Proposed Ballot Access Rules Don’t Solve the Shareholder Democracy Problem
by John C. Wilcox

The Securities and Exchange Commission has proposed new rules that would require companies to include shareholder nominees for director in company proxy statements after certain triggering events.¹ Georgeson Shareholder Communications Inc., the country’s oldest and largest firm specializing in services relating to shareholder meetings, corporate governance, and proxy solicitation, supports the Commission’s stated objective to “enhance the transparency of the operations of boards of directors,” and to improve shareholders’ ability to “participate meaningfully in the proxy process for the nomination and election of directors.” However, we have serious reservations about the radical approach the Commission takes in proposed Rule 14a-11.

We are sympathetic to shareholder complaints that the election process is not an effective accountability mechanism. Short of waging a proxy contest, shareholders lack the power to directly remove directors by voting against them. A campaign to withhold votes from directors, even when a majority is achieved, does not prevent their reelection or increase the likelihood of their removal. These are serious problems that engender skepticism about the election process and undermine good corporate governance. But proposed Rule 14a-11 will not solve those problems.

The Commission’s new rules mandating disclosure of nominating committee functions and facilitating communications between shareholders and Boards of Directors² are a good first step toward improving the election process. Boards need more access to shareholders and more information about shareholder concerns, policies, and voting practices. At the same time, shareholders need access to boards and more information about how boards make decisions and how those decisions take into account shareholder interests. These new rules should facilitate dialogue, increase understanding on both sides, encourage constructive problem solving, and increase trust between shareholders and the directors who represent them.

Unfortunately, our support for the new disclosure and communication rules does not extend to proposed Rule 14a-11. We would like to highlight what we think are the policy and practical problems inherent in that proposal. We also offer some recommendations that may more effectively achieve the Commission’s goals.

Policy Concerns

The proposed rule will promote confrontation

Proposed Rule 14a-11 establishes procedures that would polarize issuers and shareholders and interfere with constructive dispute resolution. The rule promotes public confrontation rather than private engagement. It sets up an adversarial process, modeled on Rule 14a-8, that would encourage combative tactics favored by the special interest groups that are currently the main users of Rule 14a-8. In so doing, the proposed rule overlooks the quiet but effective strategies perfected by organizations such as TIAA-CREF, CalPERS, Relational Investors, certain mutual fund management companies, and other prominent investors.

During the 2003 proxy season, only 2% of governance proposals under Rule 14a-8 were sponsored by pension funds.³ This statistic confirms that Rule 14a-8 has evolved into a forum for special interests. The threat of a shareholder proposal is still an important negotiating tool for responsible shareholder activists, but their goals are best achieved through direct negotiation and “quiet diplomacy.” They recognize that talking is usually more productive than fighting. Unfortunately, proposed Rule 14a-11 encourages the opposite approach.

The proposed procedures are complex and costly

Proposed Rule 14a-11 is likely to increase the procedural complexity and cost of the proxy process. The rule is intricate and mechanistic. It prescribes a detailed set of procedures that, while clearly designed to balance competing interests, create a highly inflexible structure that promotes election contests over other forms of dispute resolution. Proposed Rule 14a-11 encourages activist shareholders to undertake complicated proxy fights when what they really need is the means to directly remove targeted directors.

Votes on shareholder proposals do not have the significance ascribed by the Commission

Proposed Rule 14a-11 misinterprets the meaning and significance of votes cast by shareholders in favor of Rule 14a-8 proposals. The Commission appears to assume that a majority vote in favor of any shareholder proposal is a sign of general dissatisfaction with a company’s board, governance, or performance. In fact, Rule 14a-8 provides nothing more than a referendum on the specific issue voted upon.

For many years the highest levels of shareholder support have been achieved by a narrow group of policy questions—classified boards, poison pills, supermajority vote requirements, and golden parachutes. Our analysis of voting practices on these proposals indicates that shareholders vote with lockstep consistency, pursuant to standardized voting policies, without regard to differences in company performance, governance ratings, or other variables. These automatic voting practices suggest that voting results on shareholder proposals reveal little about shareholder attitudes toward company fundamentals. It is a mistake to think these votes can be used to distinguish “bad” from “good” companies.

Shareholders will automatically vote to reach triggering thresholds

The proposed rule will perpetuate standardized voting practices, both on “trigger” proposals and on the mini-election contests that will follow. We have no doubt that a trigger proposal by a qualified shareholder seeking the nomination privilege will quickly be recognized as a shareholder benefit in all cases. Why would any shareholder vote against a grant of reserve power? Even though proxy advisory service Institutional Shareholder Services (ISS) has indicated that it will take a case-by-case approach, we are convinced that investors’ voting policies will quickly become standardized and favorable votes will be cast automatically, as they are for many policy questions under Rule 14a-8.

