SEC Issues Proposed Rules Mandating Shareholder Access to Proxies

On October 8, 2003, the Securities and Exchange Commission (Commission) proposed new rules requir-ing, in certain circumstances, a company to include in its proxy statement nominees for election to the board of directors submitted by shareholders.¹ The proposed rules are subject to a 60-day comment period, ending December 22, 2003.

This is likely to be one of the Commission's most significant rulemakings in years (and one of the few major rulemaking projects that was not mandated by the Sarbanes-Oxley Act of 2002), and is anticipated to draw heavy comment. The lobbying efforts to shape this rulemaking began soon after the Commission requested public comment on the possible changes to the proxy rules in April 2003² and the release on July 15, 2003 of a report by the Commission's Division of Corporation Finance recommending a number of proposed rule changes.³ That report included recommendations about shareholder proxy access, as well as other proposed rule changes that would require expanded disclosure of a company's director nomination process and disclo-sures of the procedures by which shareholders may communicate with directors. The Commission proposed the nomination process disclosure and shareholder communication rules on August 6, 2003.⁴

Structure of the Proposed Rules

The Commission indicated that it intends the proposed rules to address situations where there is evidence suggesting that companies have been unresponsive to concerns of their long-term shareholders. The Commission does not intend these rules to be used for change of control purposes or to create annual contests for the election of directors. The proposed rules are intended to be limited in scope, applying only to certain companies and certain eligible shareholders, with limitations on the eligibility and number of nominees.

Which Companies Would Be Subject to the Proposed Rules?

The proposed rules would generally apply to all companies that are subject to the Commission's proxy rules, including investment companies that are registered under Section 8 of the Investment Company Act. The proposed rules would not apply if applicable state law prohibits a company's shareholders from nominat-ing a candidate for election to the board of directors. Additionally, if applicable state law permits companies incorporated in a state to prohibit shareholder nominations through provisions in a company's articles or certificate of incorporation or bylaws, then the proposed nomination procedure would not be available to shareholders of a company that had validly included such a provision in its governing documents.

Although the proposed rules would apply to all companies that are subject to the proxy rules, the Commission has requested comment on whether to limit application of the proposed rules to companies that are "accelerated filers" under the Exchange Act.⁵

What Events Would Have to Occur Before a Company Would Be Required to Include a Shareholder Nominee in Its Proxy Materials?

The nomination procedure would apply only after one of the following triggering events occurs:

• A shareholder proposal providing that the company shall become subject to the shareholder nomi-nation procedure (proposed Exchange Act Rule 14a-11) is submitted by a shareholder or group of shareholders owning at least one percent of a company's outstanding shares for at least one year and that proposal receives more than 50 percent of the votes cast; or
• At least one of the nominees for the company's board of directors receives "withhold" votes from more than 35 percent of the votes cast.⁶

After a triggering event occurs, the nomination procedure would apply to any annual meetings (or special meetings in lieu of annual meetings) held during:

• The remainder of the calendar year in which the triggering event occurs;
• The next calendar year; and
• The portion of the following calendar year up to and including the annual meeting (or special meeting in lieu of an annual meeting) held during that calendar year.

Under the proposed rules, a direct access shareholder proposal adopted after January 1, 2004 could be a nomination procedure triggering event. Accordingly, companies may need to consider proper procedures for dealing with such a proposal in advance of the effectiveness of the final rules.⁷

What Notice Would a Company Be Required to Give Regarding the Occurrence or Potential Occurrence of a Triggering Event?

When a company receives a shareholder proposal that may trigger the shareholder nomination procedure, the company must advise shareholders of this fact in the proxy statement relating to the meeting at which that shareholder proposal will be presented.

If a triggering event occurs, then the company would be required to disclose, in its next Form 10-Q or Form 10-QSB, the shareholder vote with regard to the triggering event and that the company is now subject to the shareholder nomination procedure. If the triggering event occurs during the fourth quarter of the company's fiscal year, then the company would be required to make this disclosure on its Form 10-K or Form 10-KSB.

