Professor Grundfest’s Reply Demonstrates that He and Commissioner Gallagher Wrongfully Accused the SRP

Jonathan R. Macey is the Sam Harris Professor of Corporate Law, Corporate Finance & Securities Law at Yale University. This post provides a detailed response to a post by Professor Joseph A. Grundfest, titled A Response to Professor Macey, and available on the Forum here. Professor Grundfest’s post responded to an earlier post by Professor Macey, titled SEC Commissioner, Law Professor Wrongfully Accuse SRP of Securities Fraud and available on the Forum here, which offered a critique of a paper by SEC Commissioner Daniel M. Gallagher and Stanford law School Professor Joseph A. Grundfest, described in a post by Professor Grundfest (available on the Forum here).

In a recent post, “SEC Commissioner, Law Professor Wrongfully Accuse SRP of Securities Fraud” (available on the Forum here), I analyzed the claims that SEC Commissioner Gallagher and Professor Joseph Grundfest made in a recent paper (hereinafter “the Paper,” described on the Forum here). In their paper, Gallagher /Grundfest allege that the SRP proposals submitted by investors working with the Shareholder Rights Project (SRP) violated the securities laws by citing only one study opposing annual elections. My analysis showed that Grundfest/Gallagher’s allegations were inconsistent with the law and with the current policy and practice of SEC staff, and I concluded that the authors had wrongfully accused the SRP.

In a subsequent post titled “A Response to Professor Macey” (hereinafter “the Reply,” available on the Forum here), Professor Grundfest attempts to offer a “point by point” detailed response to my analysis. As I explain below, the Reply reverses field and drastically modifies and weakens the authors’ allegations. Furthermore, in conceding some key points that I made and in failing to address some others, the Reply itself demonstrates that Gallagher/Grundfest wrongfully accused the SRP and should withdraw their allegations.

There are many flaws in the Reply. I will discuss certain of them to show that the Gallagher/Grundfest’s accusations are spurious and no longer tenable:

(1) In a major retreat, Gallagher/Grundfest dramatically modify their allegations by:

(a) Dropping their allegations against the overwhelming majority of SRP proposals, reducing the number of challenged proposals from 129 to seven,
(b) Completely relinquishing the claim that companies can use the alleged deficiencies to invalidate declassifications that took place in approximately 100 companies, and
(c) Conceding that even the seven challenged proposals were not deficient when submitted and could at most be allegedly faulted for not being withdrawn prior to the vote;
(2) The Reply admits that Gallagher/Grundfest’s real quarrel is with the SEC, not with the SRP proposals, and that the SRP proposals would have not been viewed by SEC staff as “false and misleading” under the SEC’s current, long-held policy;
(3) The Reply concedes that the type of enforcement action or private suit the authors urge against the SRP is without a single past precedent;
(4) The Reply conspicuously fails to explain why not a single company raised a claim of material omission against SRP proposals;
(5) The Reply inconsistently endorses the non-inclusion of references to contrary studies by issuers such as Netflix while simultaneously claiming that it is impermissible for shareholders to do so; and
(6) The Reply wrongly states that I share the Paper’s “undisputed” view of the current state of the empirical evidence.

1. In a major retreat, the authors dramatically modify their allegations

In the Paper, Gallagher/Grundfest allege that proposals violating the securities laws went to a vote in numerous instances, referring to 129 proposals or “over 120 proposals” in various places in their article starting with the first sentence of the abstract of the Paper (see also p. 5 and p. 21). The Paper states that, for the purpose of making these allegations, Gallagher/Grundfest assumed that the allegedly omitted information (the additional references) became material “as of January 2014” (p. 6). The Paper’s allegations were based on the premise that the SRP proposals were largely submitted before this critical time.

As I pointed out in the analysis of my earlier post, this critical premise is incorrect. The public information available on the SRP website, which Gallagher/Grundfest cite numerous times in their brief, indicates that all of the SRP proposals were submitted prior to this critical time. Thus, I explained, even under the authors’ own assumptions, none of the SRP proposals could be actionable.

Given the fact that their critical factual assumption was clearly not valid, the authors now change course and retreat from their allegation in the Paper that the SRP proposals generally violated the securities laws. They now return with an amended and dramatically weaker allegation, claiming violations only with respect to the seven proposals that went to a vote in 2014. Furthermore, according to the authors’ weakened allegations, the proponents and the SRP are no longer faulted for omitting material references when the seven proposals were submitted (in the fall of 2013) but for allowing the proposals to go to a vote without such references.

