The SEC has begun to implement proxy rule changes that will fundamentally alter the balance between shareholders and directors of U.S. public companies. New rules mandating expanded disclosure about a company's nominating process became effective on January 1, 2004. In addition, the SEC has issued proposed rules that would offer shareholders the opportunity to require companies to include their nominees as director candidates in annual meeting proxy statements, while obligating companies to alter other long-standing practices relating to the director nominating process.
The final disclosure rules and proposed nomination rules are part of the governance actions initiated by the SEC since Sarbanes-Oxley.
New Disclosure Rules
On November 28, 2003, the SEC promulgated final rules requiring expanded disclosure of a company's director nomination process and specific disclosure of procedures by which shareholders may communicate with directors. The rules go well beyond past requirements and will require companies to disclose:
Whether or not the company has an existing nominating committee and, if not, a statement why the company believes one is not needed;
Whether the company has a policy with regard to the consideration of any director candidates recommended by shareholders and the material elements of that policy (if no such policy exists, a statement to that affect would be required);
Names of those nominees recommended by shareholders or a group of shareholders of 5 percent or more of the company's voting stock that were not nominated and, along with the names of those shareholders that recommended the candidate, the specific reasons for not including these nominees;
Whether or not the company's board of directors provides a process for shareholders to send communications to the board and, if not, a statement why the board believes one is not needed.
To some degree, the rules add little to established practice - many companies had nominating committees and director nomination procedures before the new governance rules, and some of the new listing and other requirements have the effect of requiring companies to adopt similar procedures (for example, the NYSE's charter requirements effectively require that director qualifications be developed and Board communications standards be implemented).
Proposed Direct Access Rules
The director nomination rules proposed by the SEC in October will arguably be the post-Sarbanes-Oxley corporate governance measure that will have the greatest impact on U.S. public companies. The rules would, in certain situations, give direct access to the company's proxy statement by requiring companies to include individuals nominated by shareholders for director in their proxy statements. The proposals envision a two- or three-year process in which shareholders could utilize management's proxy statements for presenting shareholders' nominees for director. The rules would operate as follows:
Triggering Events. The proposed rules would apply only after a "triggering event" has occurred and then only if state law allows shareholder nominations.1 The purpose of the "triggering event" requirement is to limit proxy access to instances in which there is evidence that the company has been unresponsive to shareholder concerns as they relate to the proxy process. A company would be required to include shareholder nominations in its proxy statement for a two-year period if one of the following "triggering events" occurs:
the company receives "withhold" votes from more than 35 percent of the votes cast in an election for any director nominated by the company at an annual meeting; or
a shareholder or group of shareholders owning at least 1 percent of a company's outstanding shares for at least one year submits a proposal under Rule 14a-8 to provide that the company open the nomination process and provide proxy access to shareholder nominees the following year under Rule 14a-11 and more than 50 percent of the shares voted approve this proposal.
Examples Of "Triggering Events"
Imagine that the Compensation Committee of a company authorizes substantial bonuses after a year of lackluster financial performance. The bonuses are disclosed in the proxy statement for the annual meeting at which directors are to be elected. If the shareholders find the bonuses to be excessive and initiate a "withhold campaign," and if 35 percent of the shareholders cast "withhold votes" for the election of any director (for example, the Chair of the Compensation Committee), a "triggering event" has occurred. At the next two annual meetings, a shareholder or group of shareholders meeting the eligibility requirements would have the ability to nominate a director and include that nomination in the company's proxy statement.
Alternatively, imagine that a 1 percent shareholder submits a Rule 14a-8 proposal to open the nominating process and provide proxy access to shareholders. If 50 percent of the shares voted approve the proposal, a "triggering event" has occurred, and a shareholder or group of shareholders that meet the eligibility requirements would have the ability to nominate a director and include the nomination in the proxy statement for the next two meetings where directors are to be elected.
Eligibility Of Shareholders And Nominees. Only a shareholder or group of shareholders that has owned at least 5 percent of the company's outstanding shares2 for at least two years and that intends to hold the shares through the date of the shareholder meeting would be eligible to nominate a director. The shareholder or group must also be eligible to file on Schedule 13G.3 The nominating shareholder or group cannot have any agreement with the company regarding the nominating process. If more than one shareholder or shareholder group proposes a nominee, the nominee proposed by the largest shareholder or group will be proposed.
