December 22, 2003
Mr. Jonathan G. Katz
Security Holder Director Nominations
Dear Mr. Katz:
I write with respect to the proposed rule (the "Proposed Rule") of the Securities and Exchange Commission (the "Commission") that was proposed in the Commission's Release No. 34-48626 (the "Proposing Release"). I will first make several general comments and then specific comments.
I am extremely disappointed with the Proposed Rule, which suffers from at least three distinct and profound problems. First, the Proposed Rule is not based upon evidence as to its need or value. Notwithstanding the observations of many of the commentors, there is in fact very little empirical support for the proposition that the boards of directors of public companies (or their nominating committees) are rejecting inappropriately candidates for director that have been proposed by investors. The complaints as to the qualities of directors may be well founded; those complaints, however, do not of themselves support a rule that increases the likelihood that shareholders of a company should be permitted access to the company's proxy material to nominate candidates for election to the board in the absence of evidence that candidates proposed by shareholders historically have been ignored. The comments are surprising short on actual incidents of shareholder-suggested candidates having been rejected without good reason. I would have thought that Commission would insist upon a solid empirical foundation for the Proposed Rule, given the extent to which it intrudes upon traditional state law notions of corporate governance.
Second, the Proposed Rule is premature. The Commission has recently adopted extensive revisions to its proxy rules designed to facilitate and improve the functioning of nominating committees. In addition, the New York Stock Exchange (the "NYSE") and Nasdaq have recently revised their own rules relating to nominating committees for listed companies. Even if there were evidence that nominating committees historically have not functioned properly, it surely is premature to enact the Proposed Rule without at least giving the recent rule changes by the Commission, the NYSE and Nasdaq an opportunity to be implemented by public companies and their efficacy determined.
Third, the Commission has completely failed to address the fundamental obstacles to improved shareholder democracy. As the Commission has acknowledged, investors do not need the Commission's rules to nominate candidates for election as directors. The issue at stake in the Proposed Rule is not the legal entitlement of investors to nominate candidates - it is the significant cost to shareholders of being activist. In the era of the internet, with the costs of mass communication falling, one would have thought the Commission would be better off asking why it is that proxy fights are so expensive. The answer, of course, is that these costs are directly attributable to the Commission's restrictions on proxy activity and its mandatory disclosure requirements. Rather than the Proposed Rule, which simply offers certain investors an arbitrary "free pass" from certain of the Commission's proxy rules in certain circumstances, the Commission would be far better off rethinking the current costs and benefits of its proxy rules taken as a whole.
Notwithstanding my overall level of concern with the Proposed Rule, as discussed above, should the Commission proceed with the implementation of a rule along the lines of the Proposed Rule there are a number of specific matters that deserve further consideration.
Nominee Eligibility. I strongly support the requirements of the Proposed Rule that any nominee designated by a nominating securityholder or member of a nominating securityholder group must be independent of the relevant securityholder and meet all standards of independence applicable to directors of the relevant company, including standards of independence that would be applicable only to members of the audit committee, corporate governance committee or compensation committee of the relevant company. I also strongly believe that any nominee should also be required to meet all standards of independence, and other director qualifications (such as age and number of other directorships), generally applied by the relevant company to its directors as set forth in its bylaws and the charter of its nominating committee. The Proposed Rule should also clarify that any nominee must meet any applicable legal requirements with respect to membership of the relevant board of directors (for example, legal requirements relating to Section 8 of the Clayton Act or those relating to citizenship).
Trigger Number Two. In the Proposed Rule, the Commission has proposed two triggers for the implementation of "direct access": the "withhold" votes trigger and the Rule 14a-8 "opt-in" proposal trigger. With respect to the second trigger, I recommend that any securityholder that wishes to submit a proposal pursuant to Rule 14a-8 to have a company "opt-in" to the "direct access" regime must have previously submitted a proposed candidate to the nominating committee of the relevant company and had that candidate rejected. In addition, I recommend that the proponent of the securityholder proposal must have the consent of its proposed candidate for the disclosure of his or her identity in the proxy material of the relevant company.
