Mr. Jonathan G. Katz,
Re: Proposed Rules Relating to Security Holder Director Nominations (File No. S7-14-03)
Dear Mr. Katz:
This letter is being sent in response to Release Nos. 34-48626, IC-26206 in which the Securities and Exchange Commission proposed a rule that would require the inclusion of shareholder nominees for election as director in companies' proxy material in certain circumstances.
While we appreciate the Commission's good faith efforts, for the reasons described in this letter we feel compelled to oppose - and strongly - the proposal. We recommend that, at a minimum, the Commission refrain from adopting the rule for at least one year to assess whether the numerous recent changes to corporate governance requirements - most of which come into effect next year - adequately address the concerns underlying the proposal. If, however, the rule is adopted in the near term, we recommend the introduction of a transition period that would prevent any trigger event from occurring before January 2005. In addition, we believe that the rule as currently proposed would lead to undesirable and unanticipated consequences for companies and shareholders, and have suggested certain refinements and modifications to the rule in this regard.
I. Reasons That We Strongly Oppose Adoption of the Rule
1. The proposed rules exceed the Commission's authority under Section 14 of the Securities Exchange Act of 1934.
The proposed rules regarding shareholder access would directly regulate the balance of power between corporations and their shareholders, and between large shareholders and other shareholders, in a manner that exceeds the Commission's authority under Section 14 of the Securities Exchange Act of 1934. Under the guise of disclosure, the Commission would be effectively adopting federal corporate governance standards that would provide certain large shareholders with a new federal substantive right of shareholder access that does not generally exist under state law. The proposed limitation of the rules to situations in which state law does not expressly prohibit shareholder nominations is insufficient to avoid this conflict with state law, since in those states where the proposed rules would apply the Commission is substantively altering the states' corporate governance requirements.
The limits of the Commission's authority under Section 14 were the subject of a 1990 opinion of the Court of Appeals for the District of Columbia, in Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990). In that case, which related to the Commission's "one-share, one-vote" rule, the court stated that the Commission's authority to regulate proxy disclosure does not permit it to regulate "the distribution of powers among the various players in the process of corporate governance" or to regulate issues that are "part of corporate governance traditionally left to the states." In this regard, the court noted that when enacting the Exchange Act in 1934, Congress expressly disavowed any intent to regulate or interfere in the internal affairs and management of corporations. The court stated that:
Congress acted on the premise that shareholder voting could work, so long as investors secured enough information and, perhaps, the benefit of other procedural protections. It did not seek to regulate the stockholders' choices. If the Commission believes that premise misguided, it must turn to Congress. (emphasis added)
We believe that one must look beyond the form of the proposed rules to recognize that the practical effect of the rules would fundamentally and substantively change the nature of director elections, a matter which lies at the core of corporate governance. The Commission would indeed be seeking to "regulate the stockholders' choices." Mandating shareholder access to proxy statements for the purpose of nominating director candidates would create a substantive federal requirement under which a company, in effect, must solicit proxies for nominees opposed to the company's own slate. Such substantive regulation is clearly inconsistent with Congressional intent, as it goes far beyond the central and process-based purpose of the proxy rules; namely to ensure a fully informed and orderly vote on matters coming before the shareholders.1
As the Supreme Court stated in Sante Fe Industries v. Green, "corporations are creatures of state law, and investors commit their funds to corporate directors on the understanding that, except where federal law expressly requires certain responsibilities of directors with respect to stockholders, state law will govern the internal affairs of the corporations." 430 U.S. 462 (1977) (emphasis in original, quoting Cort v. Ash, 422 U.S. 66 (1975)). Clearly, the internal affairs of a corporation include the "relations between management and stockholders." Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541 (1949). Thus, the proposed rules would impose substantive regulations on existing state systems of corporate governance, and work fundamental and substantive effect on the state-determined allocation of power to govern the corporation among shareholders and directors.
The limitation of the proposed rules to those states where shareholder nominees are permitted does not affect this conclusion. Even if a state permits shareholders to recommend nominees, the proposed rules would expand these rights and, in fact, create a new right - the right to require the company to include the shareholders' nominee in the company's proxy statement at company's expense. Thus, in the states where the rules would apply (i.e., the vast majority of states), the rules would substantially modify shareholders' rights. The fact that a company could opt out of the application of the rules through a charter or by-law provision does not make the rule any less of a substantial governance rule for the purposes of the Business Roundtable analysis.
