Implications of Beneficial Ownership Distinctions for Shareowner Communications and Voting

Alan L. Beller and Janet L. Fisher are partners in the New York office of Cleary Gottlieb Steen & Hamilton LLP. This post is based on a white paper prepared by Mr. Beller and Ms. Fisher for the Council of Institutional Investors. The white paper is available here.

A shareowner’s right to vote on matters as allowed under state or federal law, stock exchange rules or otherwise is a key right. Shareowner voting has also become an increasingly important element in the consideration of public company corporate governance. Recent developments have spotlighted the nature and quality of the communication process and its impact on shareowner voting and governance. These developments include adoption by a number of public companies, especially larger companies, of majority voting in uncontested director elections, the amendment of New York Stock Exchange (NYSE) Rule 452 to prohibit broker discretionary voting in uncontested director elections and the increased influence of activist shareowners and proxy advisory firms. The confluence of these developments has heightened the likelihood of more meaningful, and contested, shareowner votes and elevated the importance of shareowner communications in the context of voting and governance.

Issues of shareowner voting and communications depend on both state and federal law. State law focuses on record ownership (i.e., the holder shown on a company’s books, whether or not the ultimate shareowner) because of administrative ease and certainty. Federal law, on the other hand, emphasizes regulation of communications by public companies for shareowner meetings and other matters, as federal regulators are more concerned with the interests of beneficial owners (i.e., the ultimate owners) in voting and receiving related disclosure. The record owner may also be the beneficial owner of the shares, but for shares held with financial institutions, the link between record and beneficial owners is not simple. A complex chain of intermediaries often separates the record owner from the beneficial owner. Companies typically do not know the identities of all beneficial owners of their shares, nor do beneficial owners know the identities of other beneficial owners generally. The information resides largely with the intermediaries. This information disconnect limits the ability of companies to communicate with their beneficial owners and of beneficial owners to communicate directly with each other.

While state law governs the rights of record owners, the SEC has focused on rules related to communications between companies and their owners, and among owners themselves. To address the gap between record and beneficial ownership, the SEC has created a framework in which companies primarily communicate with beneficial owners through broker or bank intermediaries. The framework requires brokers and banks to disclose to a company the identity of only those beneficial owners who do not object to such disclosure. Those who object are known as “objecting beneficial owners” (OBOs) under the SEC’s rules. The company cannot contact OBOs directly. The company may, however, have direct contact with shareowners who have designated themselves “non-objecting beneficial owners” (NOBOs), owners who do not object to having their identity known to the issuing company. However, while companies may communicate directly with NOBOs, SEC rules require that proxies and proxy materials nonetheless be forwarded by broker and bank intermediaries, not by companies.

The OBO/NOBO distinction impedes company communications with beneficial owners and communications among shareowners. Some market participants have proposed changes to this framework. The interests of the key players vary:

  • Companies tend to favor the elimination of the OBO/NOBO distinction. They argue that, if shareowners can participate more directly in board elections through proxy access or other means, companies should be able to contact them directly. They also argue that a direct communication framework would increase shareowner participation and reduce costs.
  • Shareowners are often said to have a privacy interest that is served by the current framework, but a 2006 survey casts doubt on this assertion. It is also unclear which information shareowners wish to keep private and from whom. Some may wish to keep their holdings or trading strategies confidential, while others seek to avoid unwanted solicitations. Shareowners seek to have unimpeded ability to communicate among the shareowner community. Shareowners also seek a level playing field with companies — to have equal access to lists of shareowners and to have their solicitation costs reimbursed as are those of management.
  • Brokers and banks have several interests — maintaining the confidentiality of customer lists, preserving fee income derived from forwarding proxy materials, and preserving stock loan revenues, which could be at risk in a direct communications framework that allows greater transparency to customers about stock loan practices.
  • Broadridge Financial Solutions is essentially the sole agent for intermediaries and companies and has an interest in preserving the fee income and cost reimbursements it receives under the current framework.

The SEC is likely to be cautious in seeking to change the current framework in significant ways, at least in the near term. Defining the objective is critical to developing a proposal. If the goal is to increase the ability of shareowners and companies to communicate directly, a number of incremental steps may be taken to address the OBO/NOBO distinction and facilitate direct distribution of proxy materials, without discarding the current distribution platform. Such an approach could lead to meaningful improvements, without seriously affecting the interests of many of the participants in the current framework, and we believe it has a greater chance of widespread support than more radical alternatives.

The compelling and competing interests we describe above are likely to make the SEC cautious in seeking to change the communications framework in significant ways, at least in the near term. These interests will also likely present issues that would probably constrain, or at least delay, the SEC’s ability to achieve significant change if it decides to try. Further, the caution that we would expect from the SEC will be particularly marked on the subject of proposed changes that could face strong opposition from the perspective of cost or reliability. That said, some change is all but inevitable given the emerging consensus that the limitations of the current framework are increasingly unworkable in an era of rising investor activism and more meaningful shareowner voting.

