SEC Proposes Rules Regarding Nominating Committee Functions and Communications Between Security Holders and Boards of Directors

Introduction

The SEC is proposing amendments to Items 7 and 22 of Schedule 14A of the Securities Exchange Act of 1934 that will require new disclosure requirements in proxy statements regarding the operation of board nominating committees and the means, if any, by which security holders may directly communicate with members of the board of directors. As proposed, the rules do not mandate any particular action by a company or its board of directors. Rather, the proposed rules expand the disclosure requirements in proxy statements relating to the election of directors regarding the nominating committee and the director nominating process. In addition, the proposed rules add a new disclosure requirement with regard to shareholder communications with board members. As proposed, the new disclosure requirements also would apply to proxy statements relating to the election of directors of investment companies. The proposed rules are subject to a comment period that expires on September 15, 2003. The release containing these proposed rules can be found on the SEC Web site at http://www.sec.gov/rules/proposed/34-48301.htm.

The proposed rules were expected in the wake of a SEC staff report issued by the SEC's Division of Corporation Finance on July 15, 2003 which recommended that the SEC propose and solicit public comment on rules that would require enhanced disclosure about (i) a company's nominating committee and the process for nominating candidates and (ii) specific disclosure about the procedures for shareholders to directly communicate with board members. The SEC staff report also recommended that consideration should be given to providing additional shareholder access to the proxy solicitation process in connection with the election of directors, though proposed rules on this matter are not expected until this fall. In anticipation of these proposed rules, which are likely to be significant and controversial, we have summarized the proxy access recommendations in the SEC staff report in this article. The full SEC staff report is available on the SEC Web site at http://www.sec.gov/news/studies/proxyreport.pdf.

Proposed Rules

Enhanced Nominating Committee Disclosure

Currently, companies must disclose in their proxy statements whether they have a nominating committee and, if so, whether the committee considers nominees recommended by security holders and how any such recommendations can be submitted. The SEC has proposed to expand the current disclosure requirements to require companies to disclose the following information:

• Nominating Committee Existence. A statement as to whether or not the company has a standing nominating committee or a committee performing similar functions, and if the company does not have a standing committee, a statement of the specific basis for the board's view that it is appropriate for the company not to have a nominating committee and the names of those directors who participate in the consideration of potential director nominees.
  
  
• Nominating Committee Charter. A description of the material terms of the nominating committee charter, if the company has one, and disclosure as to where the nominating committee charter is available (e.g., the company's Web site). If the company has a nominating committee and it does not have a charter, a statement to that effect is required.
  
  
• Nominating Committee Independence. If the company's securities are listed on a national securities exchange or in an automated inter-dealer quotation system of a national securities association that has independence requirements for nominating committee members, disclosure of any instance during the last fiscal year where any member of the nominating committee did not satisfy the independence requirements of the exchange or market on which the company's securities are listed or quoted. If a company's securities are not so listed or quoted, disclosure of whether each nominating committee member is independent. In that case, the company must use a definition of independence of a national securities exchange or national securities association that has been approved by the SEC and state which definition it used. With regard to investment companies, the proposals would require disclosure as to whether or not the members of the fund's nominating committee are "interested persons" of the fund as defined in Section 2(a)(19) of the Investment Company Act.
  
  
• Security Holder Recommendations. A description of the material elements of the policy, if the nominating committee has one, with regard to the consideration of any director candidates recommended by security holders, including a statement as to whether the committee will consider director candidates recommended by security holders. If there is no such policy, a statement to that effect.
  
  
• Procedures for Submitting Candidates. If the nominating committee will consider candidates recommended by security holders, a description of the procedures to be followed by security holders in submitting such recommendations.
  
  
• Minimum Qualifications and Necessary Qualities, Skills and Standards. A description of (i) any specific, minimum qualifications that the nominating committee believes must be met by a nominee in order to be considered for nomination by the committee to the company's board of directors, (ii) any specific qualities or skills that the nominating committee believes are necessary for one or more of the company's directors to possess and (iii) any specific standards for the overall structure and composition of the company's board of directors.
  
  
• Processes for Identifying and Evaluating Director Nominees. A description of the nominating committee's process for identifying and evaluating nominees for director, including nominees recommended by security holders, and any differences in the manner in which the nominating committee evaluates nominees for director based on whether or not the nominee is recommended by a security holder.
  
  
• Source for Each Nominee. A statement of the specific source, such as the name of an executive officer, director or other individual, of each nominee (other than nominees who are executive officers or directors standing for re-election) approved by the nominating committee for inclusion on the company's proxy card.
  
  
• Compensation to Third Parties for Identifying or Evaluating Potential Nominees. If the company paid a fee to any third party or parties (e.g., executive search firms) to identify or assist in identifying or evaluating potential nominees, disclosure of the function performed by each such third party.
  
  
• Exclusion of Certain Nominees Recommended by Large Security Holders. If the nominating committee receives a recommendation from a security holder or group of security holders who individually, or in the aggregate, beneficially own greater than 3% of the company's voting common stock for at least one year as of the date of the recommendation and the nominating committee decides not to nominate that candidate, disclosure of:
  
  
  • the names of the security holders who recommended the candidate; and
    
    
  • the specific reasons for the nominating committee's determination not to include the candidate as a nominee.
    
    

The company will not be required to disclose the identity of the excluded candidate.

Disclosure Regarding Security Holders Communications with the Board of Directors

The SEC also proposed that companies include the following information in their proxy materials where action is to be taken with respect to the election of directors:

• A statement as to whether or not the company's board of directors provides a process for security holders to send communications to the board of directors. If there is no such process, a statement of the specific basis for the view of the board of directors that it is appropriate for the company not to have such a process.
  
