Speech by SEC Commissioner:
The SEC's Shareholder Access Proposal
Roel C. Campos
U.S. Securities and Exchange Commission
7th Annual Corporate Breakfast
Yale Law School Center for the Study of Corporate Law
New York, NY
January 10, 2005
The SEC's Shareholder Access Proposal
Thank you very much for inviting me to speak today. Todd Lang was generous for agreeing to provide his views today, which I am sure will be quite insightful and will provide you with a perspective that is different than my own. I wish to thank several of the Yale Law School sponsors - Professor Jon Macey, who is moderating, Yale Law School Dean Harold Koh, and Associate Dean Toni Hahn Davis as well as Professor Alan Scwhartz.
I am substituting for my dear friend and fellow Commissioner Harvey Goldschmid, who is ill and could not be here. This is sort of a bait and switch - instead of Harvey, a New Yorker who has spent the majority of his career as a professor at the Columbia Law School, you get me - a native Texan who spent most of his legal career in California, and who has had a rather schizophrenic career at that. Prior to my time at the Commission, I was a corporate lawyer, later a business litigator, a federal prosecutor, and most recently a businessman and entrepreneur. My comments today are strictly my own and do not represent the views of the other Commissioners, the Commission or its staff.
I am going to begin with a recent painful memory for New Yorkers. You will recall (however reluctantly) that the Boston Red Sox came back to win the playoff series against the Yankees after being down 0-3, and then broke the Bambino's curse by winning the World Series. Therefore, I believe that it is fair to say that this is the year for the long shot. As such, in the same vein, I believe that it still may be possible to have the Commission adopt a version of the shareholder access rule that was proposed over a year ago. I must admit, however, that I am becoming a pessimist. I will speak more about this at the end of my comments.
It is interesting that in my two plus years at the Commission, no other issue has produced as much controversy and lobbying - witness the full page advertisements in the Wall Street Journal and the New York Times on behalf of the corporate interests by the Business Roundtable, not to mention the serious lobbying done in the halls of Congress and upon the Chairman and all of the Commissioners of the SEC. The number of comments we have received in the process, over 14,000, suggests, at a minimum, that a lot of people care about the issue.
I am sure most of you are familiar with the SEC's proposal. However, let's make sure and I will first describe the specifics of the SEC proposal, including recent thinking as to possible modifications to the proposal. I then will speak about the competing interests and criticisms of the proposal. Hopefully time will allow me to discuss several other proposals to improve shareholder access. Finally, I will describe a mechanism that seems to have a chance of producing a compromise.
II. A Description of the SEC Proposal
What exactly is this shareholder proposal that is causing such consternation? Let me describe it as contained in the SEC's release issued last year. As proposed, the rule would provide certain shareholders access to their companies' proxy materials to have their nominees to the board included along with management's nominees in an election to the board of directors. Shareholders and shareholder groups that own more than five percent of the issuer's securities for at least two years would be able to utilize this rule if one of two proposed triggers occurred.
One trigger would be shareholder approval of a shareholder proposal to opt into the proxy access system, where the proposal was submitted by a one percent shareholder. The other trigger would occur if thirty-five percent of stockholders withheld votes for any particular director candidate. If either happened, as proposed, then the next year at the annual shareholders' meeting, that issuer would be subject to a new rule in which the described five percent group of shareholders can propose one candidate for election to the board that the issuer would be required to include in its proxy materials.
The candidate has to be an independent director under listing standards applicable to the issuer and must also be independent of the shareholders that nominate him or her. The candidates to be nominated increase to two if the board is composed of nine to nineteen directors and votes are withheld from two management nominees. The number increases to three possible nominees under the same requirements if the board is composed of twenty or more directors. The proposed rule only would operate in instances where shareholders can make nominations under state law and where the nomination itself was lawful under applicable state law. The names of nominees must be submitted by a shareholder or group that owns more than five percent of shares outstanding for at least two years and who will hold the shares through the subsequent annual meeting. The nominating shareholder or group must be eligible to report its beneficial ownership on Exchange Act Schedule 13G. To be elected, any shareholder nominee must receive a plurality of the votes cast, as with any management nominee to the board.