Defining the objective is critical to developing a proposal. If the goal is to increase the ability of shareowners and companies to communicate directly, a number of incremental steps may be taken individually or together, without discarding the current platform. Such an approach could enhance communications without seriously affecting the interests of many of the participants in the current framework. A more ambitious goal to ensure not only improved communications, but also more reliable voting seems difficult to achieve without a more radical solution that is (or approaches) a pure direct communications framework with cascading executed proxies. Implementing such an approach would, however, almost certainly be more contentious, since it would implicate complex strategic, cost, logistical and other considerations of critical importance to key players. In addition, while the SEC is likely to pursue investor education initiatives in light of the continuing large retail shareowner base, the elimination of uninstructed broker voting and falling retail investor participation, the SEC might well conclude that such efforts would have to be more substantial, and changes take longer, if it pursued a more radical change in proxy mechanics. Moreover, the SEC could conclude that facilitating direct communication is more in line with its disclosure mandate than improving the reliability of voting and facilitating end-to-end audit trails for shareowner votes. On balance, we believe that an incremental approach that promotes greater transparency around shareowner lists and more opportunity for direct communications by shareowners and companies alike has a greater chance of widespread support than more radical alternatives.

A first step could be to address the OBO/NOBO distinction, preferably by eliminating it. This discrete change would likely increase the number of shareowners with whom other shareowners and companies could communicate directly in some ways, while preserving the logistical apparatus now used to compile shareowner lists and distribute communications. This step could itself, if desired, have a phased implementation starting with a mandate to make NOBO the default status for customer accounts, with full disclosure about the consequences of selecting OBO status. Election of OBO status could be coupled with a charge to defray the costs of maintaining a platform to support OBO status. Eventually, the OBO/NOBO distinction could be eliminated, with customers able to preserve their anonymity through nominee accounts at their own expense. We do not believe that proposals that eliminate the possibility of anonymity altogether are workable, at least in the near term, since they do not accommodate the strong privacy interest of many retail and institutional investors.

A second step could be to relax restrictions on the ability of companies and shareowners to distribute proxy materials and solicit proxies directly and to streamline the process for both companies and shareowners to obtain shareowner lists. We would not recommend that this step be achieved through eliminating the intermediary-agent platform altogether, since to do so could raise concerns about the reliability of communications121 and would likely face significant opposition from some players whose business model depends at least in part on aspects of the current framework. Instead, this step could be achieved in a less intrusive way through regulatory changes that would permit direct distribution and solicitation, but maintain the intermediary-agency platform as an alternative. Even in a world where direct communications are fully permissible, we believe that companies will continue to use agents for purposes of compiling shareowner lists and particularly document distribution given the advantages of large scale fulfillment in terms of cost and reliability. Similarly, we believe shareowners will continue to use the agent platform for document distribution in at least some circumstances, even as the ability to communicate directly will provide advantages in other circumstances. Preserving the role of intermediaries in this approach would continue to accommodate customer and intermediary preferences for anonymity. Likewise, preserving a “neutral” agent as the centralized repository of shareowner lists may also provide comfort to shareowners who, we understand, find the current system for requesting shareowner lists from Broadridge (or another agent) to be relatively easy and inexpensive.

A full direct communications framework in which companies control the shareowner lists, but all parties have easy access to the list and may communicate directly with each other, could also ultimately be workable. 122 The desirability of this approach would depend on whether it would protect shareowners from the risk that companies prevent or limit access to the shareowner list. If shareowners in fact have ready access to shareowner lists under existing state law, the utility of this additional step is uncertain. Even in the case of a direct communications framework, we would recommend that the framework continue to permit reliance on fulfillment services provided by Broadridge and other agents. We would note that, although not central to our analysis, taking steps to permit and facilitate direct communications by shareowners and companies alike could lead to a more competitive environment around intermediaries’ and agents’ services, including increasing pressures for competitively negotiated (and possibly lower) fees.

Other reforms would be needed to achieve reliable end-to-end audit trails, such as the cascading series of executed proxies from DTC to the beneficial owner resulting in the beneficial owner having exclusive authority to vote. The proxies returned would bear the names of the beneficial owners, allowing the tabulator to compare the votes with the list of all beneficial owners on file with the company. Without this reform, Broadridge would still verify and tabulate the majority of votes, as most beneficial owners would still return their voting instructions to Broadridge. Companies would have to rely on Broadridge to ensure that only those shareowners entitled to vote do so, as is the case under the current system. Without access to Broadridge’s procedures and results in aggregating votes, companies cannot effectively audit Broadridge’s verification process, and could not do so even if they knew who all of their beneficial owners were.

Whether the practical benefits of coupling a direct communications framework with cascading executed proxies would outweigh the costs is uncertain. The benefits are likely to be limited to a minority of contested elections in which an end-to-end audit of the vote is critical to a reliable outcome. It may be worthwhile to have more data, particularly about director elections in the wake of the elimination of uninstructed broker voting in uncontested director elections and other recent developments and the practice that emerges if the SEC adopts a proxy access regime, before moving to this more comprehensive type of solution. We also believe that this approach requires more detailed analysis by the various affected constituencies to obtain a clearer picture of the logistical changes, costs and potential disruptions it could entail.

Given the time required for that exercise, we believe that the immediate interest of shareowners and companies in better communications would be better and more effectively served with the incremental approach that promotes less reliance on — or eliminates altogether — the OBO/NOBO distinction and otherwise increases the potential for direct communications.

The SEC has indicated that it will address the OBO/NOBO issue and ask whether the distinction is needed in a concept release to be drafted in the coming months. Each of the potential reform proposals raises issues for particular groups of stakeholders. The interplay of these stakeholder interests will influence the direction of any reforms. Moreover, in considering any reform proposal with respect to shareowner communications, it is important to keep in mind the emphasis the SEC has placed historically on reliability of proxy delivery. Even where the SEC agrees with the conceptual underpinnings of a particular proposal, the details of implementation will receive significant scrutiny involving both practical and political issues.

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