SEC Commissioner, Law Professor Wrongfully Accuse SRP of Securities Fraud

Jonathan R. Macey is the Sam Harris Professor of Corporate Law, Corporate Finance & Securities Law at Yale University. This post analyzes the arguments in a paper by SEC Commissioner Daniel M. Gallagher and Stanford law School Professor Joseph A. Grundfest, described in a post by Professor Joseph Grundfest (available on the Forum here) and a post by Wachtell Lipton (available on the Forum here).

Here is something that one does not see every day. In their recent paper “Did Harvard Violate Federal Securities Law? The Campaign Against Classified Boards of Directors” posted on December 10, 2014, a sitting Commissioner of the Securities and Exchange Commission and a former SEC Commissioner accuse the Shareholder Rights Project at Harvard Law School (SRP) of violating the anti-fraud provisions of the securities laws. The alleged fraud occurred when institutional investors represented by the SRP proposed shareholder resolutions encouraging shareholders in U.S. public companies to vote to de-stagger their companies’ boards.

In this submission I present my analysis of this paper, concluding that the SRP proposals were not fraudulent or misleading and that the aggressive application of the anti-fraud provisions of the securities laws advanced by the authors of the “Did Harvard Violate Federal Securities Law?” would be inconsistent with the law and, by the authors’ own admission, inconsistent with the current policy and practice of the staff of the Securities and Exchange Commission.

Institutional investors represented by the SRP have sought to induce a number of companies to end the practice of staggering their boards of directors. The SRP has participated in as many as 100 shareholder voting campaigns to de-stagger corporate boards of directors. Largely as a result of the efforts of the SRP the number of companies with staggered boards has dropped from well over 50 percent of public companies to around 10 percent for the largest U.S. firms.

Institutional investors represented by the SRP have availed themselves of the rights granted to corporate shareholders by SEC Rule 14a-8, which requires companies to include shareholder proposals in their annual proxy solicitations to shareholders under certain conditions and circumstances. Messrs. Gallagher and Grundfest complain that the proposal submitted by the SRP’s clients (SRP Proposal) is fraudulent because it contains a “material omission” in that it cites studies finding that staggered boards are harmful to shareholders but either “omits any mention” of a “larger body of research” or “cites only one study reaching a contrary conclusion” (the Gallagher/Grundfest paper, inconsistently, makes both of these assertions. Only the latter is accurate).

Significantly, in footnote 29 of their paper, Gallagher/Grundfest stipulate that, for purposes of their analysis, the contradictory literature “did not become material in the aggregate until” January 2014 (one month after the December 7, 2013 posting on SSRN of a paper by Cremers, Litov and Sepe). While Gallagher and Grundfest assert in their paper that “it is possible to argue that the contradictory research was material before then,” they do not do so. Thus no statement made before January 6, 2014 is fraudulent according to Gallagher and Grundfest. The authors apparently assumed for the purpose of their analysis that many of the SRP proposals were submitted after this critical date. However, according to the information available on the SRP website, all of SRP’s proposals were submitted before January 6, 2014.

Most of the proposals were submitted for (and thus substantially in advance of) the 2012 and 2013 proxy seasons, and a December 4, 2013 SRP “News Alert” (available on the SRP website) announces a list of 31 companies to which proposals for the 2014 proxy season “have been submitted.” A subsequent SRP news release (March 11, 2014), clarifies that this list of 31 companies is the full set of companies to which 2014 proposals were submitted. Thus, none of the SRP proposals was actionable even under the terms of Gallagher/Grundfest’s own aggressive interpretation of the applicable SEC rules, because the proposals had been submitted before the omission that Gallagher/Grundfest allege became material under the authors’ own assumption.

In the paragraphs below I identify several legal and conceptual problems with the Gallagher/Grundfest article. On the basis of the following it is my view that even if all of the information were available at the time the SRP’s proposals were made, the failure to include these studies did not constitute securities fraud:

A. To its credit, the Gallagher/Grundfest paper contains the actual text of the SRP proposal, prominently and in the text. The paper, however, then interprets the proposal in an uncharitable and, in my view, inaccurate way, saying that the SRP proposal “is categorical in its description of the literature as suggesting no exception to the proposition that declassification benefits shareholders.” This characterization suggests that the SRP proposal purported to claim that it was providing a description of the relevant literature and then did so incompletely. This is not true. The SRP proposal does not purport to contain a literature review. The text of the proposal first describes the significant support shareholders have provided to proposals to eliminate staggered boards, and then states that “[t]he significant shareholder support for declassification proposals is consistent with empirical studies reporting that: (listing studies).” A more sympathetic, and to me natural, reading of the SRP proposal is that it truthfully states that shareholders have supported eliminating staggered boards (Gallagher/Grundfest acknowledge this fact) and that such support is consistent with the studies listed. The SRP proposal does not suggest that contrary studies do not exist. Citing other studies in this particular context is not required to make the assertion in the SRP’s carefully worded proposal either accurate or not-misleading.

