United States: Know Your 3% Shareholders: SEC Adopts Final Rules to Facilitate Shareholder Nomination of Directors

The Securities and Exchange Commission has adopted final rules on Facilitating Shareholder Director Nominations (No. 33-9136; 34-62764), enabling certain shareholders or shareholder groups to have included in company proxy materials (i) shareholder nominees for director and (ii) shareholder proposals to amend the provisions of a company's governing documents regarding the procedures for shareholders to nominate directors. While the Commission has considered adopting rules regarding shareholder access over the past several decades, the final rules are based on the rules proposed on June 10, 2009, and discussed in Drinker Biddle's Client Alert available at http://tinyurl.com/DBRProposalAlert . The final rules may be found at http://www.sec.gov/rules/final.shtml .

The final rules will take effect Monday, November 15, 2010, except for smaller reporting companies, for which the effective date is delayed three years. Once the rules go into effect, shareholders may submit nominations for directors in the first 120-day to 150-day notice period that is open, measured from the anniversary date of the mailing of the previous year's proxy statement. For the upcoming proxy season, a company will be subject to the rules if it mailed its proxy materials for the prior year's annual meeting on or after March 15, 2010. All companies should take note of the final rules, as these rules are likely to impact the dynamics of shareholder relations and director elections on a going-forward basis.

Overview of the Final Rules

The final rules include a new proxy rule, Rule 14a-11, that will enable a shareholder or group of shareholders holding 3% or more of a company's voting securities for at least three years to have information about their nominee(s) for director included in the company's proxy materials. Shareholder director nominees will be limited to the greater of one director or 25% of the board at any time. Nominating shareholders or groups will be required to make certain disclosures about their nominations on a new Schedule 14N, including a statement that these shareholders are not seeking to acquire control or a greater number of board seats than the shareholder would be permitted to nominate under Rule 14a-11. The final rules will apply to all companies subject to the proxy rules under the Securities Exchange Act of 1934 (the Exchange Act), including investment companies, controlled companies and companies that voluntarily register a class of securities under Section 12(g) of the Exchange Act, but excluding debt-only companies.¹ The final rules also include an amendment to Rule 14a-8(i)(8) narrowing the exclusion for shareholder proposals relating to the election of directors.

The proposed rules were contentiously debated. The Commission received approximately 600 comment letters on the proposal. Many institutional investors that commented on the rules suggested a link between the recent economic climate and the previous hurdles to shareholders' ability to nominate directors. Those opposing the rules argued that the rules impose a federal "one size fits all" governance model that infringes on state law and private ordering of corporate governance. Opponents also argued that the rules would facilitate "special interest" directors focused on the short-term interests of a small set of shareholders, rather than the creation of long-term value.

The following sections describe the final rules in greater detail and summarize considerations for companies as the rules become effective in light of the upcoming proxy season.

Eligible Shareholders

Under new Rule 14a-11, a nominating shareholder or group must meet an ownership threshold of at least 3% of the voting power of a company's securities in order to have their director nominees included in the company's proxy materials. The single ownership threshold under the final rules differs from the three-tiered ownership threshold outlined in the proposed rules of 1%, 3% or 5%, depending on whether a company is a large accelerated filer, an accelerated filer or a non-accelerated filer, respectively. The change from the proposed rule reflects an effort to reduce the complexity of new Rule 14a-11 by providing a uniform threshold of ownership.

In order to meet the ownership threshold, a shareholder or group of shareholders must hold both investment power and voting power, but a group may aggregate the holdings of members of the group to meet the threshold. In the context of Rule 14a-11, investment power includes the power to dispose, or direct the disposition, of the securities. As applied, a nominating shareholder or group may count securities that have been loaned by it or on its behalf, but only if the nominating shareholder or group has the right to recall the loaned securities and will recall those securities upon being notified by the company that the shareholder or group's nominee(s) will be included in the company's proxy materials. Shareholders may not count any securities sold short or any securities that could be, but have not yet been, acquired, such as securities underlying options or warrants that are exercisable but have not yet been exercised. Also in the context of Rule 14a-11, voting power includes the power to vote, or direct the voting of, the securities and is determined based on the voting power of the securities entitled to vote on the election of directors at the meeting. As applied, voting power would be calculated as a collective measure where a company has a single class of securities with equal voting rights, multiple classes of securities with equal voting rights, or multiple classes of securities with unequal voting rights where those classes vote together on directors. Where a company has multiple classes of securities with unequal voting rights that do not vote together on directors, then voting power would be calculated only on the class(es) voting on the election of the shareholder nominee.