This is a massive change in position, with three major implications:

(a) Dropping the authors’ allegations against the overwhelming majority of SRP proposals, reducing the number of challenged proposals from 129 to seve

The Reply now lists the seven proposals that are the only ones for which the authors continue to allege violations, and it states that “[a]n example based on seven instances of proxy rule violations is sufficient to make the point” and that there is “no need to push the count to the vicinity of 100 violations.” However, while the authors now see no need to push for a large number of violations, the Paper tried to do exactly that, stressing and broadcasting to a national audience the (now-disowned) large scale of the alleged violations. The Reply also does not explain how the authors failed to notice that the public information available on the SRP website, which the authors cited numerous times, undermined the Paper’s now-disowned allegations of large-scale violations.

(b) Completely relinquishing the claim that companies can use the alleged deficiencies to invalidate declassifications that took place in approximately 100 companies

While the Reply makes no mention of this fact, the modification of their allegations implies that the authors have fully given up a claim to which the Paper attaches significant importance and devotes much attention. The Paper stresses in its abstract and discusses at length (pp. 54-62) that the alleged violations in submitted SRP proposals would enable companies to petition courts to invalidate the declassifications that subsequently took place at approximately 100 S&P 500 and Fortune 500 companies. However, the seven proposals that the authors now question went to a vote in 2014 as precatory proposals (all of which passed), and none of them has yet resulted in an actual declassification. As a result, Gallagher/Grundfest’s detailed analysis urging companies to use the authors’ allegations to invalidate declassifications that have already taken place has now become completely irrelevant, as it does not apply to even a single company.

(c) Conceding that even the seven challenged proposals were not deficient when submitted and could at most be allegedly faulted for not being withdrawn prior to the vote

Finally, even with respect to the seven proposals that the authors continue to challenge, the Reply changes course. The authors’ revised claim is that, while no SRP proposals were false or misleading when submitted, seven SRP proposals became deficient after a new unpublished manuscript became available on the internet. The Reply unrealistically claims that the proponent, which under SEC rules is not entitled to amend a submitted proposal, had an option to “negotiate with the company to correct the proposal.“ According to the Reply, the proponent would be required to withdraw the proposal, and forgo a vote on the subject, if the company refuses to allow amending the proposal (as the company could be expected to do). Inexplicably, the Reply takes the view that the proponents working with the SRP were at fault for not forgoing the vote on declassification even in cases such as Netflix where the company’s opposing statement included references to the authors’ favorite studies. This novel (and in my view far-fetched) allegation of failure to withdraw submitted proposals prior to a vote because of the appearance of manuscripts on the internet is completely new to the Reply and is not discussed in the Paper.

2. The Reply admits that Gallagher/Grundfest’s real quarrel is with the SEC, not with the SRP proposals, and that the SRP proposals would have not been viewed by SEC staff as “false and misleading” under the SEC’s current, long-held policy

In my earlier post, I explained that under the long-standing policy of the SEC staff, reflected in Staff Legal Bulletin 14B, proposals that do not cite contrary studies (or allegedly cites too few of them) are not excludable as “false and misleading.” The Paper argues that this approach is an “abdication of responsibility” by the SEC (p. 9) and urges the agency to adopt a new approach. I suggested that “accusing an academic institution and a professor of committing fraud” for proposals that are consistent with current SEC staff policy and practice is “a strange way to criticize” the policy and practice of SEC staff and to urge a new approach.

To their credit, the authors now explicitly concede that their real quarrel is with the SEC’s current approach. However, they still fail to admit the wrongfulness of attacking SRP proposals (and only those proposals) as an instrument for advancing their real quarrel with the SEC. The Reply tellingly and candidly admits:

“Professor Macey is also entirely correct that the paper’s ‘real quarrel is not limited to the SRP proposals: it reflects a general indictment of the way that the SEC staff currently handles 14a-8 proposals.’”

The Reply even seeks to enlist my support for Commissioner Gallagher’s crusade to change the views of his fellow commissioners. The Reply asks whether I am “willing to join in an effort to put a bit more backbone in the staff review process,” and it invites and welcomes my participation in this effort.

