SEC submits two approaches for shareholder proposals relating to election of directors

By Cydney Posner

The SEC, unable to resolve differences among commissioners, has posted two new releases proposing two alternative approaches to shareholder proposals under Rule 14a-8 relating to the election of directors. Please click here for release 1 and release 2.

Rule 14a-8 creates a procedure under which shareholders, subject to certain requirements, may present in the company’s proxy materials a broad range of binding and non-binding proposals. The rule also addresses the issue of when a company must include a shareholder's proposal in the company's proxy statement and identifies a number of specific circumstances or substantive categories under which a company may exclude a shareholder's proposal. One of these exclusions, Rule 14a-8(i)(8), permits exclusion if the proposal relates to an election for membership on the company's board of directors.

You may recall that the controversy over shareholder proposals for the election of directors has been brewing since at least September 2006, when the 2d circuit disagreed with a 1990 interpretation of the SEC staff construing Rule 14a-8(i)(8) to permit the exclusion of shareholder proposals related to election reforms that would result in contested elections. (See my email, dated September 7, 2006, copied below, regarding the controversy.) Because the court viewed the SEC 's current interpretation as in conflict with the SEC's 1976 position and because, in the court's view, the SEC did not even acknowledge any change, let alone provide the necessary "reasoned analysis" for the shift, the court held that the SEC's recent interpretation did "not merit the usual deference we would reserve for an agency's interpretation of its own regulations." Instead, the court deferred to the SEC's 1976 position, holding that the election exclusion applied only to shareholder proposals that related to a particular election and not to proposals that would establish the procedural rules for shareholders to wage a future election contest. That decision roiled an already heated debate over shareholder access to company ballots. Apparently rankled by the 2d circuit's rebuff, the SEC reacted immediately, announcing that, on October 18, 2006, it would hold a meeting at which it would recommend a proposal to effectively undo the 2d circuit decision, a proposal that, at that point, had not yet even been developed. That event never occurred, as the commissioners clashed repeatedly over the proper approach to take.

With these two proposals now on the table, and some commissioners registering their unambiguous opposition to one or another of the proposals, it's clear that resolution is still far from being achieved. As reported by the WSJ in the article copied at the end of this email, after the SEC passed the two proposals last month, Chairman Cox, who had voted in favor of both proposals, said he favored the proposal that would give shareholders access. However, the imminent departure of Commissioner Campos, who had voted in favor of the shareholder access proposal, makes adoption problematic. Nevertheless, Commissioner Cox has announced his intent to have new rules on this topic in place for next year's proxy season. Whether that will come to pass remains to be seen.

The first proposal is intended to clarify and provide certainty as to the meaning of the exclusion for shareholder proposals related to the election of directors that is contained in Rule 14a-8(i)(8) and essentially affirms the SEC's 1990 position. The second proposal would, among other things, amend Rule 14a-8 to enable shareholders to include in company proxy materials their proposals for bylaw amendments regarding the procedures for nominating candidates to boards of directors and would require the inclusion of additional information typically required in proxy contests.

First Proposal--Affirmation of Current Interpretation and Related Amendments

Interpretive Guidance. To address concerns that the 2d circuit decision has resulted in uncertainty and confusion and may lead to contested elections for directors without adequate disclosure, the SEC issued the first release to confirm its position and to propose further clarifying amendments to the Rule.