The proposed rule will perpetuate standardized voting practices.

The second trigger mechanism (when more than 35% of votes are withheld from a director) could distort the voting process and ultimately the governance process. If withholding votes from directors is the means to achieve nominating rights, shareholders may decide to act for that reason alone rather than because of a director’s performance.

The second trigger, when combined with the ISS policy of withholding votes from directors who do not implement shareholder resolutions approved by majority vote, also could encourage more resolutions from special interests. For the same reason, shareholders might be more inclined to vote in favor of such resolutions to help achieve the majority that would then lead to more withhold votes needed for the trigger. This type of tactical voting seems an unavoidable, though unintended, consequence of the trigger mechanism.

Finally, directors might be inclined to capitulate and implement shareholder resolutions simply to avoid the threat of the second trigger, even when they disagree with the resolution on the merits. Decisions based on gaming strategies and pressure could degrade the proxy system and undermine the independence of directors.

Proxy fights are not necessary or productive

Some argue that the relatively small number of election contests that occur annually is evidence of deficiencies in the U.S. proxy system.⁴ The natural corollary to that view is that more such contests would be beneficial. We disagree.

Proxy contests should not be regarded as an everyday accountability mechanism. They are a last resort, to be used when all else fails. Election contests are the corporate equivalent of impeachment: they are extremely disruptive and are intentionally designed to be procedurally difficult so they will not be used carelessly, excessively, or abusively. Election contests should occur only in extreme cases, after other checks and balances and accountability mechanisms have been exhausted. To argue that a high number of proxy contests would evidence a good corporate proxy system is illogical. No one would measure the health of our political system by the frequency of impeachment.

The proposed rule will promote an “us versus them” mentality

Because of the rule’s adversarial structure, it could have the unintended and unwanted effect of further uniting corporate directors and managers in a defensive alliance against a perceived common enemy—the shareholders. Such a result would directly contradict efforts by the Commission, Congress, and the SROs to establish the board’s independence and strengthen its ability to understand and represent shareholder interests. Another unintended consequence might be to reinforce public skepticism and mistrust— already quite strong—at a time when companies and investors should be seeking common ground.

The proposed rule does not solve shareholders’ primary election problem

The real problem with the election process is that shareholders lack the ability to selectively remove directors without a proxy contest. Giving shareholders a procedure to force their own candidates onto the proxy makes an end run around this problem without tackling it directly.

We believe that shareholders would prefer a grant of power enabling them to remove directors to one giving them responsibility for finding replacement candidates. Shareholders are skilled at evaluating corporate performance and governance, but it is unlikely they have the resources or expertise, or even the desire, to become involved in director selection. Nevertheless, we recommend that once given the power to remove directors, shareholders also should exercise a meaningful role in the process of selecting their successors. The appointment of a qualified shareholder representative to work directly with the nominating committee would be more effective and less disruptive than unilateral nominations by shareholders in cases where a full election contest is not warranted.

Practical Concerns

Despite its cost and complexity, the U.S. proxy system works well. It famously achieves the world’s highest levels of shareholder participation at annual meetings. However, it is not perfect. The back office operations that produce these outstanding results have never been subject to careful monitoring—except in the case of election contests. During contests the proxy process shifts into a higher gear, with supplemental disclosure, special procedures, and additional regulatory oversight.

A proliferation of mini-proxy contests under Rule 14a-11 will substantially raise the stakes at many more annual meetings and will require more frequent and thorough monitoring of backoffice mechanics. The SEC staff will have no choice but to establish procedures to meet these new demands. Overseeing “high gear” Rule 14a-11 campaigns and mediating the disputes that are certain to arise will demand substantial additional resources and will engage the staff in matters of judgment even more complex than those they now face under Rule 14a-8. Following is a summary of some of the problems we foresee.

Share records are not completely accurate

The total share positions on omnibus proxies issued by the Depository Trust Company invariably fail to reconcile with the Cede & Co. record date positions on companies’ share registers. The discrepancy is usually small in percentage terms, and the problem has been ignored because there is no practical way to reconcile share positions of actively traded securities with a high degree of accuracy. The prevailing attitude has been that such inaccuracies are neutral, not favoring either party, and can therefore be disregarded.