If this proposal goes forward, I'd expect there to be changes from what the SEC originally proposed. A year after the rule was proposed and after the submission of thousands of comment letters, I believe that the chances of adopting the "opt in" trigger are significantly in doubt. Similarly, the trigger that is based on a thirty-five percent withhold vote may change into a threshold of fifty percent, not counting the broker non-votes.
B. Features of the Proposal
Let me emphasize some of the elements of the proposal. You cannot seek control under this proposal. The nominee must be independent and may not be a representative of a particular segment of the shareholders. Management can still use the treasury of the issuer to oppose the nominee. It will be expensive and take a lot of time and coordination to obtain support for the non-management nominee. Based on these restrictions and other considerations, I think it is fair to conclude that this proposal will only be used in cases of extraordinary shareholder dissatisfaction. This would include an issuer that may be described as a "dead issuer," one that is performing badly and one whose management and board are entirely unresponsive to shareholder concerns. Otherwise, it seems fair to say that the time and expense will not be worth the use of the proposed rule.
III. Competing Interests and Criticisms of the Proposal
I asked earlier: "Why all the fuss about this subject?" Well, let's take a very high level perspective - say 25,000 feet, and look down at the issue. We have two competing groups in the case of large public corporations. One is professional management (CEOs and other senior management) and, until recently, their mostly hand-picked board of directors. The other group consists of shareholders - mostly institutional shareholders, since most other shareholders will be too small to effectively participate in this form of access without extraordinary effort. The battle is essentially over who makes and participates in the critical decision-making process regarding the composition of the board of directors and other matters.
Institutional shareholders have made the case to the SEC that the proxy system as it exists today does not work. They have urged that shareholder nominees are necessary "to restore genuine accountability in a board room culture that for too long has been characterized by cozy relationships and a resulting unwillingness to challenge management." Business interests have essentially countered that the SEC's proposed rule would create "sweeping and harmful changes in corporate governance practices" which would give undue leverage to special interest groups and generate undue expense.
There are several serious issues and criticisms of the proposal.
A.Institutional Investors Are Not Representative of All Shareholders
One attack by business interests has been to challenge the legitimacy of the idea that institutional shareholders truly represent the entire class of shareholders. Essentially the criticism is that state treasurers, comptrollers, and labor union representatives that have been the most active in pressing the SEC toward the rule are not true owners of the issuers that would be subject to the rule. The argument is that these groups do not invest their own money, but the money savings of pension fund beneficiaries. Further, they argue that the investment decision-making on behalf of the beneficiaries is delegated to a wide group of pension plan managers, many of whom are not long term investors but short term traders. The heavy use of indexing further removes these institutions, it is argued, from being true owners. In the end, the detractors contend, this type of "outsourcing" of investing beneficiaries' savings does not allocate capital in the economy to its best use, and as such institutional investors do not deserve regulatory protection as a class.
Of course, institutional shareholders have much to say about questions pertaining to their legitimacy as representatives of shareholders at large. They point out that their leadership is elected by the beneficiary members themselves. Their primary mission is to maximize investment returns for their beneficiaries. If the leadership fails to discharge this duty, the beneficiaries will vote them out of office. Beneficiaries' main concern is that their pensions create long term performance and value to support retirement. In seeking to maximize returns, institutional investors have employed professional managers who have used various strategies such as indexing. However, institutional investors argue that they are increasingly concerned about laggard companies whose performance is hindered by poor management and board oversight. The group as a whole, they argue, is principally concerned about promoting long term value and not about short term trading strategies.
