December 17, 2003
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
File No. S7-19-03: Shareholder Director Nominations
Dear Mr. Katz:
The Commission in Release 34-48626 (Oct. 14, 2003) has proposed amending the proxy rules to require a company, under certain circumstances, to include its proxy statement, at the expense of the company and all its shareholders, candidates for election as director nominated by shareholders.
If adopted, the proposed amendments are likely to have sweeping consequences to governance of publicly held companies in the United States. Several of those consequences could well be harmful to investors and to the American economy. That being the case, given the absence of a compelling justification for so far-reaching an experiment, we urge the Commission not to adopt the amendments at this time. The Commission, the Congress and the self-regulatory organizations in the past two years have adopted major changes in corporate governance that greatly increase the power of independent directors and the transparency of director nominations by corporate boards. We submit that it would be only prudent for the Commission to assess the impact of the major changes already adopted, before undertaking further changes that could harm shareholders.
We also have specific comments on the proposed amendments.
Consequences of the proposed amendments
Proposed rule 14a-11 has immediately foreseeable results, and other serious possible consequences.
An immediately foreseeable result is that boards of at least some companies will be made up of two groups - one nominated by the board, based on the recommendation of a nominating committee made up entirely of independent directors; one nominated by a 5% shareholder or shareholder group.
How often would that happen? While it is not possible to predict precisely, we believe it will be far more frequent than the Commission has suggested.
The Commission in the proposing Release suggests that the new rule would be little used. We believe there is little basis for this suggestion. For example, in notes 189 and 194 to the Release, the Commission estimates that only 16 companies will receive proposals from 1% holders to become subject to rule 14a-11. This is based on an estimate that 5% of the shareholder proposals in the future will be proposals that a company be subject to rule 14a-11, corresponding to only 54 companies, and that only 30% of these proposals will be from 1% holders.
The Commission cites no data for these estimates. It may be there is no relevant data. Our guess is that these estimates are extremely - and unrealistically -- low. Many public companies have 1% shareholders. We would expect that many such shareholders - including institutional investors and aggressive hedge funds - may wish to introduce rule 14a-11 proposals.
What would flow from boards being made up of two groups - those nominated by the independent nominating committee and those nominated by a 5% shareholder?
Proponents of the amendments have suggested possible benefits, such as having some directors elected who feel directly responsible to shareholders, having been nominated by them.
We believe, however, that there is a substantial likelihood of a number of consequences that could harm investors by causing boards to be less likely to fashion and oversee the implementation of strong long-term strategies to build shareholder value. Those consequences include:
-- Polarized and contentious boards. If most directors are nominated by the board but some by a particular 5% shareholder or group of shareholders, there is a much greater likelihood that there will be two groups of directors which may clash. We have seen boards divided into groups, and the result has not been conducive to constructive oversight of the business of the company.
-- Special interest directors. The director who has been nominated by a 5% shareholder or group of shareholders is likely to feel beholden to the nominator. It is true that the director has to be elected by the shareholders as a whole. It is also true that proposed rule 14a-11(c) (3) would require the nominator to represent that the nominee is not the nominator's employee or affiliate. Nevertheless, it would be surprising if the director did not feel some obligation to his or her nominator. Will the nominator's interests necessarily be those of other shareholders? We think not, in many cases. We believe that the nominator might well be one of the following:
-- a disaffected member of a founding family
-- an employee benefit plan
-- an activist private investing fund
-- one or more institutional investors.
Each of these hypothetical 5% investors may have an axe to grind. The member of the founding family may feel passed over from a position of influence in the company. The employee benefit plan may be concerned about the company's pension policies. The activist fund may be looking for a quick sale to juice up its record of return for its limited partners. The institutional investor may be committed to a particular corporate governance measure. These interests may or may not be consistent with the interests of the company's other shareholders.
-- Costs. In addition to the dollar costs of what would amount to proxy fights, there is the cost of management distraction resulting from these contests, which in our experience can be substantial.
-- Directors with less relevant business experience. We cannot predict for sure what kinds of people will serve as nominees. Our expectation, however, is that in many instances (as with nominees in traditional proxy fights) it will be difficult to find someone with outstanding credentials and relevant business leadership experience to serve as a nominee. Is this something a serving CEO or recently retired CEO of another company will want to take on? In most cases, we don't think so.
