…If the stockholder is to regard himself as a continuing part-owner of the business in which he has placed his money, he must be ready at times to act like a true owner and to make the decisions associated with ownership. If he wants his interests fully protected he must be willing to do something of his own to protect them. This requires a moderate amount of initiative and judgment.
—Benjamin Graham and David Dodd, Securities Valuation, 1934
On April 14, 2003, the Securities and Exchange Commission announced it would consider changes to proxy regulations “to improve corporate democracy.” The SEC would examine “procedures for the election of corporate directors,” and issue a report after consulting with “pension funds, shareholder advocacy groups, business and legal communities.” The resulting dialogue focused on “proxy access”— the idea that shareowners should be allowed to place their own board nominations on the proxies distributed by management, much as they are already allowed to place their own proposals on those proxies.
New rules were expected to be in place by the 2004 proxy season. After eight years, three attempts and a major setback in court, it appears proxy access is finally on the way. Last year the SEC adopted:
- Rule 14a-11, which would require a minimum level of proxy access under specified circumstances.
- Amendments to Rule 14a-8(i)8, which would allow shareowners to submit access proposals company- by-company.
The U.S. Court of Appeals for the D.C. Circuit found Rule 14a-11 “arbitrary and capricious.” The decision could provide a blueprint for challenging many other Dodd-Frank Act rulemakings, since the three-judge panel took a very strict approach to the agency’s analysis of costs and benefits.
Changes to Rule 14a-8 were not challenged but were stayed by the SEC since related disclosure amendments were “entangled with” Rule 14a-11. The petition filed with the Court addressed Rule 14a-11 “and associated amendments to the Commission’s rules.” After the court decision, the Federal Securities Regulation Committee of the American Bar Association urged the SEC to retain the stay, set to expire when the court decision was finalized, and “either repropose the amendments to Rule 14a-8 or reopen the comment period.” Instead, the SEC let the stay expire; private ordering begins.
Before speculating on the future, let us briefly examine recent history.
In 1977, the SEC held a number of hearings to address corporate scandals. At that time, the Business Roundtable recommended amendments to Rule 14a-8 that would allow access proposals, noting that such amendments “…would do no more than allow the establishment of machinery to enable shareholders to exercise rights acknowledged to exist under state law.”
Soon, we saw several proposals. In 1980, Unicare Services included a proposal to allow any three shareowners to nominate and place candidates on the proxy. Shareowners at Mobil proposed a “reasonable number,” while those at Union Oil proposed a threshold of “500 or more shareholders” to place nominees on corporate proxies.
One company argued that placing a minimum threshold on access would discriminate “in favor of large stockholders and to the detriment of small stockholders,” violating equal treatment principles. The California Public Employees’ Retirement System (CalPERS) participated in the movement, submitting a proposal in 1988 but withdrawing it when Texaco agreed to include their nominee.
These early attempts to win proxy access through shareowner resolutions met with the same fate as most resolutions in those days. As of 1986, only two proposals of the thousands submitted had been approved— but the tides of change were turning. A 1987 proposal by Lewis Gilbert to allow shareowners to ratify the choice of auditors won a majority vote at Chock Full O’Nuts Corp., and in 1988 Richard Foley’s proposal to redeem a poison pill won a majority vote at the Santa Fe Southern Pacific Corp.
In 1990, without public discussion or a rule change, the SEC began issuing a series of no-action letters on access proposals. The SEC’s about-face may have been prompted by fear that “private ordering,” through shareowner proposals, was about to begin in earnest.
Tensions over this giant leap backward rose until AFSCME v. AIG (2006). That case involved a 2004 bylaw proposal submitted by the American Federation of State, County and Municipal Employees (AFSCME) to the American International Group (AIG) requiring that specified nominees be included in the proxy. AIG excluded the proposal after receiving a no-action letter from the SEC and AFSCME filed suit.