The SEC currently regulates contested proxy solicitations under various rules, particularly Rule 14a-12, to assure that investors receive adequate disclosure to enable them to make informed voting decisions in elections. In originally proposing the 14a-8(i)(8) exclusion, the SEC said that the "principal purpose of [Rule 14a-8(i)(8)] is to make clear, with respect to corporate elections, that Rule 14a-8 is not the proper means for conducting campaigns or effecting reforms in elections of that nature, since other proxy rules, including [former] Rule 14a-11, are applicable thereto." For purposes of Rule 14a-8, the SEC staff takes the position that a proposal may result in a contested election, and therefore may be excluded, if it is a means either to campaign for or against a director nominee or to require a company to include shareholder-nominated candidates in the company’s proxy materials, a position the SEC contends in this interpretive release to be consistent with its 1976 explanation. The SEC contends that, because a board typically includes its own director nominees in its proxy materials, allowing shareholders to include their nominees in company proxy materials would create, in effect, a contested election of directors, without the shareholders conducting a separate proxy solicitation. However, the current regulatory regime does not contemplate the presence of nominees from different vying factions in the same proxy materials, with the result that, under the 2d circuit position, an election contest could be waged without conducting a separate proxy solicitation and without providing the disclosures otherwise required for proxy contests, thus evading the SEC's stated purpose for the 14a-8(i)(8) exclusion. As a consequence, the SEC has taken the position that "a proposal may be excluded under Rule 14a-8(i)(8) if it would result in an immediate election contest (e.g., by making or opposing a director nomination for a particular meeting) or if it would set up a process for shareholders to conduct an election contest in the future by requiring the company to include shareholders’ director nominees in the company’s proxy materials for subsequent meetings." The analysis under Rule 14a-8(i)(8) does not focus on whether the proposal would make election contests more likely, but rather on whether the resulting contests would be governed by the SEC’s proxy rules for contested elections.

This interpretation of whether a proposal "relates to an election" should not be read to permit the exclusion of other proposals regarding the qualifications of directors, the composition of the board, shareholder voting procedures or board nomination procedures that would not result in an election contest or significantly conflict with the SEC's other proxy rules. More specifically, the SEC staff has taken the position that a proposal relates to "an election for membership on the company’s board of directors or analogous governing body" and, as such, may be excluded under Rule 14a-8(i)(8) if it could have the effect of any of the following:

• disqualifying board nominees who are standing for election;
• removing a director from office before his or her term expired;
• questioning the competence or business judgment of one or more directors; or
• requiring companies to include shareholder nominees for director in the companies’ proxy materials or otherwise resulting in a solicitation on behalf of shareholder nominees in opposition to management-chosen nominees.

Conversely, the SEC staff has taken the position that a proposal may not be excluded under Rule 14a-8(i)(8) if it relates to any of the following:

• qualifications of directors or board structure (as long as the proposal will not remove current directors or not disqualify current nominees);
• voting procedures (such as majority or cumulative voting);
• nominating procedures; or
• reimbursement of shareholder expenses in contested elections.

Proposed Amendments o Rule 14a-8(i)(8). Currently, the text of Rule 14a-8(i)(8) states only that a proposal may be excluded "[i]f the proposal relates to an election for membership on the company’s board of directors or analogous governing body." To clarify the meaning of the exclusion, consistent with the SEC's interpretation,, the SEC is proposing to revise the exclusion to read: "If the proposal relates to a nomination or an election for membership on the company’s board of directors or analogous governing body or a procedure for such nomination or election." The SEC believes that the added references would more appropriately reflect the purpose of the election exclusion. The SEC would also clearly indicate that the term "procedures" relates to procedures that would result in a contested election, either in the year in which the proposal is submitted or in subsequent years.

Second Proposal--Amendments to Allow Proposals Relating to Candidate Nominations

The second proposal would amend Rule 14a-8 to enable shareholders to include in company proxy materials their proposals for bylaw amendments regarding the procedures for nominating candidates to the board of directors and would require the inclusion of additional information about the proponents of these proposals under such an adopted procedure, as well as other information typically required in proxy contests. Finally, the proposed amendments would revise the proxy rules to clarify that participation in an electronic shareholder forum that could otherwise constitute a solicitation would generally be exempt from the proxy rules. The release also requests comment on whether the SEC should adopt rules to provide additional flexibility regarding non-binding proposals.

