Speech by SEC Commissioner:
Remarks at Conference on "Shareholder Rights, the 2009 Proxy Season, and the Impact of Shareholder Activism"
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
Center for Capital Markets Competitiveness
U.S. Chamber of Commerce
June 23, 2009
Thank you, David [Hirschmann], for that warm welcome. It is a pleasure to be speaking at this timely conference on "Shareholder Rights, the 2009 Proxy Season, and the Impact of Shareholder Activism" hosted by the U.S. Chamber of Commerce. Before I begin, I must remind you that the views I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or my fellow Commissioners.
As a practical matter, public company shareholders are not well-positioned to run the enterprises in which they invest. Managerial responsibility over a firm's corporate strategy and day-to-day business and affairs instead is in the charge of directors and management. That said, shareholders retain the right to vote on fundamental corporate changes, such as a merger, a sale of all or substantially all of the corporation's assets, and an amendment to the corporate charter or bylaws. Most notably, shareholders vote for board members. Shareholders also have the right of "exit," as they can sell their shares if they disapprove of the company's performance.
The animating question behind any discussion of shareholder rights thus presents itself: What is the proper institutional arrangement for ensuring that the company is managed in the best interests of shareholders when those who own the firm do not actively run it?1
Last month, in May, the SEC took a significant step toward setting the balance of control in corporations.2 The Commission proposed new Exchange Act Rule 14a-11 creating a direct right of access for shareholders to the company's proxy materials for nominating board members. For example, for the largest public companies, a nominating shareholder or group would have the right to include director nominees in the company's proxy materials if the shareholder or group beneficially owned at least one percent of the company's shares for at least one year.
The Commission also proposed amending Exchange Act Rule 14a-8(i)(8) to allow shareholders to include in the company's proxy materials a proposal to amend the company's bylaws to provide for a shareholder access regime. Notably, the SEC's proposal prohibits shareholders from adopting a bylaw that opts out of the Rule 14a-11 access regime, even if shareholders want to.
As you may know, I voted against the Commission's proposal and instead offered a counterproposal, which I will discuss later.3 First, let me explain my core concern with what the SEC has advanced. As always, I look forward to considering the comments we receive on the proposal.
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The Delaware Supreme Court has put it this way:
The most fundamental principles of corporate governance are a function of the allocation of power within a corporation between its stockholders and its board of directors. The stockholders' power is the right to vote on specific matters, in particular, in an election of directors. The power of managing the corporate enterprise is vested in the shareholders' duly elected board representatives. Accordingly, while these "fundamental tenets of Delaware corporate law provide for a separation of control and ownership," the stockholder franchise has been characterized as the "ideological underpinning" upon which the legitimacy of the directors managerial power rests.4
I have expressed it similarly: Corporate governance is about the allocation of control and the mechanisms by which those with control are held accountable. A fundamental governance challenge is to strike the appropriate balance between allowing directors and officers room to exercise their business judgment in fulfilling their fiduciary responsibilities while ensuring that there is a proper check on the managerial discretion of corporate decision makers.
Striking the right balance is difficult. While regulation by mandate often is warranted, drawing hard-and-fast regulatory lines runs a heightened risk of being counterproductive when dictates are imposed uniformly across an expanse of diverse and shifting relationships, practices, transactions, and interests. Notably, the tradition of state corporate law has not been to regulate by mandate for this very reason. To the contrary, in regulating the internal affairs of corporations, states — as Delaware clearly exemplifies — have adhered to a so-called "enabling" approach as opposed to a "mandatory" approach.5
Mandatory corporate law forces a universal governance scheme on all firms without allowing a firm the flexibility needed to adapt based on its distinct circumstances. Recognizing that one-size-fits-all mandates are inappropriate for many businesses, the enabling approach defers to private ordering, spurred on by market discipline and competition, to determine how each firm should be organized to advance its particular needs and interests most effectively. The internal affairs of each corporation can be tailored to its own attributes and qualities, including its personnel, culture, maturity as a business, and governance practices. Simply put, the same corporate governance regime is not necessarily optimal for a struggling Midwest industrial manufacturer, a small-cap biotechnology company in Silicon Valley, and a dominant financial services firm in New York.