Which Shareholder(s) Would Be Able to Submit a Nominee for Inclusion in the Company's Proxy Materials?

Once the shareholder nomination procedure is triggered, only shareholders meeting certain criteria would be able to submit a nomination pursuant to the new procedure. To be eligible, the shareholder(s) would have to:

• Beneficially own, either individually or in the aggregate as a group, more than five percent of the company's outstanding securities that are eligible to vote for the election of directors at the next annual meeting (or special meeting in lieu of an annual meeting) and have owned each of the securities used to calculate that ownership continuously for at least two years as of the date of nomination;
• Intend to continue to own those securities through the date of that annual or special meeting;
• Each be eligible to report beneficial ownership on Schedule 13G, rather than Schedule 13D; and
• Have filed a Schedule 13G or an amendment to Schedule 13G reporting its beneficial ownership as a passive or institutional investor (or group) on or before the date that it submits the nomination to the company and including a certification that the shareholder(s) has held more than five percent of the subject securities for at least two years.

Who Could Be Nominated Pursuant to this Procedure?

For a nominee to be eligible for inclusion in the company's proxy materials, the nominating shareholder(s) would be required to represent that:

• The proposed nominee meets any independence standards of a national securities exchange or national securities association (but, to the extent that any applicable independence standards require a subjec-tive determination by the board of directors or a committee of the board of directors, that element of the standard would not have to be satisfied); and
• Neither the nominee nor the nominating shareholder has any direct or indirect agreement with the company regarding the nomination of the nominee.

The nominating shareholder(s) also would be required to represent that the proposed nominee does not have any of the following relationships with the nominating shareholder(s):

• If the nominating shareholder or any member of the nominating shareholder group is a natural person, the nominee is not the nominating shareholder, a member of the nominating shareholder group, or a member of the immediate family of the nominating shareholder(s);
• If the nominating shareholder or any member of the nominating shareholder group is an entity, neither the nominee nor any immediate family member of the nominee has been an employee of the nominating shareholder(s) during the then-current calendar year or the immediately preceding calendar year;
• Neither the nominee nor any immediate family member of the nominee has, during the year of the nomination or the immediately preceding calendar year, accepted directly or indirectly any consult-ing, advisory or other compensatory fee from the nominating shareholder(s) or any affiliate of the nominating shareholder(s);⁸
• The nominee is not an executive officer or director (or person fulfilling similar functions) of the nomi-nating shareholder(s) or of an affiliate of the nominating shareholder(s); and
• The nominee does not control the nominating shareholder(s) (or in the case of a nominating share-holder that is a fund, an interested person of such fund as defined in Section 2(a)(19) of the Investment Company Act).

Notwithstanding those representations, a company would not be required to include a shareholder nomi-nee in its proxy materials if the nominee's candidacy or board membership would violate state law, federal law or rules of a national securities exchange or national securities association (other than those setting forth independence standards, as described above).

How Many Nominees Would a Company Be Required to Include in Its Proxy Materials?

The number of shareholder nominees that must be included by a company in its proxy materials would be a function of the size of that company's board of directors, requiring:

• One nominee for boards consisting of eight or fewer members;
• Two nominees for boards consisting of nine to 19 members; and
• Three nominees for boards consisting of 20 or more members.

In the event that a company receives from nominating shareholders a number of shareholder nominees in excess of these limits, then the company would be required to include in its proxy materials the nominees, up to the prescribed limits, of the shareholder or group with the largest beneficial ownership, as reported on Schedule 13G at the time the shareholder or group delivers to the company its nomination notice.

In the case of classified or "staggered" boards, the limitations on the number of shareholder nominees would take into account any current directors who were elected through this procedure but who are not up for re-election at the current annual meeting. For example, if a company's board of directors consists of ten members, and the company has two directors previously elected as shareholder nominees, and their terms will extend beyond the company's next annual meeting of shareholders, then the company may exclude any further shareholder nominees.

