance of the board an opportunity to nominate candidates for a minority of the positions on the board, without permitting undue disruption or abuse.
In general, while we would support a less cumbersome approach, we are willing to accept the "triggering event" structure of this proposal. We urge the Commission, however, to provide some avenue that does not require a two-step, two-year process. In some cases, by then it will be too late. There should be some fail-safe, for example, if 15 percent of the shareholders want to nominate a candidate up to 90 days before the anniversary of the company's last annual meeting. And the Commission should encourage companies to adopt innovative approaches so that, for example, a company with a credible system for consulting shareholders and considering any nominees they put forward would not be subject to the triggering events of this rule.
We agree with the comment filed by TIAA-CREF that a nominee should certify that he or she will fairly support the interests of all shareholders. Indeed, we would support such a certification requirement for nominees submitted by management as well. We do not believe that shareholder nominees should have to meet any standard for "independence" that is not equally applicable to management candidates. Given that management will contest the election of shareholder nominees by extensive and energetic discussions of any perceived conflicts of interest, we are confident that the determination of the relative fitness and "independence" of the candidates is best determined by those most vitally concerned, the shareholders.
We also support TIAA-CREF's suggestion of a right to challenge a nomination as frivolous or abusive, to be resolved by the Commission along the lines of no-action determinations. We suggest that penalties like assessment of costs be imposed on those who make frivolous nominations as well as those who bring frivolous challenges.
We have frankly been very disappointed by the level of discourse in the objections to this proposal made by the business community. Indeed, we believe that objections such as those raised in the Business Roundtable's letter of October 1, 2003 are in and of themselves the most compelling possible evidence in favor of the proposed rule because they demonstrate a stunning failure to recognize core principles of good governance and, even more astonishing, core principles of free market competition. This is especially disappointing because we recall that in 1978 a distinguished panel convened by the Business Roundtable recommended something very much along the lines of this proposal.
Unbelievably, the Business Roundtable now seems to suggest that there must be something must be wrong with the shareholders because they vote against management too often. Presumably, when the members of the Business Roundtable experience a high level of consumer dissatisfaction, they do not blame the consumer. But here they seem to suggest that shareholders are intelligent enough to make the decision to buy the stock, but not intelligent enough to evaluate candidates for the company's board of directors.
Their suggestion that institutional investors will blindly vote as recommended by Institutional Shareholder Services (ISS) is simply preposterous. In our experience, voting by rote in favor of management is still more pervasive than reflexive voting against management proposals or in favor of shareholder proposals opposed by management. The "broker-may-vote" rules of the New York Stock Exchange, recently repealed with respect to equity compensation plans, still result in ballot-stuffing for management on many items that once were considered "routine" but no longer are so. In fact, even when a shareholder mounts an active campaign to urge other shareholders to withhold their votes from a director, the NYSE deems that director's election to be a routine item on which brokers may vote uninstructed shares; those votes are inevitably in favor of management.
One of the signers of this letter is a former general counsel, president, and board member of ISS and a close observer (and sometime competitor) of the company in the more than a decade since she left, and we can state that this is not the case.
ISS clients are fiduciaries who understand that it would be a violation of their obligation to their beneficial holders to abdicate the responsibility to make sure that proxy votes are appropriately cast. The largest group of institutional investors is the pension funds for which the Business Roundtable CEOs themselves serve as fiduciaries. It is impossible to believe that they would use a comment on this proposal to confess that they themselves are not meeting their obligation to ensure that proxy issues are appropriately considered. If the SEC or the Department of Labor have any reason to believe that this is the case, its obligation is to enforce the fiduciary obligation by bringing an enforcement action against the regulated entity.
Fiduciaries who invest on others' behalf may formulate proxy voting guidelines that generally disfavor classified boards or poison pills, for example, based on a belief that the danger of entrenchment from these antitakeover devices overshadows any possible benefit in the form of an increased premium or protection from (now-rare) coercive bids. But such policies do not preclude voting fiduciaries from thoughtfully evaluating the merits of withholding a vote from a director or triggering access through a shareholder proposal submitted for that purpose. ISS has stated publicly that it would consider each such triggering proposal carefully, satisfying itself that the costs of shareholder access were merited at a company, before recommending that its clients vote in favor of it. Shareholders are well-enough informed, and, frankly, greedy enough, to rebuff efforts to trigger shareholder proxy access at companies where they do not believe that the election of shareholder-nominated directors will improve corporate performance.
