American Federation of Labor and Congress of Industrial Organizations
Mr. Jonathan G. Katz, Secretary
Re: File No. S7-19-03
Dear Mr. Katz:
On behalf of the American Federation of Labor and Congress of Industrial Organizations, I welcome this opportunity to offer supporting comments on Securities and Exchange Commission (the "Commission") proposal, S7-19-03, to give shareholders access to the corporate proxy to nominate directors.
The AFL-CIO is the federation of America's labor unions, representing 64 national and international unions and their membership of more than 13 million working women and men. Union members participate in the capital markets as individual investors and through a variety of benefit plans with over $5 trillion in assets. Union-sponsored pension plans ("union funds") account for $400 billion of that amount.
As you know, the AFL-CIO took the opportunity of the Commission's recent review of the proxy rules to file a rulemaking petition on May 15th specifically seeking shareholder access to the proxy to nominate directors. In our view, granting long-term shareholders a meaningful say in picking directors is the most important investor reform to be considered by the Commission in decades. Although the Commission has contemplated this reform four times in the past 60 years, this is the first time it has moved beyond consideration to propose new rules.
We commend the Chairman for his strong leadership and courage, and congratulate the commissioners and staff for formulating a comprehensive rule proposal. We generally support the Commission's approach to the new rules. In particular, we are pleased that the proposal adopts many of the same safeguards that we recommended in our petition to ensure the rules cannot be used to facilitate hostile takeovers by short-term investors nor impractically crowd the proxy materials of myriad companies with frivolous candidates.
These safeguards include significant ownership and holding period requirements for nominating shareholders and a maximum number of shareholder nominees.
The Commission's safeguards, however, are more restrictive than we believe necessary. In addition, use of the proposed rules would be conditioned upon the occurrence of one of two triggering events. As a result, we are concerned that the Commission's proposed rules will be difficult to use, and impossible to do so in a timely manner.
We do not see a need to reiterate why we believe granting long-term shareholders reasonable access to the proxy is necessary to restore genuine accountability to a boardroom culture that for too long has been characterized by cozy relationships and a resulting unwillingness to challenge management. We have already articulated our views in our petition and in a subsequent meeting with Commission staff. We continue to believe that the specific thresholds recommended in our petition are appropriate and that a triggering requirement is unnecessary. The Commission, however, appears to favor a more limited proxy access right, presumably due to concerns raised by the opponents to proxy reform that we believe are unfounded. We have therefore organized our comments as follows:
At a minimum, we urge the Commission to consider the five modifications recommended in Section IV. We believe these changes would address those few provisions of the Commission's proposal that we believe raise particular problems or that dilute the effectiveness of the rules in fundamental ways. Our other recommended changes would further enhance the effectiveness of final rules.
I. Response to Arguments Opposing Proposed Proxy Reform
Clearly granting shareholders access to the proxy to nominate directors is an issue that enjoys overwhelming support. We count almost 10,000 comment letters posted to the Commission's web site (which we believe is the most the Commission has ever received on a proposed reform), the vast majority of which strongly favor the proposed rule. Among the institutional and individual investors that the Commission is chartered to protect, the only reservations come from those concerned that the rules as proposed are too restrictive.
The opponents to director election reform, as the Commission first observed in its July 15, 2003 Staff Report, include "all of the corporations and corporate executives, most of the legal community, and the majority of associations (mostly business associations)." Among the most outspoken are the Business Roundtable (BRT), an association comprised of the chief executives of the nation's largest corporations, and Wachtell, Lipton, Rosen & Katz ("Wachtell, Lipton"), a law firm that advises executives of the nation's largest corporations.
The opponents to the proposed rules generally cite three basic arguments. They say they are being put forward before other recent regulatory reforms have had time to take effect, will be disruptive to board operations and will allow special interests to hijack the election process. As detailed below, we believe these arguments are without merit.
1. Opponents say recent regulatory reforms are sufficient.
Opponents to proxy reform, including the BRT and Wachtell, Lipton, argue that the Commission should give the reforms included in the Sarbanes-Oxley Act of 2002 and new exchange listing standards a chance to operate before moving forward with the proposed rules.
As we said in our petition, we believe recent reforms are essential to rein in the conflicts of interest that can compromise directors' loyalty to the corporation and its shareholders. But these and other possible regulatory reforms, however essential, cannot ensure that directors act independently, are responsive to shareholder concerns and contribute to building the long-term value of the corporations they serve. Given the current incumbent-controlled election process, shareholders have no cost effective means of holding directors accountable for failing to live up to these fundamental standards. By granting shareholders reasonable access to the proxy to nominate directors, the Commission will not only remedy this problem but also lessen investors' reliance on regulatory action and oversight.
