Wolf Haldenstein Adler Freeman & Herz LLP
270 Madison Avenue
New York, New York 10016
December 19, 2003
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549
Re: File No. S7-19-03
Security Holder Director Nominations
Dear Mr. Katz:
We appreciate the opportunity to comment on the matter of Security Holder Director Nominations. We are especially interested in the proposal as a means of increasing shareholder wealth through the promotion of good corporate governance. The comments submitted thus far have shown only an interest in "enhancing" shareholder democracy, and we support the Commission's proposed rulemaking as a step in that direction. The current process of nominating and electing directors provides only an illusion of shareholder democracy and makes only the slightest bow in the direction of shareholders as owners and beneficiaries of the corporation. Our position is that without at least the right to nominate candidates for the board of directors and to vote for alternative candidates, shareholders are denied an important aspect of what should be their ownership rights and that shareholder director nomination could be an important tool to ensure that corporate managers are kept directed at increasing shareholder return.
The connection between good governance and corporate performance is not only intuitive, it is real. A recent study by Paul A Gompers, Joy L. Ishii and Andrew Metrick demonstrated that an investment strategy that bought companies with strong shareholder rights and sold companies with weak shareholder rights yielded a favorable return of 8.5 percent per annum between 1990 and 1999 compared to an investment strategy that did not take shareholder rights into account. That percent increase had risen to 8.9% per annum by the end of 1999.1 Conversely, Richard Tullo of RT Asset Management Inc. estimates that "Corporate governance failures have resulted in losses of market capitalization of over 500 billion dollars" (emphasis added).
I. The Current Deficiency in Director Nomination
Nobel Laureate Milton Friedman's analysis of distortion in market economies suggests that the market for corporate directors is non-competitive in at least two significant ways. First, the number of nominated candidates is so small that shareholders are presented with essentially no choice. Second, the fact that all of the candidates emanate from a single source - namely, the board's nominating committee - eliminates any opportunity for shareholders to exercise their right to vote in proxy elections, a key aspect of their ownership of the corporation. As SEC Chairman William Donaldson has observed, corporate reliance on "the same sorts of people to fill director slots ... represents excessive reliance on one model of outside director." Ultimately, as Vice Chancellor Leo E. Strine, Jr. of the Delaware Chancery Court maintains, "[i]t is difficult to justify the current election system in its pure form."
The option presented to the shareholder - vote to approve the board's hand-picked successors or withhold one's vote and leave the present board in place for another year - is a classic Hobson's choice: vote for the board's nominees or vote for no one.2 Under this scenario, the board simply perpetuates itself. Indeed, as boards frequently nominate themselves for successive terms, this is often explicitly the case. In this sense, boards are more like a hereditary peerage or House of Lords than an elected body representative of shareholders. They are lords, however, who serve rather than police the "sovereign" management. Chairman Donaldson has noted that the general trend of directors deferring to senior managers instead of exercising their own judgment has become "an obstacle to directors' ability to satisfy the responsibility that the owners - the shareholders - have delegated and entrusted to them." Since the directors nominated on behalf of the shareholders have abdicated their oversight duties, the time has come to vest the shareholders themselves with the power to nominate directors as an important right of ownership and an improved method to control agency problems.
Many commentators opposed to the proposed rule changes have suggested to the contrary that shareholders should not have the right to influence the composition of the board of directors. In particular, Martin Lipton and Steven A. Rosenblum, in their article Election Contests in the Company's Proxy: An Idea Whose Time Has Not Come, suggest that although "shareholders may be the residual risk takers in a public company, many other groups ... make significant investments in the company" and corporations "confer different rights on shareholders, who are the residual risk takers, than are conferred on ... other stakeholders." While this contention, at least in its broadest construction, reflects the reality of the diverse ways in which companies raise capital, it ignores the crucial fact that although shareholders are only one of a number of corporate constituencies, they generally outweigh all other constituent groups in number and risk assumed, and, quite significantly, in fundamental property rights integral to their ownership of the entity. As it stands now in most U.S. corporations, two or at best three constituents - executive management, existing directors, and, rarely, employee unions - control the nominating process. Individual, very large shareholders often have an opportunity to nominate as well, but only after bargaining for the right, often under threat of divestment. The right of even large shareholders to nominate candidates for board positions ought not to depend on such "High-Noon" showdowns.
Arguments mustered by opponents of security holder director nominations claim that the proposed rule changes would negatively affect the operation of corporations. Although these objectors emphasize their concern that shareholder-nominated directors would give rise to an adversarial relationship between the board and management, this apprehension betrays their presumption that an adversarial relationship already exists between management and the shareholders. Wachtell, Lipton, Rosen & Katz takes the position that "the best route for shareholders to influence the nominating process is to propose nominees to the company's nominating committee, which should take bona fide nominee proposals from shareholders seriously" (emphasis added). If the nominating committee retains full discretion over nominations and merely "should" consider the candidates, however, this "best route" does not amount to much actual influence - and that is without considering the exceedingly vague qualification of "bona fide," which effectively leaves director qualifications at the whim of the nominating committee.
