SEC Proposes Rules Requiring Companies To Include Shareholder Nominees For Director In Company Proxy Materials

Summary

The SEC has proposed new Exchange Act Rule 14a-11 that would, under certain circumstances, require a company to include information regarding a shareholder's nominee for election as a director in the company's proxy materials. As proposed, Rule 14a-11 would apply to all companies subject to the proxy rules, including investment companies, provided one of the following triggering events has occurred:

• at least one of the company's director nominees receives "withhold" votes from more than 35% of the votes cast at an annual meeting of shareholders; or
• a shareholder proposal submitted under Exchange Act Rule 14a-8 providing that the company become subject to the nomination procedure set forth in proposed Rule 14a-11 receives more than 50% of the votes cast on that proposal at an annual meeting of shareholders.

The SEC also is considering whether to add a third triggering event that would subject a company to the nomination procedure if the company failed under certain circumstances to timely implement a shareholder proposal, regardless of the nature of the proposal.

If triggered, the nominating procedure would remain available for the two annual meetings following the occurrence of a triggering event.

Even if a triggering event occurs, a shareholder (or group of shareholders) will be eligible to submit a director nomination only if such shareholder(s):

• beneficially own more than 5% of the company's voting securities, with each such security held continuously for two years as of the date of the nomination, and intend to hold those securities through the date of the meeting; and
• are eligible to report, and have reported, beneficial ownership of such securities on a Schedule 13G rather than a Schedule 13D (i.e., the nominating shareholder(s) must be "passive" investors or certain types of institutional investors).

In addition, proposed nominees must meet certain requirements (including meeting the "independence" standards that generally are applicable to directors of the company) to be eligible for inclusion as a nominee in a company's proxy materials. Furthermore, a nominating shareholder may not have specified prohibited relations with the nominee or the company. The proposed rules also limit the number of shareholder nominees that must be included in a company's proxy materials based on the total number of board members.

Introduction

Under current SEC rules and state law, shareholders generally can nominate a director for election in one of two ways: either by requesting that the board of directors of the company or the nominating committee consider the shareholder's nominee ,or alternatively, by nominating a candidate in accordance with the company's bylaws. The first of these two alternatives provides no assurance to the shareholder that its nominee will be formally considered by the company or the nominating committee, and if considered, nominated by the company and included in the company's proxy statement and on its proxy card. The second alternative permits a shareholder's nominee to be considered at the meeting, but unless the shareholder incurs the expense to solicit its own proxies in compliance with the SEC's proxy rules, the shareholder's nominee will ordinarily not receive sufficient votes to be elected.

In response to increasing shareholder concern and dissatisfaction with the effectiveness of the proxy process, the SEC has proposed changes to its rules that would provide shareholders with direct access to the nomination process and to the company's proxy statement and proxy card for the purpose of voting upon shareholder nominated candidates for directors in certain specified circumstances. Although the SEC believes that there is a need for a more direct and effective method for shareholders to participate in the proxy process in connection with the nomination and election of directors, the SEC also recognized that giving shareholders unlimited access to company proxy materials could potentially disrupt the director election process. In this regard, the SEC explained that giving shareholders unlimited access to proxy materials could be both costly and disruptive to companies and could discourage some qualified board candidates from agreeing to appear on a company's slate of nominees.

Accordingly, the SEC's proposed rules attempt to strike a balance between these competing interests by providing limited access to the company's proxy statement and proxy card under circumstances where evidence suggests that the company has been unresponsive to shareholder concerns as they relate to the proxy process. The SEC's desire to balance these competing interests has added to the complexity of the rules outlined below. However, the proposed rules also raise a number of important questions and concerns that will require careful consideration if they are to result in an appropriate balance being struck. The release containing these proposed rules can be found on the SEC Web site at http://www.sec.gov/rules/proposed/34-48626.htm.

The proposed rules implement the second recommendation contained in the July 15, 2003 report provided to the SEC by its Division of Corporation Finance. On August 14, 2003, the SEC published for comment proposed rules implementing the first of the Division's recommendations - new disclosure standards regarding the nominating committee processes of public companies, including the candidates recommended by shareholders, as well as more specific disclosure of the procedures by which shareholders may communicate with directors. Our summary of those proposed rules is available on our Web site at http://www.goodwinprocter.com/publications/PCA_NomComFunctions_9_3_03.pdf, the release containing these proposed rules can be found on the SEC Web site at http://www.sec.gov/rules/proposed/34-48301.htm, and the full SEC staff report is available on the SEC Web site at http://www.sec.gov/news/studies/proxyrpt.htm.

