United States: SEC Proposes Rules to Increase Shareholder Proxy Access

On October 14, 2003, the Securities and Exchange Commission (the SEC) proposed new rules under the Securities Exchange Act of 1934, as amended (the Exchange Act) that would, under certain circumstances, require public companies to include in their annual meeting proxy statements and on their proxy cards nominees for director that are submitted by shareholders meeting specified standards.¹ These requirements would be "triggered" if:

• more than 35 percent of the shareholders voting on directors at an annual meeting "withhold" votes on one or more company nominees; or

• a shareholder (or shareholder group) holding at least 1 percent of the company’s outstanding shares submits a Rule 14a-8 proposal to an annual meeting to activate the shareholder access requirements and the proposal receives a majority of the votes cast at that meeting.

The number of nominees that may be directly recommended by shareholders will depend on the size of the board in question. Comments on these proposed rules are due by December 22, 2003.

The proposed shareholder access rule, which will apply if a "triggering event" occurs at an annual meeting held after January 1, 2004, is the second and more far reaching part of the SEC’s initiative to increase shareholder access to the process of nominating and electing directors. The first part of this initiative, proposed by the SEC on August 8, 2003, focused on increasing disclosure regarding the operation of a company’s board nominating committee and proposed new disclosure requirements regarding the means by which shareholders may communicate with a company’s board of directors.²

Both sets of proposed rules follow the recommendations made by the Division of Corporation Finance in its July 15, 2003 staff report to the SEC on direct shareholder access to the director nomination process.³ The July 15 staff report was produced at the direction of the SEC for the purpose of examining current proxy regulations and developing possible changes to those regulations in order to improve corporate democracy.⁴

Because the SEC has announced that the proposed shareholder access rule will become operative upon the occurrence of a triggering event occurring after January 1, 2004, even if the final rule is not adopted at that point, this rule raises some immediate concerns with respect to the 2004 proxy season. These concerns are discussed below.

Under proposed Exchange Act Rule 14a-11, provided that applicable state law does not prohibit a company’s shareholders from nominating a candidate for election as a director, the SEC would require any company subject to the proxy rules (generally, any company with publicly registered equity securities that is not a foreign private issuer,5 including a registered investment company)6 to include in its proxy materials the names and other specified information regarding shareholder nominees after the occurrence of either one of the two following "triggering" events:

• any of the company’s nominees for director for whom the company solicited proxies receives "withhold" votes totaling more than 35 percent of the total votes cast at an annual meeting (or special meeting held in lieu of an annual meeting) of shareholders (except in the case of a contested election where individuals are nominated in opposition to the company’s nominees, and except in an election to which the shareholder nomination procedure in proposed Rule 14a-11 applies); or

• a shareholder proposal to activate the shareholder nomination procedure is submitted pursuant to Rule 14a-8 for a vote of shareholders at an annual shareholders meeting by a shareholder or group of shareholders who have held at least 1 percent of the company’s outstanding shares entitled to vote on the proposal for one year as of the date the proposal was submitted, and such "direct access" proposal receives a favorable vote of at least a majority of the votes cast on it at that shareholders meeting.

As part of the proposing release, the SEC has requested comment on whether to add a third triggering event, which would occur if:

• a shareholder proposal (other than a director nomination under proposed Rule 14a-11) is submitted by a shareholder or group of shareholders who have held at least 1 percent of the company’s outstanding shares entitled to vote on the proposal for one year as of the date the proposal was submitted and included in the company’s annual meeting proxy materials pursuant to Rule 14a-8;

• such shareholder proposal receives the favorable vote of at least a majority of the votes cast at the shareholders meeting; and

• the board of directors of the company fails to implement the proposal by 120 days prior to the anniversary of the date that the company mailed its proxy materials for the prior year’s annual meeting.