What Notices and Filings Would Be Required of Nominating Shareholders?

Nominating shareholders would be required to deliver a notice to the company of their intent to submit a nominee no later than 80 days before the anniversary of the date that the company mailed its proxy materials for the preceding year's annual meeting, and would be required to file that notice with the Commission no later than two business days after delivering the notice to the company. The notice would be required to contain representations and supporting documentation regarding the eligibility of the nominating shareholder(s) to submit a nominee, the nominee's eligibility, information regarding the nominee typically required to be dis-closed for director nominees in proxy statements, a copy of the Schedule 13G of the nominating shareholder(s) and information about the methods by which the nominating shareholder(s) may solicit shareholders, including any Website address on which the nominating shareholder(s) may publish soliciting materials.

The notice filed by the nominating shareholder(s) with the Commission would be filed under the company's Exchange Act file number and under a Schedule 14A cover page and would be viewed as soliciting material of the nominating shareholder(s), and accordingly would be subject to the general anti-fraud provisions of Exchange Act Rule 14a-9.⁹

What Would Be the Obligations of the Company After It Receives a Nomination Notice?

Determination Regarding Inclusion

Companies would be able to reject shareholder nominations if:

• The proposed rules are not applicable to the company because of state law or provisions in the com-pany's governing documents;
• The nominating shareholder(s) has not complied with the proposed rules;
• The nominee does not meet the requirements of the proposed rules;
• Any representation required to be included in the notice to the company is false in any material respect; or
• The company has received more nominees than it is required to include, and the nominating shareholder(s) is not entitled to have its nominee included in that situation.

In any such case, the company would be required to notify the nominating shareholder(s) of its determi-nation to exclude the nominee promptly after that determination and in no event less than 30 calendar days before the anniversary of the date the company's proxy statement was released to shareholders in connection with the previous year's annual meeting. If the company did not hold an annual meeting in the previous year, or if the date of the current year's annual meeting has been changed by more than 30 days from the date of the previous year's meeting, then the notice would be required to be provided a reasonable time before the company mails its proxy materials for the current year.

If the company determines that it is entitled to exclude the nominee, then the notice must include the following information regarding the company's determination:

• A description of the determination made by the company's board of directors, including an affirmative statement of its determination not to include that specific nominee;
• A discussion of the specific requirement of the proposed rules that the board has determined permit the company not to include that specific nominee; and
• A discussion of the specific basis for the board's belief that the company is permitted to not include that specific nominee.

The company also would be required to include in its proxy statement a statement that it has made such a determination and to disclose the information relating to that determination that the company included in its notice to the nominating shareholder.

Procedures for Inclusion

If the company does not determine to exclude a nominee, the company would be required to inform the nominating shareholder(s) that the nominee will be included in the company's proxy materials. The company also would be required to include in its proxy materials the Website address, if any, on which the nominating shareholder(s) intends to solicit in favor of its nominee.

In the event that a company elects to include any statements in the proxy materials supporting or opposing the nominees, other than a mere recommendation to vote in favor of, or to withhold votes from, a particular candidate, then the company must also provide the opportunity to the nominating shareholder(s) to include in the company's proxy materials a statement of support for the candidate not exceeding 500 words. The company must advise the nominating shareholder(s) of the date by which this statement must be provided to the company, which may not be less than 10 business days from the date of the company's notice to the nominating shareholder(s). The supporting statement of the nominating shareholder(s) would be viewed as soliciting material and, therefore, would be required to be filed as such by the nominating shareholder(s), on or about the date that the company's proxy statement is first released to shareholders.

On the company's proxy card, the company may identify any shareholder(s) nominees as such and rec-ommend that shareholders vote against, or withhold votes from, those nominees and in favor of the manage-ment nominees on the form of proxy. The proposed rules would not, however, permit a company to provide shareholders the option of voting for or withholding authority to vote for the company nominees as a group. Rather, each candidate must be voted on separately. In all other respects, the company must present the information in an impartial manner.