The ownership threshold is calculated as of the date a Schedule 14N is first filed. In order to determine the calculation, nominating shareholders or groups may rely on the most recent annual, quarterly or current report filed by the company, unless the shareholder or group knows or has reason to know that the information contained in the report is inaccurate.

The nominating shareholder or group must continue to meet the ownership threshold through the date of the meeting at which directors are elected. The nominating shareholder or group must make certain disclosures on Schedule 14N, including that the shareholder or group is not holding any securities with the purpose or effect of changing control of the company or seeking more than the maximum number of board seats than it would be permitted to nominate under Rule 14a-11.

Additionally, under the final rules, the ownership threshold requires a three-year holding period, in contrast to the one-year holding period suggested under the proposed rules. This change from the proposed rules is based on comments that a longer ownership period better represents shareholders with a significant, long-term interest in a company.

Number of Directors

Consistent with the proposed rules, the final rules require a company to include the greater of one shareholder nominee or the number of nominees representing 25% of the board. The 25% maximum is cumulative and not election-specific. Where the term of a shareholder-nominated director continues past the date of the next meeting at which directors are elected, that director will continue to count toward the 25% maximum. Where a company has a staggered board, the 25% maximum is calculated on the total number of board seats, not the number up for election at a specific meeting. If shareholders only have the right to elect a subset of the board, the maximum number of shareholder nominees may not exceed the number of directors that the class of securities held by the nominating shareholder or group has the right to elect.

The 25% maximum also is cumulative with respect to shareholders and groups of shareholders. Where multiple shareholders or groups meet the ownership thresholds, the shareholder or group with the highest percentage of voting power would have its nominee(s) included. The preference to the shareholder or group with the highest percentage of voting power differs from the proposed rules, which suggested a "first-in, first-on" standard that could have encouraged a race to nominate. The change from the proposed rule reflects comments that what matters most is not who is fastest, but who has the greatest stake in the company.

Director Qualifications

Consistent with the proposed rules, shareholder nominees must meet the independence standards of the applicable securities exchange, but are not required to meet any other company or nominating committee qualifications for directors. In contrast to the proposed rules, the final rules require that the nominating shareholder or group disclose on Schedule 14N whether, to the best of its knowledge, its nominee meets the company's qualifications for directors. The Commission staff considered comments suggesting that shareholder nominees should be required to meet company-specific qualifications, but ultimately decided that if a shareholder nominee does not meet company qualifications, the company could describe the lack of qualifications in its proxy materials in order to enable shareholders to make an informed vote.

Schedule 14N Disclosures

The nominating shareholder or group must provide notice to the company of its intent to use Rule 14a-11 to nominate directors on a new Schedule 14N. The Schedule 14N will require a nominating shareholder or group to disclose:

• The name and address of the nominating shareholder or each member of the nominating group of shareholders;
• The amount and percentage of securities held and entitled to vote on the election of directors at the meeting and the voting power derived from securities that have been loaned or sold in a short sale that remains open;
• A statement verifying that the shareholder has continuously held the qualifying amount of securities for at least three years (unless the shareholder is the registered holder or attaches or incorporates by reference a previously filed Schedule 13D or G or Form 3, 4 or 5, as amended, to prove ownership);
• A statement of the nominating shareholder or group's intent (i) to continue to hold the qualifying amount through the election of directors, and (ii) with respect to continued ownership after the election of directors;
• Certain information required by Items 4(b) and 5(b) of Schedule 14A of the Exchange Act;
• A statement that the nominee consents to be named in the company's proxy materials and to serve on the board of directors, if elected;
• Whether the nominating shareholder or any member of the shareholder group has been involved in certain legal proceedings during the last 10 years;
• Whether the nominee meets the independence criteria of the applicable exchange;
• Whether the nominee meets the company's qualifications for directors;
• The relationship between the nominating shareholder or group, the nominee and/or the company or any affiliate of the company;
• Any website address where the nominating shareholder or group may publish soliciting materials; and
• A statement in support of the nominee(s), not to exceed 500 words per nominee.

Additionally, the nominating shareholder or group must represent that it does not have an agreement with the company or company management regarding the nomination of the shareholder candidate. If the nominating shareholder or group thereafter reaches an agreement with the company to include the nominee as a management nominee, the nominating shareholder or group would then be proceeding outside of Rule 14a-11 and would be required to amend its Schedule 14N. The nominating shareholder or group must also certify that it does not intend to effect a change of control or gain more than the maximum number of board seats provided for under Rule 14a-11.