We believe that it is important to note that Congress, in enacting the Sarbanes-Oxley Act of 2002, made significant and sweeping changes relating to corporate governance, financial reporting and related matters, and would have had ample opportunity to expand the Commission's authority in the area of director elections. However, nothing in the Sarbanes-Oxley Act relates at all to shareholders' rights in director elections or (other than the audit committee rules) to director responsibilities, nor does the Sarbanes-Oxley Act modify Section 14 of the Exchange Act. We believe this lack of Congressional action should lead the Commission to act cautiously in interpreting its authority under Section 14 to relate to matters of corporate governance.
2. Recent enhanced nominating committee and other corporate governance requirements obviate any need for the proposed rules.
The New York Stock Exchange, the Nasdaq Stock Market and other major stock exchanges, acting in response to a Commission request, have each recently adopted significant changes to their corporate governance listing standards. Under these new standards, the independent directors, generally in the form of an independent nominating committee, will have greater involvement in the director nomination process. In addition, these new standards heighten the requirements for determining whether a director is "independent" of management and the company. Numerous additional corporate governance changes have been imposed by the stock exchanges and by the Commission under the Sarbanes-Oxley Act of 2002, with the goal of enhancing the accountability, integrity and transparency of the listed companies. These enhanced corporate governance requirements are supplemented by the rules recently adopted by the Commission that will require disclosure in company proxy statements as to the nominating committee process and actions.
We believe that these new stock exchange rules and Commission rules obviate any need for direct shareholder access to the issuer proxy statement. As the Commission has previously recognized, use of independent nominating committees addresses the same concerns that underlie the shareholder access proposals.2 The recent exchange and Commission rules are likely to have a major impact on the director nomination process, and we believe that the Commission should give these carefully considered, heavily debated reforms an opportunity to work before determining whether direct shareholder access to the issuer proxy is necessary.
We believe, in fact, that the system contemplated by the stock exchange and Commission disclosure rules, which emphasize the involvement of independent directors and the transparency of the nominating process, is a superior system for protecting the interests of all shareholders as compared to the shareholder access requirements. The company's directors have a fiduciary duty running to all shareholders, and the new heightened independence standards will ensure that the independent directors can truly act in a manner independent of management. These independent directors are in the best position to weigh all recommendations - from management, shareholders or other sources - and make recommendations to the full board as to the nominees for inclusion in the issuer proxy.
The proposed shareholder access rules would give certain large shareholders the ability to force the company to expend funds to advance the nomination of the shareholders' nominees. These shareholders do not owe a fiduciary duty to the corporation or to other shareholders, and there is no reason to think that they will strive to act in the best interests of the other shareholders or of the corporation. The interests of all shareholders would be best served by having the independent directors, and not large shareholders, serve as the primary filter for director nominees.
3. Shareholder access will be costly and disruptive to companies and will impair the functioning of boards to the detriment of all shareholders.
The potential negative effects of a shareholder access rule on the election process and the functioning of boards of directors need to be carefully considered. It seems clear that if the proposed rules are adopted, election contests will become much more common occurrence for all companies. An election contest is inevitably an extremely disruptive event for a company, and vast amounts of time, energy and funds will need to be diverted from the company's business and put toward defending the company against dissident shareholders, who would now be able to wage proxy battles without even expending their own funds. It is likely that most shareholder nominees will be advanced by the types of activist shareholders that traditionally have used the shareholder proposal mechanism for the promotion of parochial interests or political or social issues having little to do with the company's business. To the extent that such shareholders are actually successful in electing special interest or "protest" directors, the effect may be to create divided boards of directors with a diminished capacity to function effectively. If management or directors feel that certain other directors are working with an agenda other than the best interests of the company, this could actually cause management to limit discussion with the board, or could cause the board to create working committees that exclude the special interest directors, which would work against the goals of the recent stock exchange proposals.
More generally, creating an environment where election contests are a constant threat will turn the company-shareholder relationship into an essentially adversarial relationship, instead of one where the parties' interests are aligned and the parties are working toward a common purpose. We also believe that the threat of acrimonious, contested elections and the resulting uncertainty may dissuade many qualified directors from board service. The recent stock exchange rules, and the Commission's rule-making under the Sarbanes-Oxley audit committee requirements, have already made it much more difficult for companies to find qualified independent directors who have the time, ability and inclination to serve, and the proposed rules would aggravate this situation.