Is it possible that they view a contentious relationship between management and shareholders, mediated only by management's selected board members, as the ideal condition for running a company? This hardly seems logical, and yet it is a constant undercurrent in the comments opposing the proposed rule changes. A corollary to this line of reasoning says that frequent election contests would unduly disrupt the operation of the companies. First, the proposal on the table hardly seems likely to result in frequent contests. Second, in his comments on the matter Professor Lucian Bebchuk of Harvard Law School has pointed out the rather obvious analogy that "Members of Congress who face regular challenges are certainly regularly distracted from other work by such contests, but that has not led us to prefer a system that makes challenges to incumbents exceedingly rare." Quite to the contrary, the fact that all Representatives face reelection every two years has kept them responsive to the needs of their constituents and has contributed to maintaining the integrity and viability of our representative government. One hopes a shareholder nomination process would work nearly so well.
The most extreme variations on this theme, such as Sullivan & Cromwell's contention that "all shareholders would be best served by permitting the independent directors to determine the slate to be included in the issuer proxy statement, rather than certain shareholders," reflect the most outrageous corporate arrogance. The preponderance of evidence suggests that open and competitive markets for directors would benefit shareholders, just as competitive business markets benefit the national economy. Milton and Rose Friedman, in their book Free to Choose, conclude that the market "on the whole when it is permitted to work, protects the consumer better than do alternative governmental mechanisms that have been increasingly superimposed on the market." Their analysis clearly underscores SEC Commissioner Harvey Goldschmid's astute observation that "shareholders, under our free-market system, not only supply capital, but have the right economic instincts ... these shareholder interests are consistent with the nation's economic needs." After centuries of observing the positive social benefits of democratic elections and economic benefits of competitive markets in this country, it is high time the same principles were applied to corporate governance.
II. Specific Comments on the Proposed Rules
Although the need for reform of director nomiantion is clear, there are a number of ways in which it might be accomplished. We would therefore like to reflect upon some of the specifics of the SEC's proposed rule changes. In particular, we would like to suggest different trigger points as improvements to the proposed rule to further promote the interests of shareholder wealth.
A. Trigger Conditions Hinder the Shareholder Nomination Process
The proposed trigger conditions essentially provide for closing the barn door after the horse has escaped. Whether we consider the 35% "withhold" vote trigger or the Rule 14a-8 proposal trigger, it is clear that shareholder dissatisfaction must arise at some point before the annual meeting at which the votes were cast or the proposal presented. After the shareholder nomination process is triggered, it is yet another year - until the following annual meeting - before shareholders have an opportunity to vote on alternative nominees for the board. Consequently, there is a lag of nearly two full years between initial shareholder discontent and any real opportunity to rectify the situation. Such a delay is clearly undesirable. The downfalls of Enron and WorldCom happened in less than a year. Presently, a large shareholder would be more likely to move its investment than to face the difficulty and expense of a proxy fight. In order to be effective, this proposal must offer a better alternative than to cut and run. The only hope to prevent such scandals in the future is to allow shareholders to nominate directors well in advance of any management misbehavior or promptly upon its disclosure.
If the trigger conditions remain in the proposal, however, they must be modified to rectify several crucial problems. First, although a 35% "withhold" vote would certainly indicate shareholder discontent, shareholders must be informed in advance that this would trigger the shareholder nomination process. If the shareholders are not clearly informed in advance of the impact of their "withhold" vote, ideally on the proxy card, this provision will have limited impact. Second, although determining the 35% threshold from total votes cast is more appropriate than calculating it based on total votes outstanding, it is worth considering that, especially in a situation where there is really only one choice, many shareholders may see refusing to vote altogether as the most effective form of protest. At any rate, certainly a significant portion of those who do not vote should be considered as having withheld authority. Rules should be developed, perhaps based on empirical studies, to extrapolate from votes cast the number of votes not cast that would have withheld authority, recognizing that many unvoted shares are effectively "withhold" votes.
In addition to the proposed trigger conditions, a corporation's restatement of earnings more than once per fiscal year should serve as a trigger condition. While some restatements of earnings are inevitable and do not in all cases indicate mismanagement, frequent restatements can indicate that the managers are taking too many liberties with the accounting. Such liberties often are taken to conceal mismanagement or outright wrongdoing. This use of restatements as a trigger event would limit the flexibility with which management could creatively interpret their accounting without adding excessive regulatory burdens to the existing accounting rules.
B. Shareholder Thresholds for Nominating Are Too High
The 1% threshold for submitting a Rule 14a-8 proposal to trigger the shareholder nomination process and the 5% threshold for nominating a shareholder are simply too high. First, there is no need to have separate holding requirements for the Rule 14a-8 proposal and the nominating privileges: one year sufficiently indicates a long-term interest for both purposes. In any event, the financial implications of the suggested holding percentages are staggering. For the S&P 500, an average 5% stake amounts to nearly one billion dollars, and even for the MidCap 400 an average 5% stake still exceeds one hundred million dollars. Very few investors place such large amounts of money in a single investment. Indeed, the figures presented in the SEC proposal show that, even with a one-year holding requirement, nearly half of the companies subject to the proposed procedures have no single shareholder who can meet the 5% threshold.3 Consequently, we suggest lowering the threshold for nominating a director and, if it is to remain a trigger condition, submitting a Rule 14a-8 proposal for shareholder nomination, to 2% and 0.5%, respectively. We also believe that a one-year holding period is sufficient in both cases. These changes would mean that, based on the estimates presented in the SEC proposal, more than 80% of companies would have at least one shareholder who could nominate a director. These changes will ensure that the proposed rule changes will truly affect the way boards of directors are elected and, thus, enhance pressures on management to deliver increased wealth to shareholders.
