Roundtable on the Federal Proxy Rules and State Corporation Law
May 7, 2007
TOPIC ONE: THE FEDERAL ROLE IN UPHOLDING SHAREHOLDERS' STATE LAW RIGHTS
What is the scope of shareholders' rights under state law to propose and vote on corporate matters, such as director elections and amendments to the corporate
by-laws? What limitations should there be to the shareholders' ability to govern the corporation?
Background: Under state corporate law and current practice, the basic allocation of powers and duties between boards of directors and shareholders is as follows: the business affairs of the corporation are managed by the corporation's executive officers under the direction and policy guidance of the board of directors. Shareholders have the right to vote to elect directors and to approve extraordinary matters such as mergers, sales of all assets, dissolutions and amendments to the articles of incorporation. They may also vote to adopt, amend and repeal by-laws; to remove directors in some circumstances; and to adopt shareholder resolutions to ratify board actions or to request the board to take certain actions. But they may not involve themselves in the management of the corporation.
This basic arrangement has come under question in recent years. Some observers believe that, as owners of the company, shareholders should be able to exercise more meaningful oversight and control over the company they own and to be more involved in the company's governance. Other observers caution that encroachment by shareholders into the management and direction of the corporation, which is reserved under state law for the board of directors, is already adversely affecting the board's and management's ability to manage the corporation, thereby ultimately harming the shareholders of the corporation.
What should be the relationship of federal and state law with respect to shareholders' voting rights and ability to govern the corporation?
Background: Regulation of the proxy process is a core function of the Commission and one of the original responsibilities assigned to the Commission upon its creation in the Securities Exchange Act of 1934. When Congress charged the Commission with regulating the proxy process, it created a federal role in vindicating shareholders' state law rights. The federal interests include the importance of fair corporate suffrage and the prevention of abuses that would frustrate the free exercise of shareholders' voting rights. At the same time, however, Congress also recognized the traditional role of state corporation law, particularly with respect to the board's powers to manage the company's affairs. While the Commission has sought to use its authority in a manner that does not conflict with the primary role of the states in regulating corporate governance, some observers have expressed concern that federal regulation increasingly intrudes upon corporate matters that historically have been the province of state law. Other commenters believe the federal role should be enlarged.
TOPIC TWO: THE PURPOSE AND EFFECT OF THE FEDERAL PROXY RULES
How does federal regulation of the proxy process affect the way shareholders exercise their state law rights to propose by-law amendments, nominate directors, and vote as if they were present in person at a meeting?
Background: The proxy system that Congress authorized the SEC to devise was meant to replicate as nearly as possible the opportunity that shareholders would have to exercise their voting rights at a meeting of shareholders, if they were personally present. State law generally allows shareholders to nominate candidates for director at the company's annual meeting. State law also generally allows shareholders to present proposals for a vote at the company's annual meeting. For example, shareholders may present proposals from the floor at an annual meeting, including nominations of directors, subject to compliance with applicable state law requirements and the requirements contained in the company's by-laws, such as an advance notice requirement.
Most shareholders, however, vote through the grant of a proxy before the meeting instead of attending the meeting to vote in person. Therefore, an important function of the proxy rules is to provide a mechanism for shareholders to present their proposals to other shareholders and to permit other shareholders to instruct their proxy how to vote on such proposals. The Commission's proxy rules provide various means for shareholders to propose matters to other shareholders at the annual meeting. There are some proposals that may be presented by shareholders at the annual meeting that the federal proxy rules require be included in the company's proxy materials. Other proposals are included on proxy materials prepared by the shareholders themselves. For example, the proxy rules permit any shareholder to nominate a director for election to the board through a proxy solicitation by that shareholder. But they do not require a company to include a shareholder's nominee for director in its proxy materials, either directly or through a proposal that would establish a mechanism for the means for the inclusion of such a shareholder nominee in the company's proxy materials. This matter has been considered by the Commission since the adoption of the federal proxy rules and has generated much debate, most recently in 2006, when the U.S. Court of Appeals for the Second Circuit held that Rule 14a-8 requires a company to include a proposal to amend the by-laws to permit, under certain circumstances, the inclusion of shareholder nominees in the company's proxy materials.
While the federal proxy rules have required shareholders to conduct their own proxy solicitation for the nomination and election of directors, they have permitted use of the company proxy for proposals less closely connected to the fundamental state law rights of shareholders. The increasing incidence of non-binding proposals may be due in part to the fact that they are relatively advantaged under the proxy rules.
How have the proxy rules affected the ability of shareholders to make proposals on subjects that fall within the province of directors and management under state law?
Background: Exchange Act Rule 14a-8 creates a procedure under which shareholders may present in the company's proxy materials a broad range of non-binding proposals, including proposals regarding matters that traditionally are within the province of the board and management. The rule permits a shareholder owning a relatively small amount of the company's shares to submit his or her proposal to the company, and requires the company to include the proposal alongside management's proposals in the company's proxy materials. If a proposal concerns a matter that is not a proper subject for shareholder action alone under state law, but would be a proper matter if approved by the board of directors, Rule 14a-8 requires a company to include the proposal in its proxy materials if it is cast as a recommendation or request that the board take specified action. In all cases, the proposal must satisfy procedural requirements and must not fall within one of thirteen substantive categories. In this way, the federal proxy rules may act to increase the incidence of proposals on subjects that are not closely connected with the core rights of shareholders under state law, but rather fall within the province of the board of directors and management.
If the company believes a shareholder proposal is not required to be included under Rule 14a-8, it must first submit its reasons for that determination to the Commission. The Commission's Division of Corporation Finance or Division of Investment Management usually issues a written response in which it either concurs or declines to concur with the company's determination to omit the proposal from the proxy materials.