It is important to underscore that the enabling approach is not without legal standards governing behavior. State corporate law imposes upon directors and officers fiduciary duties of care and loyalty. Directors and officers are obligated to act in what they honestly believe is the best interests of the enterprise and its shareholders. More particularly, state corporate law, from which the shareholder vote originates, defends the shareholder franchise. The Delaware Chancery Court, for example, explained in the Blasius case that the standard of judicial review is especially demanding when boards act with the primary purpose of frustrating the right of shareholders to vote. Instead of being subject to the business judgment rule, a board "bears the heavy burden of demonstrating a compelling justification" when its principal intent is to compromise the vote.6
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The enabling approach has worked in recent years to allow companies to craft governance standards that afford shareholders greater influence. Over the past few years, as more attention has focused on the importance of the shareholder vote, a notable trend has developed. Corporations have evolved from plurality voting toward majority voting for directors, even in the absence of legislative, regulatory, or judicial requirements. Majority voting empowers shareholders in holding directors and management accountable by affording shareholders a more impactful collective voice. Over 50 percent of the S&P 500 companies now have some form of majority voting. On a percentage basis, fewer smaller companies have seen fit to switch to majority voting, although many have. States have been responsive, accommodating this governance innovation by amending their corporations codes to facilitate majority voting.7
That companies have not uniformly adopted majority voting is not an indictment of enabling corporate law. To the contrary, diversity among corporations is the predicted outcome. The virtue of private ordering is that it does not force all corporations into the same governance box. Instead, it fosters the value of allowing a company to tailor its internal affairs. In yielding to the unique circumstances of different companies, enabling corporate law expects firms to follow different paths to achieving the best results for the enterprise.
Even more to the point, states are in the midst of promoting a tailored company-by-company approach to shareholder director nominations, whatever the required vote may be for a director to win election. Consider, for example, new section 112 of the Delaware General Corporation Law.8 In April of 2009, the Delaware legislature adopted section 112, which explicitly authorizes, but does not require, bylaws granting shareholders access to the corporation's proxy materials to nominate directors. In contrast to the mandatory quality of proposed SEC Rule 14a-11, section 112 recognizes the value of variation across firms, affording boards and shareholders flexibility to strike what they deem to be the proper governance balance.
In addition, Delaware has adopted new section 113. Section 113, which also is enabling, permits a bylaw providing for the corporate reimbursement of shareholders soliciting proxies for the election of directors. Even without access to the company's proxy materials, a shareholder can nominate directors on its own independent proxy. Section 113 is directly responsive to the argument that shareholders are discouraged from waging a proxy contest because of the cost.
Active consideration is being given to amending the Model Business Corporation Act — which 30 states have adopted, at least in part — along the lines of sections 112 and 113 of the Delaware code. These developments illustrate how state corporate law has been adaptive in facilitating shareholder director nominations, consistent with private ordering. Shareholders increasingly will have the opportunity to offer and adopt bylaw amendments that they believe are best for the company. In some instances, shareholders may decide that no access or reimbursement bylaw at all is appropriate.
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This leads to why I unfortunately was not able to support the Commission's proposal. The proposal, especially proposed Rule 14a-11 dictating a direct right of access to the company's proxy materials, encroaches far too much on internal corporate affairs, the traditional domain of state corporate law, and in doing so, denies each corporation the flexibility needed to adapt its governance practices to its distinct qualities and circumstances.
The whole of the Commission's access proposal is about far more than the driving goal of the '34 Act to empower investors by putting information in their hands. The proposal reaches too far past the point of being about disclosure or even about the voting process. Rather, the essence of the proposal is to realign corporate control at the federal level, upsetting the longstanding federalism balance in the area of corporate governance. The mandatory quality of Rule 14a-11 — particularly when one recognizes that the proposal allows a firm to adopt a more generous access regime but not one with more restrictions — belies that the rule is about disclosure or process as compared to achieving a particular substantive outcome.
Indeed, in a key respect, Rule 14a-11 is in tension with the overall disclosure philosophy of the federal securities laws. An example best illustrates the point. Assume that the shareholders of Delaware Corp., a large public company, adopt a proxy access bylaw pursuant to section 112 of the Delaware code, and that the bylaw requires that a nominating shareholder or group has beneficially owned at least three percent of Delaware Corp.'s shares for at least two years. The interplay between state law and Rule 14a-11 would result in the substantive negation of the shareholder-approved bylaw, as the lower one-percent/one-year Rule 14a-11 eligibility requirements would, in effect, override the shareholder-approved three-percent/two-year requirements. Put differently, the mandates of Rule 14a-11 not only work to displace private ordering and state law, but risk negating the importance of a shareholder vote.
The disclosure philosophy of the federal securities laws presupposes that, when armed with information, shareholders are positioned to evaluate enterprises and, as each shareholder sees fit, agitate for change or reallocate its investments. Yet the mandatory nature of Rule 14a-11 cuts in a different direction, frustrating the kind of shareholder choice that disclosure seeks to empower. Even if a majority of a company's shareholders determine that Rule 14a-11 is not in the firm's best interests, the proposal would nonetheless force the company's shareholders into the Rule 14a-11 access regime, as shareholders cannot opt out of Rule 14a-11 by prohibiting access or by adopting eligibility requirements more restrictive than those of the rule.