Historically, the SEC has sought to use its authority in a manner that does not conflict with the primary role of the states in establishing corporate governance rights. One of the key rights that shareholders have under state law is the right to appear in person at a shareholders' meeting and to present proposals, including candidates for director. The SEC's regulations have been designed to facilitate the corporate proxy process so that it functions, as nearly as possible, as a replacement for an actual, in-person gathering of shareholders, Currently, the proxy rules permit any shareholder to solicit votes for the election of a nominee to the board through a proxy solicitation by that shareholder, but do not require a company to include a shareholder’s nominee for director in its proxy materials. From time to time, the SEC revisits the proxy rules to ensure their proper functioning. Recently, the SEC held three roundtables to address the proxy process and, in light of those discussions, is proposing that the current proxy rules and related disclosure requirements be revised and updated to more effectively serve the essential purpose of facilitating the exercise of shareholders’ rights under state law

Proposed Amendments to the Proxy Rules and Related Disclosure Requirements

The SEC is proposing changes to Rule 14a-8(i)(8) that would permit a shareholder to have a bylaw proposal for director nomination procedures, including a proposal comparable to the one in the 2d circuit case, included in the company’s proxy materials, along with additional amendments that would require additional disclosure regarding the bylaw proposal and its proponents as well as any director nominated pursuant to any such bylaw provisions.

Proposed Amendments Concerning Bylaw Proposals for Shareholder Nominations of Directors. The proposed amendments to Rule 14a-8(i)(8) would enable shareholders to have their proposals for bylaw amendments regarding the procedures for nominating directors included in the company’s proxy materials so long as:

• The shareholder (or group of shareholders) that submits the proposal is eligible to file a Schedule 13G (i.e., has acquired and continues to hold the securities beneficially owned without "a purpose or effect of changing or influencing the control of the issuer, or in connection with or as a participant in any transaction having that purpose or effect" ) and files a Schedule 13G that includes specified public disclosures regarding its background and its interactions with the company;
• The proposal is submitted by a shareholder (or group of shareholders) that has continuously beneficially owned more than 5% of the company’s securities entitled to be voted on the proposal at the meeting for at least one year (which time period would be applied individually to each group member) by the date the shareholder submits the proposal; and
• The proposal otherwise satisfies the requirements of Rule 14a-8 (i.e., it could still be excluded on another basis).

The nominating procedures could require a minimum level of share ownership for those making director nominations that would be included in the company’s proxy materials, specify the number of director slots subject to the procedure or prescribe a method for the allocation of any costs; the only substantive limitations on the nominating procedures would be those imposed by state law or the company’s charter and bylaws. The SEC believes that using the Schedule 13G regime would save on compliance costs and minimize the risk of inappropriate circumvention of the disclosure and procedural regulations intended to apply in contested elections. If the Schedule 13G requirements were not met, a company could then exclude the proposal. Note that the SEC confirms that proposing a bylaw amendment pursuant to proposed amended rules would not, by itself, eliminate the ability to file a Schedule 13G, but eligibility would continue to require a facts-and-circumstances determination. The vote required to adopt the bylaw would be determined by state law or the company's charter or bylaws. The SEC is seeking comment as to whether the percentage threshold should be changed, including the possibility of variation depending upon the size of the company.

Proposed Disclosure Requirements Related to Shareholder Proponents and Nominating Shareholders. To trigger the requirement that the proposal be included in the company's proxy materials, under amendments to Schedule 13G and a new Item 24 of Regulation 14A, the proposing shareholder and, in some instances, the company, would need to provide disclosure about the shareholder's own background and intentions and the course of dealings between the shareholder and the company. This information is particularly important because the proposing shareholders owe no fiduciary duty to the company or to the other shareholders, but are, at the same time, using company assets.

The proposal would require any shareholder (or group of shareholders) that forms any plans or proposals regarding an amendment to the company’s bylaws concerning shareholder nominations of directors to file or amend and keep updated a Schedule 13G to include information regarding the shareholder proponent’s "relationships" with the company and additional relevant background information on the shareholder proponent. "Formation of any plans or proposals" would include the submission of a proposal to amend the company’s bylaws and discussions in which the shareholder indicated to management an intent to submit such a proposal or indicated an intent to refrain from submitting such a proposal conditioned on the taking or not taking of an action by the company.