Professor Roberta Karmel has argued in her recent article in the Business Lawyer that a large shareholder or group is not necessarily more representative of the interests of the shareholders as a body than management and the board, who have fiduciary duties to all of the shareholders.1 By contrast, she explains, one shareholder or minority shareholder group does not owe or have fiduciary duties to other shareholders. Professor Karmel argues that before granting institutional shareholders nominee rights under the SEC rule, institutional shareholders should be required to have obligations to the corporate enterprise as well as to other shareholders, much like controlling shareholders have obligations to minority shareholders.
As a general matter, the SEC has not distinguished among classes of shareholders in allocating rights under the proxy system. The proposed access rule is no exception. The proposed ownership requirements of the access rule are intended to make sure that the ability to use the rule is limited to shareholders or groups of shareholders that have made long term investments in the company and that are not interested in situational or mischievous action. It does not differentiate between institutional and individual shareholders. The rule would allow non-institutional shareholders to aggregate their holdings to be eligible to make nominations under the rule. In fact, the five percent requirement normally will require several institutional investors to form a five percent block. Few institutions hold even one percent of the outstanding shares in major public companies. The Council of Institutional Investors ("CII") estimates that public pension funds, one of the most active groups of institutional investors, hold less than eight percent of the total U.S. equity market.2 The CII also indicates that there are wide differences of opinion, investment strategies, and political views among the full body of institutional investors. For example, some institutional investors routinely challenge management, while other institutional investors support management under almost any circumstances.
This issue raises other considerations. Apart from traditional institutional investors such as pension funds and banks, there exist other large classes of institutional investors, such as mutual funds and hedge funds, which hold trillions of dollars in capitalization. These two groups have not been historically active in this arena, but there is nothing to prevent them from becoming active in the future. In fact, recently it was reported that hedge funds in Europe were acting in concert in the arena of mergers and acquisitions and using their large blocks of shares to impact transactions for their financial benefit.
It is hard to see what the SEC itself can do about specific shareholder rights and obligations per se. Shares of stock, with attendant rights to dividends and preferences are subject to an issuer's governing instruments and are a matter of state regulation. For the foreseeable future, the SEC must deal with all shareholders as legitimate and not discriminate among them - as there is no basis for engaging in that kind of discrimination among classes of securities under federal securities laws.
B.Give Sarbanes-Oxley Reforms A Chance to Work
The enactment of the Sarbanes-Oxley Act has led to a number of reforms in corporate governance. It required that the SEC direct SROs to make changes to their listing standards to require that audit committees be comprised entirely of independent directors, who will manage the outside auditor. In addition, in response to Sarbanes Oxley, the NYSE and the NASD imposed listing requirements under which an issuer's nominating and compensation committees must be composed entirely of independent directors. The SEC also adopted rules aimed at improving communications by the nominating committee. Among other requirements, these rules require that an issuer disclose its nomination procedures and whether it considers candidates for director nominees put forward by shareholders.
Through Sarbanes Oxley, Congress has focused on independent directors as the vehicle for making management more accountable and for having boards of directors that truly discharge their oversight duties. The frank truth is that the jury is out on whether directors who are on the surface "independent" can actually stand up and hold managers accountable. I believe that even independent directors still can possibly be compliant and controlled by management.
Unlike director independence reforms, the shareholder access rule is not a part of Sarbanes-Oxley reforms. It as an aspect of proxy reform that has its own unique history of consideration by the Agency dating back to the 1970s. All along the way, the Agency's view has been that if the proxy system is "broken," then it should be fixed. The current access proposal is just the latest edition of these efforts, and should be viewed separately and apart from Sarbanes-Oxley inspired reforms.
The proponents of this "wait and see" approach also argue that there are too many regulations hitting business all at once. Citing the new internal controls, certification and other requirements, these critics of the proposal argue that the imposition of all of the new requirements has created regulatory overload. I recognize this as a very serious concern. However, the counter-argument is that unlike other new regulations, most companies would not be affected by the proposed access rule. Due to the high thresholds proposed as triggers and the difficulty that shareholders will face in using the rule, I suspect that it will be used very infrequently. Consequently withhold vote campaigns would be very few and very selective.
