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With the U.S. Court of Appeals for the District of Columbia Circuit having struck down Rule 14a-11 in Business Roundtable et al. v. Securities and Exchange Commission, 1 the question is where does proxy access now stand and what can now be expected?
The Court overturned the SEC's attempt to give shareholders the right under the federal proxy rules to have their director nominees included in management's proxy materials. In its ruling, the Court specifically cited the SEC's failure to adequately justify Rule 14a-11 on a cost-benefit basis.
Background of Proxy Access
Proxy access has been a controversial subject for the SEC, and has had a long and difficult history. The modern era debate began in earnest in 2003 with the SEC review of the proxy process for the nomination and election of directors,2 followed by its proposal in October 2003 for proxy access for those companies that were "unresponsive to security holder concerns," including through a shareholder opt-in process.3 This proposal was not adopted.
Shareholder activists then began to use Rule 14a-8 to make proxy access proposals and, in 2006, the U.S. Court of Appeals for the Second Circuit in the AFSCME v. AIG 4 decision held--contrary to the position taken by the SEC--that a proxy access shareholder proposal could not be excluded under the director election exclusion to Rule 14a-8. In 2007, in order to avoid uncertainty and confusion while it considered proxy access more fully, and after issuing an alternative proposal that would permit proxy access proposals under Rule 14a-8, the Commission clarified Rule 14a-8 to allow exclusion of proxy access proposals.5
In June 2009, the Commission proposed a mandatory proxy access rule as Rule 14a-11, which it adopted in revised form in August 2010.6 Rule 14a-11, as adopted by a divided 3-2 Commission vote, would allow shareholders who have owned at least 3% of the company's voting power for at least three years and who do not have a control intent to have their nominees for up to 25% of the company's board of directors included in the company's proxy material. At the same time, the Commission adopted an amendment to Rule 14a-8 to permit shareholder proxy access proposals. In October 2010, the Commission stayed the effectiveness of both Rule 14a-11 and the amendment to Rule 14a-8 pending resolution of the court challenge of Rule 14a-11 and further notice from the SEC. On July 22, 2011, the D.C. Circuit Court of Appeals upheld the challenge to Rule 14a-11.
In response to the Court ruling, the SEC has several alternatives which undoubtedly are being considered. For example, the SEC could:
--seek rehearing either by the panel or en banc or appeal the decision to the U.S. Supreme Court;
--amplify its analysis of the economic justification for Rule 14a-11 and readopt the rule;
--modify Rule 14a-11 and seek to justify the modification in a way that it believes will pass judicial scrutiny; or
--do nothing on Rule 14a-11 and let it disappear.
Under any of these alternatives, the question is what the SEC will do about the amendment of Rule 14a-8, which offers another route to proxy access through shareholder proposals. As noted, the amendment has been stayed pending resolution of the Court action challenging Rule 14a-11 and further notice from the SEC. Again, the SEC has several alternatives--it could lift the stay and let the amendment take effect as adopted, or it could revisit the Rule 14a-8 amendment. This article does not presume to predict what the SEC will do, or worse, tell it what it should do regarding Rule 14a-11. However, this article does have some observations regarding a path forward.
The D.C. Circuit Court of Appeals has set a high bar for the SEC to clear in justifying a mandatory proxy access rule. For example, in addition to finding the Commission's cost-benefit analysis to be flawed, the Court criticized the SEC for failing to establish that proxy access would result in improved board and company performance, and increased shareholder value. There are many (the author being one) who--although believing the SEC acted unwisely in adopting proxy access, at least in the form of Rule 14a-11--are concerned about the high, nigh impossible, bar the Court set. Indeed, such a high bar could put in jeopardy most SEC rulemaking of any complexity or controversy. It remains to be seen whether the high bar established by the Court in this case will be limited in subsequent cases on the basis that, because the SEC was encroaching on areas traditionally left to the states, its burden to justify its proxy access rule--notwithstanding the Congressional grant of authority--was greater.
In discussing proxy access, it is important to remember what it is, and more importantly what it is not. Proxy access is not a right to elect directors--that is left to the shareholder election process. Also, it is not a right to nominate directors--that is a matter of state law and the corporation's governing documents. Rather, it is a right to have a proponent's nominees who qualify included in the corporation's proxy material. Stripped to its essentials, aside from cost savings, proxy access is the ability to have a universal proxy card.
Focus on Rule 14a-8
In the absence of Rule 14a-11 or a substitute mandatory access rule, the focus shifts to the amendment of Rule 14a-8, which would permit access proposals by shareholders. Although it might be tempting for the SEC to simply lift the stay and get on with it--particularly given all the demands on its resources as a consequence of its new rulemaking mandates under the Dodd-Frank Wall Street Reform and Consumer Protection Act7--I do not believe it is that easy because of the requirements of the Administrative Procedure Act8 and important policy considerations.
Even if lifting the stay itself did not require a full-blown cost-benefit analysis, I believe that the circumstances under which the SEC did its analysis at the time of adoption of the Rule 14a-8 amendment have changed so significantly as a result of the invalidating of Rule 14a-11, that it is questionable whether the SEC can, and indeed whether it should, make the amendment effective without a new cost-benefit analysis, preferably with the opportunity for a new comment period. As the Commission said in its Order granting a stay, "the amendment to Rule 14a-8 was designed to complement Rule 14a-11 and is intertwined."9 In fact, the playing field for shareholder-initiated proposals for proxy access is different without Rule 14a-11 because the leavening effect of the proxy access rule is no longer there. As a result, the number of access proposals under Rule 14a-8 can be expected to increase and the absence of the discipline created by Rule 14a-11--with which a Rule 14a-8 proposal could not be inconsistent--disappears. Thus, significantly more and potentially unworkable proposals are likely to be made. These considerations also suggest that the SEC should go back to the drawing board with the Rule 14a-8 amendment in the absence of Rule 14a-11. A failure to do so is likely to leave the SEC vulnerable to another court challenge similar to the one that was successful on Rule 14a-11.