4. There has been no compelling, objective showing of need for the new rules.
The potential adverse consequences of a shareholder access rule could, in theory, be justified if there was a clear, demonstrable need for the introduction of such a rule. But the proposing release does not advance any objective basis for believing that shareholder access to company proxy statements would be a benefit to shareholders or an improvement to the director election process. Instead, the proposing release cites comments that it received, in response to its solicitation of views on the proxy process, in support of shareholder direct access to support the view that "some" or "many" security holder have "concerns" that the imposition of a shareholder access regime might address. Putting aside the question of whether the comments supporting the shareholder access rule come from a representative cross-section of shareholders, as opposed to a limited universe of large activist organizations, we simply do not believe that the presence of these concerns among some shareholders is adequate justification for the adoption of such a far-reaching proposal in the absence of any objective evidence for its necessity or value.
For all of the reasons discussed above, we respectfully oppose the adoption of the proposed rules.
II. Application of Rule
Although we oppose adoption of the rules entirely, if the rules are nevertheless pursued by the Commission, we believe that certain changes to the provisions of the rules are necessary to avoid serious damage to the director election process and the rights and interests of all shareholders. The remainder of this letter describes these recommended changes.
We believe that it is prudent and appropriate for the federal regulator to assure itself that it has intruded into matters traditionally overseen by the states only to the extent necessary to achieve the legitimate goals of the Commission. Accordingly, we believe the Commission should take a cautious approach in implementing any shareholder direct access rules. We believe that the proposed rules proceed further into the area of corporate governance than the Commission has previously ventured and that, as the proposing release confirms, the impact of the rules is difficult to predict. To the extent that any thresholds or requirements adopted by the Commission appear to be preventing the rules from accomplishing the purpose for which they are intended, the Commission could always expand the scope of the rules. It would be difficult, however, to pull back on shareholder access rights if the rules go too far, as we believe the proposed rules do, and the resulting harm to corporations and shareholders would be impossible to reverse.
1. No trigger event should be deemed to occur prior to January 1, 2005.
The proposing release provides that any annual meeting of shareholders that occurs after January 1, 2004 could be the basis for the occurrence of a trigger event. Considering that the deadline for comments on the proposing release is December 22, 2003 and that the Commission will then need to sort through a possibly record-breaking number of comments on a very large number of open questions, it is virtually certain that the final rules will be adopted after January 1, 2004, perhaps well after that date. As a result, unless the effective date is delayed the rule would seem to have retroactive effect. In fact, in determining the effective date of the rule, the Commission should consider that the preparation for each annual meeting begins months in advance, and that the actions taken in preparation are driven in part by the proxy requirements that will be in effect for the annual meeting.
We urge the Commission not to permit trigger events to occur during the upcoming proxy season. The annual meetings for calendar year companies will generally not occur for a number of months, but these companies, their boards of directors and their shareholders are currently in the process of preparing for the meetings by considering director nominees, preparing proxy materials, and dealing with the submission and consideration of proxy proposals. Companies, boards and shareholders have been making these efforts without any knowledge of what the specific (or even non-specific) provisions of a shareholder access rule will be, or even if one will be adopted and applied to the upcoming annual meeting at all. We believe that it is contrary to sound public policy for the actions taken or omitted during this comment period to lead to substantive differences in the application of the new rules.
We believe that application of the trigger requirements to upcoming annual meetings could be deemed to violate the Administrative Procedures Act, 5 U.S.C. §§ 551-559. The APA, to which the Commission is subject, provides that except in limited circumstances a substantive rule shall be published in the Federal Register at least 30 days prior to its effective date. Application of the trigger events to a 2004 annual meeting would require retroactively applying the rule's provisions to a direct access shareholder proposal that was submitted, and considered by the company, prior to the adoption of the final rule. For instance, existing proxy rules, as interpreted by the SEC staff, would permit companies to reject such proposals under Rule 14a-8(i)(8) as relating to a director election.3 In addition, the proposing release would require the shareholder submitting such a proposal to "provide evidence that they satisfy the more than 1% and one-year thresholds when they submit their proposals," even though these requirements are different from those currently included in Rule 14a-8(b)(1) and, in fact, may be different from the thresholds ultimately adopted by the Commission. Companies and shareholders are currently operating in an informational vacuum with regard to the proposed rules, and actions are being taken based upon best guesses as to ultimate application and provisions of the rules. We believe that retroactive application of a shareholder access rule in this manner will lead to disparate and unfair results among different companies and their shareholders, and is neither sound nor legitimate rule-making.