Relationships with the company would include:

• any direct or indirect interest of the shareholder proponent in any contract with the company or any affiliate of the company (including any employment agreement, collective bargaining agreement or consulting agreement);
• any pending or threatened litigation in which the shareholder proponent is a party or a material participant, involving the company, any of its officers or directors or any affiliate of the company; and
• any other material relationship between the shareholder proponent and the company or any affiliate of the company not otherwise disclosed

A shareholder proponent would also need to describe any material transaction of the shareholder proponent with the company or any affiliate of the company and any discussion regarding the proposal between the shareholder proponent and a proxy advisory firm, that, in either case, occurred during the 12 months prior to the formation of any plans or proposals or during the pendency of any proposal or nomination. The shareholder would also be required to provide disclosure regarding any holdings of more than 5% of the securities of any of the company's competitors (defined as any company with the same SIC code), as well any material relationships, other than as a shareholder, with any competitors, including a current or prior employment or consulting relationship. The amendments would also require disclosure regarding any meetings or contacts, including direct or indirect communication by the shareholder proponent, with the management or directors of the company that occurred during the prior 12-month period, including discussion of whether that communication referred to the possibility of the proposal and the company's response. Substantial information would be required concerning the background of the shareholder, including information regarding qualifications, fiduciary duties, special interests not shared by other shareholders (such as contractual arrangements, current or previous employment with the company, employment agreements, consulting agreements and supplier or customer relationships) and the persons at an entity-shareholder responsible for the plan.

Proposed new Item 24 to Schedule 14A would require the company to disclose similar information, including:

• the nature and extent of the relationship between the company and the shareholder proponent and its affiliates, executive officers and agents and persons acting in concert with the shareholder with respect to the proposed bylaw amendment;
• any direct or indirect interest of the shareholder proponent in any contract with the company or any affiliate of the company (including any employment agreement, collective bargaining agreement or consulting agreement); any pending or threatened litigation in which the shareholder proponent is a party or a material participant involving the company, any of its officers or directors, or any affiliate of the company; and
• any other material relationship between the shareholder proponent and the company or any affiliate of the company not otherwise disclosed.

Additionally, Item 24 would require disclosure of any material transaction of the shareholder proponent with the company or any affiliate of the company and any meetings or contacts between the shareholder proponent and management or directors of the company with respect to the prior 12-month period. With respect to the date on which the shareholder proponent formed any plans or proposals, the company would be entitled to rely on the Schedule 13G disclosures of the shareholder proponent.

Disclosure by Nominating Shareholders–Proposed New Rule 14a-17. To address basic concerns that shareholders need adequate information regarding the candidate nominated, the SEC is proposing a new Rule 14a-17, which would, in effect, apply the existing disclosure requirements for solicitations in opposition (either for a short slate or for a majority of board seats) to nominating shareholders and their nominees under any shareholder nomination procedure. These disclosure requirements would provide basic information regarding the nominating shareholder (or shareholder group) and nominee or nominees, including biography and shareholdings, other interests of the individuals, methods and costs of the solicitation and other information. The information would appear in the company's proxy statement or, in the internet version of the proxy statement, incorporated by hyperlink to a website address where those disclosures would appear. The nominating shareholder would be responsible for providing the information to the company, including a statement that the shareholder nominee consented to being named in the proxy materials and to serve if elected.

New Rule 14a-17(b) would require any nominating shareholder to provide to the company the new disclosures required on Schedule 13G at the time the shareholder formed any plans or proposals (including instances where the shareholder had indicated an intent to management to submit a nomination or to refrain from submitting a nomination conditioned on the taking or not taking of a corporate action) with respect to submission of a nominee for director to the company for inclusion in the proxy materials. The company would be required to immediately provide the information on its website either directly or by a link to a website address where the disclosure would appear. New Item 25 of Schedule 14A would require the company to include the disclosure in its proxy statement or, in the internet version of its proxy statement, provide a link to a website address where the disclosure would appear. If a nominating shareholder failed to provide the required information, the company would not be required to include the shareholder’s nominee in the company’s proxy materials.

Liability Issues. The SEC intends that a shareholder who nominated a director under a bylaw provision concerning the nomination of directors would be liable for any materially false information. The proposed rules contain express language providing that the company would not be responsible for that disclosure nor would that information be incorporated by reference into SEC filings unless the company determined to incorporate that information by reference specifically into that filing. However, to the extent the company does so incorporate that information, it would become responsible for the disclosure of that information for liability purposes.