In order to provide shareholders with notice of a triggering event, the SEC has proposed requiring companies to disclose in their proxy statements when any shareholder proposal is submitted that may trigger the shareholder nomination procedure, as well as requiring disclosure in their periodic reports of the results of any vote that does trigger the shareholder nomination procedure.⁷

Upon the occurrence of a triggering event, the proposed shareholder nomination procedure would remain operative for those annual meetings or special meetings that are held during the period beginning on the date on which the triggering event occurs and ending on the date of the annual meeting (or special meeting in lieu of an annual meeting) held during the second calendar year following the date of the triggering event.⁸

During any period in which the shareholder nomination procedure is effective, a shareholder or group of shareholders that (a) has beneficially owned more than 5 percent of the company’s outstanding voting shares continuously for at least two years and (b) expresses the intent to hold such shares through the date of the next annual meeting or special shareholder meeting at which directors will be elected, would have the right to specify one or more nominees to the company’s board of directors for inclusion in the company’s proxy materials, provided that the following requirements are satisfied:

• The nominating shareholder or group of shareholders must be eligible to report beneficial ownership on Exchange Act Schedule 13G, in reliance on Exchange Act Rule 13d-1(b) or (c);⁹

• The shareholder or group must have filed a Schedule 13G or an amendment to Schedule 13G reporting beneficial ownership as a passive or institutional investor (or group) on such schedule before or on the date of submission of the nomination to the company, with such schedule including a certification that the shareholder or group of shareholders has held more than 5 percent of the company’s voting securities for at least two years; and

• The candidacy or election of the board nominee or nominees must not violate controlling state law, federal law or the rules of a national securities exchange or national securities association applicable to the company (other than the rules regarding director independence). However, as discussed below, proposed Rule 14a-11 does require that the nominating shareholder or group of shareholders represent that the nominee meets the objective independence criteria that are set forth in the rules of a national securities exchange or national securities association that apply to the company, if any.

The number of board nominees that may be recommended by shareholders will vary depending upon the size of the board of directors as follows:

• One nominee, if the board of directors has 8 members or less;

• Up to two nominees, if the board of directors has between 9 and 19 members; and

• Up to three nominees, if the board of directors has 20 or more members.

Adjustments to the maximum number of shareholder nominees would be made in the event that a company has a "staggered" board of directors.¹⁰

If the company receives shareholder nominations in excess of the applicable maximum number of nominees set forth above, then it is proposed that those nominees from the shareholder or group of shareholders with the largest beneficial ownership (as reported on Schedule 13G) will be permitted to be nominated for election to the board of directors.

In order to have a nominee included in the company’s proxy materials, the nominating shareholder or group of shareholders would be required to notify the company of its intent to require that the company include that shareholder’s nominee in the company’s proxy materials no later than 80 days before the anniversary of the date that the company mailed its proxy materials for the prior year’s annual meeting.¹¹ This notice would also be filed with the SEC by the shareholder or group no later than two business days after the notice is provided to the company. The notice would be considered soliciting material, subject to the prohibition against false or misleading statements contained in Exchange Act Rule 14a-9. The notice to the company would be required to include the following:

• A representation that, to the nominating shareholder’s knowledge, the nominee’s nomination (or if elected, board membership) does not violate controlling state law, federal law or the rules of a national securities exchange or national securities association applicable to the company (other than the rules regarding director independence);

• A representation that the nominating shareholder is eligible to submit a board nominee under the shareholder nomination procedure and satisfies the conditions of proposed Rule 14a-11(b);

• Representations that the board nominee or nominees do not have certain specified relationships with the nominating shareholder or group of shareholders;¹²

• A representation that the board nominee or nominees meet the objective independence criteria that are set forth in the rules of a national securities exchange or national securities association that apply to the company, if any;¹³

• A representation that the nominating shareholder or group of shareholders does not have any direct or indirect agreement with the company regarding the nomination of the board nominee;

• A copy of the Schedule 13G filed by the nominating shareholder or group of shareholders indicating ownership of at least 5 percent of the company’s voting securities, together with certain specified information to be included in the proxy statement with regard to each nominating shareholder or group of shareholders that is not included in their Schedule 13G;¹⁴

• A statement from the nominee, to be included in the proxy statement, that the nominee consents to be named in the proxy statement and form of proxy and, if elected, to serve on the board of directors;

• Disclosure regarding the nominee for inclusion in the proxy statement; and

• The methods by which the nominating shareholder or group of shareholders may solicit shareholders, including any Web site on which soliciting materials may published.