Proposed Security Holder Director Nomination Rule

What triggering events must occur before a company would be required to include a security holder nominee in its proxy materials?

The security holder nomination procedure (which will be set forth in new Rule 14a-11 of the Securities Exchange Act) would require any company subject to the proxy rules to include information regarding certain security holder nominee(s) for election as director in the company's proxy materials when the conditions of the proposed rule are met. The SEC is considering whether initially the proposed rules should apply only to "accelerated filers" and investment funds.

The SEC made it clear that nothing in the proposed rules establish a right of security holders to nominate candidates for election to a company's board of directors. In fact, the SEC emphasized that a pre-existing state law right to nominate a candidate for election as a director must exist in order to utilize the proposed nomination procedures. In addition, the following triggering events must occur:

• Withheld Votes. At least one of the company's nominees for director for whom the company solicited proxies must receive "withhold" votes from more than 35% of the votes cast at an annual meeting of security holders held after January 1, 2004 (except in the case of a proxy contest or an election to which proposed Rule 14a-11 applies); or
  
  
• "Direct Access" Security Holder Proposal. An eligible security holder or group of security holders properly submits a proposal under Exchange Act Rule 14a-8 for a vote of security holders at an annual meeting of security holders held after January 1, 2004 providing that the company become subject to the nomination procedure set forth in proposed Rule 14a-11 (referred to as a "direct access" proposal) and such direct access proposal receives more than 50% of the votes cast on that proposal at the meeting. Eligible security holders or groups of security holders under Rule 14a-8 are those security holders who provide satisfactory evidence to the company at the time such holder(s) submit the Rule 14-8 proposal that the holder(s) have held more than 1% of the company's securities entitled to vote on the proposal for at least one year as of the date the proposal was submitted.
  
  

The SEC also is considering whether to add a third triggering event that would subject a company to the nomination procedure if the company failed under certain circumstances to timely implement a security holder proposal, regardless of the nature of the proposal. However, the SEC expressed concerns regarding whether it is appropriate to include this third possible triggering event in light of the fact that disagreements between security holders and board members regarding the board's judgment on implementing a shareholder proposal is a less directly linked indication of ineffectiveness of the proxy process than a "withhold" vote on a director nominee or an affirmative vote for a direct access proposal.

Once a triggering event has occurred, how long would the nominating procedure be available to eligible security holders?

The SEC intends that the nominating procedure would remain available for the two annual meetings following the occurrence of a triggering event. Accordingly, the nominating procedure would remain operative for any annual meetings held during:

• the remainder of the calendar year in which the triggering event occurs:
  
  
• the calendar year following the calendar year in which the triggering event occurs; and
  
  
• the portion of the second calendar year following the calendar year in which the triggering event occurs, up to and including the annual meeting held during that calendar year.
  
  

For example, if a triggering event occurred at an annual meeting held in May 2004 any eligible security holder could submit a director nominee for inclusion in the company's proxy materials for election at the annual meeting in 2005 and 2006.

What notice must a company give regarding the occurrence of a triggering event?

To ensure that eligible security holders can utilize the security holder nomination procedure set forth in proposed Rule 14a-11, companies would be required to disclose to security holders the vote with regard to either of the nomination procedure triggering events (i.e., withheld votes for directors or approval of a direct access proposal) in its Form 10-Q for the quarter in which the matter was submitted to a vote of security holders (or Form 10-K where the nomination procedure triggering event occurred during the fourth quarter of the fiscal year) and, if applicable, information disclosing that the company is subject to the security holder nomination procedure as a result of such vote.

Once a triggering event has occurred, which security holders can use the nomination procedure?

Primarily because the SEC does not intend the proposed nomination procedure to be available to security holders who are seeking control of a board of directors, only passive 5% security holders can submit nominations. Accordingly, to be eligible to submit a nomination for election as a director under proposed Rule 14a-11, a security holder or group of security holders must:

• beneficially own, either individually or in the aggregate, more than 5% of the company's securities that are eligible to vote for the election of directors at the next annual meeting of security holders, with each of the securities used for purposes of calculating that ownership having been held continuously for at least two years as of the date of the nomination;
  
  
• intend to continue to own those securities through the date of that annual meeting;
  
  
• be eligible to report beneficial ownership on Schedule 13G rather than Schedule 13D; and
  
  
• have filed a Schedule 13G (or an amendment thereto) reporting their beneficial ownership as a passive or institutional investor (or group) on such schedule before or on the date of the submission of the nomination to the company (including certifying within such schedule that the security holder or security holder group has held more than 5% of the company's eligible voting securities for at least two years).
  