The court ruled the prohibition on shareowner elections contained in Rule 14a-8 applied only to proposals “used to oppose solicitations dealing with an identified board seat in an upcoming election” (also known as contested elections). The SEC subsequently adopted a rule banning proposals aimed at prospective elections, but in 2010 adopted both a widely discussed federal mandate in Rule 14a-11 and less discussed amendments to Rule 14a-8(i)(8) to allow access through private ordering.
What does the future hold? My own personal past may offer perspective on the push for more democratic corporate elections.
Turning Point on the Road to Democracy
On a 1987 trip to China, I met my wife’s uncle who was touring universities advising a gradual approach toward democracy. He cautioned students about that “funny period” when Red Guards broke his arms, thinking engineers weren’t needed to design or build dams. Tiananmen Square protests followed in 1989; knowledge, freedom and democracy were again repressed.
In May 2002, I addressed an Asian Development Bank conference in Shanghai. Corporate governance in a post-Enron America, I argued, required greater democracy both at the top, in the accountability of boards and CEOs, and at the bottom, in the form of increased ownership and participation by employees. America, too, had its democratic challenges. I told participants, one of our most sorely needed reforms was proxy access. As a sociologist, I had learned how labeling and socialization “harden” the objectivity of socially constructed worlds. We begin to see our institutions and laws as fixed, even though they are of our own making. Now, after expressing the need for reform to an audience halfway around the world, I knew I should be making more of an effort to bring about proxy access at home.
On August 2001, I petitioned the SEC with Les Greenberg, who was largely responsible for the first Internet proxy campaign (at Lubys Inc.). We argued that “entrenched managers and directors will only improve corporate governance when they can be held accountable, e.g., voted out of office and replaced with directors chosen by shareholders.” Our proposal was summed up in one sentence: “The intended effect of the suggested modifications is that the solicitation of proxies for all nominees for director positions, who meet the other legal requirements, be required to be included in the company’s proxy materials.”
According to the Council for Institutional Investors, our petition “re-energized” the “debate over shareholder access to management proxy cards to nominate directors.” Indeed, shortly thereafter, the SEC proposed a rule that began the current journey toward proxy access.
Getting Proxy Access Right
When Chairman Mary L. Schapiro announced that the SEC would not appeal the Court’s decision to vacate Rule 14a-11, she reaffirmed her commitment to “finding a way to make it easier for shareholders to nominate candidates to corporate boards.” While that leaves open the possibility of a broad federal mandate, “private ordering” on a company-by-company basis under Rule 14a-8 will prevail for the foreseeable future.
Proxy access will now join the litany of proposals for majority voting, declassified boards, separation of CEO and chair, the right to call special meetings and other governance matters. Access is seen by many as a fundamental right and a form of insurance that can save both shareowners and companies money.
In most cases troubled companies have already lost substantial value by the time they face a contested board election. Costs for contests involving changes in control are generally estimated to range from 2 percent to 4 percent of firm value. Defensive measures often destroy more value. Takeovers and transitions back to profitability are expensive. There may also be heavy transaction costs to employees as well as communities.
In contrast, the cost of proxy-driven board transitions has run considerably below 1 percent, according to Patrick McGurn, executive director of Institutional Shareholder Services. Competition for board positions has traditionally stimulated share value. Firms with stronger shareowner rights have higher firm value, higher profits, and higher sales growth, lower capital expenditures and fewer corporate acquisitions. Investors who bought firms with the strongest rights and sold those with the weakest rights would have earned abnormal returns of 8.5 percent per year, according to a widely cited study by Paul Gompers and Andrew Metrick.
Jill E. Fisch, a professor at the University of Pennsylvania Law School, recently wrote a paper, The Destructive Ambiguity of Federal Proxy Access. After examining the 70-year history of efforts to obtain proxy access and offering a searing critique of SEC efforts, Fisch reaches a similar conclusion to our 2002 petition: “The SEC should amend Regulation 14A to require the issuer to disclose, in its proxy statement, all properly-nominated director candidates…provide comparable disclosure in the proxy statement for all director candidates…[and] require the issuer’s proxy card to give shareholders the opportunity to vote for any of the candidates included in the proxy statement.”
