Shareholder Proxy Access for Director Elections

Shareholder proxy access for the election of directors is about to arrive. Directors of public companies, shareholder activists and shareholders generally soon will be dealing with an important new set of issues and dynamics associated with the election of directors and the management of the board process. This memorandum is intended to provide a briefing on key aspects of this important subject.

What is The Issue?
In a nutshell, the issue is whether and, if so, under what conditions, a shareholder of a public company should have the right to include — in the company’s proxy statement and on the company’s proxy card — nominees proposed by the shareholder in opposition to the company’s candidates for election to the board of directors.

A sharp distinction has always existed in director election contests between how company and dissident candidates are presented for shareholder consideration. Company candidates are presented in the company’s proxy material — proxy statement and card — and dissident candidates are presented in separate proxy material prepared, paid for and presented to shareholders by the dissidents. Classic election contests are typified by each side preparing various forms of dueling soliciting materials — such as formal proxy statements, print and electronic media advertisements, letters to shareholders, investor presentations — which are delivered to shareholders through an active solicitation campaign by each side. Although proxy reforms in recent years have been designed to streamline the proxy solicitation process, an election contest can still involve real cost and effort.

The rise of corporate governance concerns in recent years has increasingly focused on board performance and the rights of shareholders to change directors in response to perceived deficiencies in performance. One mechanism that has been proposed to facilitate shareholder action seeking to change directors is to give shareholders direct access to the company’s proxy statement, permitting the inclusion of shareholder-proposed candidates and a supporting statement. Among the arguments advanced for this mechanism is that including shareholder-sponsored director candidates directly in the company’s proxy statement (and on its proxy card) will make it significantly easier and less costly to present to shareholders meaningful choices regarding board composition with a view toward improving performance.

Where Does The Issue Stand?
The proxy access issue has been debated for some time. In 2003 and again in 2007, shareholder proxy access proposals were considered by the Securities and Exchange Commission (SEC). However, no rule was adopted, or position taken, by the SEC either directly granting a proxy access right under the federal proxy rules or permitting shareholders to include in a company’s proxy statement, under Rule 14a-8, a shareholder proposal to amend the company’s bylaws which, if adopted by shareholders, would provide for shareholder proxy access in the election of directors (proxy access bylaw). In fact, in 2007 the SEC codified an exclusion from Rule 14a-8 that made it clear that a proxy access bylaw could be excluded by a company from its proxy statement.

The issue has not disappeared, however. Events of the last year, which have raised concerns about board oversight associated with, among other things, risk assumption leading to the financial system meltdown and executive compensation practices, have reinvigorated the corporate governance focus on board performance, including proxy access reform.

This renewed focus has led to legislation in Delaware and confirmation by the new SEC Chairman, Mary Schapiro, that a rulemaking proposal on shareholder access to management’s proxy materials for director elections will be on the SEC’s agenda in May 2009.

The Delaware Response
On Friday, April 10, 2009 the governor of Delaware signed into law enabling legislation, effective August 1, 2009, which expressly permits, but does not require, Delaware companies to adopt bylaws governing access to the company’s proxy material for board nominees proposed by shareholders and reimbursement of proxy solicitation expenses incurred by a nominating shareholder. Either the board of directors or shareholders may adopt these bylaws. The provisions were specifically designed to offer flexibility to companies, their boards and shareholders.

New Section 112 of the Delaware General Corporation Law (DGCL) allows a company’s bylaws to provide that if the company solicits proxies for the election of directors, the company would be required, subject to such procedures and conditions as are provided in the bylaws, to include in its proxy materials one or more nominees submitted by shareholders in addition to those individuals nominated by the board of directors. Although the bylaws may prescribe any lawful condition to the exercise of a right of access to the company’s proxy materials, Section 112 also includes a nonexclusive list of prerequisites that the bylaws may impose before allowing access. Among other things, the bylaws may condition access on such factors as a minimum level of stock ownership by the nominating shareholder, the number or percentage of board seats to be contested and whether nominations are related to an acquisition of a significant percentage of the company’s stock.