  

Who can an eligible security holder or security holder group nominate for director?

• Requirements for Nominees; Independence Standards. A company would not be required to include a security holder nominee for director in its proxy materials if the nominee's candidacy or, if elected, board membership would violate controlling state law, federal law or rules of a national securities exchange or national securities association. In addition, the nominee would be required to meet the definition of "independence" that generally is applicable to directors of the company. We believe further clarification of this requirement is necessary but as proposed the rules suggest that a shareholder nominee would be required to satisfy objective categorical standards for independence, if adopted by the company and applicable to such company's director nominees, as well as pass the "bright line" tests set forth by the applicable national securities exchange or national securities association that automatically disqualify a director from being independent. To the extent a national securities exchange or national securities association rule imposes a standard regarding independence that requires a subjective determination by the board of directors, that standard of independence would not have to be satisfied.
  
  
• Prohibited Relationships. To address concerns that "special interest" or "single issue" directors would advance the interests of the nominating security holder(s) over the interests of security holders as a group, the SEC proposes that, to be eligible to nominate a candidate under Rule 14a-11, a nominating security holder (or nominating security holder group) may not have certain specified relationships with the nominee. These prohibited relationships include:
  
  
  • No Family Relationships. If the nominating security holder is a natural person, the nominee can not be the natural person, a member of the nominating security holder's group or a member of the immediate family of the nominating security holder (or of any member of the nominating security holder group);
    
    
  • No Employee Relationships. If the nominating security holder is an entity, neither the nominee nor any immediate family member of the nominee may have been an employee of the nominating security holder (or any member of the nominating security holder group) during the then-current calendar year or during the immediately preceding calendar year;
    
    
  • No Fees From the Nominating Security Holder(s). The nominee and the nominee's immediate family members can not have accepted, during the year of the nomination or in the immediately preceding calendar year, any consulting, advisory, or other compensatory fee from the nominating security holder (or any member of the nominating security holder group) or any affiliate of such holder or member (subject to certain exceptions with regard to fixed amounts under a retirement plan (including deferred compensation) for prior service with such holder or any such member);
    
    
  • No Position as an Executive Officer or Director. The nominee can not be an executive officer or director (or person fulfilling similar functions) of the nominating security holder (or any member of the nominating security holder group) or of any of their affiliates; and
    
    
  • No Control of the Nominating Security Holder(s). The nominee cannot control the nominating security holder (or any member of the nominating security holder group).
    
    

In addition, the SEC is proposing that the nominating security holder(s) be required to include a representation regarding relationships between the nominee and the company and between the nominating security holder(s) and the company. Specifically, each nominating security holder(s) would be required to represent to the company that:

• the submitted nominee satisfies the standards of the applicable national securities exchange or national securities association regarding independence (except where a rule imposes a standard that requires a subjective determination by the board); and
  
  
• neither the nominee nor the nominating security holder(s) has a direct or indirect agreement with the company regarding the nomination of the nominee.
  
  

What is the maximum number of security holder nominees that the company must include in its proxy materials?

The SEC made clear in the release regarding the proposed rule that it does not intend the security holder nomination procedure to be available for any security holder or security holder group that is seeking to gain control of a company. Accordingly, the proposed rule limits the number of security holder nominees that are required to be included in a company's proxy materials as follows:

• if the total number of board members is eight or fewer, the company would only be required to include one security holder nominee;
  
  
• if the total number of board members is greater than eight and less than 20, two security holder nominees; and
  
  
• if the total number of board members is 20 or more, three security holder nominees.
  
  

In the case of companies with classified or "staggered" boards, the proposed rules contemplate that a company take into account any director currently serving on its board who was elected as a security holder nominee and whose term extends past the date of the meeting of securities holders for which the company is soliciting proxies, for purposes of determining the maximum number of security holder nominees that the company must include in its proxy materials.

If more than one security holder (or group of security holders) is eligible to nominate directors, the company would be required to include in its proxy materials, the nominee or nominees of the security holder (or group of security holders) with the largest beneficial ownership (as reported on Schedule 13G), up to and including the total number required to be included by the company. For purposes of determining the security holder with the largest beneficial ownership, the company must use the percentage set forth for that security holder at the time of delivery of the security holder's notice of intent to nominate a director.