2. Opponents argue the proposed rules will disrupt board operations.
Opponents argue the proposed rules will lead to significant disruption from annual election contests, balkanization of the board, creation of adversarial relationships and adverse impact on director recruiting and increased aversion to risk.
These arguments are all premised on the notion that collegiality among directors should be preserved regardless of the consequences to the corporation and its shareholders. Good working relationships among directors may be important. But the shareholders of Enron and Worldcom, including the worker funds that lost $35 billion in value from the collapse of these firms, would be far better off today had those boards been less collegial and more willing to challenge their CEOs with uncomfortable questions.
The need for directors willing to challenge management extends well beyond the potential to uncover the kind of wrongdoing that nearly destroyed companies like Enron, Worldcom, Tyco and HealthSouth. Directors must be willing to challenge management to ensure that management's business strategy is in the long-term interests of the corporation and its shareholders, and that management is effectively executing that strategy and managing risk. Directors must also be willing to deny demands for excessive compensation by executives, including the majority of CEOs who also chair their boards. Skyrocketing executive pay that bears little relation to long-term performance suggests that directors are not as independent as CEOs would like their shareholders to believe.
Finally, implicit to the opponents' argument regarding widespread board disruption is the presumption that the new rules would be used frequently at many companies. As discussed in section III below, we believe any new rule with significant ownership (e.g. 3%) and holding period (e.g. more than one year) requirements for nominating shareholders would only be used on a limited basis. As currently proposed, the rules include a 5% ownership requirement, two-year minimum holding period and an additional triggering event requirement that would make them particularly difficult to utilize.
3. Opponents warn that shareholders will nominate special-interest directors.
The BRT, ConocoPhillips and others warn that shareholders "may nominate director candidates for any number of purposes, regardless of whether those purposes are self-interested or designed to promote other agendas." Wachtell, Lipton is more specific, arguing that "the institutional shareholders most likely to take advantage of the proposed election contest rules are the politically active institutions, such as labor unions and public pension funds, that have interests and agendas beyond the economic performance of the company." A similar concern is expressed by the 350 individuals who sent a letter drafted by Americans for Tax Reform1(see Form Letter E on the Commission's web site).
If we understand correctly, the BRT and others are concerned that a shareholder nominee will be elected to a board, even though the nominee is seeking to pursue interests other than those of shareholders. In order to protect shareholders, therefore, the BRT believes "the nominating committee is best positioned to assess the skills and qualities desirable in new directors."
These arguments are often used by those who oppose democratic elections. The fact remains that, in a contested director election, a shareholder nominee must receive a substantial plurality of votes from the company's shareholders to be elected to its board. Moreover, shareholders generally place the onus on the dissidents to demonstrate why they are better qualified than the incumbent directors. Thus, there is little risk that a nominee intent upon using his or her directorship to pursue an agenda at odds with the interests of the corporation and its shareholders would be elected. In practice, we expect shareholders--including the union and public pension funds whose interests Wachtell, Lipton and others question--will nominate highly qualified and widely respected candidates who are likely to win support from a majority of a company's shareholders.
In response to Wachtell, Lipton's specific concerns, it is true that union and public pension funds have been the most active institutional shareholders in calling for company-specific and regulatory reforms to enhance corporate governance and performance. During the 2003 proxy season, for example, Georgeson Shareholder Communications, Inc., estimates that union pension funds sponsored 48% of the 427 governance proposals that actually came to a vote.2 Most of these proposals sought to rein in excessive executive compensation or enhance auditor and board of director independence. By contrast, investment managers and mutual funds submitted fewer than 4%.
Union fund shareholders have been calling for these reforms since well before recent corporate scandals contributed to a $7 trillion collapse in the capital markets. In 1998, for example, the International Association of Bridge, Structural and Ornamental Iron Workers Local 25 Pension Fund sponsored a proposal at HealthSouth calling for an independent compensation committee. That same year the International Brotherhood of Electrical Workers Pension Benefit Fund sponsored a proposal at Tyco calling for a majority of independent directors on the company's board. Neither proposal passed, but their underlying reforms are now required of all listed companies as a result of new exchange listing standards and the Commission's implementation of Sarbanes-Oxley.
