[The Charles Schwab Corporation logo]
THE SCHWAB BUILDING 101 MONTGOMERY STREET SAN FRANCISCO, CA 94104 (415) 636-7000
December 19, 2003
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Security Holder Director Nominations, File No. S7-19-03
Dear Mr. Katz:
This comment letter responds to the Commission's Proposing Release to require companies, under certain circumstances, to include in their proxy materials security holder nominees for election as director under Section 14(a) of the Securities Exchange Act of 1934.
As a publicly traded company in the financial services industry, The Charles Schwab Corporation wholeheartedly supported the Commission's efforts, and those of self-regulatory organizations, to strengthen corporate governance processes to restore confidence of investors in the markets and to increase the transparency of the companies in which they invest. As outlined in President Bush's Ten Point Plan to Improve Corporate Responsibility and Protect America's Shareholders, these reforms were designed to "improve corporate disclosure, make corporate officers more accountable, and develop a stronger, more independent audit system all without inviting endless litigation."1
We fear, however, that adoption of the proposal to allow security holder director nominations attenuates the work undertaken by the President, Congress, the Commission and self-regulatory organizations to restore confidence in the markets. In particular, we believe that such proposals will:
In particular, we offer the following specific comments on the proposal:
No, we do not believe that director independence will be enhanced by adoption of these proposals. There is a fundamental conflict of interest between an interested shareholder nominating a director and the same director exercising judgment on behalf of all shareholders.
While the proposal seeks to limit the impact of having conflicted directors on the board by prohibiting certain relationships with the nominating shareholder, the solution that the director meet various independence tests, including independence as defined by the applicable self-regulatory organization, is an imperfect one. Whether or not the director had a pre-existing relationship with the nominating shareholder, the director's nomination to the Board would be a direct result of the interests of that shareholder. The director's ability to secure and retain the seat will be a function of the director's representation of the nominating shareholder's interest, which may conflict with the interests of other shareholders and the corporation as a whole.
Recent corporate governance reforms significantly strengthened the nominating process and disclosures surrounding the process. Shareholder nominees are not subject to these new processes designed to protect all shareholders.
For example, the New York Stock Exchange requires listed companies to have a nominating committee comprised solely of independent directors.2 The nominating committee must have a written charter that outlines its authority, including identifying individuals qualified to become board members, consistent with criteria approved by the board, and the charter must be disclosed on the company's web site.3 The Commission's rules on nominating committee disclosure strengthened the transparency of the process; companies are required to disclose in their proxy statements their nominating committee's process for identifying and evaluating candidates, qualifications and skills that the nominating committee considers desirable for board members, and the process for shareholders to send communications to the board of directors (or if the company does not have a process, why it believes it appropriate not to have such a process).4
Under the proposed rules, shareholders lose the protections of the new nominating and disclosure rules. Nominating shareholders do not have independent nominating committees. They do not have written charters. They are not required to disclose to other shareholders their criteria for nominating candidates. A nominating shareholder who owns 5% of the company's securities is not required to disclose to the other 95% of shareholders a process for communicating with its board or representative.
There are practical problems implementing the proposal, not apparent on the surface, that impede a company's inclusion of essential expertise on its board. Unlike an independent nominating committee, a nominating shareholder is unlikely to evaluate a candidate's experience in light of the expertise represented on the entire Board. The nominating shareholder process, as currently proposed, is more likely to lead to boards that lack particular expertise, experience, or diversity than under the nominating system overseen by a committee of independent directors.
We believe that a proposal that invites certain shareholders to nominate directors undermines the substantial work undertaken by the President, Congress, the Commission and self-regulatory organizations to restore confidence in the markets. We believe that the consequences of having contested elections and divided boards on the subject company, on the market, on capital formation and competitiveness should be thoroughly understood before such a proposal is adopted.
It is doubtful that a board that is divided by disagreement and shareholder special interests will be as effective in discharging its oversight duties as a board that is focused on its responsibilities to the company and its shareholders. While the Commission's proposals are intended to provide greater accountability to the shareholders, the unintended consequence is likely to be erosion in shareholder value. Will investors continue to hold shares of a company that has protracted disagreements with dissident members on its board? It would be instructive for the Commission to analyze historic returns for such companies.
Direct access is based on an assumption that corporate boards are monolithic and remain static even in response to shareholder dissatisfaction. Research, however, shows that ownership and board structure are relatively dynamic over time. In a survey of 583 firms in the ten year period from 1983 1992, two researchers found that changes in ownership and board structure are strongly related to executive turnover, prior stock price performance, and corporate control threats.5 They found that board structures adjusted frequently to economic shocks and were less stable than commonly believed.6 The direct access proposal ignores these dynamic processes and unfortunately subjects all boards to the destabilizing conditions that are normally the cause of changes in board structure.
A process that leads to contested elections and may result in the appointment of directors by dissident shareholders has similar effects of a proxy contest. Although the dissident shareholder may not have the possibility of gaining control of the board as in a proxy contest, it is a much easier and convenient way to exert influence than a full proxy contest. In fact, unlike a proxy contest in which a shareholder either gains control of the company or does not, the direct access proposal could have a more lasting and harmful effect because the source of strife will not be limited to a single event but rather will be ongoing.