The application of the new rules to the upcoming annual meeting season would also exacerbate the pressures that many companies are facing due to the unexpected acceleration of the new stock exchange corporate governance requirements. The NYSE corporate governance rules, for example, which were approved by the SEC last month, generally require companies to comply with the new requirements, including the heightened independence requirements, by the time of the 2004 annual meeting. This is in contrast to the earlier proposed transition period of 18 months. In addition, the final NYSE rules removed a proposed transition provision that would have prevented director relationships that existed prior to the adoption of the rules from tainting a director's independence. Therefore, many companies suddenly learned that they had very little time to locate new independent directors and that their proposed independent directors may not actually meet the new independence standards. Adding new unexpected proxy-related requirements at this late date would greatly increase the pressure on companies and may lead to important governance changes being made without adequate consideration, which would not be in the best interest of shareholders.
Finally, it is not consistent with the stated purpose of the proposed rules to put them into effect in the upcoming proxy season. According to the proposing release, the trigger events are designed to identify "those instances where evidence suggests that the company has been unresponsive to security holder concerns as they relate to the proxy process." As discussed above, the stock exchanges and the Commission (both under the Sarbanes-Oxley audit committee requirements and through its nominating committee disclosure rules) have recently adopted rules designed to improve the director nomination process, enhance shareholder communication with the board, and generally improve corporate transparency, board oversight and director responsiveness to shareholder concerns. For the most part, these provisions are not even in effect yet, and most will take effect in 2004. Allowing trigger events to occur in 2004 would mean that evidence of director or company "unresponsiveness" is being sought before the new governance regimes designed to enhance responsiveness are even in place.
For all of the above reasons, we believe that no trigger event should occur until the company's 2005 annual meeting. This would give companies enough time to adapt to the new corporate governance requirements and would give shareholders enough time to evaluate the functioning of the board and the company under these new requirements. In addition, it would give all parties time to prepare for the potential triggering event in an informed, organized manner.
2. Shareholders should be able to opt out of the proposed access regime by voting to approve an alternative system.
Shareholders of some companies may determine that the costs of a shareholder access rule (e.g., the time and attention of management and the board and the funds of the company being spent on addressing potential trigger events and election contests as opposed to on business matters) outweigh the benefits, and in such cases should be allowed to opt out of the application of proposed Rule 14a-11. The proposing release seems to recognize this when it provides that "If state law permits companies incorporated in that state to prohibit security holder nominations through provisions in companies' articles of incorporation or bylaws, the proposed procedure would not be available to security holders of a company that had included validly such a provision in its governing instruments." This concept, however, is not clearly provided in the proposed rules themselves. Therefore, we suggest that Rule 14a-11(a)(1) be modified to limit application of the rule to situations where: "Neither applicable state law nor any validly authorized provision of the registrant's articles of incorporation or bylaws prohibit the registrant's security holders from nominating, or impose alternative requirements for the nomination of, a candidate or candidates for election as director."
3. If the rule is adopted, it should apply to all issuers that are subject to the proxy rules, not just accelerated filers.
The proposing release contemplates that the new shareholder access rules would apply only to "accelerated filers" as defined in Exchange Act Rule 12b-2. We believe that if the rule is adopted it should apply to all issuers, not just accelerated filers. It is our sense that most shareholder direct access proposals and withhold vote campaigns will have no relation to the actual responsiveness or performance of the relevant company, but rather will just reflect the efforts of activist shareholders to use this process to advance their respective agendas. This explains why, as the proposing release notes, the vast majority of shareholder proposals are submitted to accelerated filers - it is not because those companies are more poorly managed, but because they provide higher visibility for the proposing shareholder. If the new rules apply only to a limited universe of issuers, then these issuers will unfairly bear the costs of the new system. The concept of "accelerated filer" was specifically crafted for the purposes of determining appropriate time periods for the filing of periodic reports. There is no basis for using this definition as a random dividing line for the imposition of the burdens of the new shareholder access requirements. Furthermore, if the Commission, despite our concerns, believes that direct access by shareholders to company proxies is a benefit to shareholders, there is no reason to deny these benefits to certain shareholders due to the size of the company in which they hold shares.
III. Trigger Events
1. There should be only one trigger event.
The proposed rules would have two separate trigger events - the direct access opt-in trigger and the withhold votes trigger - both designed to identify situations where shareholders are discontent with the corporate or board responsiveness to proxy-related concerns. In addition, the proposing release requests comment on whether a third trigger should be added relating to the failure to implement a shareholder-approved proposal.