What Would Be the Potential Liability for Statements Made by the Company and by the Nominating Shareholder(s) Under the Federal Securities Laws?

Exchange Act Liability for False or Misleading Statements

The proposed rules provide that the nominating shareholder(s), and not the company, would be responsible for any false or misleading statements included in the notice provided by the nominating shareholder(s) to the company.¹⁰

Securities Act and Exchange Act Liability Resulting from Incorporation by Reference

Under the proposed rules, any information that is provided to the company by the nominating shareholder(s), and then included in the company's proxy materials, would not be incorporated by reference into any filing under the Securities Act or the Exchange Act unless the company determines to incorporate that information by reference specifically into that filing. To the extent that the company does incorporate that information by reference in any future filing, then the information would be treated as being the company's own disclosure for purposes of the antifraud and civil liability provisions of the Securities Act and the Exchange Act.

How Would Nominating Shareholders' Solicitations Be Treated Under the Proxy Rules?

The proposed rules create an exemption from the proxy rules for any solicitation by or on behalf of any shareholder in connection with the formation of a nominating shareholder group, provided that:

• Either:
  • The total number of persons solicited is not more than 30; or
  • Each written communication includes no more than:
    • A statement of the intent of the shareholder(s) to form a nominating shareholder group in order to nominate a director under the proposed rule;
    • The percentage of shares that the shareholder(s) beneficially owns or the aggregate per-centage owned by any group to which the shareholder(s) belongs; and
    • The means by which other shareholders may contact the soliciting party; and
• Any soliciting material published, sent or given to shareholders is filed with the Commission by the nominating shareholder(s), under the company's Exchange Act file number and under a Schedule 14A cover page, no later than the date the material is first published, sent or given to shareholders.

To enable the nominating shareholder(s) to solicit in favor of its nominees outside of the company's proxy statement, the proposed rules create a new exemption from the proxy rules, which is available if:

• The soliciting party does not, at any time during the solicitation, 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 other-wise request, or act on behalf of a person who furnishes or requests, a form of revocation, abstention, consent or authorization;
• Each written communication includes:
  • The identity of the nominating shareholder(s) and a description of his or her direct or indirect interests, by security holdings or otherwise;
  • A legend advising shareholders, among other things, that a shareholder nominee is or will be included in the company's proxy statement and explaining where shareholders can find the proxy statement; and
• Any soliciting material published, sent or given to shareholders must be filed with the Commission by the nominating shareholder(s), under the company's Exchange Act file number and under a Schedule 14A cover page, no later than the date the material is first published, sent or given to shareholders.

What Reporting Obligations Would a Shareholder Group Face?

Schedule 13G

In connection with the proposed rules, the Commission would also add an instruction to the description of persons who may report their ownership on Schedule 13G to make clear the Commission's belief that the shareholder or group of shareholders should not be deemed to have a purpose or effect of changing or influencing the control of the company solely by virtue of making the nomination (or forming a group of shareholders to make the nomination), soliciting in connection with the nomination or having a nominee elected as a director.

The Commission proposes to amend Schedule 13G to require that the shareholder or group certify that they have owned the securities for the minimum time period of two years, as required under the proposed rules. A shareholder(s) that previously filed a Schedule 13G would be required to amend that schedule to provide the required certification to make a nomination under the proposed rules. Upon termination of the nominating shareholder group, the group would file a final amendment to the Schedule 13G disclosing termination of the group and, therefore, the group's filing obligation on Schedule 13G.