Although I appreciate the authors’ invitation to join their campaign to change the current SEC approach, I respectfully decline because, as I explained in my earlier post, the approach advocated by the authors would have a large chilling effect on shareholder proposals. Regardless of the merits of the authors’ proposed changes, Commissioner Gallagher should not pursue this campaign by attacking SRP proposals that were fully consistent with the current policy and practice of SEC staff.

3. The Reply concedes that the type of enforcement action or private suit the authors urge against the SRP is without a single precedent

In my earlier post, I explained that I am unaware of, and the Paper does not identify, any instance of enforcement actions or private suits against a proponent (or those assisting it) of the kind that the Paper urges against the SRP proposals. The Reply concedes that there is no past precedent for such an enforcement action or private suit, stating:

“Professor Macey observes that the paper fails to point to a single instance of a ‘case or enforcement action taken against a shareholder proponent for fraud.’ I agree, and also know of no such case.”

The Reply goes on to claim that “there are many possible explanations for the absence of such precedent that are entirely unrelated to the accuracy of the paper’s analysis.” The Reply, however, fails to explain what those unspecified explanations, or why it claims that the absence of precedent is not relevant for assessing the Paper’s allegations.

Furthermore, the Reply still fails to answer the question in my earlier post “why the first such enforcement action ever to be taken would be lodged against corporate proposals whose only alleged fault was not to include an additional reference to contrary studies.” The Reply also does not explain why the Paper failed to highlight the “the absence of precedent” for the authors’ allegations against SRP proposals that the Reply concedes.

4. The Reply conspicuously fails to explain why not a single company raised a claim of a material omission

In my earlier analysis, I explained that, in assessing the merits of the Paper’s claim, “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.” The Reply, however, fails to engage with, and does not even comment on, the uniform decision by companies not to raise a claim of a material omission to exclude the proposals.

The case of Netflix discussed in the Reply (and in the Paper) nicely illustrates this point. In his Reply, though not in the original Paper, Professor Grundfest reveals that he advised Netflix on the declassification proposal it received. This disclosure raises significant questions. Is it the case that Professor Grundfest did not advise Netflix to exclude a proposal that he thought was excludable as false and misleading? This would appear to be a significant omission. Or is it the case that he understood that the claimed basis for exclusion (the omission of a contrary study) that is the focus of his brief with Commissioner Gallagher is very weak? Or did Professor Grundfest advise Netflix to exclude the proposal but the company, wisely in my view, rejected that advice?

Rather than seek exclusion of a proposal that Gallagher/Grundfest allege to have been excludable as false and misleading, Netflix chose instead to include the SRP proposal in the company’s proxy statement as well as to include references favored by the authors in the company’s statement of opposition. (I note that the shareholders of Netflix were not persuaded by the inclusion of the references and the proposal passed with the support of over 80% of the votes cast.) Netflix’s decision not to seek exclusion on the grounds suggested by the authors, and the identical decision of all the other companies receiving SRP proposals, is telling; it reflects the spurious nature of the authors’ allegations.

5. The Reply fails to explain why the authors inconsistently endorse the non-inclusion of references to contrary studies in the opposing statements of Netflix and other issuers, while simultaneously claiming that it is impermissible for shareholders to do so

My earlier post explained that the authors did not take any issue with issuers’ not citing studies contrary to positions taken by the issuers’ statements of opposition, as Netflix did in its opposition statement, and that the authors therefore maintain a double standard for issuers and proponents. The Reply attempts to explain the endorsement of issuers’ non-inclusion of contrary studies, but utterly fails to do so.

The studies listed in the SRP proposals were published during the period 2002-2008, and the Paper discusses eight more recent (post-2008) papers, most of which have not yet been published in journals. The Paper categorizes three of these more recent studies as supporting annual elections and the five other studies as supporting classified boards. Netflix’s 2014 opposition statement stated that “the studies cited by the proposal “have been called into question by more recent and more comprehensive research.” Netflix cited and described two of the recent studies the Paper identified as supporting board classification but did not include a reference to any of the three studies that the Gallagher/Grundfest themselves identified as more recent studies supporting annual elections. Thus, if the theory developed by the authors with respect to citing contrary studies were to be adopted, Netflix would clearly be guilty of securities fraud.

Trying to defend Netflix’s non-inclusion of any references to recent research contrary to the position Netflix’s opposition statement took with respect to the results of more recent research, the Reply argues:

“[I]t is trivially easy to defend Netflix’s decision not to discuss the additional literature in support of the proponent’s position because: (1) it is not legally required to do so, and (2) the addition of those citations could be argued to be immaterial given the disclosures already contained in the proposal.”

