Proxy Rule Changes on the Horizon
by David E. Brown, Jr., Bryan E. Davis, and Dennis O. Garris

To all interested observers it appears the Securities and Exchange Commission is serious about significant proxy rule reform. In July the SEC released a report by the Division of Corporation Finance (Division) concerning its review of the SEC’s rules regarding the nomination and election of directors, including a number of recommendations to the SEC for amendments to the proxy rules.¹ Assuming the staff meets Chairman Donaldson’s announced schedule, the SEC will be considering proposed rulemakings regarding the staff ’s recommended disclosure changes in August and some form of stockholder access to companies’ proxy materials in September.²

Background of the Division’s Review

The SEC has previously considered variations on the shareholder access theme, in 1942 and again in 1977. The 1977 rule amendments included the current Schedule 14A Item 7 requirement that companies state whether they have a nominating committee and, if so, whether the committee will consider shareholder recommendations. According to a 1980 SEC staff report to the Senate Committee on Banking, Housing, and Urban Development, the staff concluded that the SEC should defer consideration of a shareholder access rule “due to the emerging concept of nominating committees.” ³ More recently, in 1992, the SEC chose not to propose a shareholder access rule, but did adopt, as part of broader changes to the proxy rules, a bona fide nominee rule permitting shareholders seeking minority board representation to submit a “short slate” of nominees.

During the 2003 annual meeting proxy season, the American Federation of State, County and Municipal Employees Pension Plan (AFSCME) submitted a shareholder proposal to six companies that would have required the companies to include in their proxy materials the nominee of any shareholder or group of shareholders beneficially owning 3% or more of the companies’ outstanding common stock. The Division allowed the companies to exclude the proposals under Exchange Act Rule 14a-8(i)(8), which permits omission of any proposal that “relates to an election for membership on the company’s board of directors or analogous governing body.”⁴ The AFSCME then requested that the SEC review the Division’s no-action position.

On April 14, 2003, the SEC informed AFSCME that it had chosen not to review the Division’s decision,⁵ but also announced that it had directed the Division “to formulate possible changes in the proxy rules and regulations and their interpretations regarding procedures for the election of corporate directors.”⁶ The SEC later issued a press release requesting that interested members of the public submit views regarding possible proxy rules reform to aid the Division’s review.⁷

The Division’s Report

On July 15, 2003, the SEC published the Division’s report on its review. The report states that the SEC received nearly 700 comment letters. The vast majority of the comments were from individuals, frequently submitting form letters supporting proxy reform generally and, in many cases, direct shareholder access to companies’ proxy materials. The proponents of shareholder access usually argue that shareholders’ current alternatives for participating in the governance process (submit recommendations to board nominating committees, withhold voting authority for specific nominees, or bear the expense of a formal proxy contest) are not meaningful.

The comments submitted by business associations, companies, and law firms usually urged caution and encouraged allowing the Sarbanes- Oxley Act and pending NYSE and Nasdaq listing requirement amendments to become effective before implementing radical changes to the proxy rules. Some commenters also questioned the SEC’s authority to adopt shareholder access rules, and expressed concern about possible conflicts with governing state law.

The proponents of shareholder access usually argue that shareholders’ current alternatives for participating in the governance process … are not meaningful.

The report categorized the principal alternatives for increasing shareholder involvement in the nomination and election of directors (noting that certain of these could be used in combination with others) as follows:

• Requiring companies to include shareholder nominees in company proxy materials; • Requiring companies to deliver nominating shareholder proxy cards along with company proxy materials;
• Requiring expanded disclosure regarding companies’ nominating committees, the nominating process, and nominating committee consideration of shareholder recommendations, with possible requirements under applicable listing standards that nominating committees consider shareholder recommendations;
• Requiring expanded disclosure regarding shareholder communications with board members, with possible requirements under applicable listing standards that companies provide shareholders with increased access to, and direct communication with, boards of directors; and
• Revising Exchange Act Rule 14a-8 to allow shareholder proposals relating to a company’s nomination process.

The report includes extensive discussion about these alternatives, including efforts to address the likely advantages and disadvantages of each and raising numerous questions for public comment. For example, with respect to the option of requiring companies to include shareholder nominees in company proxy materials, the report notes that two “fundamental considerations” in proposing a shareholder access rule are “when the rule may be used and by whom.” The report identifies 13 different design decisions that must be made, including such matters as whether there should be “trigger events” for shareholder access, whether there should be shareholder eligibility requirements (such as percentage ownership thresholds, minimum holding periods, or both), whether there should be limits on the number of shareholder nominees, whether there should be independence standards for shareholder nominees, and whether nominating shareholders should be deemed to have a “control” intent for purposes of beneficial ownership filings and disclosure requirements.