Under the proposed rule, if a company receives timely notice from a shareholder or group of shareholders activating the shareholder nomination procedure, unless the company determines that it is not required to include the shareholder nominee in its proxy materials, the company would be required to include the name of the nominee on the company’s proxy card, as well as certain information regarding the shareholder nominee in its proxy statement (including any Web site address on which the nominating shareholder or group of shareholders intends to solicit in favor of such nominee).¹⁵

In addition, the company would be required to advise the nominating shareholder or group of shareholders that its nominee would be included in the company’s proxy statement and to state whether the company intends to include in its proxy statement a statement opposing the shareholder nominee and/or supporting company nominees, other than a recommendation to vote in favor of or withhold votes from specified nominees. If the company includes such a statement, the company would be required to permit the nominating shareholder or group of shareholders to include in the company’s proxy statement a statement of up to 500 words supporting the shareholder nominee. The nominating shareholder or group of shareholders would be required to file that supporting statement with the SEC as soliciting material.

In the event that the company determines that it is not required to include the shareholder nominee in its proxy materials, it would be required to send written notice of its determination to the nominating shareholder or group of shareholders no less than 30 days prior to the anniversary of the date that the company mailed its proxy statement for the previous annual meeting.¹⁶ This notice (as well as the company’s proxy statement) would be required to contain information regarding the board’s determination to exclude the shareholder nominee.¹⁷

In order to allow shareholders to form nominating groups that meet the 5 percent minimum ownership requirement without being subject to the full array of proxy procedural and disclosure requirements,18 the SEC has proposed exempting from these requirements solicitations solely for the purpose of forming a group to propose a board nomination under proposed Rule 14a-11, provided that either:

• The total number of people solicited is not more than 30; or

• No written communication used in the solicitation includes anything more than a statement of the shareholder’s intent to form a nominating shareholder group, the percentage of securities that the shareholder beneficially owns or the aggregate percentage owned by any group to which the shareholder belongs, and the means by which shareholders may contact the soliciting shareholder.

In addition, a nominating shareholder or group of shareholders would benefit from the same proxy rule exemptions in connection with a solicitation in support of a nominee placed on the company’s proxy, provided that the following requirements are satisfied:

• The soliciting party must not seek, directly or indirectly, the power to act as proxy for a shareholder and must not furnish or otherwise request a form of revocation, abstention, consent or authorization;

• Each written communication must contain the identity of the nominating shareholder or group of shareholders and a description of his or her direct or indirect interests, by security holdings or otherwise; and

• Each written communication must include a prominent legend advising shareholders that (a) a shareholder nominee is or will be included in the company’s proxy statement and to read it when it becomes available because it includes important information, and (b) the proxy statement, other soliciting material and any other relevant documents are available at no charge on the SEC’s Web site.

The nominating shareholder or group of shareholders relying on these two exemptions must file with the SEC all soliciting materials published, sent or given to shareholders in connection with those solicitations.

A proposed instruction to paragraphs (b) and (c) of Exchange Act Rule 13d-1 provides that the nominating shareholder or group of shareholders will not be deemed to have a purpose or effect of changing or influencing the control of a company solely as result of participating in the director nomination process of proposed Rule 14a-11. Similarly, the SEC’s proposed amendment to Exchange Act Rule 16a-1(a)(1) provides that, for Section 16 reporting purposes, members of a nominating group of shareholders that own in the aggregate over 10 percent of the company’s securities, will not be deemed to have a control purpose or effect as a result of participating in the director nomination process, so that the members of the group (not otherwise subject to Section 16) will not be subject to the reporting requirements of Section 16(a) or liability for "short swing" profits under Section 16(b).

Under the proposed rule, the nominating shareholder or group of shareholders would be liable for any false or misleading statements included in the notice provided to the company and included, as required by proposed Rule 14a-11, in the company’s proxy statement, and the company would not being responsible for that disclosure. In addition, disclosure that is provided by the nominating shareholder to the company that is required to be included in the company’s proxy materials would not be incorporated by reference into any of the company’s SEC filings, unless the company specifically decided to incorporate such information in its filings.

Comments on the SEC’s proposal are due by December 22, 2003. In the release, the SEC has included extensive lists of questions on virtually every aspect of its proposal. For example, the SEC has specifically requested comment on whether (a) additional "trigger" events should be adopted, (b) the proposed ownership thresholds are appropriate, (c) there should be any additional limitations on shareholder nominee eligibility, and (d) there should be any limit on the number of shareholder nominees, and if so, whether the proposed limits are appropriate.