Nominees must meet independence requirements including the absence of any financial arrangements between the shareholder(s) and the nominee. The nominee would also have to meet the objective criteria for independence of the relevant stock exchange. The number of potential nominees would depend on the company's board size.4
Notice. Eligible shareholders or groups must give the company notice of their nominee at least 80 days before the anniversary of the date the company mailed its prior year's proxy statement. The notice must contain information about each nominee as well as representations of compliance with the rules.
Statements In Support. If the company wants to include arguments against the shareholder nominees and in support of its own nominees, it must permit the nominating shareholders to include a supporting statement in the proxy.
Timing. The triggering events began to apply January 1, 2004, even though the rules were not finalized by then. Therefore, if the rules are ultimately adopted, shareholders could use the proxy statement and nominate directors as early as meetings held in 2005.
Proposed Actions In Response To The Proposals
As previously mentioned, the proposed rules would not apply if applicable state law prohibits a company's shareholders from nominating a candidate for election to the board of directors. The laws of most states do not specifically prohibit these nominations; however, state legislatures may respond by making changes to the laws or establishing other "roadblocks" in the event the proposed rules are adopted. In the meantime, companies should review their charter and by-law provisions to determine how they are currently able to respond if the proposed rules are enacted.
Many corporations have requirements that shareholders provide advance notice of and specified information regarding board nominations. These advance notice requirements should be reviewed in order to ensure that they require the maximum amount of time for notices under state and federal law and that they are unambiguous as to the required information concerning nominees. Boards should also consider what qualifications they will require for all directors. These qualifications may be enumerated in nominating committee charters, corporate governance guidelines or other documents that are publicly accessible. Finally, boards should consider requiring every director to sign a confidentiality agreement when joining the board. These agreements would help to ensure that directors could not disclose non-public information about the company to anyone.
The Bigger Picture
For almost 70 years, since the adoption of the federal securities laws, the regulatory emphasis generally was on assuring adequate disclosure so that the marketplace could operate fairly. Governance matters were, by and large, left to state law notions predicated on the presumption of the "business judgment rule." In the post-Sarbanes-Oxley era, instead of the marketplace itself, governmentally mandated rules are purportedly being designed to give an ever-shifting and, to some extent, short-term oriented body of shareholders a far larger voice in governance in order to avoid debacles like Enron, Adelphia, and WorldCom in the future.
The wisdom of this shift can be challenged. To date, most companies have stayed out of the debate. We feel that companies owe it to their constituents to express their views on at least the proxy access proposals. These new proxy proposals, however, take a further step to purportedly support the underlying assumption - that the current system is broken. In the context of the proxy solicitation and director nominees by shareholders, this assumption has not been established and the inevitable consequences of the new rules, particularly the elevation of short-term performance goals over long-term investment and strategic objectives, could result only in weakening U.S. companies in the global marketplace.
The foregoing is a highly condensed and generalized discussion of some key provisions of recently proposed rules. Application of the proposed rules to particular circumstances will require further, detailed consideration and may be affected by further rule-making and subsequent administrative, judicial, and other interpretation.1 To date no state has been identified that clearly prohibits shareholder nominations.
2 The Commission is proposing to carve out a limited exemption to Exchange Act rules dealing with shareholder communications and proxy solicitation to allow shareholders to form a group to meet the 5% threshold without having to file and distribute a proxy statement.
3 Schedule 13G is available to shareholders that are not seeking to change or influence "control" of the company. The SEC is proposing to add an instruction to Schedule 13G to clarify its view that shareholders or groups that nominate a director under the new rules would not become ineligible to file under Schedule 13G.
4 One nominee is allowed for a board with eight or fewer members, two nominees are allowed for boards between nine and 19 members, and three nominees are allowed for boards with 20 or more members.
Louis Rorimer is a Partner and Lisa K. Kunkle is an Associate in the Cleveland Office of Jones Day.