If Rule 14a-11 mini-contests become common, there will be pressure to eliminate any inaccuracies in the shareholder register that could possibly affect the outcome of a close election. Establishing the means to achieve accurate reconciliation would require a comprehensive review of record-keeping practices by all participants in stock clearing, settlement, registration, and custody. Is the Commission prepared to take on such a project?

Proxy card design will become a contentious issue

Rule 14a-11 mandates an election contest with competing candidates carried on a single card or ballot. If there are 11 candidates for a nine-person board, how will the proxy card be designed to clearly distinguish the two shareholder candidates from the nine incumbents? The card format must strike the right balance— segregating incumbents and shareholder candidates, while not isolating either group.

The staff has always reviewed proxy card format in full-fledged election contests with a view to ensuring fairness and preventing bias or shareholder confusion. It will now have to mediate these design questions for 14a-11 campaigns as well. Furthermore, ADP’s Investor Communication Services Division uses its own Voting Instruction Form (VIF) to solicit instructions from broker and bank customers, which it tabulates internally before voting on a master ballot. SEC staff will be called upon to mediate design disputes over ADP’s VIF.

Voting in blank may become impossible

Shareholders are accustomed to signing proxies in blank, relying on proxy card disclosures that in the absence of specific instructions their shares will be voted as management recommends. Will this arrangement work for the 14a-11 universal proxy card? Activists and sponsors of shareholder candidates will certainly argue that the practice gives an unfair advantage to incumbent candidates. If voting in blank were prohibited by the SEC staff or by a court, a comprehensive informational campaign would be required to educate investors and prevent their inadvertent disenfranchisement.

Discretionary broker voting may become impossible

The availability of discretionary broker voting in Rule 14a-11 campaigns will also be in question. It will be difficult for the New York Stock Exchange to permit brokers to vote in their discretion under NYSE Rule 452 when there are competing candidates for board seats.

Rule 452 relies on a presumption that customers knowingly authorize their broker to vote as management recommends if they do not return the instruction form. Brokers do not make independent voting judgments under Rule 452 (although they may do so by separate agreement with their customers).

In a Rule 14a-11 campaign, it may not be clear which incumbent(s) will be unseated if one or more shareholder candidates is elected. This uncertainty could be seen as introducing an element of judgment into the broker’s discretionary vote, thereby invalidating the arrangement under Rule 452. In any event, it is certain that shareholder activists would oppose discretionary broker voting in 14a-11 campaigns. If the practice were disallowed, a comprehensive effort by regulators to educate investors about the changes and their additional responsibilities would be necessary.⁵

Issuers will demand monitoring of back office tabulation procedures

ADP uses proprietary electronic systems and the Internet to handle proxy processing for institutional accounts, and increasingly for retail customers as well. In 14a-11 campaigns it is likely that issuers will insist that these electronic processes be carefully monitored for accuracy and to prevent fraud. There is no precedent for such oversight. Even in election contests, access to back office processing of beneficial owners’ vote instructions has been granted only by court order in rare cases. The Inspectors of Election in a contest are allowed to look behind the voted proxies only when there is an overvote or other evidence to justify an inquiry. Trust in the reliability of back office procedures or faith that processing errors have neutral impact will not suffice if 14a-11 campaigns become commonplace.

Shareholder confusion will proliferate

The type of hybrid mini-contests contemplated by Rule 14a-11 is likely to generate substantial confusion among shareholders. Initially, it will take time for shareholders to become comfortable with the complex mechanical alterations the rule will engender, such as the loss of the group voting privilege and the potential loss of discretionary broker voting and voting in blank.

The type of hybrid mini-contests contemplated by Rule 14a-11 is likely to generate substantial confusion among shareholders.

Even more serious, however, is the concern that in 14a-11 campaigns, shareholders will have difficulty deciding which candidates deserve their vote on the merits. Will there be enough disclosure for shareholders to judge an individual candidate’s character, expertise, and credentials? ISS and others making voting recommendations to institutional clients will face the same problem. Will ISS routinely support shareholder candidates, or will it attempt to decide case-bycase? Will ISS be conflicted when one of its institutional clients sponsors or supports a shareholder candidate? If the issuer decides to conduct an aggressive campaign in support of its candidates but the shareholder proponent lacks the resources to do the same, will the outcome be subject to challenge on the grounds of fairness?

The perception of lopsided or politicized campaigns, unequal financing, and other fairness issues can confuse and alienate shareholders and undermine the credibility of the election process generally. These concerns arise in election contests now, and must be dealt with strategically by the participants in the conduct of each campaign. SEC staff oversight plays an important role in ensuring the conduct of election contests is fair. If mini-contests under Rule 14a-11 become common, the wholesale challenge of monitoring these issues would have to be met by regulators. Failure to perform such monitoring could undermine the integrity of the proxy system.