TOPIC THREE: NON-BINDING PROPOSALS UNDER THE PROXY RULES
Should the federal proxy rules serve to facilitate shareholder proposals on subjects concerning which shareholders cannot direct management or the board of directors under state law? Does an alternative to the proxy process exist to give shareholders the ability to voice concerns on such matters? Are there ways in which the Internet and other recent advances in communication can be used to promote discussion about non-binding proposals among shareholders, managements, and boards of directors?
Background: The current proxy system provides a relative advantage to many kinds of non-binding proposals, which are at the periphery of shareholders' state law rights, as compared to proposals concerning subjects that are at the core of shareholder rights under state law, such as the nomination and election of directors. It is questionable whether the proxy system is the most efficient means of shareholder communication with management on purely advisory matters.
Deficiencies in the proxy system for these purposes include its expense, the highly complex legal and regulatory requirements that must be met in order to use it, its cumbersome nature and the lead time required, and the involvement of Commission staff as arbiters on often close questions of state law. In addition, given the now-prevalent opportunities for collaborative discussion and decision-making afforded by the Internet and related technological innovations, the proxy mechanism seems particularly deficient in offering only rare opportunities - usually only the annual meeting - for shareholders to offer advice to management.
Alternatives or supplements to the proxy machinery that exploit the advantages of telecommunications technology have been suggested that could offer shareholders more powerful means to advance non-binding proposals. For example, an online forum, restricted to shareholders of the company whose anonymity is protected through encrypted unique identifiers, could offer the opportunity for shareholders to discuss among themselves the very subjects that most concern them, and which today are considered - if at all - only indirectly through the proxy process. Such a discussion forum could also provide the opportunity for shareholders to conduct non-binding votes. Moreover, the opportunity for this enhanced level of shareholder participation could be extended 24/7 throughout the year, rather than only at annual meetings. From the company's standpoint, such a shareholder forum could provide much more accurate and frequent information about the interests and concerns of investors.
In order to facilitate innovations such as this, however, the current proxy rules would have to be amended to ensure that the participants were not deemed to be conducting a solicitation, and otherwise to provide investors comfort that legal and regulatory requirements were being met. The Commission is considering whether such amendments are advisable, and also the potential interaction of an electronic shareholder forum with the current approach to advisory matters.
What benefits and detriments accrue from the current system of allowing certain non-binding proposals and not others? If shareholder access to the corporate proxy were broadened, would this create a higher incidence of non-binding proposals not contemplated by state corporate laws?
Background: Because Rule 14a-8 places the Commission's staff at the center of frequent disputes over whether a non-binding proposal must be included in the company's proxy materials - and particularly because the determination whether the proposal falls within one of thirteen substantive categories is often subjective, reliant upon state law determinations, or both - the Commission's staff frequently is asked to make difficult judgments about the suitability of particular proposals. In this way, the current system inevitably puts the Commission staff in a position of allowing certain proposals and not others. This, in combination with the lack of purely objective standards in all cases, may contribute to a lack of predictability and transparency in these decisions. It has certainly resulted in frequent criticism.
Notwithstanding these deficiencies, the current system does provide benefits. It permits companies to avoid incurring significant cost in addressing proposals that may have little relevance to their businesses. And it provides a dispute resolution mechanism for companies that wish to challenge the determination of shareholders that a proposal should be included in the company's proxy materials.
In one area, however, both shareholders and companies concur in their criticism of non-binding proposals: in light of the fact that a board of directors, in the exercise of its business judgment, may choose not to implement a non-binding shareholder proposal - even one that has received the support of a majority vote of the shares voted at the meeting - there is widespread skepticism about the ultimate utility of such proposals under current conditions.
TOPIC FOUR: BINDING PROPOSALS UNDER THE PROXY RULES
Do the federal proxy rules fully vindicate shareholders' rights in those areas which are most clearly the responsibility of shareholders under state law - viz., proposing and voting on by-law amendments, and nominating and voting on directors? Are there examples of proposals that shareholders would have the right to make under state law, but for the operation of the federal securities laws and the proxy rules?
Background: The structure of Rule 14a-8 is not based on the premise that because proposing and voting on by-law amendments, and nominating and voting on directors, are the core rights of shareholders under state law, they should be similarly advantaged under the proxy system. Rather, shareholders are given far greater latitude to advance proposals at the periphery of their state law rights. Nominating a director has traditionally been prohibited under Rule 14a-8. If a shareholder seeks to use the Rule 14a-8 process to amend the company's by-laws to establish procedures by which a shareholder may nominate a director, for many years Rule 14a-8 has been interpreted to prohibit that as well.
Some observers express concern that for these reasons, the Rule 14a-8 process may hinder shareholders' ability to exercise their state law rights by allowing companies to exclude certain shareholder proposals that not only would be permitted if offered in person at a meeting of shareholders, but which vindicate the most fundamental shareholder prerogatives under state law. These observers question whether it is appropriate for the Rule to place the Commission's staff, as federal regulators, in the position of potentially thwarting the exercise of the shareholder franchise.
Should the Commission revise the proxy rules to permit shareholders to offer any proposal that may be made binding under state or foreign law?
Background: An alternative to the current approach of Rule 14a-8 is a system in which shareholder proposals that vindicate fundamental state law rights would be given priority. At the same time, shareholder proposals on subjects that actually fall within management's and the board's authority under state law would generally be excludable in light of this state law consideration. Whether such a system would implicate other issues is an important consideration in determining the advisability of such an approach. The rights of shareholders to propose binding proposals under foreign corporate law may be instructive in this regard.