One of the major flaws in the SEC’s now-vacated Rule 14a-11, according to the D.C. Court of Appeals panel, was its failure to fully analyze the cost of proxy access to companies. The Court cited comments from the Chamber of Commerce predicting that boards would incur substantial expenditures through “significant media and public relations efforts, advertising…mass mailings and other communication efforts, as well as the hiring of outside advisors and the expenditure of significant time and effort by the company’s employees.”
Yes, some companies will spend a fortune to keep their boards fully intact. We saw that in 1991 when Sears budgeted $5.5 million over and above its normal proxy solicitation expenses to keep one board seat from Robert A. G. Monks.
We have learned many lessons in the last 20 years. One is that half measures are unlikely to appease. For example, by proposing their own proxy access standard, subject to shareowner vote, companies may exclude conflicting shareowner proposals from their proxy under Rule 14a-8(i)(9). However, if no dialogue has taken place, know that war may come. Shareowners expect authenticity, fairness, transparency and good faith. Distrust can lead to disaster.
In November, I worked with members of the United States Proxy Exchange (USPX) to develop a Model Proxy Access Proposal, which has already been submitted to several corporations.
Standard rules of procedure, including Robert’s Rules, allow any member of an assembly to nominate. This reflects the philosophy that, although the majority decides, all should be encouraged to participate and to be heard. The challenge should lie in the election, not the nomination. Our model proposal is designed to ensure that long-term shareowners could participate through one of two tracks. One track—mostly suited for larger institutional shareowners— allows any group of shareowners that has continuously held 1 percent of the company’s stock for two years to nominate. The other—more suited to individual shareowners or smaller institutional shareowners—allows any group, 100 of whose members satisfy the Rule 14a-8 eligibility requirements for shareowner proposal submission, to nominate.
Our reasoning is that shareowners with a demonstrated commitment to holding a substantial stake in a company will be motivated to nominate quality candidates for its board, as will shareowners who must invest considerable effort to nominate.
Changes in control should generally be pursued through independent proxy solicitations, not through proxy access. The Model proposal ensures this through a variety of impediments that make it an unattractive alternative to an independent proxy solicitation for such purposes. For example, each nominating group is limited to one nomination (or a number of nominations equal to 12 percent of board seats, if the board has more than 16 members). Multiple parties are prohibited from coordinating efforts. Unlike either typical control or short-slate contests, proxy access would allow split votes, further reducing the likelihood of capture by any “special interest,” including entrenched incumbent boards.
In short, we have developed a Model Proxy Access Proposal that can be presented to poorly governed corporations. We encourage experimentation with company-specific approaches to determine what works best.
Reflections on Freedom and Democracy
Knowledge has surpassed machines and capital as the driving force behind the world economy. It has long been recognized that workers add more value if they are able to participate in meaningful decision making. The same is true for shareowners.
Social networking platforms will soon move shareowner forums well ahead of those envisioned by former SEC Chairman Christopher Cox to virtual deliberative bodies with consensus-building mechanisms and the ability to transfer and compile unsolicited voting rights. Shareowners, customers and employees will conspire for change through tools on their desk, in their purses and pockets.
The movement to more democratic forms of corporate governance is important not only for creating wealth; it cuts directly to our ability to maintain a free society. Corporations that embrace participatory democratic systems should be better equipped to create wealth, compete in global markets, and solve the highly complex problems of the third millennium by unleashing the wealth-generating capacity of “human capital,” which is based in the skills and knowledge not only of corporate managers but of boards, employees and shareowners alike.
James McRitchie is publisher of CorpGov.net, an online resource for news, commentary and transformation that he started in 1995 to help diversified long-term investors exercise their rights and responsibilities as owners.