Tabulation procedures will need to be refined

Tabulation procedures will present the most intractable problems, requiring a substantial commitment by the SEC staff to mediate disputes. How will tabulators determine the intent of shareholders who mistakenly or carelessly vote in favor of all 11 candidates for a nineperson board? Will it be possible for management to disclose in the proxy statement or on the card how such votes will be allocated? Will management need to cooperate with the sponsors of shareholder candidates to make such a determination? When customers with shares in street name make voting errors, how will brokers or ADP decide how to vote the shares? Will issuers insist on the right to review street-name tabulation records? Will shareholder proponents object to the independence of Inspectors of Election appointed by issuers? Will shareholders be given equal access to the review process, as is common in election contests? Will procedures be available to cure voting errors?

The voting of loaned stock presents a wellknown tabulation enigma. Brokers commonly are entitled to lend shares in margin accounts without the customer’s knowledge or consent. At proxy time these shares are sometimes doublevoted, with instructions coming both from the lending customer (who does not have voting rights) and from the borrower (who does). This practice has largely escaped regulatory scrutiny. In Rule 14a-11 campaigns it is doubtful a handsoff attitude toward this arrangement could continue. The SEC staff and the SROs would be called upon to develop a solution.

Election costs will increase for all parties

It is impossible to predict the cost of dealing with the issues outlined above and the many other complexities that will undoubtedly arise under proposed Rule 14a-11. However, the types of costs are clear: greater staff time and resources for the SEC; increased legal and advisory fees, executive time, and out-of-pocket expenses for issuers; outlays in time, money, and resources for new technology and procedures by brokers, banks, and intermediaries; and costs to shareholders for preparing and conducting 14a-11 campaigns.

Recommendations

The Commission’s proposed Rule 14a-11 calls attention to the inner workings of the proxy process. Consideration of this proposal offers an opportunity to simplify the proxy system, encourage better use of technology, reduce costs, and make the election process more responsive and accurate. The recommendations that follow are designed to achieve these goals.

Implement direct access and revoke the NOBO-OBO rules

The Commission should rescind the NOBOOBO rules and establish procedures permitting issuers to identify and communicate directly with all their shareholders, including all beneficial owners who hold in “street name.” Direct access could readily be accomplished by mandating the issuance of a second tier of omnibus proxies by DTC participants.

The Commission should rescind the NOBO-OBO rules and establish procedures permitting issuers to identify and communicate directly with all their shareholders.

DTC’s current practice is to pass Cede & Co.’s voting rights to participant banks and brokers by issuing an “omnibus proxy” and participant listing. Under a new direct access program, banks and brokers in DTC would then issue their own omnibus proxies passing voting rights to the customers for whom they hold shares on the record date. Issuers would receive these lists of record date customers and would be entitled to distribute proxy materials directly to them and to communicate with them by telephone, mail, or electronically. The customers would be fully empowered to sign and vote proxies.

Direct access has been debated for decades, but advances in technology and changing shareholder attitudes have increased support for the idea. In the context of new NYSE listing requirements, we have suggested that direct access could help prevent quorum problems in the event discretionary broker voting under Rule 452 were further cut back or eliminated altogether.⁶

In contests occurring under proposed Rule 14a-11, the benefits of direct access would be greater than simply protecting quorum. Direct access would bring transparency to proxy mechanics and would eliminate the delays, confusion, and additional costs that are now serious obstacles to communication between issuers and shareholders. It would give beneficial owners increased recognition and standing to act directly with respect to the companies they own. It would facilitate the creation of an audit trail, which is an essential first step in establishing end-to-end vote confirmation—a goal sought by both issuers and shareholders.

Direct access would bring transparency to proxy mechanics.

The sole cost of direct access would be the loss of customer anonymity—primarily a competitive concern of brokers. However, brokers’ objections to customer identification could be eliminated by not disclosing broker affiliation on the record date customer lists. The information would not be needed because brokers would no longer participate in the voting process.

Beneficial owners who persisted in choosing to conceal their identity from issuers could do so by continuing to maintain private nominee accounts. However, expenses related to such accounts, including intermediaries’ postage and handling charges, would be paid by beneficial owners—not by issuers. Direct access could eliminate the current burdensome arrangement that requires issuers (and therefore all shareholders) to underwrite the expenses associated with street name ownership. Direct registration and equal treatment of registered and beneficial owners make sense both economically and from a policy perspective.