Filing Requirements. A company proxy that included a candidate for director nominated in accordance with a shareholder nomination bylaw procedure would need to be filed as a preliminary proxy in the same manner as applicable to proxy contests. Any additional soliciting materials, whether from the company or the shareholder, must be filed as definitive additional soliciting material no later than the date they were first sent or given to shareholders.

Electronic Shareholder Forums

One of the suggestions arising out of the SEC's recent roundtables was the idea of an online forum, restricted to shareholders of the company (whose anonymity is protected through encrypted unique identifiers), that would allow shareholders to discuss among themselves throughout the year the subjects that most concern them. Shareholder expressions of interest on particular suggested actions, tabulated based on their ownership interest, could be determined on a real-time basis. The company could use the forum to provide information, such as a copy of press release information regarding record dates and expression of views by the company. While the SEC is not seeking to devise an approved regulatory version of an electronic shareholder forum, it recognizes that the current proxy rules were not devised in contemplation of widespread internet communications and "strongly encourages" these creative new developments. As a result, the SEC is proposing amendments designed to remove any unnecessary real and perceived impediments to continued private sector experimentation and use of the internet for communication among shareholders, and between shareholders and their companies.

Proposed Amendment to Facilitate the Use of Electronic Shareholder Forums. The proposed amendments are designed to clarify that a company is not liable for independent statements by shareholders on a company’s electronic shareholder forum and to address any ambiguity concerning whether use of an electronic shareholder forum could constitute a proxy solicitation.

Proposed Rule 14a-18(a) would make clear that both companies and shareholders are entitled to establish and maintain an electronic shareholder forum under the federal securities laws, provided that the forum is conducted in compliance with the federal securities laws, applicable state law and the company’s charter and bylaws. Rule 14a-18(b) would provide that a company or shareholder that simply establishes, maintains or operates an electronic shareholder forum would not be liable under the federal securities laws for any statement or information provided by another person to the forum (in the same way that the federal telecommunications laws protect an interactive computer service). Persons providing information to or making statements on the electronic shareholder forum would remain liable for the content of those communications under traditional liability theories under the federal securities laws, including anti-fraud prohibitions against primary or secondary participation in fraud, deception or manipulation.

In light of the broad definition of "proxy solicitation," the SEC also proposes to exempt any solicitation in an electronic shareholder forum by or on behalf of any person who does not seek directly or indirectly, either on its own or another’s behalf, the power to act as proxy for a shareholder and does not furnish or otherwise request, or act on behalf of a person who furnishes or requests, a form or revocation, abstention, consent or authorization, so long as it occurs more than 60 days prior to the date announced by the company for its annual or special meeting of shareholders (or if the company announces the meeting less than 60 days before the meeting date, the solicitation may not occur more than two days following the company’s announcement). Solicitations not within these time periods (e.g., communications and data that remain on the forum within the 60-day period) may no longer be exempt. In addition, a person who participates in an electronic shareholder forum and makes solicitations in reliance upon the proposed exemption would continue to be eligible to solicit proxies outside of the proposed new rule in compliance with Reg 14A.

Bylaw Amendments Concerning Non-Binding Shareholder Proposals

Currently, the proxy rules require the company to include in its proxy materials non-binding resolutions of eligible shareholders on subjects unrelated to the company’s ordinary business unless the proposals fall within one of the substantive bases for exclusion in Rule 14a-8. Proposals regarding matters that traditionally are within the province of the board and management, such as a proposal concerning a matter that under state law would not be a proper subject for shareholder action alone if it were cast as a binding proposal, may nonetheless be included in the company’s proxy materials under Rule 14a-8 if cast as a recommendation or request that the board take specified action. The SEC is soliciting comment on whether it should adopt rules that would enable shareholders, if they chose to do so, to determine the particular approach they wish to follow with regard to non-binding proposals, that is, whether shareholders should have the ability to propose and adopt bylaws that would establish the procedures that the company would follow for including non-binding proposals in the company’s proxy materials.