Section 16 Reports

Similarly, the Commission has proposed an amendment to Exchange Act Rule 16a-1(a)(1), the rule that defines who is a 10 percent owner for Exchange Act Section 16 purposes, to exclude a nominating shareholder group from the definition. These groups would remain subject to the general condition of the rule that they not have the purpose or effect of changing or influencing control of the issuer, but a note to Rule 16a-1(a)(1) would provide that members of nominating shareholder groups would not be deemed to have a control purpose or effect solely by virtue of group membership.

In the proposal, the Commission also addresses the "deputization" theory developed by courts in Section 16(b) short-swing profit recovery cases.^{11 Under this theory, it is possible for a person to be deemed a director subject to Section 16, even though the issuer has not formally elected or otherwise named that person a director. Because the proposed rules include standards for establishing the independence of the nominee from the nominating shareholder(s), the Commission has affirmatively stated that the "deputization" theory would not apply to members of any shareholder nomination group that meets the requirements of the proposed rules.}

How Would the Proposed Rules Apply to Investment Companies?

Under the proposed rules, the shareholder nomination procedure would apply to funds in the same manner that it applies to operating companies, subject to some minor modifications to reflect the different circum-stances and reporting requirements applicable to funds:

• Because funds do not file Form 10-Q, they would be required to provide disclosure regarding the occurrence of nomination procedure triggering events in their next semi-annual Form N-CSR;
• Although funds do not normally file Form 8-K, they would be required to do so to the same extent as operating companies under the proposed rules; and
• A nominating shareholder(s) would be required to represent that its nominee is not an "interested person" of the fund as defined in the Investment Company Act,^{12 rather than independent under the listing standards of a national securities exchange or national securities association, as in the case of operating companies. This "interested person" test also would apply to nominees for election to the board of directors of a business development company.}

In addition, because shareholders of a fund are not required to file a Schedule 13G, nominating shareholder(s) for a fund would be required to include the following information as part of the notice to the fund:

• The percentage of each class of securities of the fund that the individual owns beneficially, directly or indirectly, and the number of shares as to which the person has:
  • Sole power to vote or to direct the vote;
  • Shared power to vote or to direct the vote;
  • Sole power to dispose or to direct the disposition of such shares;
  • Shared power to dispose or to direct the disposition of such shares; and
• A certification, signed by each person on whose behalf the notice is filed or his or her authorized representative, that the securities have been held continuously for at least three years.

This information would be in addition to the other information required to be included in the notice provided to the company and filed with the Commission by any nominating shareholder(s). The shareholder notice, as well as any soliciting material published, sent or given to shareholders in connection with the formation of a nominating shareholder group, would be required to be filed under the fund's Investment Company Act file number.

If Adopted, When Would the Proposed Rules Become Effective?

In the proposal, the Commission indicated that the proposed rules would become effective for shareholder meetings held after January 1, 2004.

The proposed rules have been the subject of much attention and controversy, as shareholder activist groups and public companies alike have waded into the public debate surrounding their much-anticipated release. Several commentators have suggested that the Commission will receive at least 1,000 comment letters regard-ing the proposed rules. In an effort to address this issue head on, while remaining sensitive to the interests of affected parties, the Commission exercised great care in drafting the proposal, which spans 107 pages, contains 238 footnotes and, amazingly, poses 320 separate questions for commentators to consider.

The Commission appears particularly interested in the opinions and real-life experiences of public companies. Accordingly, we encourage companies to submit comment letters, even if those comments pertain only to a portion of the proposed rules. The 60-day comment period ends December 22, 2003.

FOOTNOTES

1. Proposed Rule: Security Holder Director Nominations, Exchange Act Rel. No. 34-48626, Investment Co. Act Rel. IC-26206, http://www.sec.gov/rules/proposed/34-48626.htm (Oct. 14, 2003). This advisory supersedes our earlier Special Alert regarding these proposed rules. See Alston & Bird LLP Securities Law AdvisoryÑSpecial Alert, "SEC Proposes New Rules Mandating Shareholder Access to Proxies," http://www.alston.com/articles/Special%20Alert%2010-8-03.pdf (Oct. 8, 2003).