Dematerialize equity securities

The United States lags other industrialized nations in not having fully dematerialized equity securities. The persistence of physical stock certificates is a costly and anachronistic impediment to development of efficient equity trading, electronic communication, and share voting. The Commission should work with state governments and the NYSE to eliminate rules requiring certificates. Mandatory book-entry record keeping would facilitate the creation of direct electronic links between issuers and beneficial owners. This would permit the use of electronic tags to track the voting instructions of specific beneficial ownership positions even as they move through pooled accounts and custodial layers, thereby providing an effective means of vote confirmation.

Change the calculation of voting results

Proposed Rule 14a-11 follows the Rule 14a-8 practice of calculating results as a percentage of votes cast rather than as a percentage of outstanding shares. The Commission should eliminate the “votes cast” measurement standard entirely and replace it with a uniform standard based on outstanding shares. There are obvious advantages. Calculating votes as a percentage of outstanding shares provides greater certainty by utilizing a number that is disclosed in the proxy statement that cannot be manipulated. It avoids the disputes and questions of fairness that arise from differing treatment of abstentions and discretionary broker votes. It allows statistical comparability from year to year and from company to company.⁷

Give weight to “withheld” votes

Former SEC Commissioner Joseph Grundfest submitted a comment letter to the SEC with an ingenious proposal to penalize directors from whom a majority of votes are withheld.⁸ His approach, which could be implemented through exchange listing requirements, is a straightforward and low-cost method of making “withhold” have real impact on targeted directors.

The Grundfest proposal directly addresses the underlying problem—shareholders lack the power to remove individual directors without a contest—by making it impractical for targeted directors to continue serving on the board. This suggestion deserves more study and discussion. It is certainly far less disruptive and costly than proposed Rule 14a-11, and could serve as a temporary expedient until state laws could be amended to provide shareholders the right to remove directors.

Encourage new approaches and creative ideas

Recommendation 6.04 of “Restoring Trust,” the report on corporate governance for the future of MCI Corp. authored by former SEC Chairman Richard C. Breeden,⁹ calls for the establishment of an “electronic town meeting” to discuss and vote on shareholder proposals—even those that would not meet the requirements for inclusion on the company’s proxy. The mechanics of the Breeden plan are still unclear. However, the concept is forward-looking. It would have the benefit of giving shareholders greater control over the resolution process by permitting proponents to conduct informal straw votes to determine which issues attract substantial shareholder support and therefore merit inclusion in the company’s proxy statement. Properly organized, this approach could be used to screen out and eliminate low-scoring proposals before they reach Rule 14a-8, which would reduce costs and make the shareholder proposal process more meaningful.

Conclusion

The Commission’s goal of maintaining a fair and efficient proxy system that protects the investing public, provides an effective means of dispute resolution, and fairly distributes power among management, directors, and shareholders is laudable, but, for the reasons outlined in this article, proposed Rule 14a-11 would not achieve that goal.

Notes

1. SEC Release No. 34-48626 (Oct. 14, 2003), available at <www.sec.gov/rules/proposed/34-48626.htm>.

2. SEC Release No. 33-8340 (Nov. 24, 2003), available at <www.sec.gov/rules/final/33-8340.htm>.

3. See Georgeson Shareholder, “Annual Corporate Governance Review, 2003,” p.5, available at <www.georgesonshareholder.com/pdf/2003WrapUp.pdf>.

4. See, e.g., Lucian Arye Bebchuk, “Shareholder Access to the Ballot,” Discussion Paper No. 428, available through links at <www.law.harvard.edu/programs/olin_center/>.

5. See John C. Wilcox, “What Next for the 10-day Rule?” in THE CORPORATE GOVERNANCE ADVISOR, Vol. 11, No. 5, September/ October 2003, p.12.

6. Id.

7. Of course, if the denominator for the calculation is changed from “votes cast” to “outstanding shares,” the Commission may wish to reduce the triggering thresholds.

8. Comment letter of Joseph A. Grundfest, October 22, 2003, available at <www.sec.gov/rules/proposed/s71903/jagrundfest102203.htm>.

9. “Restoring Trust, Report to the Hon. Jed S. Rakoff, the United States District Court for the Southern District of New York on Corporate Governance for the Future of MCI,” by Richard C. Breeden, Corporate Monitor (Aug. 2003), available at <www.nysd.uscourts.gov/rulings/02cv4963_082603.pdf>.

About the Author

John C. Wilcox (jwilcox@georgeson.com) is Vice Chairman of Georgeson Shareholder Communications Inc.