As long-term shareholders, often through passively managed index funds, union fund fiduciaries undertake these activities to comply with their duties under the Employee Retirement Income Security Act of 1974 (ERISA), which regulates most private sector pension plans. Although public pension funds are governed by state laws and regulations rather than ERISA, the ERISA fiduciary principles often are found in state law as well. As interpreted by the Department of Labor, ERISA both encourages fiduciaries to exercise their legal rights as shareholders3 and requires that they act solely in the "economic best interests" of plan participants and beneficiaries. With respect to shareholder activism, the DOL states:
To the extent that shareholders have differing interests, for example with respect to time horizon or appetite for risk, we believe it is a company's long-term shareholders whose interests are most closely aligned with those of the corporation. In light of ERISA's requirements, what is notable is not that union funds have been such active long-term shareholders, but that other institutional shareholders have been so passive. This is particularly the case with the large mutual funds that are in a powerful position to demand pro-shareholder reforms as owners of one-fifth of U.S. publicly-traded equities.
Although mutual funds have a similar fiduciary duty to act in the best interests of their investors, they have interests and agendas beyond the economic performance of their portfolio companies, notably selling employee benefit and other fee-based services to these same companies. For example, Fidelity Investments, the nation's largest mutual fund company, earned $2 million in 1999 managing employee benefit plans for Tyco. Fidelity also voted against the above proposal at Tyco in 1998. We note that none of the large mutual fund companies are among those mutual funds that sponsored the above referenced 4% of corporate governance proposals in 2003.
We are optimistic that the Commission's recent rules requiring mutual fund proxy voting disclosure will lead to voting practices that are more consistent with the best interests of fund investors. But we believe the same conflict that transformed mutual fund proxy votes into rubberstamps for corporate management will deter the large institutional money managers from using the proposed rules to nominate directors.
Finally and most importantly, we remind the Commission that corporate executives have interests and agendas beyond the economic performance of the company. Absent strong, independent board oversight, they also have virtually unrestrained power to pursue those interests at the expense of the corporation and its shareholders.
II. Triggering Requirement Considerations
As proposed, the Commission's rules would apply only to those companies at which one of two triggering events has occurred and would remain in effect for two years after the occurrence of either event. The events would include
We believe a triggering event is unnecessary because the 3% minimum ownership requirement recommended in our petition-not to mention the more restrictive 5% proposed by the Commission-already represents a sufficiently high barrier to utilizing any proxy access rule. Given this requirement, we expect shareholders would only undertake to organize such an effort on a limited basis, most notably at companies where they could clearly demonstrate that the board of directors had already failed to respond to serious shareholder concerns. Furthermore, each of the two proposed triggering events raise particular problems, and both entail a two-year delay between the point at which shareholders wish to nominate a candidate and when one could actually be elected. This delay can be untenable at a company in crisis.
With respect to the proposed withhold trigger, the 35% threshold is far too high to serve as a useful trigger in light of historical experience with such votes. A random survey of 308 companies by the Council of Institutional Investors found only six companies in the S&P 1500 at which a director received a withhold vote above 35% in 2003, and none of these are S&P 500 firms.5
Our own experience urging fellow Lockheed Martin shareholders to withhold their votes from a former Enron director re-nominated to the Lockheed Martin board illustrates how difficult it can be to achieve 35%, regardless of the how compelling one's case. Following a report by a special committee of Enron's own board that concluded the board failed in its oversight duties, mailings to shareholders holding a substantial majority of outstanding shares in which we detailed Mr. Savage's specific role on Enron's board, follow-up conversations with institutional shareholders, and the support of independent proxy voting services like Institutional Shareholder Services, Lockheed Martin shareholders withheld 28% of the votes cast from him in 2001 and again in 2002. We believe these votes reflect very substantial shareholder dissatisfaction, yet they would fail to constitute a triggering event under the Commission's proposal.
The Commission's 1% ownership requirement for sponsoring an opt-in proposal is also problematic. It should not be the share ownership of a shareholder proponent that is important, but rather the level of voting support that the opt-in proposal receives from shareholders. A shareowner of the average S&P 500 company would need to hold shares worth over $180 million merely to sponsor an opt-in proposal (see table in Appendix B). Moreover, as discussed above, the few institutional shareholders large enough to individually satisfy the 1% threshold are unlikely to make use of the proposed rules. While it may be appropriate to require shareholders to organize into groups for the purposes of nominating directors using the corporate proxy, such a requirement is too burdensome for the purposes of sponsoring an opt-in proposal that may or may not receive a majority vote.
We understand the Commission is considering an additional triggering event premised on a company's not implementing a shareholder proposal that received a majority shareholder vote. As noted in our petition, corporate boards that ignore majority votes on shareholder proposals are perhaps the starkest example of directors failing to respond to shareholder concerns. Notwithstanding our serious concerns, however, we do not support the contemplated trigger since it does not, and cannot, distinguish between failing to implement a majority shareholder proposal and failing to respond to a majority shareholder vote. As a result of negotiation with shareholders, for example, some companies may adopt reforms that address shareholders' underlying concern without necessarily implementing the specific proposal. We are also concerned that this additional trigger could lead to a proliferation of shareholder proposals designed to receive majority votes, where the proponent may be more interested in creating a triggering event than in the underlying change sought by the proposal.