The final rules regarding Schedule 14N include some modifications from the proposed rules, including the requirement to disclose whether the nominee meets the company's qualifications for directors, the extent of the relationship between the nominating shareholder or group and its nominee(s), and the existence of certain legal proceedings from the past 10 years, rather than the past five years, consistent with other recent Commission rule changes.

The filing requirements for Schedule 14N also differ in the final rules from the proposed rules. Under the final rules, the Schedule 14N must be filed on EDGAR and sent to the company on the same date, which must be no earlier than 150 days before the anniversary of the mailing date of the prior year's proxy statement and no later than 120 days before that anniversary date. As proposed, the notice was to be provided in accordance with the advance notice provisions of a company's governing documents or, if the company does not have advance notice provisions, at least 120 days before the mailing date of the prior year's proxy statement. The final rules establish a definitive window period for notice of shareholder nominees for director, notwithstanding the effect of a company's advance notice provisions.

Liability for Nominating Shareholder Statements

Consistent with the proposed rules, under a new Rule 14a-9(c), a nominating shareholder or group would be liable for any false or misleading statements made regarding its nomination for director, regardless of whether those statements are included in a company's proxy materials. The final rules modify the standard for company liability for shareholder-provided statements regarding shareholder nominees. As proposed, companies would not have been liable for information provided by a nominating shareholder or group and included in the company's proxy materials, provided that the company did not know or have reason to know that the information is false or misleading. The final rule removes the knowledge proviso, such that companies will not be responsible for information provided by nominating shareholders or groups under Rule 14a-11 and Schedule 14N and included in the proxy materials. Rather, liability rests solely with the nominating shareholder or group.

Company Response and Timeframe

When a company receives notice from a nominating shareholder or group, the company would decide whether to include or exclude the shareholder nominee(s) from the proxy materials. Under the final rules, if a company decides to include a shareholder nominee, it must notify the shareholder or group by a notice postmarked or transmitted electronically no later than 30 calendar days before the company files its definitive proxy materials. If a company decides to exclude a shareholder nominee, the timeframe would operate as follows:

• No later than 14 calendar days after the close of the window period for submission of shareholder nominations, the company must notify the nominating shareholder or group of its decision to exclude the nominee(s).
• No later than 14 calendar days after the nominating shareholder or group's receipt of the company's notice, the nominating shareholder or group may respond and cure any deficiencies.
• No later than 80 calendar days before the company files its proxy materials, the company must notify the Commission, with a copy to the nominating shareholder or group, of its decision to exclude any nominee(s) and may seek a no-action letter with respect to its decision.
• No later than 14 calendar days after the nominating shareholder or group's receipt of the company's notice to the Commission, the nominating shareholder or group may submit a response to the Commission.
• As soon as practicable and if requested, the Commission staff would provide an informal statement of its views to the company and the nominating shareholder or group.
• Promptly following receipt of the Commission staff's views, the company must notify the nominating shareholder or group whether it will include or exclude its nominee.

Companies may decide to exclude shareholder nominees under new Rule 14a-11(g) on grounds that: (i) Rule 14a-11 does not apply to the company; (ii) the nominating shareholder or group or its nominee does not meet the eligibility requirements; or (iii) including the nominee(s) would require the company to include more than the maximum number of shareholder nominees. Under the proposed rules, a company would also have been able to exclude a nominee if any information required to be included in the notice to the company about the nominee is false or misleading in any material respect. This exclusion is not available under the final rules, but a nominating shareholder or group would be liable for any such false or misleading information. Also, a company may exclude the statement of support about a shareholder nominee if it exceeds 500 words if the nominating shareholder or group fails to revise the statement to cure the defect and if the company notifies the Commission of its intent to exclude the statement, but the company must otherwise include the nominee unless there are other grounds for exclusion.