C.Directors Elected Under This Rule Would Be Disruptive
Another argument made frequently is that any directors elected under this rule would be disruptive to business. Essentially, corporate interests fear any encroachment on the existing system. They point out that the conduct of business depends upon boards working well and having a cooperative and respectful board room dynamic. Many characterize corporate boards as working through the process of consensus. As such, an outside director chosen by shareholders, even if independent, will be disruptive and upset the careful balance in the board room.
The short answer to this, of course, is that consensus may not be a good thing in the long run for a board. Different views and perspectives may enhance corporate decision making. Indeed, this argument is precisely the view of those who support diversity on boards as I do.
Another corporate fear is that shareholder interests will be empowered in their negotiations with management, because they can threaten to use the shareholder access process to challenge a director. Because management will seek to avoid the cost and embarrassment of such a procedure, shareholders will obtain leverage in their negotiations. The real concern that underlies this argument is that corporate managers do not trust activist institutional investors. Corporate interests believe that the state comptrollers and treasurers and union pension funds have political and self-serving agendas that are not about creating long term value. Again, the institutional investors argue that their beneficiaries will not let their focus stray from achieving acceptable long term returns on their savings. Even if institutional investors had a non-economic agenda, the wide body of shareholders would not approve nominees if management opposed them and pointed out the harm they might do to the corporation. A recent example of this may be found in CalPERs' recent withhold campaign against Warren Buffet's election to Coca Cola's board of directors. Despite its reputation as one of the most prolific advocates for corporate governance, CalPERs was unsuccessful in gaining support for its campaign against the reelection of Warren Buffet. This demonstrates that institutional investors do not necessarily have a hold over shareholders of large public corporations.
D. The SEC Does Not Have the Authority to Adopt The Rule
One of the most vocal criticisms of the rule is that the Commission does not have the authority to adopt it. Instead, it is argued, such issues are within the exclusive authority of state law. The state law question is a tough and real issue. I do not have enough time to get into a lot of detail regarding the SEC's authority to adopt the shareholder access rule, but I can summarize my view. The SEC's authority to adopt the access rule turns on whether the rule is within the powers granted to the SEC by Congress in the enactment of Section 14 of the Exchange Act. The leading case in the area is Business Roundtable vs. SEC, 284 U.S. App. D.C. 301 (D.C. Cir 1990). In that case, the Court of Appeals for the D.C. Circuit concluded that the Commission's adoption of the one share-one vote listing standard exceeded the authority granted by Congress in its enactment of Section 19 of the Exchange Act. In contrast to that rule, we have based our proposal of the access rule on our authority to improve shareholder communications through the proxy. The purpose of proxy regulation, ultimately, is to ensure that shareholders are fully informed of matters for which their proxies are being solicited. In essence, the proxy rules put shareholders in the same place they might have been if they attended the meeting. I believe that the access rule does that. Further, the proposed rule specifically provides that the rule will not be effective if state law provides to the contrary. Based on these considerations, I believe that the rule is fully within our authority. I am not alone in my view. Several academics have expressed support for the SEC's authority to adopt the proxy access rule.3
IV. Alternatives to the SEC Proposal
I have been and remain open to considering other alternatives to shareholder access. For example, Professor Grundfest of Stanford has proposed that the Commission adopt an "advice and consent" procedure. Under this approach, the Commission would, through listing standards requirements or other tools, impose restrictions on directors that receive significant numbers of withhold votes in the applicable election. For example, directors receiving more than forty percent withhold votes would be restricted from signing an issuer's 10-K or registration statement, or would not be deemed "independent." The idea is that this would provide an incentive for the board to remove that director and submit for election only directors that they believe shareholders support.
Others have suggested attacking the issue through other proxy rules. For example, one suggestion I have gotten is to change Rule 14a-7, which allows management to choose between providing a shareholder that seeks to conduct a proxy solicitation with a list of record holders, or mailing the shareholder's solicitation materials on his or her behalf at that shareholders' expense. The suggestion was that we consider revising that rule to lessen the costs of such a solicitation. While each of these suggestions is worth considering, I am not sure whether they offer any significant advantages over the current proposal, or would face any less opposition.