As previously noted, the SEC release proposing Rule 14a-11 states that the rule will apply if a triggering event occurs after January 1, 2004, whether or not the rule has been adopted. To drive the retroactivity message home, the SEC has recommended that, pending final action on the proposed rules, companies identify in their proxy statements any shareholder proposals that could trigger the shareholder nomination process, including traditional proposals under Rule 14a-8 that could trigger the process if the SEC adopts the "third trigger event" of approval by a majority vote of any Rule 14a-8 proposal that is not thereafter implemented by the board. The SEC notes that companies should consider whether the failure to make any such identification has implications for them under the anti-fraud rule, Rule 14a-9.

The question of the authority and propriety of the SEC giving retroactive effect to its adoption of Rule 14a-11 remains to be decided. In the meantime, companies must immediately consider how to address potential proposals to activate the shareholder nomination process, as well as whether other shareholder proposals received under Rule 14a-8 for the 2004 proxy season could trigger the process. In addition, campaigns to withhold votes on directors will have real significance, since if a director receives more than a 35 percent withhold vote based on votes cast at the 2004 annual meeting, that vote would be a valid trigger event under proposed Rule 14a-11, without regard to the effective date of the rule.

Until proposed Rule 14a-11 is final, companies will not be in a position to definitively address shareholder nomination proposals because the requirements for a shareholder nomination proposal (including who may make the proposal, what the proposal must say and what procedures must be followed for it to qualify) are subject to final rulemaking, and proposals submitted in advance of the adoption of final rules, although meeting the proposed criteria, may not qualify under the criteria ultimately adopted. It is possible that companies may seek to eliminate the need for including proposals to activate the shareholder nomination process in their proxy materials on various grounds, such as challenging the SEC’s interpretation that existing Rule 14a-8 permits such proposals, or taking the position that including such a proposal in the face of uncertainty regarding the content of final rules would be misleading and therefore violate Rule 14a-9.

Companies receiving more traditional proposals under Rule 14a-8 will also face difficult disclosure questions, since the possible effect of such proposals as triggering events is even more uncertain. Disclosing that shareholder approval of such a proposal might trigger a shareholder nomination procedure under proposed SEC rules would almost certainly increase the likelihood of approval for such a proposal, regardless of its nature. This result appears to raise the very concerns that prompted the SEC to exclude the "third triggering event" from proposed Rule 14a-11 in the first place.¹⁹ Therefore, companies receiving such Rule 14a-8 proposals may wish to consider taking a more aggressive approach to determinations regarding whether such proposals need to be included in their proxy materials. In any event, companies receiving shareholder proposals (whether for activating the shareholder nomination procedure or otherwise) should attempt to determine whether the 1 percent and one year tests for shareholder eligibility are satisfied, and if so, whether disclosure regarding the possible effect of the proposal as a triggering event may be necessary.

Because of the uncertainty surrounding direct access proposals pending final rulemaking, commentators have suggested that "withhold vote" campaigns may be the preferred strategy among shareholder groups for triggering the shareholder nomination process.²⁰ To counter the risk of such a campaign, companies should consider some or all of the following steps:

• Be proactive in identifying a "withhold vote" campaign. Because such a campaign would not involve solicitation of proxies, it would not be subject to SEC or other notice requirements, and likely would be conducted by telephone calls and e-mails among activist shareholders and like-minded investors and via Web sites favored by institutional investors and shareholder advocacy groups or created specifically for the withhold vote campaign. By thoroughly monitoring the internet, early detection may be possible and may increase the effectiveness of the company’s response.

• Get the vote out. A higher "withhold vote" percentage will result if fewer votes in favor of management’s nominees are cast. Therefore a more active solicitation of proxies will be important in defeating a "withhold vote" campaign.

• Upgrade the role of your proxy solicitor. Although more traditionally used in connection with contested elections and not in the context of an annual meeting, a pro-active and comprehensive utilization of a professional proxy solicitor could be effective, perhaps crucial, in defeating a "withhold vote" campaign and/or a Rule 14a-8 access proposal. If a company wants to avoid being vulnerable to direct shareholder access, it should take every precaution to prevent a trigger event in its 2004 proxy solicitation, including spending more money on proxy solicitors and other professional advisers.

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