-- Pressure for short-term vs. long-term strategies. If the nominator is an activist fund, while the fund would have to be a Schedule 13G filer1 in order to be eligible to make a nomination, isn't it possible that the fund's managers will be hoping that the company will be sold in the near term? To understate: it is not unheard of for fund managers to be looking for a portfolio company to be put in play, so that they can realize a gain and go on to the next investment. In some cases, however, if the company is successfully implementing a long-term strategy, shareholder return over time would be maximized if the company is not sold right away.
We do not suggest that all of these adverse consequences will occur in all cases in which candidates are nominated under the proposed rule. We do suggest, however, that these are likely consequences in a significant number of cases. That being the case, we believe it would be imprudent to adopt the proposed amendments unless it can be demonstrated that there is a clear need for the amendments, and that the foreseeable benefits outweigh the risks.
We do not believe that any such demonstration can be made at this time - particularly in light of the major changes that have been adopted by the Congress, the Commission and the stock exchanges in recent years.
The extent of recent changes in corporate governance and director nominations
The need for the proposed amendments should be considered in the context of the new rules the Congress, the Commission and the stock exchanges have just recently put into effect - rules that greatly increase the role and power of the independent directors and the transparency of boards' nominations.
Those major rule changes include:
-- New stock exchange requirements, adopted on November 4, 2003, under which:
-- a majority of the directors must be independent;2
-- the tests for determining independence have been made more rigorous;3
-- all members of the nominating, audit, governance and compensation committees must be independent directors;4
-- the independent directors are to meet regularly in executive session by themselves without management present.5
-- The Commission's changed interpretations of its shareholder proposal rule, requiring companies to include in their proxy statements many proposals relating to board composition, staggered boards, poison pills, and other corporate governance matters.6
-- Requirements in the Sarbanes-Oxley Act for greater independence of the audit committee.7
-- The Commission's new rules, adopted November 25, 2003, requiring much greater disclosure of the workings of the nominating committee and how shareholders can submit nominations and may otherwise communicate with the directors.8 Under the new rules, among other things, a company must disclose:
-- its policy for consideration by the nominating committee of shareholder recommendations for nominees
-- its procedures for shareholder submission of nominees
-- the process for identifying and evaluating nominees
-- any specific qualifications a nominee must meet to be recommended by the board, and any specific skills or qualities the committee believes one or more directors should possess
-- how shareholders may send communications to the board.
The company must also disclose if it has received any nomination from a shareholder or group that has owned at least 5% of the stock for at least one year, and, with appropriate consents, must name the candidate and the recommending group and disclose whether the company chose to include the candidate in its proxy statement.
In addition to these rules, the Commission should not disregard the large effects on corporate governance and on the attitudes of directors that have resulted from non-regulatory developments such as:
-- The public attention to Enron, Worldcom and other highly visible corporate failures; and
-- The increased role of intermediaries - including those engaged regularly by major institutional investors - in reviewing and commenting on the corporate governance practices of particular companies.
The Commission should not adopt the proposed rules at this time. There is a substantial question, which we will leave for others to debate, whether the Commission has the authority to change the proxy rules so fundamentally, given the recognition in the case law that corporate governance is traditionally a matter of state law9, and that the federal securities laws are primarily directed at requiring disclosure and preventing fraud.
But even if the Commission has the authority to adopt the proposed rules, we submit they should not be adopted at this time. As discussed above, we believe adoption of the proposed rules is likely to cause harm to shareholders, without offsetting benefits. That being so, the rules should not be adopted absent a compelling justification. We see no such compelling justification. On the contrary, we see that many major changes have recently been enacted that will increase the role of independent directors and the transparency and responsiveness of the nominating process.
Specific comments on the proposed rules
While we do not believe the proposed rules should be adopted at this time, we also respond to some of the Commission's requests for comments:
Eligibility requirement for maker of 14a-11 proposal. The Commission asks in Question C.4 for comments on the proposal that to trigger applicability of rule 14a-11, the proponent should have owned at least 1% for at least a year.
We believe the threshold is too low both in amount and in duration to be a good screen for a shareholder that is long-term and a significant holder. If the rule were to be adopted, we suggest a higher threshold, such as 2%, and a longer holding period such as three years.
Withheld vote trigger. The Commission asks in Question C for comments relating to its proposal that the nomination procedure could be triggered by withhold votes for one or more directors of more than 35% of the votes cast.
