SEC Proposes New Rules Relating to Director Nomination Process and Shareholder Communications with Directors

On August 6, 2003, the Securities and Exchange Commission (Commission) proposed new rules requiring expanded disclosure of companies'[1]director nomination processes and specific disclosure of procedures by which shareholders may communicate with directors. The proposed rules would require very specific disclosures in proxy statements for meetings at which directors will be elected. At the open meeting at which the proposed rules were approved, Alan Beller, Director of the Division of Corporation Finance (Division), indicated that the staff recommended that the Commission adopt specific disclosure requirements in an effort to avoid boilerplate disclosure and to assure that shareholders are provided transparency with respect to the director nomination process.

These proposals come quickly on the heels of the July 15, 2003 release of a Division report recommending a number of rule changes, including recommendations about these proposed rules and rules to be proposed that would provide, under certain circumstances, direct shareholder access to the company's proxy materials in connection with the nomination of directors.[2] Alan Beller indicated that the staff intends to submit the shareholder access proposal to the Commission by late September or October.

Proposed Disclosures Regarding Nominating Process

Item 7(d)(2) of Schedule 14A currently requires proxy statements for meetings at which directors will be elected to state whether the company has a nominating or similar committee and, if it does, state "whether the committee will consider nominees recommended by [shareholders] and, if so, describe the procedures to be followed by [shareholders] in submitting such recommendations."[3] The Commission proposes to significantly expand these disclosure requirements in order "to provide [shareholders] with additional, specific information upon which to evaluate the boards of directors and nominating committees of the companies in which they invest." The new disclosure requirements include specific disclosures about the nominating process, the nominating committee's charter, and the independence of nominating committee members.

What new disclosures would be required about a company's nominating process?

The proposed rules would require the following additional disclosures about a company's nominating process (the first two of which arguably just rephrase the existing requirements of Item 7(d)(2) of Schedule 14A):

• Whether the nominating committee has a policy with regard to the consideration of any director candidates recommended by shareholders, and, if it does, a description of the material elements of that policy, and a statement as to whether the committee will consider candidates recommended by shareholders;
• If the nominating committee will consider candidates recommended by shareholders, a description of the procedures to be followed by shareholders in submitting such recommendations;
• A description of any specific, minimum qualifications that the nominating committee believes must be met by a nominee, any specific qualities or skills that the nominating committee believes are necessary for one or more of the directors to possess, and any specific standards for the overall structure and composition of the board;[4]
• A description of the committee's process for identifying and evaluating nominees, including nominees recommended by shareholders, and any differences in the manner in which the nominating committee evaluates nominees for director based on whether a nominee is recommended by a shareholder;
• Disclosure of who proposed each nominee approved by the nominating committee for inclusion on the company's proxy card, except when the nominee is an executive officer or a director standing for reelection;[5]
• If the company pays a fee to any third party to identify or assist the company in identifying or evaluating potential nominees, disclosure of the function performed by the third party;
• If the nominating committee (a) receives a nominee recommendation from a shareholder or group of shareholders that has beneficially owned more than 3% of the company's voting common stock for at least one year as of the date of the recommendation,[6] and (b) the nominating committee decides not to nominate that candidate, disclosure of the name or names of the stockholder(s) who recommended the candidate and the specific reasons that the nominating committee decided not to include the candidate as a nominee.[7]

Would the proposed rules require a nominating committee to consider candidates recommended by a company's shareholders?

No. Under the proposed rules, a company would only be required to disclose whether it has a policy with respect to the consideration of candidates recommended by shareholders and whether the nominating committee will consider such candidates. The portion of the proposed rule that would require disclosure of the specific reasons for not including a candidate proposed by a large shareholder or group of shareholders might imply that the nominating committee will have undertaken some level of consideration of the candidate. However, in the case of a company whose policy is not to consider shareholder nominees, it arguably would be acceptable under the proposed rules for a nominating committee to simply state that it does not consider such candidates, without further comment.

Would the nominating committee be required to have a written charter?

No. A nominating committee is not required to have a written charter under the proposed rules, but the pending amendments to the NYSE listing requirements would require NYSE-listed companies to have a written nominating committee charter. The proposed rules would only require companies to disclose whether the nominating committee has a written charter, the material terms of the charter[8]and the location (which could be the company's Website) where shareholders may obtain a copy of the charter. The Commission does solicit comments on whether companies that do not have a nominating committee charter should be required to disclose the reasons that they do not have one.

What disclosures would be required about the directors serving on the nominating committee?

The company would be required to disclose whether any member of the nominating committee did not satisfy the definition of independence in the listing standards applicable to the company. As with existing disclosures regarding the independence of audit committee members, non-listed companies would assess the independence of nominating committee members under any listing standard chosen by the company (but would be required to use the same listing standard that it uses to assess the independence of its audit committee members).

