Founder, The Corporate Monitoring Project
268 Bush Street #3934
San Francisco, CA 94104, USA
Voice/Fax: (415) 680-1521
June 11, 2003
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
RE: File No. S7-10-03 (Solicitation of Public Views Regarding Possible Changes to the Proxy Rules)
Dear Mr. Katz:
I am a financial economist doing independent research on corporate governance for the past seven years. (For details on my background, my resume is on the web at www.corpmon.com/MLresume.htm .)
I support the general idea of finding a practical way for shareowner-nominated director candidates to appear in the company-paid proxy. Giving shareowners a choice of candidates should strengthen directors' incentives to serve shareowner interests. However, I suggest that the Commission also consider ways of enhancing shareowners' ability to make intelligent choices when voting.
The free-rider problem greatly limits incentives for shareowners to monitor management, whether by nominating director candidates, evaluating director and management performance, or researching how best to vote. Even an institutional investor typically owns less than 1% of a company's stock, bearing 100% of the cost of any monitoring they do while getting less than 1% of the benefit.
Allowing competing director candidates into the company-paid proxy reduces the free-rider problem by reducing the cost of soliciting votes. But comparing the quality of one director candidate versus another is a complex task, and the free-rider problem saps shareowners' incentive to spend the time or money needed to judge and vote carefully. To fully benefit from competitive director elections, we need to solve this incentive problem.
Although many institutional investors have professional staffs who analyse proxy voting decisions, and subscribe to voting advice from such firms as ISS (Institutional Shareholder Services), the free-rider problem pervasively restrains spending on such guidance. "Comprehensive analyses of proxy issues and complete vote recommendations for more than 10,000 U.S. companies are delivered by ISS's seasoned U.S. research team consisting of more than 20 analysts." [www.issproxy.com/institutional/proxy/pas/index.asp] We can thus estimate only about four hours of analysis per proxy.
Brand reputation is a common device for simplifying voting decisions. For example, political parties can be seen as brands that make it easy for people to vote in civic elections. If we have competitive director elections, we can expect brands to evolve for signaling director quality to shareowner voters. Certification by such organizations as the Council of Institutional Investors or the National Association of Corporate Directors might fill this role. Ideally, brands would compete for the reputation of certifying directors who act in shareowners' interests. To do this most effectively would require costly ongoing monitoring of director performance however, so again the question of how to fund it would arise. Perhaps directors would pay for certification, and perhaps the need to maintain brand reputation would minimize any corrupting influence of such payments.
Most individual investors face a severe free-rider problem because of their small shareholdings. As a result they give minimal attention to voting, if indeed they vote at all. This offers a prime opportunity to use brands for improving the quality of voting. Individuals could, for example, learn the brand reputation of CalPERS (California Public Employees Retirement System) as a guide to voting. CalPERS publishes its proxy voting decisions on hundreds of major stocks, on its website (www.calpers-governance.org/alert/proxy/) about two weeks before each voting deadline. The majority of individuals lack the time and expertise to make detailed decisions on their proxies. Instead, they could simply make the judgement that CalPERS is a better brand than the board-of-directors-recommendation brand, based on reputations they read about in the financial media.
Individuals do not yet vote this way because it is not yet available in a convenient form. The free-rider problem gives individuals insufficient incentive to take the time to manually look up decisions on CalPERS' website and copy them, so those that vote tend to choose the board-of-directors brand conveniently displayed in every company proxy. But now that internet voting is available for most stocks, some system development could offer individuals the choice of copying CalPERS' or any other voting guide available on the internet, with a simple mouse-click. The trend toward greater disclosure of institutional investor voting brings valuable competition for such voting guidance.
Unfortunately, the ubiquitous free-rider problem gives individuals almost no incentive to pay for using such a system, so system developers may have trouble recovering their development costs. Thus even though the CalPERS website with voting decisions, and this voting-brand idea, have been publicly available for over three years (see www.corpmon.com/IntCM.htm), no such development has occurred. Individual investors remain on the sidelines during the many important votes where the interests of directors diverge from those of shareowners.
Such a brand voting system would be a public good, so there is an appropriate role for a public body like the SEC to at least facilitate if not lead its development. I suggest that the Commission consider these possibilities:
- Develop an internet brand voting system, perhaps as a pilot program.
