The SEC, Corporate Governance, and the Election of Directors

Last week, The Race to the Bottom blog posted on a story in the Wall Street Journal about the SEC’s circulation of a proposal to amend Rule 14a-8.  The SEC’s proposed amendment, according to the article, would allow shareholders to submit proposals that relate to the election of directors, apparently addressing the issue raised by the Second Circuit’s decision in AFSCME v. AIG.  The article indicates that the authority to submit such proposals would be limited to shareholders–or, presumably groups of shareholders–owning more that 5% of the outstanding shares.

The approach raises a fundamental question about the role of the SEC in the corporate governance process, and that question is the subject of my paper, Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure.  The topic is much too broad to address in a single post.  Suffice it to say that those who debate whether the SEC should be involved are behind the curve. 

The SEC is actively involved in the governance process, mostly using disclosure as a mechanism for influencing the behavior of executive officers and directors.  Just take a look at Item 407 of Regulation S-K.  The Commission does so for an obvious and ineluctable reason.  The Agency’s focus is disclosure, but no system of disclosure can function adequately absent an appropriate governance system within the company.  As state law continues to weaken governance requirements, the SEC (and now Congress) has had to step in to impose–or try to impose–higher standards.  Take, for example, the emphasis in SOX on internal controls.  Would it have been necessary had fiduciary standards required that boards adopt a meaningful system for ensuring that directors have adequate information about the activities of the company? 

At one time, the SEC sought to improve governance through the use of listing standards–but the Commission was stopped in what has to be one of the most Pyrrhic of victories in Business Roundtable v. SEC.  Unable to use listing standards, the Commission was largely left with disclosure, which did not work adequately.  The case can be made that had the SEC been able to make use of listing standards to regulate governance directly, many of the provisions in SOX would have been unnecessary and never adopted by Congress.

All of this brings us back to the proposal to amend the proxy rules.  The proxy rules themselves affect the corporate governance process.  While shareholders have the right under state law to make proposals at the company’s annual meeting, that authority is meaningless in the context of large public companies.  Rule 14a-4 allows management to obtain discretionary authority to vote proxies at the meeting.  Management can then use this authority to vote down any proposal that comes up at the meeting. 

As a result, shareholders wishing to make use of their state-law right to make proposals at the annual meeting must solicit proxies.  But again, the proxy rules interfere.  Unless soliciting fewer than 10 shareholders, Rule 14a-3 requires that a solicitation be accompanied or preceded by a proxy statement.  Shareholders, therefore, must go through the process of drafting a proxy statement and distributing it (sometimes made a bit easier by the use of electronic dissemination under recently adopted Rule 14a-16).  In other words, the regulatory construct makes soliciting proxies, and thus raising proposals at annual meetings, prohibitively expensive for most shareholders. 

It is, therefore, the proxy rules that effectively deny shareholders the right to exercise their state-law authority to make proposals.  The Commission has mitigated this effect through the adoption of Rule 14a-8.  Shareholders can include proposals in the company’s proxy statement, greatly reducing the cost of the solicitation.   Thus, 14a-8 is not an example of bureaucratic benevolence but a necessary companion to a regulatory scheme that otherwise would deny shareholders their state-law rights. 

Shareholders almost certainly have the right under state-law to raise proposals that affect the election of directors–and the draft rule under circulation would, therefore, permit these types of proposals.  The SEC apparently intends, however, to limit this right to the largest shareholders.  In other words, the draft rule would allow the class of shareholders most able to pay the costs of a proxy solicitation, given their substantial stakes in the company, to have a free ride–while denying those least likely to be able to afford those costs the same rights.  The proposal would effectively deny the vast majority of shareholders the ability to exercise their state-law right to make certain types of shareholder proposals.

Would the absence of an ownership threshold mean that these types of proposals would fill up proxy statements?  They would certainly become more common; but 14a-8 already permits the exclusion of a proposal “that substantially duplicates another,” so there wouldn’t be multiple proposals seeking to accomplish the same thing on a single proxy.  Would they pass?  The proposal inserted into the Hewlett-Packard proxy statement by AFSCME last year failed after a vigorous campaign.  

What impact would an ownership restriction have on these types of proposals?  I think the impact likely to be substantial, at least at the largest companies.  Finding a 5% shareholder in a large public company is no easy matter.  In the Fortune 500, for example, the two largest companies are Wal-Mart and Exxon-Mobil.  Wal-Mart has, according to its most recent 10-K, 4,124,451,341 shares of common stock; Exxon-Mobil has 5,693,398,774.  To make a proposal under the draft rule, shareholders would have to own more than 205 million shares of Wal-Mart–currently, a stake worth more than $9 billion–and more than 280 million shares of Exxon-Mobil, now worth more than $24 billion.  To present a proposal on the company’s proxy, then, shareholders in large public companies would need to organize and form ownership groups, which would itself generate costs, including regulatory filings (a Schedule 13D, perhaps). 

What ought the SEC to do?  The simple answer is nothing.  The Commission should continue to follow the Second Circuit’s interpretation of Rule 14a-8 and otherwise leave well enough alone.  To the extent there is a need for an ownership threshold like the proposed 5% restriction, state law is the appropriate place to impose it.  (North Dakota, for example, already has a 5% ownership threshold.) 

The Second Circuit has interpreted Rule 14a-8 to permit these types of shareholder proposals without imposing any ownership requirement.  State law allows shareholders to present these proposals.  If the SEC chooses to allow managers to exclude these proposals from the company’s ballot–or to limit the power to raise them to owners of 5% of the shares–the Commission would step further into the governance process, but in a manner that hinders rather than helps shareholder rights.