A proponent of an "opt-in" proposal under Rule 14a-8 should not be permitted to argue, in effect, that the nominating committee of a relevant company is not functioning properly without at least having tried to use the nominating committee's own procedures for the suggestion of candidates. In addition, once the proponent of an "opt-in" proposal has suggested a candidate for election, the company should be permitted to defend the action of its nominating committee in rejecting that candidate without artificial constraints with respect to preserving the confidentiality of the identity of that candidate.
Suggested Third Trigger. In the Proposing Release, the Commission also suggested for consideration a third trigger for direct access, which was that the relevant company had not implemented a securityholder proposal submitted in accordance with Rule 14a-8 that had received support from a majority of the votes cast. I am opposed to this third trigger. First, a decision by the board of directors of a company not to implement a Rule 14a-8 proposal does not of itself necessarily reflect upon the quality of the directors or the efficacy of the nominating committee process for that company. There are many issues on which a careful, prudent board of directors may disagree with shareholders. Unless the Commission is seeking completely to overturn the existing relationship between the board of directors and the shareholders of a public company, the Commission must permit boards of directors to continue to exercise their best business judgment with respect to matters placed within their purview by relevant state law. Second, the factual ambiguity associated with a standard of "having failed to implement" a Rule 14a-8 proposal would lead either to a very significant amount of the time of the staff of the Commission being spent arbitrating implementation questions or to substantial litigation. Third, the current process whereby securityholder proposals are included in proxy material under Rule 14a-8 is already overly complex, time-consuming and antagonistic. It would only become more so if a potential consequence of the decision by a board of directors not to implement a precatory resolution was to subject the company to the direct access regime.
Beneficial Ownership Reporting Requirements. In the Proposing Release, the Commission has correctly identified the complex interplay between the Proposed Rule and the existing beneficial ownership reporting requirements under Schedule 13G and Schedule 13D. The requirements for eligibility to file beneficial ownership reports on Schedule 13G, including in particular the requirement of passivity, are very important to public companies and their shareholders, and any substantial relaxation of those requirements requires careful consideration. Unfortunately, the Proposed Rule creates arbitrary distinctions and ample scope for manipulation. It is very hard to see why nominating a candidate for election under the Proposed Rule should be deemed consistent with passivity for Schedule 13G purposes, while nominating a candidate for election other than pursuant to the Proposed Rule would (consistent with longstanding staff interpretations) be inconsistent with passivity. It is also difficult to imagine that solicitation activities in connection with forming a group for the purpose of the Proposed Rule or for the purpose of supporting an "opt-in" proposal under Rule 14a-8 would not include discussion among shareholders of plans or proposals for changes in the management and policies of the company (again, under longstanding staff interpretations, all of which would be inconsistent with filing on Schedule 13G).
Given these concerns, I suggest a compromise position. I propose that soliciting activities toward the passage of an "opt-in" proposal under Rule 14a-8 would not be inconsistent with passivity and eligibility to file under Schedule 13G. Once an otherwise passive investor actually nominates a candidate, or is a member of a group that actually nominates a candidate, under the Proposed Rule, however, that investor would lose eligibility to file under Schedule 13G. On careful analysis, it does not seem that loss of Schedule 13G eligibility would be problematic in this regard. Institutional investors have traditionally focused on two separate problems regarding filings on Schedule 13D. First, there is the accelerated requirement for disclosure of trading activity. In a situation where an investor has proposed a candidate for election to the board of directors of a company under the Proposed Rule, it seems that accelerated disclosure of purchases or sales would be valuable disclosure to the other shareholders of the company. Second, institutional investors have traditionally been opposed to the requirements of Schedule 13D with respect to the disclosure of "plans or proposals" with respect to the company. Once again, if an investor has proposed the election of a particular individual to the board of a company, other shareholders are entitled to know the views of the proposing shareholder.