What notice must the security holder provide to the company and file with the SEC?

To have a nominee included in the company's proxy materials, the SEC has proposed that the nominating security holder (or security holder group) must provide notice to the company of its intent to require the inclusion of its nominee on the company's proxy card no later than 80 days before the date that the company mails its proxy materials for the annual meeting. This is calculated by determining the mailing date disclosed in the previous year's proxy statement, increasing the year by one and counting back the required number of calendar days. The notice would require certain representations and evidence from the nominating security holder(s), including, among others, representations and evidence that the nominating security holder (or security holder group) has satisfied the shareholder eligibility requirements and that the director nominee satisfies the nominee eligibility requirements. In addition, the nominating security holder(s) would be required to file such notice with the SEC as soliciting material no later than two business days after providing such notice to the company. We believe further clarification of the interrelationship between this notice requirement and advance notice bylaw provisions would be helpful.

What must a company do after it receives such a notice?

Under the proposed rule, once a company receives notice of a nominee from a nominating security holder(s), the company must include (unless the company determines that the nominating security holder(s) has not complied with proposed Rule 14a-11 and therefore is not required to include such nominee) information regarding the security holder nominee in the company's proxy statement that it sends to its security holders, as well as the Web site address, if any, on which the nominating security holder(s) intends to solicit in favor of its nominee, and include the name of the nominee(s) on the company's proxy card that is included in the proxy materials. The company may also include statements in the proxy statement supporting company nominees and/or opposing security holder nominees. If the company includes such statements in its proxy materials, other than a mere recommendation to vote in favor or withhold votes from specified candidates, a nominating security holder must be given the opportunity to include a statement in the proxy statement in support of its nominee (not to exceed 500 words). In addition, both the company and the nominating security holder(s) will be able to solicit in favor of their nominees outside of the proxy statement, for example on a designated Web site, as long as such solicitations fall within the parameters of the applicable proxy rules.

With regard to a company's proxy card that includes security holder nominees, the proposed rules would not permit a company to provide security holders the option of voting for, or withholding authority to vote for, the company nominees as a group. Rather, the proxy card must include and identify as such any security holder nominees in an impartial manner. The company may on the proxy card recommend that the security holders vote against, or withhold votes from, security holder nominees and in favor of the management nominees.

If the company determines under proposed rule 14a-11 that it is not required to include security holder nominees in its proxy materials, it must provide written notice of such determination to the nominating security holder(s) no less than 30 calendar days before the date the company's proxy materials were released to security holders in connection with the previous year's annual meeting (or if no meeting was held in the previous year, or if the date of previous year's meeting has been changed by more than 30 days, a reasonable time before the company's proxy materials are mailed). The notice must set forth, among other things, a description of the determination by the company's board of directors, including an affirmative statement of its determination not to include that specific nominee, and a discussion of the specific requirement(s) of Rule 14a-11 that permitted the company to exclude such nominee.

If the company determines that it must include the security holder nominee in its proxy materials, it must advise the nominating security holder(s) of this determination and state whether the company intends to include a statement in opposition (or support) of the nominee in its proxy statement. If it does, it also must advise the nominating security holder(s) of its right to submit a statement (no more than 500 words) supporting its nominee and the date by which this statement must be provided. The SEC has advised that this supporting statement is soliciting material and must be filed by the nominating security holder(s) with the SEC on or about the date the company's proxy statement is first released.

Other Securities Law Issues

In addition to new Rule 14a-11 and certain changes to Schedule 13G, the SEC is proposing amendments to rules under Section 16 of the Exchange Act to exclude a Rule 14a-11 nominating security holder group from the definition of 10% owner. However, the SEC is not proposing to exclude from that definition security holders whose individual ownership exceeds 10% and who are not otherwise excluded under the current rules. Furthermore, the SEC expressed its view that the standards for establishing the independence of the nominee from the nominating security holder(s) were sufficient such that the "deputization" theory (i.e., director status is imputed to the nominating security holder(s) even though the company has not formally elected or otherwise named that security holder a director) should not apply in this instance.

The complexity of proposed Rule 14a-11 illustrates the difficulties of implementing the recommendations set forth in the SEC report. We expect that this proposed rule will elicit numerous comments, and we will keep you informed of further developments related to these important matters.