B. The article takes the position that shareholder proposals under Rule 14a-8 must be treated as “stand-alone disclosures.” But, as a purely descriptive matter, 14a-8 proposals are always part of a company’s own proxy solicitation. As such, anything that a 14a-8 proposal contains can be countered by the company that is distributing the proposal on the shareholder’s behalf. The SEC’s Division of Corporation Finance understands this, of course. SEC Staff Bulletin 14B specifically reflects the possibility that a shareholder proposal can be countered and states that “it would not be appropriate for companies” to exclude a shareholder proposal that “while not materially false or misleading, may be disputed or countered” (see SEC Staff Bulletin 14B here). A shareholder’s proposal under 14a-8 that cites studies can be countered by citing contrary studies, and this appears to me to be exactly the sort of thing the Division of Corporation Finance had in mind when it opined that a company should not be able to exclude from a company’s proxy statement a proposal that can be countered.

It makes little sense, in my view, to take the view that Gallagher/Grundfest appear to embrace, which is that companies should willingly include a shareholder’s proposal in their proxy solicitations and then turn around and successfully sue the proponents for a fraud that they were aware of when they themselves distributed the proposal. And as a matter of simple logic, the only way that a proxy proposal can be countered is if it does already not include arguments or data that are counter to its point.

Tellingly, the only complaint that Gallagher/Grundfest have with the SRP proposal is that it does not cite contrary studies. Their view is that this is a material omission that renders the proposal materially false. On this hypothesis, companies are routinely distributing shareholder proposals that they know to be false. I find this hypothesis implausible. It is far less plausible than the alternative hypothesis which is that even though companies can exclude fraudulent shareholder proposals from their proxies, these companies—and their lawyers—felt that they had no legal basis to exclude the SRP’s proposals.

C. As noted above, 14a-8 proposals such as those made by shareholders working with SRP are part and parcel of a proxy solicitation in which 14a-8 proposals appear alongside the contrary arguments and solicitations by management. It seems logical and just that one should look at the totality of the disclosure to determine whether there are disclosure deficiencies in a proxy solicitation. Supporting this point are the following facts:

  • Rule 14a-8 has a strict 500 word limit for proponents. As such it is unlikely in the extreme to think that a proponent possibly can include all the information necessary to make assertions made not misleading when such a standard is interpreted, as Gallagher/Grundfest interpret it, to mean that proponents must cite studies that opponents of the proposal might want to cite. The SRP proposal is 428 words. Adding references and a brief discussion, particularly one as complete as that envisioned by Gallagher/Grundfest, likely would have brought the proposal substantially beyond the 500-word limit.
  • The core purpose of Rule 14a-8 is to permit proponents of shareholder proposals to advocate a particular position. Accusations of fraud must be considered in that context particularly since companies who receive 14a-8 proposals may respond to them.
  • Companies responding to shareholder proposals can convey counter-arguments and cite the sort of data that Gallagher/Grundfest assert should have been adduced in the SRP’s proposal. Clearly, if a company distributing an SRP 14a-8 proposal believes that voters would benefit from additional information such as references to other studies, the company has the responsibility to provide this information to shareholders. This, it seems to me, is a fatal flaw in the brief being circulated by Gallagher/Grundfest.
  • By way of example, Netflix, which the authors use as an example in their brief, did exactly this (see Netflix proxy statement here). Citing the very studies that Gallagher/Grundfest claim the SRP proposals should have cited, Netflix informed its shareholders that the studies cited by the proponent “have been called into question by more recent and more comprehensive research.”
  • Tellingly, Netflix listed only recent studies that supported staggered boards but did not list any of the recent studies supporting board declassification that Gallagher/Grundfest discuss. Thus the treatment of Netflix suggests a double standard in which shareholders’ proposals must be completely self-contained, while the companies’ counter-proposals may invoke particular examples of recent research without including references to contrary research studies.

D. It seems obvious that the way that companies and the SEC ought—and are intended—to deal with shareholder proposals that they perceive to be flawed is not by waiting until after a proposal has been made, included in a proxy and then approved by shareholders and then suing the proponent. Rather, the appropriate way to respond to a flawed or fraudulent proposal is to exclude it from the ballot in the first place. In fact any company that knowingly permitted a flawed proposal to go forward would be facilitating a fraud. In this context it is telling that none of the approximately 130 S&P 500 and Fortune 500 companies availed themselves of their legal right to exclude the SRP proposal if it were false and misleading as Gallagher/Grundfest claim.

