Shareholder Rights: Assessing the Threat Environment

In July 2023, Republican members of the House Committee on Financial Services (the “Committee”) sponsored a series of hearings on ESG. While prior committee hearings and state level efforts to challenge the inclusion of ESG information into the investment process had focused on the large asset managers and Department of Labor ESG regulations, the July hearings shifted the focus onto the shareholder proposal process regulated by the Securities and Exchange Commission (“SEC”) under Rule 14a-8, and on the support for shareholder proposals by proxy advisors, passive investors and registered investment advisors. This  culminated in  bills being voted out of committee that would significantly reduce the power of the SEC, change the shareholder proposal process to bar the presentation of  ESG proposals and alter  proxy voting on shareholder proposals to be more costly and cumbersome for many investors.

Overview of proposed legislation

The assault on shareholder rights proposed by the anti-ESG legislation is twofold – first, curtailing shareholders’ ability to file proposals and secondly, suppressing votes for those proposals.

The Protecting Americans’ Retirement Savings from Politics Act (“PARSPA”) (H.R. 4767) includes provisions to eliminate the ability of the SEC to require companies to publish in the corporate proxy statement environmental, social and political proposals (or proposals that raise a significant social policy issue). Other elements of the bill would steeply increase resubmission threshold and bar the SEC from adopting proposed amendments to the shareholder proposal rule refining the agency’s approach to exclusions based on duplication, resubmission or substantial implementation. A separate bill would eliminate the authority of the SEC to regulate shareholder proposals in their entirety, mirroring the objective of an ongoing lawsuit intervention by the National Association of Manufacturers (NAM) in National Center for Public Policy Research v. Securities Exchange Commission, No. 23-60230 (5th Cir.)  In their intervention in that lawsuit, NAM contends alternately under First Amendment and statutory grounds that the SEC lacks the authorization to require companies to publish shareholder proposals.

The legislation also includes numerous provisions to suppress support of shareholder proposals by registered investment advisors, proxy advisers and passive fund managers. For instance, it would require proxy advisory firms to provide prior disclosure of their voting recommendations to issuers and hold them liable for misstatements in any favorable advice on proposals later found to violate federal or state law. It would require large asset managers to provide economic analyses for proxy voting decisions and “clarify [to customers] that shareholders are not required to vote on every proposal.” With respect to proxy voting, it would mandate that passively managed funds either vote according to the instructions of beneficiaries, vote in accordance with management’s recommendations, or otherwise abstain from voting, except for “routine matters.” In other words, index fund investors could no longer rely on the expertise of index fund providers to cast proxy votes in accordance with their best interests. Finally, it would require registered investment advisers to obtain “informed consent, in writing” prior to the consideration of so-called “non-pecuniary” factors in investing strategy.

Impact: Gutting the shareholder proposal rule and disrupting productive market activity

Shareholder proposals are an important part of the information exchange between companies and their owners. In US corporate governance, the board of directors oversees corporate strategy, management makes day-to-day decisions, but equity investors also have important rights — to elect the board and to provide input and advice on issues relevant to governance and risk management. The shareholder proposal process is the most effective tool and right that shareholders have to ensure a voice in corporate policy that affects risk outcomes, both enterprise value and systemic risk.

The rules governing the shareholder proposal process are clear, fair and efficient.

Under SEC Rule 14a-8, shareholder proposals must meet a rigorous series of SEC procedural and substantive tests in order to qualify for the proxy (e.g., Is the proposal relevant to the company? Does it transcend ordinary business matters that are reserved for the board and management?)

In contrast, the legislative package would erase the rights of investors to exercise their voice in encouraging portfolio companies to engage in forward looking management of emerging risks to the bottom line and to their portfolios. It would have the effect of disrupting a wide array of productive free-market activity, curtailing shareholder democracy and insulating corporate directors and managers from significant concerns of investors, including management of systematic risks or beta that is currently addressed through an array of shareholder proposals.

The legislation seems likely to suppress otherwise sound, diversified investment strategies, by limiting shareholder voice. As Boston University law professor David H. Webber has stated in his examination of the legislative package:

Diversified shareholders have almost no meaningful exit option. Because they must remain diversified, their ability to sell and walk away from an investment if they are unhappy with the company or its management is quite limited. Lacking the exit option only enhances the importance of empowering them to exercise voice. There is basically only one way to do that. Diversified investors make their voices heard by voting at annual meetings and voting on (and themselves filing) shareholder proposals. By sharply reducing the capacity to vote or to file shareholder proposals, in an environment in which exit is effectively impossible, the proposed bills basically tell retirement plans and other investors: give us your money, but you get no say over how it is spent. David H. Webber, “The Federal Anti-ESG Bills: An Attack on Diversified, Middle Class Investors, July 18, 2023 (unpublished paper shared with author).