We strongly recommend that the rule should have only one trigger. This would permit shareholders and companies to focus their attention and energies on a single benchmark, and would more likely result in an outcome that represents the actual view of the shareholders. Having multiple trigger events being pursued simultaneously will lead to confusion among shareholders and companies about what exactly should be done to support or oppose the occurrence of a trigger, and will make the occurrence or non-occurrence of a trigger depend less on the actual view of shareholders with regard to the company, and more on the relative success of the parties' solicitation tactics. Furthermore, in keeping with our comments at the start of Section II above regarding the wisdom of a cautious approach to rule-making in this area, we note that the Commission could easily add additional triggers, or modify the adopted trigger, if it appears that the desired result is not being achieved. On the other hand, eliminating a trigger that is, in practice, determined to be unnecessary or excessive could be extremely difficult, and would likely face significant opposition among shareholder groups.
We believe that the decision as to which trigger to eliminate and which to retain is less important than the realization that having a single trigger rather than multiple triggers would make the election process vastly more efficient and less damaging to all parties. As discussed further below in subsection 1(a), we believe the withhold votes trigger should be retained in the modified form we discuss below, since the latter, as so modified, would be a more telling indicator of true shareholder dissatisfaction with the board and with the election process. Under this approach, the direct access opt-in trigger would be eliminated.
(a) The withhold votes trigger should be more narrowly tailored to apply only if a majority of votes outstanding are withheld for a majority of company nominees.
We believe that the 35% withhold votes trigger sets too low a threshold and is not appropriately structured so as to identify situations of broad shareholder dissatisfaction with the board or the proxy process. There is no reason to think that the withholding of 35% of votes cast for a single nominee is indicative of widespread lack of shareholder confidence in the proxy process or the board as a whole. This trigger could occur in a situation where a significant minority of shareholders has decided not to vote in favor of one particular nominee. This is not evidence of what most shareholders think of the board as a whole. A shareholder who withholds a vote for a particular nominee may, in fact, merely be expressing dissatisfaction with the nomination of that one individual, and might not know that this action will be deemed by regulatory fiat to convey some broader dissatisfaction.
We believe this trigger should be revised so that the thresholds bear some relationship to the situation they are designed to identify. The trigger should occur only if the relevant percentage of votes are withheld for a majority of management-supported nominees. In addition, for the reasons stated above with regard to the direct access opt-in trigger, the relevant percentage should be a majority of votes outstanding, not 35% of votes cast. Again, the statistics given in the proposing release as to the frequency of 35% of votes being withheld are completely inapposite, since currently shareholders have no incentive to withhold votes or to initiate a campaign to get others to do so.
If the trigger is not modified to apply to a majority of management-supported candidates, but continues to apply if a single nominee receives the requisite percentage of votes, we believe that companies should be given the opportunity to address this focused shareholder action by removing the directors who receive the requisite number of withheld votes. Specifically, if more than the requisite percentage of votes are withheld for a director, this should not be deemed a trigger event if that director is removed from the board of directors prior to the company's next annual meeting or is not re-nominated for election at the next annual meeting.
(b) The direct access opt-in trigger is the one that should be eliminated or, alternatively, should be more narrowly tailored to isolate true instances of widespread shareholder dissatisfaction.
As discussed above, we believe that having duplicative triggers is confusing to all parties and is completely unnecessary, particularly since the proposing release admits that both triggers are aiming to identify the same concerns. Under the approach we favor, the direct access opt-in trigger is the one that would be eliminated, since it not an effective indicator of widespread shareholder dissatisfaction with the board or the company. The submission of a direct access proposal by a large shareholder or a group of shareholders does not, in our view, provide as good an indication of widespread shareholder discontentment as the withhold votes trigger in the modified form we discuss above. We believe the withhold votes trigger would be a fairer method for shareholders to convey a desire to open up the proxy to shareholder nominees, because it does not place large shareholders - the only class eligible to initiate an opt-in vote - in a disproportionately powerful position with respect to smaller shareholders, but rather empowers all shareholders in proportion to their voting share.