New Section 113 of the DGCL allows a company’s bylaws to require it to reimburse expenses incurred by a shareholder soliciting proxies in connection with the election of directors, subject to conditions that may be set forth in the bylaws. Section 113 also identifies a nonexclusive list of conditions that may be imposed on any such right to reimbursement. Among other things, the bylaws may limit reimbursement based on the number or proportion of persons nominated by, or the proportion of votes cast in favor of one or more of the persons nominated by, the shareholder seeking reimbursement. A reimbursement bylaw could apply to election solicitations by shareholders in connection with or apart from nominees submitted pursuant to a proxy access bylaw.

The flexibility offered by Sections 112 and 113 should provide boards of directors and shareholders with an opportunity to craft proxy access and expense reimbursement bylaws that are balanced, designed for the specific circumstances of each company, and do not permit unreasonable intrusions on the company’s proxy materials or corporate funds.

The SEC’s Current Focus
SEC Chairman Schapiro has stated that the SEC’s 2009 shareholder proxy access proposal will “ensure that a company’s owners have a meaningful opportunity to nominate directors.” This clearly reflects the basic mindset of the Obama administration — that something has gone seriously wrong with the system and active efforts to fix it are in order. Still, there can be no assurance as to when, or if, the SEC will act. A case can be made that no action need be taken now in light of the Delaware legislation. However, the basic fix-it mindset, coupled with the fact that the Delaware response has not (yet) been adopted elsewhere, points to the likelihood of quick SEC action.

As in the past, one choice for the SEC would be to adopt a rule directly providing proxy access to shareholders. This would tread on territory traditionally left to state corporate law. It also would require the SEC to determine what conditions to access should apply, rather than permitting a company’s shareholders or board to decide this as provided by the Delaware legislation.

An alternative would be for the SEC to amend Rule 14a-8(i)(8) to specifically authorize shareholders to include in management’s proxy materials shareholder proposals related to access bylaws. The SEC staff has issued a number of no-action letters adhering to an interpretation of that rule which allows companies to exclude shareholder proposals from management’s proxy materials that may result in a contested election. Without an amendment, continued application of that interpretation will foreclose shareholders from using Rule 14a-8 to promote bylaw amendments such as contemplated by the Delaware legislation.

Of course, nothing would foreclose a shareholder from proposing a proxy access bylaw outside of Rule 14a-8 through means of a traditional proxy solicitation using its own proxy materials. The SEC might be concerned, though, that defaulting to this approach would impose the cost of the proxy solicitation on the shareholder. However, that concern may be unfounded. The shareholder proposing the proxy access proposal also could propose, under the general right to amend bylaws noted below, an expense reimbursement bylaw which could provide that, if adopted, it would apply to the expense of pursuing the concurrent proxy access proposal.

Other Related Issues and Considerations

Non-Delaware Companies
At this juncture, Delaware is the only state which has adopted legislation expressly dealing with shareholder proxy access bylaws. What about those companies incorporated elsewhere? Obviously this is a state by state inquiry. However, in most if not all states, whether or not enabling legislation such as Delaware’s is enacted, directors and shareholders have the general right to amend their companies’ bylaws, which is likely to include adopting procedural-related bylaws providing for proxy access in connection with the election of directors (and providing for election solicitation expense reimbursement). The fact that Delaware chose to enact legislation expressly enabling these bylaws should not be taken to mean that shareholders of Delaware companies do not otherwise have the right to adopt them.

Whether And When The Board Should Act
Boards need to consider whether and, if so, when they should act to adopt a shareholder proxy access bylaw (and an election solicitation expense reimbursement bylaw). For now, at least, these should be considered company-specific assessments. Focusing on shareholder proxy access bylaws, factors to be considered include:

• Assessment of impact of shareholder proxy access bylaw. Boards will need to assess what they expect the impact will be of a shareholder proxy access bylaw. Will it turn some, perhaps many, annual meetings into election contests? Will it facilitate the election of “special interest” directors to the board and, as a result, impair the board’s ability to function effectively? Will it facilitate creating a better relationship between the board and shareholders? Will it facilitate or hamper getting directors with needed skill-sets on the board? Depending on its overall assessment, a board may determine to embrace or oppose adoption of a shareholder proxy access bylaw.

• Assessment of company’s ability to defeat proposal. In determining whether to oppose adoption of a shareholder proxy access bylaw, a board should assess whether it has the ability to defeat any proposal for such a bylaw. If defeat is uncertain or unlikely, alternatives to outright opposition should be considered.