  
• If there is a process for security holder communications to the board, then disclosure regarding this process must be made including:
  
  
  • a description of the manner in which security holders can send communications to the board;
    
    
  • identification of the board members to whom security holders can send communications;
    
    
  • if all such communications are not sent directly to the board, a description of the process for determining which communications will be relayed to board members, including disclosure of the department or other group within the company that is responsible for making this determination; and
    
    
  • a description of any material action taken by the board during the preceding fiscal year as a result of communications from security holders.
    
    

SEC Staff Report Regarding the Nomination and Election of Directors; Shareholder Access to a Company's Proxy Materials

The SEC staff report issued on July 15, 2003 also recommended that the SEC propose and solicit public comment on rules that would allow a shareholder or group of shareholders access to company proxy materials in order to present their director nominees to shareholders. Currently, shareholders desiring to make a change to the composition of the board may conduct a proxy contest (which requires a shareholder to prepare and disseminate to shareholders, at its own expense, a separate proxy statement and proxy card), nominate a candidate at an annual meeting or recommend candidates to a company's nominating committee. Proposed rules regarding this significant issue are expected this fall and are likely to incorporate certain recommendations set forth in the SEC staff report. In the SEC staff report, two possible alternatives for shareholder access are described.

Alternative A - Require Companies to Include Shareholder Nominees in Company Proxy Materials

Under this alternative, a company would be required to include on its proxy card the shareholder nominee or nominees and also would be required to include specified information, such as biographical information, about the shareholder nominee in the company's proxy statement. Arguments for and against each of the company's and the nominating shareholder's candidates could be included either in a word-limited form in the proxy statement or wholly outside of the proxy statement (e.g., on one or more designated Web sites). All soliciting materials, including Web site postings, would be filed electronically with the SEC.

Alternative B - Require Companies to Deliver Nominating Shareholders' Proxy Cards with Company Proxy Materials

Under this alternative, a company would be required to include a nominating shareholder's proxy card along with the company's proxy materials and proxy card in its mailing to shareholders. The company would be required to note briefly in its proxy materials that a shareholder or shareholder group had nominated a candidate to the board of directors, that the shareholder's proxy card is included in the company's mailing, and that additional disclosure about the shareholder nominee may be found on a specified Web site. Disclosure relating to shareholder nominees and campaign materials for shareholder nominees would appear on a Web site maintained by nominating shareholders and would be required to be filed electronically with the SEC. Similarly, a company's soliciting materials would be required to appear on the company's Web site. This alternative primarily differs from alternative A in that shareholder nominees would not appear in the company's proxy materials. Rather, the company would absorb the cost of mailing a nominating shareholder's proxy card. The SEC staff report noted that this alternative would be a substantial departure from the current requirement that specified disclosure (i.e., a definitive proxy statement) be included with, or precede, the delivery of a proxy card to shareholders.

Limitations and Requirements on Shareholder Access to Proxy Materials

It is expected that any proposed rules regarding shareholder access to proxy materials will be subject to certain limitations and requirements, in particular with regard to when the access rules may be used and by whom.

• When the Shareholder Access Rules May be Used; Triggering Events. The SEC staff report suggests that one or more types of triggering events should occur before a shareholder could invoke the rule to access company proxy materials with regard to nominating a director or directors. The SEC has suggested that the triggering events should be tied to evidence of ineffectiveness in the proxy process rather than economic consequences (e.g., lagging a peer index for a specific number of consecutive years would not be a triggering event). Examples of possible triggering events described in the SEC staff report include:
  
  
  • failure to act on shareholder proposals that receive majority votes;
    
    
  • the receipt of significant percentages of "withhold" votes in director elections; and
    
    
  • the approval of a shareholder proposal to activate the shareholder access rule.
    
    
• Who Can Use the Shareholder Access Rules; Shareholder Eligibility. The proposed rules are likely to include minimum eligibility requirements with regard to share ownership in the company before a shareholder or group of shareholders could access company proxy materials for the purpose of soliciting proxies for director nominees. The SEC staff report discussed potential ownership thresholds ranging from the $2,000 threshold required to submit a Rule 14a-8 shareholder proposal to larger share ownership percentages (from 3% to 10% or more). In addition, the SEC staff report suggests that nominating shareholders will be required to have held their shares for a minimum number of years that might range from one to three years.
  
  
• Other Potential Limitations. The SEC staff report raised other important questions regarding potential limitations, including, among others, whether shareholder access rules should limit the maximum number of shareholder nominees or the percentage of the board that shareholders may nominate in order to avoid the use of shareholder access rules in contests for corporate control. In addition, the SEC staff report questioned whether shareholder access rules should require that shareholder nominees meet applicable independence requirements. Another important issue raised in the SEC staff report related to questions regarding potential conflicts between shareholder access rules and state law.
  
  

Certain Securities Law Issues

In the SEC staff report, the staff acknowledged that shareholder access rules raise questions with regard to other securities law issues depending on the level of any shareholder eligibility requirement, including, among others:

• Schedule 13D/G. Should nominating shareholders, including groups, be deemed to have a control purpose that would trigger Schedule 13D or 13G reporting?
  
  
• Section 16. Should nominating shareholder groups with greater than 10% beneficial ownership be exempted from reporting under Section 16(a) of the Securities Exchange Act?
  
  

Affiliates. Should the SEC create a safe harbor that provides nominating shareholders will not be deemed "affiliates" of the company solely as a result of using a shareholder nomination procedure?