The report further identifies 23 questions for public comment, touching on the various design considerations, including:

• Would amended proxy rules giving shareholders the right to place shareholder nominees in a company’s proxy materials conflict with state law (e.g., requirements applicable to the expenditure of corporate assets or nominating procedures)?
• Which, if any, of the proxy rules should apply to soliciting activities by nominating shareholders or by shareholders attempting to form a nominating shareholder group?
• Should there be prescribed qualifications for shareholder nominees? If so, should shareholder nominees be screened by the company’s nominating committee? Should the nominating committee be able to reject shareholder nominees based on objective criteria related to the nominee’s qualifications?
• Is there a risk that companies will form “friendly” nominating groups to ensure that a candidate of the company’s choice is nominated through any new shareholder access rule?
• Should companies be exempted from a shareholder nomination procedure for any election of directors in which another party commences, or evidences its intent to commence, a contested election contest?
• Do large and small shareholders share the same interests? If not, how do they differ and how would each be served under a shareholder access rule? • Is a shareholder access rule consistent with Congressional intent regarding Exchange Act Section 14(a)?

With respect to the alternative regarding additional nominating committee disclosure, the report discusses a number of possible changes, including filing of nominating committee charters, disclosure of the criteria used by nominating committees to screen nominees, the nominating committee’s process for developing and considering nominees, and, in certain circumstances, discussion of why the nominating committee did not include a particular candidate as a nominee. The report also discussed the possible interplay of any enhanced disclosure of nominating committee functions with the pending proposed rule changes of the NYSE and Nasdaq relating to the independence of nominating committees and, in the case of the NYSE, the content of the nominating committee’s charter.⁸

As with the nominating committee disclosure, the report notes that the impact of disclosure about what processes, if any, companies have in place for shareholders to communicate directly with directors would be more effective “if coupled with a change in market listing standards.” The report specifically notes that the NYSE has proposed a rule that would require companies to “disclose a method for [interested] parties to communicate directly and confidentially with the presiding director or with nonmanagement directors as a group.”

Finally, with respect to the alternative regarding revisions to Exchange Act Rule 14a-8(i)(8), the report notes that the Division’s current analysis under Rule 14a-8(i)(8) permits a company to exclude a proposal if the proposal will directly or indirectly result in an election contest. This alternative would consider changing the analysis to allow the inclusion of proposals (precatory proposals, where state law would prevent shareholders from adopting binding proposals) seeking to “establish a process to allow shareholders to access a company’s proxy card in a non-control context.” The report considers how such a change might implicate other proxy rules, including the rules relating to election contests.

The Division’s Recommendations

The report concludes by recommending that the SEC publish proposals and solicit public comment in three areas: expanded disclosure of the nominating committee process, specific disclosure of the processes by which shareholders may communicate directly with directors, and “conditional” shareholder access to a company’s proxy materials for purposes of nominating candidates for election as director.

The Division’s report makes the following specific recommendations:

Expand disclosure regarding a company’s nomination process to include:

• The nominating committee charter, if any;
• Nominating committee member independence;
• The criteria used to screen nominee candidates, including candidates recommended by shareholders;
• The committee’s policy with regard to candidates recommended by shareholders;
• The qualifications the nominating committee believes company directors, or a given director, should have;
• The committee’s process for developing and considering nominees;
• The source of each of the company’s nominees;
• How shareholders can recommend a nominee; and
• If the nominating committee receives a recommendation from a shareholder who has beneficially owned greater than a specified amount of the company’s voting common stock for a minimum specified period of time, and the committee chooses not to nominate that candidate, disclosure of who recommended the candidate, why the committee did not include the candidate as a nominee, and whether each member of the nominating committee believes that it was in the company’s best interest not to nominate the candidate.

Require disclosure regarding shareholder communications with board members, including:

• The manner in which shareholders can send communications to the board and specifically to whom those communications may be sent;
• If all shareholder communications are not sent directly to board members, the company’s process for determining those communications that are relayed to board members;
• The number of times individual board members met with shareholders in the prior year; and
• Any action taken by the board as a result of the communications.

Permit stockholders to have access to company proxy materials under the following parameters:

• Applicable state corporate law must provide the company’s shareholders with the right to nominate a candidate for election as a director;
• Neither the candidacy nor the election of a shareholder nominee may otherwise violate, or cause the company to violate, controlling state law, federal law, or listing standards;
• The availability of a shareholder nomination process should be premised upon the occurrence of one or more triggering events that are objective criteria evidencing potential deficiencies in the proxy process such that shareholder views—especially those of a majority—may not otherwise be adequately taken into account;
• There should be appropriate standards for independence of shareholder nominees;
• There should be minimum standards with regard to shareholdings and holding periods for a nominating shareholder or shareholder group; and
• There should be limitations on the total number or percentage of permitted shareholder nominees.