To flesh out the point, let me note two related reasons why shareholders may not prefer a regime of ready access to nominate directors. Here, it is worth observing that subjecting shareholders to an access regime they do not want is unlikely to restore investor confidence and actually may erode it.
First, shareholders are not monolithic, and some shareholders may be skeptical of how other shareholders may take advantage of the access they are afforded. One particular concern may be the possible untoward influence of so-called "special interest" directors. The concern has been expressed that special interest directors may have goals that compete with maximizing firm value, putting such directors at odds with the best interests of shareholders.
Second, disagreement at the highest levels of a firm can be important to ensuring that there is a full airing of issues and a robust deliberative process. However, too much conflict can generate the kind of distrust and disharmony that undercuts the ability of the board and management to run the business productively. Mediating the tipping point requires careful balancing. What is important to recognize is that the enterprise and its stakeholders as a whole may be disserved by the additional dissension and disruption that could result if certain shareholder nominees run and are elected. On this, it is worth observing that boards of directors are more independent today than ever and that companies continue to separate the positions of CEO and board chairman and appoint lead directors.9
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At the open meeting where the SEC's access proposal was adopted, I offered a counterproposal, which I will reiterate — namely, we should consider amending Rule 14a-8(i)(8) to permit shareholders to include in the company's proxy materials a bylaw proposal that would allow shareholders proxy access for nominating directors so long as the company's jurisdiction of incorporation has adopted a provision explicitly authorizing a proxy access bylaw. Such an amendment would accommodate recent state corporate law developments and step back from the SEC's earlier decision to amend Rule 14a-8(i)(8) to allow directors to omit from a company's proxy materials shareholder proposals providing for an access bylaw.10 Such a targeted amendment to Rule 14a-8(i)(8) also would rest on firmer legal ground than the Commission's recent proposal.
Not only does this counterproposal benefit from allowing private ordering, but it has practical benefits over the Commission's proposal. Allowing firms to craft their own access regime relieves the Commission from having to devise intricate procedures for implementing access and from having to draw a number of lines to establish eligibility requirements.
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All of this ultimately speaks to a more general topic — that is, the degree to which the government should intervene in the economy. So let me conclude by broadening out my discussion.
We already have experienced an historic expansion of the government's role in the economy in the aftermath of the financial crisis, with the government intervening in unprecedented and sometimes unpredictable ways. Just last week, the Obama Administration offered its plan for what would be the most far-sweeping overhaul of financial regulation since President Roosevelt's New Deal.11
There is a fundamental role for government in overseeing our financial markets and the economy more generally, and we need a regulatory framework that is current and fits our increasingly vast and complex financial system. Without question, change is needed; but so is caution. As we consider the parameters of regulatory reform, it is essential that we do not overreact to the recent hardships.
Notwithstanding the struggles and difficulties we have been persevering through, it remains possible for regulation to go too far, particularly if the regulatory calculus overemphasizes "tail events" or so-called "black swans" and underestimates the cost of regulating to avoid them. Responding to turmoil while living through it increases the chance that new regulatory demands will be exceedingly precautionary at the expense of future economic growth. The misfortune of the current crisis is salient, constantly weighing on us, whereas the future cost of burdening our economy with overregulation is not nearly as evident or tangible. To temper the prospect that regulation will be overdone, it is important to remind ourselves what the cost of excessive regulation means in real-life terms. When regulatory demands overburden the economy and constrain and chill private enterprise, the unfortunate consequences of lower economic growth are felt throughout society as fewer jobs are available; as investors earn lower returns on their portfolios; as fewer innovations are commercialized and brought to market; as health care becomes harder to come by; and as college tuition becomes harder to pay for.
The goal of avoiding and managing excessive risk in our financial system has become a driving focal point of the regulatory reform debate. I certainly do not champion excessive risk taking; but nor do I welcome excessive conservatism. Not taking certain risks itself can be imprudent. A dynamic economy that robustly grows over time requires a financial system that allows for private-sector innovation and entrepreneurism that is unburdened by undue government restrictions. I am concerned that the totality of the government's involvement in the economy to date, only to be coupled with the anticipated regulatory revamp, ultimately will prove to be unnecessarily costly.
Indeed, as the SEC considers its own mission, the agency must recognize that in addition to protecting investors from fraud and manipulation, we have an obligation to be vigilant in promoting capital formation and ensuring that markets have room to be flexible, adaptive, and competitive. Only by focusing on all parts of our mission can the SEC strike the right balances in advancing the full range of investor interests.
I will leave you with one final thought. As lawmakers, we need to approach the challenges we face with humility. We need to appreciate the complexity of what is before us and guard against being overconfident that we can craft well-calibrated solutions. Striking appropriate balances is never easy. Even in times like this, when the benefits of regulation seem apparent and there is pressure to act, we cannot overlook the risk of overregulating.