If the direct access opt-in trigger is not eliminated, we believe it should be modified so that it would better isolate instances of truly widespread shareholder dissatisfaction. The proposed rules would permit a shareholder or group of shareholders to submit a proposal to open up the proxy for shareholder nominees if the shareholder or group held more than 1% of the securities entitled to vote, and if those securities had been held for more than one year as of the date the proposal was submitted. We believe these thresholds are so low as to nearly eliminate the proposal submission as a substantive requirement. The proposing release notes that most companies have at least one shareholder satisfying these standards, and it seems likely that even more companies have other shareholders with large enough stakes that a small number of them could form a 1% group. If the thresholds are not raised, these large shareholders will have an inordinate amount of power over the corporation and, therefore, the other shareholders. The statistics cited by the proposing release as to the low percentage of proposals submitted by 1% shareholders are not useful as predictive guides, since currently shareholders do not have the incentive to form 1% groups or to submit direct access proposals. To avoid abuse of this trigger by dissident shareholders to the detriment of the company and the other shareholders, we recommend that the relevant percentages be conformed to the 5%/two-year standards used in Rule 14a-11(b) as the threshold for nominating shareholders. If there is indeed widespread shareholder discontent, it certainly should not be too difficult for large shareholders to put together a 5% group to submit the proposal. Again, we note that if, in practice, this threshold appears too high to satisfy in cases of genuine shareholder discontent, the Commission can lower the threshold in the future.
We also note that setting the threshold too low will require the Commission staff to spend significant resources in dealing with a flood of shareholder proposals and the issues that they raise, such as shareholder eligibility, conformity with procedure, company requests for exclusions, adequacy of supporting and opposing statements, etc.
Under Rule 14a-11 as currently proposed, a trigger event will occur if the direct access proposal is approved by more than 50% of the votes cast on the proposal. This could result in a trigger event occurring when only a minority of shareholders indicated support for the proposal. Since shareholders who are discontent with the company are more likely to participate in the vote than shareholders who are content, this threshold is skewed toward approval of the proposal. We note in this regard that, under stock exchange rules, brokers will not be permitted to vote on a direct access opt-in proposal in the absence of specific customer instructions.4 The general standard under state law for shareholder approval of major corporate actions, such as amendments to organizational documents, mergers, etc., is a majority of the votes outstanding.5 We believe that triggering an election contest is a significant enough event that it should be subject to this same standard, assuming the Commission's stated respect for state law is to be taken seriously.6
In order to prevent a single shareholder or group of shareholders from continually draining corporate resources with repeated unsuccessful attempts to get a direct access proposal approved, we believe that any shareholder who submits, or is part of a group that submits, a direct access proposal that is not approved by the requisite majority of shareholders should be prohibited from submitting another such proposal for five years.
2. There should be no trigger for failure to implement a shareholder-approved proposal.
In the proposing release, the Commission requests comment whether an additional trigger should be added for failure to implement a shareholder-approved proposal within a specified time period. We oppose adding this trigger for a number of reasons. As discussed above, we believe that having multiple triggers designed to identify the same types of problems is unnecessary, confusing and counterproductive. In addition, we oppose adding this trigger due to the practical and logistical concerns set out in the proposing release. In the event of dispute, the Commission would need to make subjective judgments about whether the proposal was or was not adequately "implemented." This process could lead to extended litigation or procedural actions, and in any event will infuse a significant level of uncertainty into the process.
Moreover, we believe that there is no connection between this trigger and the widespread shareholder dissatisfaction that the triggers are designed to identify. There is no reason to think that the board's failure to implement an approved proposal is evidence of general unresponsiveness. It is possible that the board did not implement the proposal because, for example, there were logistical, legal or other obstacles that made it impossible or impracticable to do so. Such obstacles would not necessarily be apparent to the shareholders when they approved the proposal. The decision by the directors as to whether to implement the proposal should be made by them in the exercise of their business judgment. The Commission should respect the long-standing state law policy of deferring to the business judgment of the directors as to the management of the company, and should not introduce a trigger event that might skew this judgment or subject it to outside influences or self-preservation concerns.
3. A trigger event should open the nomination process only for one year, not two years.
Under the proposed rules, the occurrence of a trigger event would cause the company proxy to be open to shareholder nominees for the following two years. We believe this is entirely inappropriate. If a trigger event occurs, the proxy should be opened to shareholder nominees only for the next year, not for two years. Large shareholders should be encouraged to put forth nominees in the year following a trigger event so that the other shareholders' concerns are promptly addressed. In addition, a lack of shareholder action in the year following the trigger event is evidence that shareholders are not overly concerned about the company's leadership.
