United States: Shareholder Democracy: A Brave New World for Large U.S. Public Companies

Originally published on Law360, Securities Law, September 1, 2010

The Securities and Exchange Commission (SEC) adopted major changes to the U.S. proxy rules on August 25, 2010, which will facilitate the shareholders' exercise of their rights under state law to nominate and elect directors to public company boards of directors. The SEC adopted the new rules by a vote of 3-2 along party lines in substantially the same form as originally proposed on June 10 of last year. This action by the SEC represents a major flip-flop from its position just two years ago when it chose to preserve a company's prerogative to exclude shareholder proposals to nominate directors under Rule 14a-8 of the proxy rules. The new rules are intended to improve corporate suffrage, the quality of disclosure provided in connection with proxy solicitations and the level of communication between shareholders who choose to engage in the proxy process. The new rules are, however, likely to be challenged in the courts.

The centerpiece of the SEC's new proxy rules is Rule 14a-11, which will apply to U.S. companies domiciled in states that do not prohibit shareholder nominations of directors, as well as to foreign issuers that are subject to the U.S. proxy regime when applicable foreign law does not prohibit shareholder nominations. Consistent with the proposal, a company cannot opt out of the rule, and the new rule will apply without any triggering events and regardless of whether the company is subject to a concurrent proxy contest. As proposed, the new rule also will apply to investment and controlled companies that are subject to the Securities Exchange Act of 1934 (Exchange Act) proxy rules, but not to "debt only" companies. Although new Rule 14a-11 will apply to smaller reporting companies, they will have a threeyear grace period in which to observe the rule's operation and to prepare for implementation of the new rules. To qualify under Rule 14a-11, a nominating shareholder or group will be required to satisfy an ownership threshold of at least 3% of the voting power of a company's securities entitled to vote at a shareholders' meeting. The final rule eliminates the proposed 1% and 5% thresholds that were tied to the Exchange Act filing status of the company, or the net asset value of the company in the case of an investment company. The final rule requires that a nominating shareholder (or group) must have held both investment and voting power with respect to the company's securities continuously for a least three years as of the date it submits notice on new Schedule 14N of its interest to use Rule 14a-11. The nominating shareholder must continue to own the qualifying securities through the date of the shareholder meeting and disclose whether it intends to continue ownership after the election of directors.

Rule 14a-11 also requires that a nominating shareholder (or group) not be holding the company's securities with the purpose or effect of changing control of the company or of gaining more than 25% of the company's board seats. The nominating shareholder must not have an agreement with the company regarding the nomination of the board nominee(s) prior to filing its Schedule 14N. The nominating shareholder must file Schedule 14N no earlier than 150 days prior to the anniversary of the mailing of the prior year's proxy statement and no later than 120 days prior to that date. The company will be permitted under Rule 14a-11 to exclude a shareholder nominee whose election would violate controlling state or foreign law, as the case may be, or the applicable standards of a national securities exchange or association, a violation that could not be cured within the prescribed time period.

Where there are multiple nominating shareholders or groups, the shareholder with the highest percentage of the company's voting power would have its nominees included in the company's proxy materials. The new rule also includes a provision to facilitate negotiation between a company's management and nominating shareholders. The new notice on Schedule 14N will be required to include disclosure concerning the nominating shareholder's compliance with the requirements under Rule 14a-11, as well as comprehensive information about the nominating shareholder and its nominee(s). These disclosure requirements are largely consistent with the original proposal.

A company that receives a notice on Schedule 14N from an eligible nominating shareholder will be required to include in its proxy materials the name and relevant information about the shareholder and its nominee(s). The nominating shareholder will be liable for any false or misleading statements of any material fact included in the notice on Schedule 14N or incorporated in the company's proxy materials. Consistent with the existing approach in Rule 14a-8, a company will not be responsible under Rule 14a-11 for any information provided by the nominating shareholder or group and included in the company's proxy statement, even in instances when the company knows or has reason to know that the information is false or misleading.

A company that determines that it can exclude a shareholder nominee under Rule 14a-11 must provide a notice to the SEC of its intention to exclude the nominee. Alternatively, the company may file a "no action" request with the SEC requesting the staff's informal view with respect to its determination to exclude a shareholder nominee. A company may also pursue either course of action if it determines that the notice on Schedule 14N is deficient because the statement in support of the nominee exceeds the 500- word limitation. In certain circumstances, a company will be required to include a substitute nominee if other eligible nominees are available prior to the time the company commences printing the proxy materials.

The new rules include two new exemptions to the proxy rules for solicitations related to shareholder nominations. The first exemption covers qualifying written and oral shareholder solicitations that seek to form a nominating shareholder group. The second exemption covers written and oral solicitations by a nominating shareholder or group whose nominee(s) will be included in the company's proxy materials pursuant to Rule 14a-11 in favor of those nominees or for or against company nominees. Both of these exemptions impose certain disclosure and filing requirements upon the nominating shareholder or group in order to qualify for the exemption.

Finally, consistent with new Rule 14a-11, the SEC is narrowing the scope of the exclusion in Rule 14a-8(i)(8) relating to the election of directors. The revised rule will provide that companies must include in the proxy materials shareholder proposals that seek to establish a procedure in the company's governing documents for the inclusion of one or more shareholder director nominees in a company's proxy materials. This is a reversal of previous practice, which was upheld by the SEC as recently as two years ago.

The changes to the federal proxy rules adopted by the SEC to facilitate direct shareholder participation in the director nomination and election process represent a dramatic departure from the previous federal proxy regime, which permitted companies to exclude any shareholder proposal related to an election of directors. When reviewed in the context of recent reforms in corporate governance under Sarbanes-Oxley and evolving state corporation laws like Delaware's, these changes appear to be driven as much by the current mood on Capitol Hill as by a determination to achieve their stated purpose. Perhaps emboldened by provisions contained in the recently enacted Dodd-Frank bill, the SEC adopted the new measures by a split vote of 3-2 along party lines. Curiously, when faced with a deadlock situation in 2008 resulting from two fundamentally different approaches to proxy reform, the SEC chair at the time decided to maintain the status quo, voting to preserve the previous prohibition against direct shareholder participation in the director-nomination process.

An argument could be made that these changes to the proxy rules are incongruent with the SEC's stated purpose for adopting them, which is to make corporate boards appropriately focused on shareholder interests and more accountable for their decisions. Under the new rules, only relatively large shareholders of large companies who have held their shares for at least three years will be able to participate directly in the nomination and election of a company's directors. This may benefit certain constituencies like pension funds and labor unions but will do nothing for smaller shareholders or investors who are interested in a change of management or control of a company. Thus, by excluding smaller companies from the new requirements for at least three years and setting the bar so high for shareholders of large companies who want to participate in the selection of directors, the SEC has greatly limited the effectiveness of the new rules.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.