E. Commissioner Gallagher himself has noted that in 63% of the cases in which the SEC has permitted companies to exclude shareholder proposals, companies sought exclusion of proposals that they argued were either vague or contained one or more material misrepresentations or omissions. See Daniel M. Gallagher, Commissioner, U.S. Securities and Exchange Commission, Remarks at the 26th Annual Corporate Law Institute, Tulane University Law School: Federal Preemption of State Corporate Governance II.2.b n.xx (March 27, 2014). I am informed that most of the proposals considered by the SEC pertain to exclusions on the basis of vagueness and other criteria that are unrelated to the question of whether there was a material omission. If the staff is willing to entertain exclusions because they are vague, they would have likely be even more willing to entertain claims by companies that SRP proposals were false and misleading had any company chosen to make such a claim.

F. The purpose of SEC Rule 14a-8 is to improve corporate governance by facilitating shareholder democracy. It is unfortunate to have an SEC Commissioner take an aggressive view of the responsibilities of individual shareholders—but not companies. Adoption of the position being advocated by Gallagher and Grundfest would, in my view, have a major chilling effect on the ability of any shareholder to make a shareholder proposal without fear that such shareholder and its advisers will become the target of an SEC enforcement action and a defendant in private lawsuits of the kind that Gallagher and Grundfest claim could be taken against SRP. The pretexts that managers could raise for excluding shareholder proposals involving issues of complex science such as climate change, or involving entrenchment devices such as shareholder rights plans (poison pills), appear limitless.

G. The authors of the paper fail to point to a single case or enforcement action taken against a shareholder proponent for fraud. I am aware of no such cases. The authors do not explain, and I am at a loss to imagine why the first such enforcement action ever to be taken would be lodged against proposals whose only alleged fault was not to include an additional reference to contrary studies.

H. The accusations and conclusions in “Did Harvard Violate Federal Securities Law? The Campaign Against Classified Boards of Directors” are perplexing in light of the fact that Mr. Gallagher is a sitting SEC Commissioner. Apparently, when an SEC Commissioner believes that a fraud is occurring he has no legal obligation to request that the staff pursue an enforcement action before making public accusations against the alleged perpetrator of the fraud. There is no way of knowing whether Commissioner Gallagher request the staff of the Enforcement Division to investigate the SRP’s proposals, because such a request would be confidential under the SEC’s rules. That said, Gallagher and Grundfest real quarrel is not limited to the SRP proposals: it reflects a general indictment of the way that the SEC staff currently handle 14a-8 proposals. Not enough succor is provided by the SEC to companies who wish to exclude shareholders’ proposals according to Gallagher and Grundfest. Accusing an academic institution and a professor of committing fraud appears to me to be a strange way to criticize the SEC staff or to press for a change in enforcement practices, particularly when the accusation is being made by a sitting government official.

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  1. David Bernstein
    Posted Monday, December 15, 2014 at 5:35 pm | Permalink

    As a practicing lawyer who drafts proxy statements and other SEC disclosure documents and does M&A transactions, and a graduate of Harvard Law School, I think the argument about whether Harvard could be liable for misleading proxy statement disclosures is an unfortunate digression from the real issue.

    There is no reason Lucian Bebchuck can’t present an advocate’s view of the effects of staggered Boards or use student’s to help with that effort. What is unfortunate is that Professor Bebchuck has used Harvard’s name to try to give added credibilty to the position he is taking.

    With regard to the effort to equate staggered Boards with share value, has anybody ever heard of a potential investor who, after hearing the finacial merits of investing in a company, said to his or her broker, or the investment analyst, “That sounds good, but does teh company have a staggered Board.” And of all the things that affects Board decision making, I have to believe the existence or non-existence of a staggered board is at the bottom of the list, if it is on the list at all.

    You can debate the benefits of staggered Boards in takeover contexts, but to suggest the existence of staggared Boards has other material (or even noticeable) effects on share value is, I believe, a meaningless academic effort to quantify effects that don’t exist.

  2. Robert Barker
    Posted Monday, December 15, 2014 at 11:16 pm | Permalink

    It seems that the complaint here is that there was too much transparency and intellectual debate when the popular, politically correct way of thinking was not only challenged by empirical evidence, but when serious people like Commissioner Gallagher and Professor Grundfest challenged that politically correct norm. It seems like Gallagher and Grundfest have pointed out that the authors of the SSRN study wrote too quickly — they published their report before waiting for the mounting evidence that contradicted what they wanted to say.

    Corporations can — and do — favor directors who are elected for more than one year at a time. In fact, some of the best directors are those who have spent many years on a board. Certainly it is difficult to be an effective director of a public company at the first board meeting, or maybe even in the first year. Staggered boards are very effective at companies with long term strategies. They may not be effective at other companies.

    It is hard to imagine how any research could demonstrate that a “one size fits all” model works for every corporation. I would rather have the debate against the Gnostics who argue for an academic standard for “good corporate governance” from real world officials before more serious damage is done to the economic interests of US shareholders.

  3. Cliff
    Posted Thursday, December 18, 2014 at 2:44 pm | Permalink

    Bernstein, Harvard is the investor. Why would they not use their own name?

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