Certain types of event triggers, such as material restatements in issuers' audited financials, are attractive because they would allow shareholders at these companies to nominate directors at the most immediate annual meeting. However, such triggers are too inflexible to be a substitute for a general right of access.
III. Ownership Threshold Considerations
The Commission believes its proposed ownership threshold of more than 5% for two years strikes an appropriate balance between shareholders' interest in using the corporate proxy to nominate directors against companies' concerns about the potential disruption that some contend may result from frequent use of the process by shareholders who do not represent a significant ownership stake in the subject company. The Commission notes that roughly 42% of filers have at least one shareholder that can meet this threshold, while roughly 50% of filers have two or more shareholders that each has held at least 2% for the appropriate period.
One cannot estimate the frequency with which shareholders will use the proposed rules based solely on the potential number of shareholders that meet the eligibility requirements. Interpreting these data requires corresponding, qualitative information on who these large shareholders actually are. A review of the shareholder list of most publicly traded companies, and in particular the nation's largest 150 companies whose executives comprise the Business Roundtable, would show that it is almost exclusively a small number of large mutual fund companies and investment management firms that meet these thresholds.
To demonstrate this point, we refer you the table attached in Appendix A, which identifies those institutional shareholders holding more than 2% of eight publicly traded companies (regardless of holding period), and each one's percentage ownership. The companies are listed in order of market capitalization, which exceeds $1 billion in all eight cases. The companies include Pfizer and Boeing, whose CEO and recently departed CEO respectively, are co-chairs of the BRT, and six other companies that oppose the proposed rules. With the exception of ATA Holdings-which has 70% inside ownership, only two institutions holding more than 2%, and a market value of $111 million-we believe the table includes all of the publicly traded companies whose opposing letters were posted to the Commission's web site as of December 11th. The table also shows the union or public fund with the single largest holding at each company, in each case a public pension fund.
The eight companies have an average of 7.13 shareholders holding 2% or more of outstanding shares, which is consistent with the BRT's survey of 80 member companies that found an average of 6.89 shareholders with this ownership amount. The table reveals that there is substantial overlap among the institutions holding these large stakes. Barclays Global Investors and State Street Global Advisors own more than 2% at all eight companies, Fidelity at seven, Vanguard at four and Capital Research at three. Based on their historical reluctance to engage in shareholder activism, including sponsoring no shareholder proposals in 2003, we believe these institutions will rarely use the proposed rules.
In fact, while Barclays, the largest investment management firm in the world and a substantial manager of union fund assets, signaled its support for the proposed rules in its June 13, 2003 comment letter, it appears that Fidelity, Vanguard and Capital Research and Management, the three largest mutual fund companies in the world, oppose the rules. We base this assumption on the fact that these are the largest and most influential members of the Investment Company Institute, which signaled its opposition to the proposed rules in its June 13, 2003 comment letter.
By contrast, not one of the union or public pension funds that Wachtell, Lipton, and other opponents believe will most likely take advantage of the proposed rules holds even 1% of any of the eight companies. On average, the pension fund with the largest stake holds only 0.50%. Moreover, there are only a handful of public funds, and no union-sponsored funds, large enough to hold such a significant stake in these companies given their diversified portfolios.
We want to make one final comment with respect to companies' concerns about frequent use of the process by shareholders who do not represent a significant ownership stake in the subject company. A shareholder that held 3% of outstanding shares of the average S&P 500 company would own securities with a market value in excess of $550 million, a stake which we believe to be significant by any standard. As the table in Appendix B shows, this same stake would be worth $64 million at the average S&P Mid-Cap 400 company and $19 million at the average S&P Small-Cap 600 company, which we also believe represent significant ownership stakes.
IV. Key Recommendations
As noted above, we continue to believe that the specific thresholds recommended in our petition are appropriate, and that a triggering requirement is unnecessary. At a minimum, however, we urge the Commission to modify its more restrictive thresholds as follows.
V. Other Recommended Changes
We believe the following changes will further enhance the proposed rules:
We strongly support the adoption of rules granting shareholders access to the proxy to nominate directors. We thank you for this opportunity to comment on this important proposal and encourage the Commission to consider the above comments in formulating its final rules. Please contact William Patterson, Director of the AFL-CIO Office of Investment, at (202) 637-3900 with any questions.
cc: William H. Donaldson, Chairman
Market Capitalization of S&P 1500 Companies (at 9/30/03)
*S&P Composite 1500 consists of S&P 500, Mid-Cap 400 and Small-Cap 600 companies.