4. Provisions should be put in place to avoid duplicative and confusing application of the rules.
The proposing release and the rule as proposed appear not to consider very clearly the cumulative effects of multiple proposals, trigger events, shareholder nominations, solicitations in opposition, etc. occurring over multiple years. In order to avoid unnecessary confusion and duplicative efforts, we believe the following provisions should be put in place regarding the interplay of various provisions of the proposed rules:
IV. Eligibility Requirements for Nominating Shareholders and Nominees
1. The eligibility requirements for nominating shareholders should be increased.
(a) Ownership percentage
We believe that the two-year holding period for nominating shareholders is appropriate. However, we recommend increasing the requisite ownership percentage from 5% to 10%. In the situation where a trigger event has occurred, interested shareholders will have plenty of time to coordinate efforts and create a 10% shareholder group, particularly in light of the Commission's view that a trigger event will only occur where there is widespread shareholder dissatisfaction. Leaving the threshold at 5% would make it too easy for a handful of dissident shareholders to work together to put forth a special interest candidate. Such an outcome would work against the interests of the large percentage of shareholders whose votes helped to create the trigger event.
(b) Continuation of ownership and other eligibility requirements
We believe that the disclosures and representations proposed to be required from nominating shareholders are appropriate. However, we believe that any such shareholder should be required to express an intent to hold the requisite number of shares not merely through the date of election, but rather through the entire term of the nominee. This will help ensure that the shareholder is, in fact, considering the effect on the company or the other shareholders of the nominee's election, and not merely advancing a personal agenda unrelated to the company's business.
(c) Limit on repeated nominations by a shareholder
If a shareholder (either individually or as part of a group) has a nominee included in the company's proxy statement, then whether or not that nominee is elected, the company should not be required to include another nominee of that shareholder in the proxy in any of the following three years. Since the trigger events are intended to be indications of broad shareholder discontentment, a single shareholder should not be able to monopolize the nomination process year after year.
(d) Schedule 13G eligibility
The proposing release would modify the Schedule 13G eligibility requirements to permit a nominating shareholder to use Schedule 13G instead of 13D. We believe that proposing a nominee for director should subject a shareholder to the expanded disclosure requirements of Schedule 13D in order to ensure that all shareholders have enough information about the nominating shareholder to make an informed decision. We agree that in order to include a nominee in the proxy statement, a shareholder or group must be otherwise eligible to file on 13G.
2. The eligibility requirements for shareholder nominees should address compliance with applicable corporate governance requirements.
The proposed requirements for shareholder nominees contain appropriate provisions relating to the relationship between the nominee and the nominating shareholder. However, if the nominee is to be added to the company's board, then the qualifications and independence of the nominee under the standards applicable to the company will need to be considered.
(a) Satisfaction of board criteria for directors
In response to the various corporate governance requirements adopted by the stock exchanges and the Commission, many companies now publish criteria that all board members must satisfy. We believe that any shareholder nominee should satisfy any criteria for board membership adopted by the board that (i) apply to all director-nominees subsequent to the effective date of the new rules, (ii) are consistent with state law and (iii) have been published by the company. The company should not be required to lower its standards to accommodate a shareholder nominee.
(b) Stock exchange subjective independence standards
The new stock exchange rules generally require listed companies to have a majority of independent directors. The proposed shareholder access rules would require any shareholder nominee to satisfy any objective independence standards under the stock exchange standards, but not any subjective standards (such as the requirement for an affirmative board determination that there are no material relationships). This could put the board in the difficult position of needing to make an independence determination as to a shareholder nominee in a situation where the board does not support the nominee and where a failure of the nominee to be independent would cause the company to fail to satisfy the stock exchange's standards. To avoid this situation, we suggest the following rule: If (i) an applicable stock exchange has an independence standard with a subjective element; (ii) at least one management-supported candidate is independent; and (iii) a loss of one independent director will cause the company to fail to have sufficient independent directors under the applicable stock exchange's standards, then the company should not be required to include in its proxy statement any shareholder nominee who has any relationship whatsoever with the company (other than relationships that are deemed immaterial under any categorical standards for independence published by the company).
(c) Satisfaction of audit committee, Section 162(m) and Rule 16b-3 qualifications
The stock exchange rules and Rule 10A-3 under the Exchange Act impose additional requirements for audit committee members. The proposing release provides that in no event will a shareholder nominee be required to meet these higher audit committee standards. We believe that if there is any risk that the company will lose an audit committee member in the election contest, then any shareholder nominee should satisfy the relevant audit committee requirements. In particular, if any of the management-supported nominees are members of the company's audit committee, then all shareholder nominees should satisfy the audit committee standards of Rule 10A-3, applicable stock exchange rules for audit committee members (such as independence under the stock exchange rules), and any other criteria for audit committee membership adopted by the board and published by the company.