Under the current rules, investors are free to invest for or against company commitments on issues like diversity and climate change. However, shareholder proposals play a critical role in giving voice to shareholder concerns on these issues. Elimination of shareholder proposal rights ruptures an ecosystem of trust that is built upon these legal rights.

While the origins of the shareholder proposal rule may be in ensuring informed shareholder voting, as used by investors and issuers today, the shareholder proposal process offers value in harmonizing disparate investment strategies among an ecosystem of diverse investors, and in inviting open dialogue that allows investors of all sizes to contribute to the success of the corporation. Some subgroups in the investment ecosystem—such as activist hedge funds and short-term traders—may pressure companies for short-term stock price increases, but they do so largely without availing themselves of Rule 14a-8. In contrast, the typical proponents of shareholder proposals under Rule 14a-8 are often providing early warnings of long-term risk issues, or seeking disclosure of metrics or governance changes that bring a longer-term value creation perspective to corporate deliberations.

The legislation attacking support for shareholder proposals appears intended to legislatively micromanage the fiduciary judgments that already underlie investor voting and management processes. For instance, asset managers and investment advisers already have fiduciary duties to act in the best interest of beneficiaries and not to just blindly follow institutional proxy recommendations. But to bog the voting and advisory processes down in economic analysis obligations and high friction interactions with issuers would raise the costs of voting in favor of shareholder proposals and weaken the collective voice of diversified investors who often vote and engage companies through their asset manager.

The legislation is a solution in search of a problem

The narratives of Committee members in support of the proposed legislation centers around the notion that shareholder proposals have little to do with profitability or business matters, but simply promote “activist” agendas. The narrative put forth in the hearings treats shareholder proposals as a mere distraction from the important work of boards. The reality is that shareholder proposals have always played a pivotal role in surfacing key controversies facing companies that boards – the representatives of shareholders – are inclined to ignore, conceal or spin. Although anti-ESG factions have generated polarization theater by filing reactionary proposals on diversity and climate change that create a “both sides” narrative, most of those proposals are not winning support from investors because they ask companies to go backwards rather than leaning into the future. Most investors recognize that their companies’ success depends on leaning into the future, not attempting to turn the clock backwards.

The narrative also repeatedly attacked the SEC for withdrawing the “nexus” test for determining ordinary business exclusions of shareholder proposals. In 2009, SEC staff informally created the concept of “nexus” to evaluate ordinary business exclusions in Staff Legal Bulletin 14E. Nexus was a confusing, philosophical, open-ended add-on created by staff, and it was inconsistent with the functional relevance rule that is already contained in Rule 14a-8. The successful repeal of that added requirement in SEC Staff Legal Bulletin 14 L, which merely returned the law concerning proposal relevance to its pre-2009 state, has been twisted into a narrative that a proposal no longer has to be relevant to a company. That is inaccurate. Under Rule 14a-8(i)(5), a proposal that is not “significant to a company’s business” would not withstand challenge under the rule. Rule 14a-8(i)(5) allows exclusion of a proposal where there is neither a substantial economic (5% of profits or proceeds) connection of the issue to the company and the proposal is not otherwise significantly related to the company’s business. See my prior detailed analysis of this issue.

Finally, there was a redundant narrative in oral and written testimony asserting that shareholder proposals cost companies $150,000 each. This controversial figure represents an upper-boundary of possible expenditures on proposals. In the 2020 SEC rulemaking release promulgating amendments to the shareholder proposal rule (fns 63 and 332), it was noted that the only hard costs required by SEC rule is the cost of publishing 500 words in the proxy statement, with a cost of less than $20,000. In the same rulemaking, the Business Roundtable submitted estimates from members of $50,000 to $100,000, focusing on legal fees to challenge proposals plus the estimated value of the board’s attention to a shareholder proposal.  From investors’ perspective, the “attention costs” are balanced by large potential benefits to the corporation. Prudent attention and engagement to issues surfaced by proposals is more likely to be a net benefit to the corporation than a cost.

The shareholder proposal process benefits investors and companies

The proposal process has helped investors make their companies more lucrative, more resilient, and responsive to key social and environmental challenges facing the companies. These results are achieved at individual companies and across the economy, with minimal government intervention. The shareholder proposal process is also a critical tool for cementing a relationship of trust and accountability that encourages investment.

The legislative package would sharply reduce the market’s recourse to managing long-term risk at both the enterprise and systemic level. In a year of global flooding, wildfires and heat – a climate emergency worldwide — it would silence the voice of investors and ask them to invest as if climate change is not happening.