- Encourage others to develop an internet brand voting system, by:
(a) publishing a feasibility study;
(b) specifying desirable features of the system;
(c) clarifying regulations that may affect such a system, such as proxy solicitation rules;
(d) funding system development via a mechanism similar to the way proxy voting is funded now.
- Reassess the desirability and interpretation of SEC rule 14a-8(i)(8), by which a shareowner proposal to study the feasibility of an internet brand voting system was omitted from a proxy as relating to an election for membership on the board of directors. (See SEC no-action letter to Visteon on March 7, 2003.)
Presumably rule 14a-8(i)(8) is intended to serve the SEC mission of protecting investors and maintaining market integrity, so I guess there must be cases where it does so. But it seems to this observer that in this case it does not, given the potential for such a voting system enhancement to protect investor interests and enhance market integrity. Perhaps new rules could be drafted that better distinguish proposals with potential for benefit from those with potential for harm. (The "ordinary business" exclusion rule 14a-8(i)(7) might benefit from a similar reappraisal.) A public explanation of how these rules serve the SEC's mission would also be helpful.
I'm not a lawyer, but would like to comment on how proxy solicitation rules may relate to these voting system proposals. It seems well established that merely publishing (e.g. on a website) how one intends to vote is not deemed a solicitation [rule 14a-1(l)2(iv)(A)?], since this has become a common practice. However, it might help if the Commission clarified that building a system to let shareowners conveniently copy voting decisions would likewise not be deemed a solicitation. There is no need for such a system to ever involve assigning proxy voting rights. An individual need not even notify the source (e.g. CalPERS) that its decisions are being copied.
The development of such an internet brand voting system will also encourage shareowners to find ways of solving their free-rider problem so as to fund the brands and increase their quality. This is explained in the three papers referenced at the end of this letter.
Regarding the complex issue of determining the rules for director nominees to appear in the company-paid proxy, one strategy to consider is letting shareowners decide this by vote at each company. The institutional investor community has demonstrated their ability to muster majority votes against the board's recommendations on issues like poison pills, where the board's interests seem to diverge from shareowner interests. Investors could use this clout to pass resolutions giving the degree of access they consider appropriate for nominations in the proxy. ("Degree of access" would include such rules as how much stock one needs to own in order to nominate candidates.) Thus rather than trying to determine and impose a one-size-fits-all rule on all listed companies, the SEC could more flexibly facilitate shareowner autonomy by:
- Amending or deleting rule 14a-8(i)(8), and explicitly allowing binding shareowner resolutions that would affect director elections.
- Defining two or three standardized levels of access for nominees in the proxy, without actually imposing them as a regulation. This could simplify and thus facilitate debate and decisions of the many participants involved. Shareowner resolutions could simply refer to whichever SEC-defined level they desire.
Perhaps the greatest advantage of this flexible approach is that it would enable the investment community to try opening access to the proxy at, for example, five percent of all listed firms in the first year. This is a cheaper way to learn the pros and cons of new nomination rules than to introduce them at all listed firms simultaneously.
I would also suggest that some thought be given to avoiding the problem of vote-splitting when there are more than two competing slates of board nominees. In such a situation, if the only type of preference shareowners can show on the ballot is to vote "For" a number of nominees up to the number of empty board seats, then the candidates with the most votes may actually not be preferred by a majority of voters. For example, one can imagine a case where 60% of voters want to replace the incumbent board, but if there are two challenger slates splitting that vote then incumbents could win with 40% of the vote. This problem can be solved by letting each shareowner give a preference ranking of the three slates instead of just indicating the most-preferred one - see www.corpmon.com/VotingReform.htm.
The ideas in this submission are explained further in these articles available at www.corpmon.com/publications.htm:
"Vote Your Stock" (draft manuscript, June 2003)
"Democracy and Infomediaries" (Corporate Governance: An International Review, April 2003)
"The Internet Will Drive Corporate Monitoring" (Corporate Governance International, June 2000)
Thank you for inviting comments on these important issues. Feel free to contact me with any questions. Best wishes for success in improving corporate governance.