If a company elects to seek a no-action letter regarding its decision to exclude a shareholder nominated candidate, it should seek a comprehensive letter covering decisions regarding all nominees sought to be excluded, since under certain circumstances a company may be required to include a substitute nominee. Companies will be required to include information about shareholder nominated candidates up to the maximum number of directors required by Rule 14a-11. Where a shareholder or group with the highest qualifying voting power nominates some but not all of the maximum number of directors allowed by Rule 14a-11, the company must then include the nominee(s) of the shareholder or group with the next highest qualifying voting power until the maximum allotment has been reached or the company has exhausted the list of eligible shareholder nominees. If a nominating shareholder or group is subsequently disqualified (e.g., fails to meet the ownership threshold) after the company notifies the shareholder or group that it will include information about that shareholder or group's director candidate in the company proxy materials, a company will be required to include a substitute shareholder nominee from the nominating shareholder or group with the next highest qualifying voting power. If a shareholder nominee withdraws or is disqualified after notice that a company will include information about that nominee in the company proxy materials, the company will be required to include a substitute nominee submitted by the nominating shareholder or group. If the nominating shareholder or group did not nominate any other eligible candidates, then the company would look to the shareholder or group with the next highest voting power percentage. The foregoing is qualified, however, in that once a company commences printing its proxy materials, it would not be required to include a substitute nominee if one is disqualified or withdraws.

Additionally, under an amendment to Rule 14a-4, when a shareholder nominee is included in the company's proxy materials under any of Rule 14a-11, state law, or a company's governing documents, the form of proxy may not provide the option for shareholders to vote for a slate of company-nominated directors. Instead, the form of proxy must require a vote on each nominee. Companies may specify which nominees are company or shareholder nominees, may determine the order in which company and shareholder nominees are listed, and may disclose the potential effects of electing shareholder nominees. The nominees must otherwise be presented in an impartial manner.

Solicitation Exemptions

Under the final rules, new Rule 14a-2(b)(7) provides a limited exemption from the proxy rules to enable shareholders to communicate and form groups to nominate directors, provided that the shareholders are not holding the company's securities with the purpose or effect of changing control or obtaining a number of board seats that exceeds the maximum number of nominees that it would be permitted to nominate under Rule 14a-11. The solicitation would be filed on Schedule 14N and may include no more than: (i) a statement of the intent to form a nominating group; (ii) identification of and a brief statement on the potential nominee(s) or, where there are no nominee(s), the characteristics of the intended nominee(s); (iii) the percentage of the voting power entitled to be voted on the election of directors that each soliciting shareholder holds, or the aggregate percentage held by a shareholder group to which the shareholder belongs; and (iv) the means by which shareholders may contact the soliciting party.

The final rules also provide an exemption under Rule 14a-2(b)(8) to enable nominating shareholders or groups to solicit support for their nominees. A nominating shareholder or group would be entitled to the exemption provided that: (i) it does not seek the power to act as a proxy; (ii) each written communication includes the identity of the nominating shareholder or group, a description of its interests, and a prominent legend advising shareholders (a) that a nominee is or will be included in the company's proxy materials, (b) that shareholders should read the proxy statement when it becomes available and (c) where shareholders can find the relevant proxy materials on the Commission website; and (iii) any soliciting material published or given to shareholders in accordance with the exemption is filed by the nominating shareholder or group on Schedule 14N.

Amendment to the Election Exclusion

The final rules include an amendment to Rule 14a-8(i)(8) that will narrow the election exclusion such that companies will not be able to rely on Rule 14a-8(i)(8) to exclude from the proxy materials a shareholder proposal seeking to establish in a company's governing documents procedures for shareholders to nominate directors. For example, a shareholder may propose to amend a company's governing documents to adopt a lower ownership threshold for shareholder nominations if the shareholder deems that the 3% ownership threshold under Rule 14a-11 is too high. The amendment also codifies prior Commission staff interpretations that permit companies to exclude shareholder proposals that (i) would disqualify a nominee who is standing for election; (ii) would remove a director from office before his or her term expired; (iii) question the competence, business judgment, or character of one or more nominees or directors; (iv) seek to include a specific individual in the company's proxy materials for election to the board other than pursuant to Rule 14a-11, an applicable state law provision or the company's governing documents; or (v) otherwise could affect the outcome of the upcoming election of directors.

Intersection with State Law and Company Governing Documents

The rule facilitating shareholder nominations for director candidates, Rule 14a-11, will apply only when state law or a company's governing documents do not prohibit shareholder nominations for director candidates. The Commission staff is not aware of any currently effective state law that prohibits shareholder nominations, but notes that, if such a state law were enacted in the future, Rule 14a-11 would not apply. If a company's governing documents prohibit shareholder nominations, Rule 14a-11 also would not apply, but shareholders could use Rule 14a-8 to submit a proposal to amend the prohibitive sections of the governing documents. The Commission staff anticipates that there may be situations where state law or a company's governing documents are more permissive or restrictive than Rule 14a-11. In that case, a shareholder or group could use either avenue to nominate candidates, but must clearly specify whether it is relying on Rule 14a-11, state law or a company's governing documents. Many commenters and the dissenting Commissioners noted that the final rules seem to infringe on traditional state law substantive rights, and this aspect of the final rules is one to watch.