Similar concerns arise in connection with satisfaction of the standards contained in Section 162(m) of the Internal Revenue Code (which exempts certain performance-based compensation from the cap on deductibility if a compensation committee composed of "outside directors" establishes and certifies the relevant performance goals) and Rule 16b-3 under the Exchange Act (which provides an exemption from short-swing profit recovery under Section 16 of the Exchange Act for certain transactions between issuers and their directors and officers that are approved by a committee of the board that consists solely of two or more "Non-Employee Directors"). Replacement of a director that satisfies one or both of standards with a shareholder nominee who does not could significantly impact the board's ability to function effectively and the company's ability to administer its compensation policies. We believe that if any of the company-supported nominees satisfies the Section 162(m) or Rule 16b-3 standards, then all shareholder nominees should be required to satisfy the same standards.
(d) Listing on multiple stock exchanges
Finally, we recommend that if a company is listed on multiple stock exchanges, then any shareholder nominee must satisfy the independence and other eligibility standards of all applicable stock exchanges. The company should not be required to delist or violate the standards of any exchange on which it is listed.
V. Number of Nominees
(a) Relation of number of nominees to size of board
The proposed rules would require inclusion of one shareholder nominee if the board size is eight or fewer. We believe that "eight or fewer" should be "nine or fewer." A staggered board with three sets of three directors is a fairly common structure, and permitting two out of three directors elected in a given year to be shareholder nominees would be unnecessarily disruptive to the functioning of the board. Alternatively, we suggest determining the number of shareholder nominees to be included in the proxy statement based not on the total size of the board, but rather on the number of directors who may be elected in any given year. In that case, if there were three directors up for election in a given year, only one shareholder nominee would be able to be elected. This will prevent the number of directors elected in a given year from being disproportionately weighted toward the shareholder nominees.
(b) Elimination of limit on number of nominees included in proxy
We believe that a limit should be imposed on the number of shareholder nominees who may be elected in any given year, but not on the number required to be included in the proxy statement. If a shareholder or group with a sufficient ownership percentage puts forth a nominee, there is no rationale for excluding that nominee just because another shareholder or group put forth another nominee. The fact that two separate shareholders or groups put forth separate nominees indicates that their interests may be divergent enough that neither would be satisfied with the other's nominee. Other shareholders should be permitted to vote on all eligible nominees.
(c) Involvement of nominating committee
If the rule continues to limit the number of shareholder nominees required to be included in the proxy statement, then the company's nominating committee or independent directors should be responsible for determining which shareholder nominees to include. The recent stock exchange rules have placed great emphasis on the importance of having independent nominating committees evaluate candidates, and these independent directors are in the best position to consider the qualifications of each nominee in relation to the needs of the board and the company.
VI. Information Provided by Nominating Shareholder
It is crucial that shareholders obtain accurate, complete and timely information in order for this process to work. Therefore, we support the proposal to require nominating shareholders to file the relevant information with the Commission and to have liability for such information under Rule 14a-9 and under the antifraud provisions of the securities laws. If this information is not provided by the relevant deadlines, the company should not be required to include the nominee.
We support the proposal to require all solicitations by any shareholder in connection with the formation of a nominating shareholder group to be filed with the Commission. Because such filing with the Commission will make the solicitations available to all shareholders, the exception for solicitations to less than 30 persons is irrelevant and should be eliminated. The restriction on content of solicitations should, therefore, be applied to all such solicitations.
All nominating shareholders should be required to provide all information reasonably requested by the board and nominating committee to determine eligibility under state law, company director qualification policy, stock exchange standards, Commission rules and other federal laws (e.g., industry-specific provisions limiting the number of non-U.S. directors). If the nominating shareholder does not respond to the request with a specified deadline - e.g., five business days - the company should be able to exclude the nominee from the proxy statement.
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We appreciate the opportunity to comment to the Commission on the proposed amendments, and would be pleased to discuss any questions the Commission may have with respect to this letter. Any questions about this letter may be directed to David Hirschmann, Senior Vice President, at (202) 463-5609.
cc: Hon. William H. Donaldson, Chairman, U.S. Securities and Exchange Commission