2. News Release: Commission to Review Current Proxy Rules and Regulations to Improve Corporate Democracy, http://www.sec.gov/news/press/2003-46.htm (Apr. 14, 2003).

3. The Division's report and related summary of comments can be found at http://www.sec.gov/news/studies/proxyrpt.htm (Jul. 15, 2003). See also Alston & Bird LLP Securities Law AdvisoryÑSpecial Alert, "SEC Releases Staff Report on Proxy Review Process," http://www.alston.com/articles/Special%20Alert%207-15-03.pdf (Jul. 15, 2003).

4. Proposed Rule: Disclosure Regarding Nominating Committee Functions and Communications between Security Holders and Boards of Directors, Exchange Act Rel. No. 34-48301, Investment Co. Act Rel. IC-26145, http://www.sec.gov/rules/proposed/34-48301.htm (Aug. 8, 2003). See also Alston & Bird LLP Securities Law Advisory, "SEC Proposes New Rules Relating to Director Nomination Process and Shareholder Communication with Directors," http://www.alston.com/articles/Director%20Nomination%20Process.pdf (Aug. 13, 2003).

5. A company becomes an "accelerated filer" after it first meets the following conditions as of the end of its fiscal year:

• The company's common equity public float was $75 million or more as of the last business day of its most recently com-pleted second fiscal quarter;
• The company has been subject to the reporting requirements of the Exchange Act for at least twelve calendar months;
• The company has previously filed at least one annual report pursuant to the Exchange Act; and
• The company is not eligible to use Exchange Act Forms 10-QSB and 10-KSB.

6. The Commission specifically requested comment on whether to add a third triggering eventÑthe failure of a company to imple-ment a shareholder proposal submitted in accordance with Exchange Act Rule 14a-8 that receives support from a majority of the votes cast.

7. The SEC is proposing a change to Rule 14a-8 to make clear that a shareholder proposal proposing a direct access procedure under proposed Rule 14a-11 may not be excluded under Rule 14a-8. In addition, the staff of the Division of Corporation Finance intends to take the position that such a proposal is not excludable under Rule 14a-8(i)(8).

8. Compensatory fees would not include the receipt of fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with a nominating shareholder or affiliate of a nominating shareholder (provided that such compensation is not contingent in any way on continued service).

9. Exchange Act Rule 14a-9 prohibits the use of false or misleading statements made by means of any proxy materials.

10. The proposed rules regarding the responsibility for false or misleading statements based upon information received from nominat-ing shareholders are modeled after Exchange Act Rule 14a-8(l)(2). Exchange Act Rule 14a-8(l)(2) applies with respect to proposals and supporting statements that are submitted by shareholders and then required to be repeated in the company's proxy materials by Exchange Act Rule 14a-8. In this regard, Exchange Act Rule 14a-8 states that "the company is not responsible for the contents of [the shareholder proponent's] proposal or supporting statement."

11. See Feder v. Martin Marietta, 406 F.2d 260 (2d Cir.); Blau v. Lehman, 368 U.S. 403 (1962); and Rattner v. Lehman, 193 F.2d 564 (2d Cir. 1952). The judicial decisions in which this theory was applied do not establish precise standards for determining when "deputization" may exist. However, the express purpose of Exchange Act Section 16(b) Ã which begins, "For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer ...." Ã is to prevent the unfair use of information by insiders through their relationships to the issuer. Accordingly, one factor that courts may consider in determining if Exchange Act Section 16(b) liability applies is whether, by virtue of the "deputization" relationship, the "deputizing" entity's transactions in issuer securities may benefit from the deputized director's access to inside information.

12. The Commission has proposed to substitute the independence test set forth in Section 2(a)(19) of the Investment Company Act for the test applied to operating companies because the Section 2(a)(19) independence test is tailored to better capture the broad range of affiliations with investment advisers, principal underwriters and others that are relevant to "independence" in the case of funds.