No matter what criteria are used to trigger the shareholder nomination process, the election of one or more shareholder nominees should extend the shareholder nomination process through the election following the last shareholder-nominated director's resignation from the board. This will ensure that, for as long as the shareholders feel it is necessary to elect their own nominees to the board, they will have the means to do so. Ultimately, waiting for any trigger condition brings the shareholders into the nominating picture too late. Ideally, shareholders should be able to nominate directors from the outset in order to prevent rather than just correct corporate misbehavior.
C. A Preferable Alternative to Trigger Conditions
Vice Chancellor Strine proposes an attractive alternative to triggering conditions. He suggests that, instead of waiting for trigger conditions to initiate shareholder nomination, all corporations should place shareholder nominees on the ballot at least once every three years. Although, as noted above, we feel that the 5% stake that Chancellor Strine suggests is simply too high, we agree with the overall thrust of his proposal. We recommend that corporations with a board of eight or fewer must reserve one seat for a shareholder-nominated director, increasing to two seats on a board of nine to fourteen and three seats on a board of fifteen or more. In keeping with Vice Chancellor Strine's proposed system, at least one shareholder-nominated director should come up for election every three years.4
D. The Need for Increased Transparency
Finally, the proposed rule should improve transparency in the nomination of corporate directors. The current nominating process suffers from nearly complete opacity. Proxy cards provide only such information as management feels will ensure the election of the board nominees. Candidates' business, financial, and personal relationships with the CEO and other board members are not disclosed, and their real independence cannot be assessed. Sometimes, these relationships can make boards function less like a group of independent directors and more like a tight circle of friends. Typically, these relationships are not disclosed in proxy materials. Few investors have the resources to research the public record for such information about any corporate board, let alone to research the board of each company in which they invest. The suggestion by the National Association of Corporate Directors that "the proxy statement should be expanded to include, at a minimum, the most recent business or professional position held by the candidate" does not go far enough. The only way to protect shareholders from directors with flagrant conflicts of interest - financial, professional, and personal - is robust disclosure by nominating committees. By allowing shareholders to nominate alternative board candidates, the SEC's proposed rulemaking should make the election of directors a more transparent process.
III. The Path to Increased Shareholder Wealth
Whether the SEC adopts a modified process for shareholder nomination, as we have recommended, or enacts the rule changes as proposed, with the inherent limitations we have identified, the result will be to improve corporate governance. These changes will encourage large shareholders to monitor boards and ensure that those boards are guarding the interests of the shareholders. By allowing shareholders to nominate directors - which should be recognized as a prerogative of ownership - this process will promote good corporate governance and thus increase shareholder wealth.
Allowing the principal owners of a corporation to participate in the process of nominating directors will advance shareholder value. Despite our concern that the trigger conditions will unduly limit the applicability of these changes and even when met will severely delay the effects of shareholder nomination, we nevertheless applaud this important step. The nomination option will, at the least, force large shareholders to consider its exercise and the pressure that will apply to managers will likely increase shareholder wealth. We urge the SEC to consider expanding this proposal to provide true competitive elections with real alternative candidates in corporate proxy elections. It is time for corporate governance to reflect what economists have acknowledged since the late 18th Century and what the Founders of our country understood: the easiest way to ensure that governors serve the public interest is to entrust their selection to the public marketplace. The time has come to create a competitive market for corporate directors.
/s/ Jeffrey G. Smith
Wolf Haldenstein Adler Freeman & Herz LLP
|1|| Paul Gompers, Joy Ishii and Andrew Metrick, "Corporate Governance and Equity Prices," Quarterly Journal of Economics 118 no. 1 (Feb. 2003): 107-155.
|2|| Even this scenario presumes that every shareholder votes against the candidates. As Professor Joseph Grundfest of Stanford Law School has pointed out, most if not all state laws base director election on a plurality, not majority, of votes. Consequently, a director could be elected even if most shareholders withheld authority, an outrageous outcome in a supposedly democratic process.
|3|| Although the proposed rule changes would permit shareholders to aggregate their holdings to meet the proposed percentages, grouping shares to exceed a 5% holding could potentially subject those shareowners to the increased disclosure rules of Form 13D. This severely limits the likelihood of such a coalition, as many investors, for a variety of reasons unrelated to director nominations, would seek to avoid this expanded disclosure.
|4|| Although not germane to the particular rule under consideration, we also urge the SEC to consider a rule that would establish three-year term limits for all non-management directors, whether nominated by the board or by shareholders.