Perhaps more important, shareholders are eminently capable of discriminating between legitimate and illegitimate users of the access right. Much has been made of the idea that if the Proposed Access Rules are adopted, "special interest" directors will easily win a place on the ballot and be elected. This concern is baseless. First, it will be exceedingly difficult for these so-called special interests-or any shareholder, really, outside the largest mutual fund families--to assemble a coalition representing 5% of the shares of a U.S. corporation of any size. (Indeed, the difficulty of putting such a group together makes additional triggering mechanisms unnecessary, in our opinion.)
Second, shareholders apply a higher standard to non-management director candidates than management candidates. This disparity is evident in proxy contests today, where management is much more likely to prevail: Of 37 proxy contests tracked by Georgeson Shareholder in 2003 (including "vote no" campaigns in which dissidents distributed their own proxy cards and battles over conversion of funds from closed-end to open-end), dissidents won only eight, with one more reported as "settled/dissident" and one, confusingly, as "management/dissident."1
Finally, incumbent boards and managements can be counted on to attempt to unearth and inform shareholders about any "special interest" agenda a shareholder nominee may be inclined to advance. Accordingly, it is unlikely that a shareholder or group with such an agenda would go to the trouble of assembling a coalition, convincing a credible candidate to run and incurring proxy solicitation, legal and other expenses, only to be rejected by fellow shareholders. In sum, shareholders are smart enough to make decisions about the deployment of corporate resources, including the corporate proxy statement, and about who should represent them on corporate boards.
Investors often vote with ISS for the same reason they become clients of ISS; they respect the ISS positions. They do not hesitate to read the ISS analysis of complex or contested proposals and come to a different conclusion. The HP/Compaq merger is one high-profile example.
Simply stated, these claims show that public corporations do not want to subject their boards to a market test. If that is the case, they should not go to the public markets for capital. We believe that the most significant contribution of this rule will be its deterrent effect. Companies who know that shareholders have a real (if extremely cumbersome) alternative will go past "the usual suspects" and make sure that the nominees they put forward are ones the shareholders will trust.
Like most observers of corporate governance--at least those with a shareholder orientation--we are deeply concerned about the so-called "crisis of investor confidence," or what we refer to as the crisis of corporate accountability. Having seen billions of dollars of market capitalization at companies like WorldCom, Enron and Tyco evaporate as a result of management malfeasance and board passivity, shareholders now refuse to trust blindly that managers and directors always have shareholders' best interests at heart. We are on the front lines of the attempts by investors and the intermediaries who serve them to understand better the risks created by irresponsible corporate governance.
Increased regulation of corporate governance by Congress, the New York Stock Exchange and the Nasdaq market-requiring more formally independent directors, meeting of those directors in executive session and creation of a mechanism for shareholders to contact the independent board leader, to name a few-are valuable measures designed to strengthen the ability of the board to exercise its crucial oversight functions. To hear some corporations and their lobbying organizations tell it, though, reform should stop there. These interest groups urge the Commission not to adopt the Proposed Access Rules, arguing that it is wiser to wait to see whether Sarbanes-Oxley and the stock exchange reforms are effective in ensuring that corporations will behave responsibly and that boards and managements will act in shareholders' interests.
That would be a mistake. The Proposed Access Rules supply the last, missing piece of the accountability puzzle: giving responsible, long-term, substantial shareholders a cost-effective way to elect a small number of directors when the incumbent board has shown itself to be entrenched and unresponsive to the concerns of shareholders. Shareholder proxy access is at bottom a market-based solution, one which corporate market participants ought not be able to defeat by raising the spectre of the "never-ending proxy contest" or implying that shareholders lack the discernment to use an access right responsibly.
Indeed, the beauty of a proxy access right for a sizeable shareholder or group is that it relies on the collective wisdom of shareholders-not regulators, or lawyers, or the incumbent board-to decide when it is worth spending funds from the corporate treasury, which is, in the end, their money, to carry shareholder-nominated candidates on the company proxy statement. Although some shareholders do have other relationships with the company whose stock they hold, as a group shareholders are least disabled by conflicts of interest and have the best incentives to inform themselves and decide when change is necessary.
Shareholders can and should be entrusted to make the decisions entailed in a shareholder access right in a way that improves board functioning across our economy.
/s/ Nell Minow /s/ Beth Young
The Corporate Library, at www.thecorporatelibrary.com, is an independent research firm specializing in corporate governance and the relationships among company management, boards of directors and shareholders. The Corporate Library was founded by Nell Minow and Robert A.G. Monks, formerly with Institutional Shareholder Services and LENS Investment Management and co-authors of Power and Accountability and the textbook, Corporate Governance.
We appreciate the opportunity to comment and would be pleased answer any further questions or present testimony if the Commission holds hearings on this proposal.