What disclosures would be required for companies that do not have separate nominating committees?

A company without a nominating committee or a committee performing similar functions would not escape any of the new requirements. If a company does not have a nominating committee (or committee serving similar functions), the company would be required to state in its proxy statement the specific basis for the view of the board of directors that it is appropriate for the company not to have such a committee. The company would also be required to disclose the names of those directors who participate in the consideration of director nominees in lieu of a nominating committee. The proposed rules would also require that the disclosures described in response to the preceding questions be provided with respect to any committee performing a function similar to a nominating committee, or for groups of directors fulfilling the role of a nominating committee, including the entire board, where applicable.

How would the new disclosure requirements relate to existing and proposed NYSE and Nasdaq listing standards?

The proposed rules will not affect the listing standard changes proposed by the NYSE and the Nasdaq. However, certain of the disclosures required by the proposed rules (most notably the nominating committee charter and committee member independence disclosures) would be affected by the proposed listing standard changes. As noted in the proposing release, the Commission acknowledges that the proposed listing standards demonstrate the importance of the nominating process and represent a strengthening of the role of an independent nominating committee and states that the proposed rules are intended to complement these standards.

How would the proposed rules interrelate with companies' bylaw provisions relating to shareholder nominations?

As proposed, the new rules would only require disclosure regarding the methods and manner in which a company's nominating committee approaches shareholder recommendations of candidates to the committee. The proposed rules are not structured to directly correlate with state law and bylaw provisions that govern shareholder nominations of persons for election to the board of directors, such as bylaw provisions requiring advance notice of a director nomination. If the proposed rules are adopted, companies will need to reexamine their bylaw provisions and other policies relating not only to nominating committee review of recommendations by shareholders, but also the method in which the company handles direct nominations and the election of directors generally.

Disclosures Regarding Shareholder Communications with Board Members

The Commission stated that it has become increasingly aware of investors' desire for a means to communicate with boards of directors and that it believes that providing shareholders with disclosure about the process for communicating with board members will improve the transparency of board operations, as well as shareholder understanding of the companies in which they invest. To address those concerns, the Commission proposes to create a number of new disclosure requirements relating to the manner in which shareholders may communicate directly with directors.

What new disclosures would be required?

Companies would be required to disclose the following in their proxy statements for meetings at which directors will be elected:

• Whether or not the company's board of directors provides a process for shareholders to send communications to the board of directors and, if not, the specific basis for the view of the board that it is appropriate for the company not to have such a process;
• The manner in which shareholders can send communications to the board and the identity of those board members to whom shareholders can send communications;
• If all shareholder communications are not sent directly to board members, the company's process for determining which communications will be relayed to board members, including disclosure of the department or group within the company that makes that decision; and
• Any material actions taken by the board of directors as a result of communications between shareholders and board members during the preceding fiscal year.

Would the proposed rules require companies to institute any procedures to facilitate shareholder communications with directors?

No. The proposed rules would only require disclosure in the annual meeting proxy statement of whether the company provides a process by which shareholders may communicate directly with directors and, if not, why the company believes it is appropriate not to have such a process. However, as with many Commission disclosure requirements, the disclosure requirement will most likely have the effect of encouraging companies to adopt procedures in order to avoid potentially embarrassing disclosures.

Are there any comparable disclosure requirements under existing or proposed NYSE and Nasdaq listing standards?

The Commission has published a proposed NYSE listing standard that would require a company to disclose a method for interested parties to communicate directly and confidentially with the "presiding director" of the non-management directors or with the non-management directors as a group. The NYSE's proposal states that this method could be analogous to the method in the proposed NYSE listing standards that would require audit committees to establish procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls or auditing matters, including procedures for the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.[9]

Scope of Proposed Disclosure Requirements

Would the new disclosures apply to companies that are not subject to the proxy rules?

No. The proposed rules for disclosure of both the nomination process and shareholder communication with the board would amend only Schedule 14A. Therefore, the proposed disclosure requirements would not apply to any company that is not subject to the requirements of Section 14(a) of the Exchange Act, including, for example, foreign private issuers and companies that file Exchange Act reports pursuant to either Section 15(d) of the Exchange Act or an indenture covenant.

Would the new disclosures apply to investment companies?

Yes. The Division's July 15, 2003 report specifically notes that the Division's review focused on operating companies and that the Commission would need to determine, and request comment on, how any changes to the proxy rules should apply to investment companies. Under the proposed rules, both the director nominating process and the director communication proposals would be applicable to investment companies with slight modifications. [10]

Comment Process and Likely Effectiveness

When will the comment period end?

The comment period for the proposed rules will end on September 15, 2003.

Assuming the Commission adopts new rules, when would the new disclosure requirements be applicable?

The comment period is relatively short due to the Commission's desire to have new rules in place for the 2004 proxy season.