Considerations for Companies

The final rules will become effective on Monday, November 15, 2010, except for smaller reporting companies, for which the effective date is delayed three years. Once the rules go into effect, the shareholders may submit nominations for director in the first 120-day to 150-day window period that is open, measured from the anniversary of the mailing date of the prior year's proxy statement. A company that mailed its proxy materials for the prior year's annual meeting on or after March 15, 2010, will be subject to the rules in the upcoming proxy season. We recommend that companies evaluate their shareholder base and corporate governance record to prepare for these rules and to consider any issues that may be raised by nominating shareholders or groups or their director nominees.

First, we recommend that companies continue to monitor their shareholder base. While shareholders or groups may be required to file beneficial ownership reports on Schedule 13D or 13G, many shareholders eligible to use Rule 14a-11 may not trigger these disclosure thresholds. In one study of share ownership concentrations cited in the Commission's release adopting the final rules, it was noted that approximately 33% of nonaccelerated filers and 32% of large accelerated filers have at least one 3% shareholder, as adjusted to give effect to the three-year holding period. Accordingly, companies should consider who their significant shareholders are and whether those shareholders are likely to exercise their rights under the new rules. Engaging in a continuous dialog with significant shareholders and institutional investors may provide a company with advance notice of those investors' intentions, rather than a surprise nomination within the window period specified for shareholder nominations.

We also recommend that companies consider whether their shareholders have short-term or long-term investment motives. While the final rules suggest that a 3% shareholder would have a "significant, long-term interest" in a company, multiple commenters have suggested that such shareholders may have a short-term focus that is not representative of the broader shareholder base as a whole. Moreover, these shareholders, which are likely to be institutional investors, may not be representative of a company's retail investors. While any directors nominated by such candidates and thereafter elected would be bound by fiduciary duties, questions remain as to whether shareholdernominated directors would be most effective at overseeing a company's long-term goals.

In addition, companies should consider whether bylaw amendments may be appropriate in light of the new rules. The Rule 14a-11 nominating notice window is between 150 and 120 days before the mailing date of the prior year's proxy statement. A company with an advance notice bylaw provision that ends later may wish to change its bylaw notice period to coincide with the Rule 14a-11 access notice period, so that the company will be aware of all nominees when making exclusion and other decisions as to access nominees. Also, given that nominees not vetted by the nominating committee will now have access to company proxy statements, a company may wish to review its director qualifications and consider adding them to its bylaws in order to put shareholders on notice of the qualifications that the company requires of its directors. These qualifications may include, for example, restrictions on service on other boards, age limits or a requirement to sign an advance resignation in order to give full effect to majority voting.

Finally, we recommend that companies evaluate their corporate governance record. Companies that employ current best practices in corporate governance may be less likely to see nominations from shareholders or groups that are anxious to advance their own agenda, or may be better able to convince shareholders to withhold support for shareholder nominations if they can demonstrate a proven track record of solid governance. Companies should examine whether they have been responsive to past shareholder proposals and, if not, whether shareholders would be likely to nominate their own director candidates to direct attention to those proposals. Companies also may wish to review the historical voting tallies from director elections. Commenters have suggested that, once the final rules become effective, institutional investors may first target those companies that have had contested elections or elections by narrow margins. Companies that have had contested elections or elections by narrow margins may want to consider whether any particular governance issues have prompted the results of those elections and whether the company has since addressed those particular issues. Additionally, companies may consider whether provisions of its governing documents may be preempted by the final rules or subject to shareholder proposals that cannot be excluded under Rule 14a-8.

Conclusion

The final rules will likely have a significant impact on the dynamics of shareholder relations and the election of directors. If shareholder nominees for director are elected to a company's board, there is potential for a shift in board interactions as company-nominated directors interface with shareholder-nominated directors who may not be representative of a company's shareholder base as a whole. Ultimately, companies should consider how the final rules will be viewed by their shareholder base, what shareholders or groups of shareholders would be likely to nominate director candidates, and what governance concerns or agenda those shareholders or groups may seek to advance through their nominees.

Footnote

1 This Client Alert focuses on the implications of the final rules for public companies. The final rules also apply to registered investment companies. For information regarding the application of the final rules to registered investment companies, please contact your regular Drinker Biddle Investment Management Group contact.

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