In examining proxy contests, researchers have shown a direct market impact as a result of the contest. For example, the announcement of a proxy contest is believed to cause a wealth effect, either positive or negative, as investors and analysts reevaluate the firm under its current management.7 The proxy contest presents a call option (the right to exchange the value of the firm under current management or policies for new management or policies).8 While one researcher found the call option generally to be positive prior to the proxy date (an expected result, if dissident shareholders have an incentive to wage a proxy fight), the change in the underlying stock price could be positive or negative, with the trend generally negative.9 Another researcher observed a decline in profitability following a proxy contest for firms in which dissidents acquired some seats on the board.10 Significantly, the research shows that contested elections, and the possibility of a change in policies, impacts the markets and value of the firm. If the Commission makes it easier to wage contested elections, through the use of the board's proxy, we expect such changes to lead to greater volatility and uncertainty in the markets, undermining the work accomplished since the passage of the Sarbanes-Oxley Act.
No, the proposal will advantage certain larger shareholders, to the detriment of shareholders with smaller holdings.
The board, mindful of what constitutes a triggering event, likely will be more sensitive to the interests of larger shareholders (those who own sufficient shares to cause a triggering event or place a nominee on the ballot). The practical result of such a system, therefore, is a board that is disproportionately sensitive to the special interests of shareholders large enough to own or form a group that can gain access to the board's proxy. Such a system would be detrimental to the interests of other shareholders, especially individual investors. This dynamic runs counter to the purposes of the Sarbanes-Oxley Act by creating a potential conflict of interest for the board, which, in the interest of self-preservation, may be more attentive to the special interests of larger, more activist holders.
No, a remedy that entails direct influence on a board by a dissident shareholder should be limited to instances of serious and intractable underperformance that is unrelated to market cycles or conditions beyond management control. The triggering events, however, are related to certain types of accountability that are not necessarily related to such severe mismanagement.
The Commission proposes access to the proxy and the prospect of electing candidates of dissident shareholders as a remedy for certain events it considers failures in accountability to shareholders. Those events include "withhold" votes from more than 35% of votes cast for a nominee to the board of directors; or a "direct access" shareholder proposal that receives more than 50% of votes at the annual meeting. In addition, the Commission is considering as a third triggering event, the failure to adopt a shareholder proposal that received more than 50% of votes cast at an annual meeting, by the 120th day before mailing of proxy materials for the next annual meeting.
The events outlined by the Commission are ones that may require explanation or accountability by the board, but the remedies proposed by the Commission, as explained above, are ones that may jeopardize the company's performance. Factors resulting in proxy contests are usually financial ones; a study conducted in 1993 analyzing 97 proxy contests linked inferior operating performance to firms facing proxy contests.11 However, the failures cited by the Commission do not necessarily relate to financial underperformance (and even so, financial performance can be driven by a variety of factors). A board of directors may have failed to implement a shareholder proposal for very good reasons, but its failure to do so under the proposed rules could place the company in a precarious position.
There may be remedies for the enumerated instances of accountability. For example, if a company fails to adopt a shareholder proposal that garnered more than 50% of the vote, it could be required to explain in its proxy statement why it did not adopt the proposal. Or, if a nominee receives "withhold" votes of more than 35% of the votes cast, the company or its nominating committee could be required to explain, if it decides to re-nominate the director after his or her term has expired, why the company has chosen to re-nominate the director. These types of remedies would increase information to shareholders and make the board accountable in its publicly filed statements for its actions.
Alternatives considered by the Commission would require further study and analysis. In any event, they should not entail the remedies and consequences normally reserved for a proxy contest.
The proxy statement submitted by the board of directors is and should be a document drafted on behalf of the board. In the context of a proxy contest, proxies from dissident shareholders are separate documents. Introducing a proxy that is a hybrid document risks confusing shareholders.
Additional shareholder confusion may be caused by the fact that board nominees receiving too many "withhold" votes will trigger proxy disclosures while shareholders whose nominees receive the same number of "withhold" votes will not have to offer an explanation. Unlike the board, the nominating shareholder will not be held accountable for the large "withhold" vote, and yet the shareholder may use the board's proxy statement to promote its interests.
The direct access proposals undermine recent corporate governance reforms and will likely lead to a tangled web of adversarial governance. Instead of a system requiring a majority of interested directors to represent the interests of all shareholders, directors will become increasingly polarized, representing interests of larger shareholders who can cause a triggering event. Larger shareholders interested in influencing boards will have a relatively cheap and easy way to exert such influence without resorting to a full-fledged proxy contest.
Such a system of adversarial governance negatively impacts the management of companies, capital formation, competitiveness, and the securities markets. Before adoption of such a proposal, substantial research and examination should be undertaken in these areas to measure these effects.
We appreciate the opportunity to provide input on this proposal and would be happy to discuss these comments in further detail.
/s/ R. SCOTT McMILLENR. Scott McMillen
1 President Bush, "Ten Point Plan to Improve Corporate Responsibility and Protect America's Shareholders," March 7, 2002.
2 New York Stock Exchange Listed Company Manual §303A.04.
3 New York Stock Exchange Listed Company Manual §§303A.04, 303A.09.
4 Disclosure Regarding Nominating Committee Functions and Communications Between Security Holders and Boards of Directors, Release Nos. 33-8340, 34-48825.
5 Denis, D. and A. Sarin, "Ownership and Board Structures in Publicly Traded Corporations," Journal of Financial Economics, Vol. 52, No. 2 (1999), 187-223.
7 Hancock, G.D., "The Call Option Implicit in Proxy-Contested Firms," Review of Financial Economics, Vol. 1, No. 2 (1992), 53-67.
10 Ikenberry, D. and J. Lakonishok, "Corporate Governance through the Proxy Contest: Evidence and Implications," The Journal of Business, Vol. 66, No. 3 (1993), 405-435.
11 Ikenberry, D. and J. Lakonishok, "Corporate Governance through the Proxy Contest: Evidence and Implications," supra.