V.Future Possible Compromises
I have already discussed the likely dropping of the one percent opt-in trigger and the modification of the withhold vote trigger to become fifty percent of the vote cast (excluding broker non-votes and abstentions). The Business Roundtable has also discussed a so-called "cure" provision. Under this approach, a company would have an opportunity to avoid the operation of the access rule if the board removes and replaces any director(s) receiving the triggering amount of withhold votes within a particular time frame, i.e., 90 days from the date of the election. Any director in this position could be asked to resign, or the board could remove the director (if permitted by state law). After the removal, the issuer could appoint a new director as permitted by their bylaws or have a special election for a replacement director. This could mean that the new director nominee, if still unacceptable, would have to be the subject of a second withhold vote of fifty percent at the following shareholder meeting, which would then allow the shareholders to place their nominee in the following shareholder meeting (the third such meeting after the original withhold vote). This idea gives me some concern. I am concerned that it only extends the operation of the access rule further, making it three years before shareholders have an opportunity to use the rule. I am also concerned that the cure approach could result in the situation where the "bad" company replaces an ineffective director, "Bozo A" with another ineffective director "Bozo B."
Two modifications have been discussed to go along with the cure provision. One mechanism would provide for very large shareholder groups to be able to place a nominee on the issuer proxy. For example, shareholders owning some absolute percentage of an issuer's stock (15-20%) could place a nominee on the proxy at any time. I do not think that the inclusion of such an exception would be used very frequently - as I mentioned earlier, the CII says that its most active institutional members collectively own less than eight percent of the large public companies. Further, as previously discussed, institutional investors, as with any other group, may see issues differently and it would therefore be difficult for such investors to agree on one particular nominee.
The second modification to the "cure proposal" would require that management disclose whether it consulted with shareholders in its selection of the replacement director. If management did not consult with shareholders in the selection of the replacement, it would have to disclose that failure in the proxy statement. The idea behind this approach is that the disclosure requirements would provide a strong incentive for management to involve shareholders in the selection process. I believe that this is a good idea, although I do not think that it goes far enough to ensure that there is meaningful shareholder input in the selection process.
The position of most commentators, particularly shareholders on this topic is that the proxy rules need to be improved to allow incremental influence by shareholders on the selection of directors. I think this should be done in a manner so as not to disrupt the conduct of business. At the heart of the debate is a mistrust of the agenda and goals of institutional investors that are actively lobbying for shareholder access and of the corporate interests lobbying against it. Some believe that the goals of the investors are non-economic in nature and political. In contrast, some believe that the goals of the corporate interests are to maintain control. There is not much that anyone can say to prove either wrong. Ideally, the representatives of both of these groups would meet and develop a joint solution within the proxy rules and present the approach to the Commission. I have personally asked institutional investors groups to meet with business groups and to develop and present to the SEC a joint position that both sides could live with. Unfortunately, I doubt that will happen. The tone in this debate has been very toxic and there does not appear much possibility for statesmanship. When there is fundamental distrust between parties it is difficult to fashion any compromise, however prudent or balanced it might be.
I continue to support a shareholder access rule that is based upon the SEC's proposal. I believe the benefits generally justify the costs. I am open to compromise on the mechanisms. I would not support the rule if I believed it would be disruptive to the conduct of business. I further believe that if a rule is not passed by the SEC, the struggle between the two sides will continue and politics rather than substance will take over, which would not be in the best interests of either party. I suspect that some modification of the cure provision would have a good chance to be passed by the Commission. I continue to urge our Chairman any my fellow Commissioners to work diligently to reach agreement on a fair rule.
As is probably clear, even I must admit that the chance of getting meaningful proxy reform at times seems like a long shot. Even characterizing this as a long-shot is fine for me. As I stated earlier, if the Red Sox can make a long-shot a reality, perhaps the Commission, corporate and shareholder interests can do the same.