Consider the following rule changes to accommodate shareholder participation in the director nomination process:

• Amend the proxy rules to address specifically soliciting activities in connection with the formation of a nominating shareholder group;
• Amend the proxy rules to address specifically soliciting activities by the nominating shareholders in support of the shareholder nominee;
• Amend the proxy rules to facilitate solicitations by electronic means on one or more specified Web sites;
• Amend the beneficial ownership reporting requirements to address specifically nominating shareholders and nominating shareholder groups;
• Amend the insider transaction reporting requirements to address specifically nominating shareholder groups; and
• Amend the definition of “affiliate” to address specifically nominating shareholders and nominating shareholder groups.

The report notes that the Division’s review focused on operating companies and that the SEC will need to determine, and request comment on, how any changes to the proxy rules should apply to investment companies.

Next Steps

Chairman Donaldson asked the Division to prepare formal rulemaking proposals as quickly as possible, with the goal of SEC consideration of the proposals as early as August for the disclosure recommendations and September for the proxy access recommendation. It is clear from all the questions the Division raises in the report that meeting Chairman Donaldson’s schedule will be difficult.

The proposal for enhanced nominating committee disclosure is by far the most straightforward and easiest issue in the report for the SEC to address quickly. Enhanced disclosure in this area should be no surprise given the changes under Sarbanes-Oxley, the new nominating committee rules by the stock exchanges, and the lack of meaningful disclosure under the current disclosure rules. However, enhanced disclosure may have the largest impact on board practices.

Given the potential complexity of an access rule, there needs to be a healthy debate on the SEC’s proposals.

The staff ’s many questions on the shareholder access alternatives demonstrates the difficulty in creating such a regulatory provision. It is likely that any access proposal will be very complex as the SEC tries to address significant competing interests. Enabling shareholders to nominate directors creates the risk that shareholder groups will use the process for their own self interests and not that of shareholders generally (ironically, the same argument certain shareholders currently make against companies). On the other hand, the Division’s report seems to indicate that the process should not be entirely within the company’s control.

Given the potential complexity of an access rule, there needs to be a healthy debate on the SEC’s proposals. It is unfortunate that the SEC has decided to move forward so rapidly with proposed rules and not give companies the opportunity to act appropriately in light of the changes under Sarbanes-Oxley and the soon-tobe- adopted NYSE and Nasdaq rules with new enhanced disclosure of the nominating process. A little bit of sunshine goes a long way.

Although there is every reason to expect the SEC will receive even more comments on the actual rulemakings than it received in response to its solicitation of public views on the Division’s review, the Chairman appears committed to taking action quickly, and we may see some new rules adopted in time for the 2004 annual meeting proxy season.

Notes

1 The SEC’s July 15 news release announcing the publication of the Division’s report can be found at <www.sec.gov/news/press/2003-83.htm>. The Division’s report and related summary of comments can be found at <www.sec.gov/news/studies/proxyrpt.htm>.

2 The Chairman’s intended timing is reflected in SEC News Release 2003-83, supra note 1.

3 Division of Corporation Finance, SEC, Staff Report on Corporate Accountability (Sept. 4, 1980)(printed for the use of the Senate Comm. on Banking, Housing, and Urban Affairs, 96th Cong. 2d. Sess.), at A60-65.

4 See, e.g., Citigroup, Inc., 2003 SEC No-Act. LEXIS 160 (Jan. 31, 2003).

5 American Federation of State, County and Municipal Employees, 2003 SEC No-Act. LEXIS 534 (Apr. 14, 2003).

6 SEC Press Release 2003-46 (Apr. 14, 2003), available at <www.sec.gov/news/press/2003-46.htm>.

7 SEC Press Release 2003-59 (May 1, 2003), available at <www.sec.gov/news/press/2003-59.htm>.

8 As currently proposed, that charter must set forth the committee’s purpose and goals, including its criteria for selecting new directors and oversight of the evaluation of the Board and management, and provide for an annual performance review of the committee.

About the Author

David E. Brown, Jr. (dbrown@alston.com) and Dennis O. Garris (dgarris@alston.com) are partners in Alston & Bird LLP’s Washington, D.C. office, and Bryan E. Davis (bdavis@alston.com) is a partner in the Firm’s Atlanta office.