We believe that the percentage should be a percentage of the outstanding shares, rather than of the votes cast.
We also are troubled by the idea of a withhold vote being a triggering event, unless holders who solicit the withholding of votes are required to disclose why they are doing so, disclose the future impact the withholding would have under the proposed rule, and file their soliciting material with the Commission so that it is publicly available..
Additional triggering event. The Commission asks in Question C.11 whether, if proposed rule 14a-11 is adopted, an additional triggering event should be the non-implementation of a stockholder approval that has received more than 50% of the votes cast on the proposal.
We strongly believe this should not trigger applicability of the proposed rule. If the additional trigger were to be added, this would greatly increase the number of companies that would become subject to the proposed rule. That is because many precatory shareholder proposals may be of interest to a number of institutional investors (examples: proposals to declassify boards or to redeem pills) but may reasonably be viewed by directors, in the informed exercise of their business judgment, as inconsistent with the best interests of shareholders. We submit there are other effective ways for the shareholders in such a case to express their views - for example, by speaking directly to management, or by withholding votes - without automatically triggering applicability of the new rule, which we believe could in many instances harm rather than help shareholders.
We note that even without the additional trigger, adoption of the proposed rule could have large and not necessarily salutary effects on corporate governance. If shareholders withhold authority if they are unhappy about a board's failure to follow a precatory proposal, and if that withholding could trigger applicability of rule 14a-11, then directors may be inclined to implement precatory proposals even if they believe them unwise, to avoid the harms to shareholders that could ensue from creating a polarized board under rule 14a-11.
In addition, we note that such a triggering event is highly likely to impose a substantial drain on the resources of the Staff of the Commission, because of the disputes that are likely to arise concerning whether a precatory proposal has been "implemented."
Schedule 13G vs. Schedule 13D. We believe that a 5% holder who proposes to nominate a candidate for election as a director can no longer make the certifications of passive intent that are needed for 13G filing. If a 5% holder is going to nominate a director, the public should have the benefit of the additional disclosures required by Schedule 13D.
14a-11 applicability should not be triggered by votes before the is adopted in final form. We agree with the November 3, 2003 comment letter from the Committee on Federal Regulation of Securities of the American Bar Association that a vote by shareholders - whether withholding authority to elect a nominee, or on a shareholder proposal to have the company become subject to rule 14a-11 - should not be a basis for triggering applicability of the proposed rule. A stockholder vote should be a predicate to triggering applicability of the proposed rule only if the rule has gone into effect a sufficient period of time before the company has mailed its proxy statement relating to the matter to be voted on, so that the company will be able accurately to inform its shareholders of the consequences of what they are to be voting on. At the moment, the rule is only proposed, and is subject to possible extensive modifications.
13G amendments. If the proposed rules were to be adopted, we believe a 13G filer should be required to amend its Schedule 13G promptly to disclose its intention to make a 14a-11 nomination. We see that as material information of which the investing public and the management of the public company should be advised.
Companies subject to the rules. If the rules were to be adopted, we believe - given the uncertain effects of the rules - they should apply in the first instance only to relatively larger companies. It would be relatively easy to meet the percentage thresholds in the case of small companies, who would also be less able to bear the cost of a proxy contest under the proposed rules.
* * *
The views set forth in this letter represent the views of this firm and not the views of our clients.
For the reasons stated above, we believe the proposed rules should not be adopted.
Very truly yours,
Debevoise & Plimpton
1 Proposed rule 14a-11(b)(4).
2 NYSE § 303A.1.
3 NYSE § 303A.2.
4 Sarbanes-Oxley § 301 and Exchange Act Rule 10A-3 (audit committee); NYSE §303.A.7(a),5(a) and 4(a).
5 NYSE § 303A.3.
6 See, e.g., Waste Management, 1991 WL 178585 (Mar. 8, 1991) (issuer cannot exclude proposal on independent directors); Int'l Brotherhood of Teamsters v . Fleming Cos., 1997 U.S. Dist. LEXIS 2980 (W.D. Okla. Jan. 24, 1997) (poison pill proposal).
7 E.g., Sarbanes-Oxley § 301 and Exchange Act Rule 10A-3.
8 Securities Act Rel. 8340 (Nov. 24, 2003).
9 See, e.g., Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1988); Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990).