• Advance adoption to mitigate proposal receipt. Having a reasonable proxy access bylaw in place may mitigate shareholder interest in submitting such a proposal — although as a Delaware law matter, subject to enforceable limitations in a company’s charter or bylaws, shareholders would be entitled to amend a board-adopted bylaw.

• Advance adoption to mitigate shareholder support of proposal. Having a reasonable proxy access bylaw in place at the time a shareholder proxy access proposal is received could play an important role in encouraging other shareholders not to support the proposal. (There is some evidence from the consideration of earlier majority voting proposals which supports the view that being proactive may have a positive effect.)

• Advance adoption to support exclusion of proposal. Having a reasonable proxy access bylaw in place at the time a shareholder proxy access proposal is received may provide a basis for seeking SEC staff no-action concurrence that the proposal may be excluded from the company’s proxy statement under rule 14a-8(i)(10) (even if permitted under an amended Rule 14a-8(i)(8)) because the company has already substantially implemented the proposal.

• Assessment of reality/timing of possible receipt of proposal. Many companies may not be under a near term threat of receiving a shareholder proxy access proposal. As to most companies with annual meetings already scheduled to be held during the Spring proxy season, the dates have passed for submission of shareholder proposals under Rule 14a-8 to be included in the company’s proxy statement and for advance notice of a shareholder proposal submitted outside of Rule 14a-8. Even for companies for which those dates have not passed, such as companies with annual meetings later in the year, whether a shareholder proxy access proposal should be expected in connection with the annual meeting may well depend on, among other things, whether the SEC has adopted a shareholder access rule and, if so, exactly what it says.

• Impact of current activist issues. Some companies with current activist shareholder issues may be subject to particular circumstances (e.g., the ability of shareholders to act by written consent or to call a special meeting), which could present an accelerated risk of receipt of a shareholder proxy access bylaw proposal.

• Value of a “wait and see” approach. Companies may benefit from taking a “wait and see” approach. This may permit looking, in advance, at what other similarly situated companies have done, what particular shareholder sponsors of proxy access proposals have suggested in the first instance and what they have accepted after negotiating with target companies, and what significant shareholders of the company were prepared to accept/support in other situations.

Bylaw Design Features
In designing the terms of a shareholder proxy access bylaw (or an election solicitation expense reimbursement bylaw) it undoubtedly will be the case that “the devil is in the details.” And the “details” will inevitably involve specific circumstances affecting individual companies  such as: What is the company’s shareholder profile (type, size of holdings, turnover pattern)? Are activist shareholders involved with the company and, if so, which ones, how much stock do they own (if detectable), who are their “friends” in the company’s stock, what positions are they espousing, etc.? What is the company’s market capitalization? What has the company’s relationship been with its shareholders and the investment community? How is the board’s performance rated? How has the company been performing, and over what period of time?

Clearly there is no “one size fits all” design for a shareholder proxy access (or an election expense solicitation reimbursement) bylaw. However, it might be useful to see how some design features could be incorporated. So, by way of example, the board of a Delaware company might consider a proxy access bylaw (pursuant to Section 112) or an expense reimbursement bylaw (pursuant to Section 113) that requires, among other things, a shareholder seeking access to management’s proxy or seeking election expense reimbursement to be a holder of record, and to own a certain percentage of stock representing a significant ownership position (perhaps somewhere between three to five percent). Another possibility would be for the bylaw to require, among other things, such a shareholder to have held its shares for a period of time (possibly for two continuous years) prior to seeking access to managements’ proxy statement or expense reimbursement, and also to contain provisions that would prohibit access to managements’ proxy materials or expense reimbursement for anyone making a takeover proposal or creeping acquisition. Such provisions would promote the interests of shareholders that have long term, vested interests in the company, and not just traders or others seeking short term opportunities.

Be Well Advised
The are many issues surrounding the approach to shareholder proxy access and many constituencies and sensitivities to be taken into account. As a highly visible — and highly charged — corporate governance subject in today’s environment, boards should pay close attention to how it is handled by their companies and should seek input from experienced advisors to avoid potentially costly missteps.