This response, rather than being trivially easy, is totally unpersuasive and highlights the double standard that the authors apply to disclosure statements made by proponents and issuers. The second part of this response asserts that citations to recent studies that support annual elections is “immaterial” given the studies that were already cited in the shareholder proposal. The proposal, however, listed only studies from 2002-2008 and thus could not have corrected Netflix’s omission of references to recent studies contrary to the company’s categorical description of what “more recent research” had shown. Netflix made the choice, which the Reply endorses, to cite only recent research that opposes the 2002-2008 articles listed in the proposal but not to include even a single reference to the “more recent” research that supports these articles.

The first part of the Reply’s response—that Netflix “is not legally required” to cite contrary studies—is telling. In the Gallagher/Grundfest world, issuers are not legally required to cite studies that contradict positions they take, but proponents are legally required to do so.

6. The Reply wrongly asserts that I share the Paper’s “undisputed” view of the current state of the empirical evidence

The Reply asserts, erroneously and with no basis, that the authors and I share the same “undisputed” view of what is a “fair summary of the current state of the academic research regarding classifieds boards” and the significance of the recent (still unpublished in journals) working papers they favor. I do not understand how they claim that I share their view of the literature, as my analysis did not comment in any way on the validity or strength of any study or on the current state of the evidence regarding staggered boards.

The Paper’s abstract alleges that the early studies listed in the SRP proposals (some of which were published in top journals in finance) “are in error” and that recent studies supporting classified boards (most of which are still not even published in journals) are “far more substantial” than the studies (both early and recent) that support annual elections. I also do not share these claims about the “errors” in the studies supporting annual elections or about the relative quality of the studies supporting staggered boards.

I found no support in the Paper for Gallagher/Grundfest’s assertion that the recent manuscripts favored by the authors (again, most of which have not yet been published in journals) are “far more substantial.” One must infer that, like me, the shareholders of Netflix, which voted overwhelmingly in favor of the declassification proposal, were unpersuaded by the company’s account of the significance of the studies favored by the authors. In my view, a sitting SEC Commissioner should not make pronouncements about which academic studies are “in error” and which academic studies are “far more substantial,” especially on subjects that are contested in the marketplace and subject of numerous shareholder votes.

Conclusion

If Gallagher/Grundfest want to get the SEC to change its approach going forward, the authors should consider writing an article advocating such a change, and Commissioner Gallagher should continue his effort, which seems to be unsuccessful thus far, to persuade his fellow SEC Commissioners to adopt that change. I am unsupportive of the authors’ tactic of seeking regulatory change through specious allegations of securities law violations accompanied by threats of liability and enforcement actions against individuals and private-sector organizations that are recognized by Gallagher/Grundfest to have acted consistently with the SEC’s current policies and practice.

The Reply fails to address key deficiencies that I identified in the Paper’s analysis. Furthermore, the Reply reinforces my conclusion that the Paper wrongfully accused the SRP. Such reinforcement comes, among other things, from:

(1) The major modification of the Paper’s position by:

(a) Dropping the allegations against the overwhelming majority of SRP proposals, reducing the number of challenged proposals from 129 to seven,
(b) Completely relinquishing the claim that companies can use the alleged deficiencies to invalidate declassifications that took place in approximately 100 companies, and
(c) Conceding that even the seven challenged proposals were not deficient when submitted and could at most be allegedly faulted for not being withdrawn prior to the vote;
(2) The Reply’s clear admission that the SRP proposals would have not been viewed by SEC staff as “false and misleading” under the SEC’s current, long-held policy, and that the authors’ real quarrel is with the SEC, not with the SRP proposals;
(3) The Reply’s concession that that the type of enforcement action or private suit the authors urge against the SRP is without a single past precedent;
(4) The Reply’s conspicuous failure to explain why not even a single company chose to raise the claims invented by the authors;
(5) The Reply’s failure to explain why the authors inconsistently endorse the non-inclusion of references to contrary studies in the opposing statements of Netflix and other issuers; and
(6) The Reply’s wrong assertion that I share the authors’ allegedly “undisputed” view of the current state of the evidence on staggered boards.

The Reply demonstrates that Gallagher/Grundfest wrongfully accused the SRP. The authors should withdraw their allegations.

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