Private Ordering Approach
Many responsible opponents of Rule 14a-11, including the American Bar Association's Committee on Federal Regulation of Securities, indicated that they would support a private ordering proxy access approach--one set up by the companies themselves instead of by government mandate--that included appropriate safeguards to protect against misuse and unworkable arrangements.10
In considering a private ordering approach, it is important to understand the role of Rule 14a-8. Rule 14a-8 complements, and in some respects amplifies, shareholder rights under state corporation law. If the subject matter of a Rule 14a-8 proposal is permissible for shareholders to adopt under state law and the corporation's governing documents, the rule gives the proponent the right to have the proposal included in the corporation's proxy material and may give the proponent the ability to have the proposal put before the shareholders when it might not otherwise have that ability. If the subject matter is not something that may be adopted by shareholders but otherwise is not inconsistent with state law, the rule gives the proponent the ability to have a non-binding shareholder vote, which itself has increasingly had practical, if not legal, consequences. Thus, while Rule 14a-8 itself does not in one sense create substantive right, it nevertheless creates important additional rights as a matter of federal law. The creation of these additional federal law rights should be considered carefully when they involve matters of corporate governance and the potential for expansion of director election contests, as would be the case with proxy access proposals.
Private ordering of proxy access is already contemplated by state corporation law. Delaware added section 112 to the Delaware General Corporation Law in 2009 to make clear the permissibility of proxy access bylaws and the flexibility to tailor them to meet company-specific circumstances.11 The Model Business Corporation Act was amended similarly.12 Therefore, it is appropriate to evaluate when and in what way the federal enhancement of those rights through Rule 14a-8 should occur. For example, rather than the usual Rule 14a-8 ownership criteria, the ability to use the rule for proxy access could be limited to long-term holders with a significant economic stake in the company, and provision also could be made so that the proposal could not be used for control purposes. In addition, an access rule could make clear that the corporation retains the ability to modify any proposal to deal with workability issues so long as it did so in a way that did not undermine the essential nature of the proposal. The SEC also could phase in any amendment to permit companies to fashion their own access regimes that fit a company's unique circumstances by only permitting non-binding proxy access proposals for some suitable transition period.
What Should Companies Do?
At the time of writing of this article, the delay in implementing proxy access, either through a mandatory proxy access rule or a shareholder proposal under Rule 14a-8, continues. That, however, could change should the SEC decide to take action on proxy access. It is unlikely that this will occur in time for the 2012 proxy season, but that is not out of the question. Therefore, companies should remain alert to possible SEC action and be prepared to respond.
If the SEC were to allow the amendment of Rule 14a-8 to take effect and it was not stayed, companies should consider how they wish to deal with proxy access. A company could fashion its own proxy access bylaw or wait to see if it receives a proposal under Rule 14a-8 or otherwise receives pressure from its shareholders to adopt one. If a company waits and receives a Rule 14a-8 proposal, it could choose to resist the proposal or adopt its own proxy access bylaw and seek to exclude the shareholder proposal, at least for that annual meeting. In any case, the company would be well advised to engage in dialog with its key shareholders.
Preparation is always a prudent step, and companies should consider in advance of receiving a proposal what kind of proxy access bylaw it might adopt. A helpful illustrative access bylaw with commentary was prepared by the American Bar Association Task Force on Shareholder Proposals and can be found on its website.13 It was prepared before the SEC's 2009 proxy access proposal and therefore does not take into account the learning gained from that proposal and the comments to it. Nevertheless, it identifies some key issues and ways to address them.
As a matter of sound policy, in the absence of a mandatory Rule 14a-11 regime, the SEC should revisit the Rule 14a-8 amendment and consider a new approach that provides for proxy access as a matter of private ordering with appropriate safeguards. Such an approach is likely to gain widespread support and finally put to rest the long and tortured battle over proxy access, and do so in a way that strikes the right corporate governance balance and enhances the shareholder voting franchise.
Stanley Keller is a partner in the Boston office of Edwards Angell Palmer and Dodge LLP. Mr. Keller is a nationally recognized corporate and securities lawyer, and a member of the Editorial Advisory Board of Wall Street Lawyer. Contact: [email protected]
1 Business Roundtable et al v. Securities and Exchange Commission (No. 10-1305, July 22, 2011).
2 Staff Report: Review of the Proxy Access Process Regarding the Nomination and Election of Directors, Division of Corporation Finance (July 15, 2003), available at: www.sec.gov/news/studies/proxyrpt.htm.
3 Security Holder Director Nominations, Rel. No. 34-48626 (Oct. 14, 2003).
4 American Federation of State, County and Municipal Employees v. Am. Int'l. Grp., Inc., 462 F.3d 121 (2d Cir. 2006).
5 Shareholder Proposals, Rel. No. 34-56160 (July 27, 2007), and Shareholder Proposals Relating to the Election of Directors, Rel. No. 34-65161 (July 27, 2007), adopted in Rel. No. 34-56914 (Dec. 6, 2007).
6 Facilitating Shareholder Director Nominations, Rel. No. 34-60089 (June 19, 2009), adopted in Rel. No. 34-62764 (Aug. 25, 2010).
7 Dodd--Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173).
8 5 U.S.C. Section 551 et seq.
9 Order Granting Stay, Rel. No. 34-63031 (Oct. 4, 2010); Notice of Stay of Effective and Compliance Dates (Oct. 14, 2010).
10 Comment Letters of the American Bar Association Committee on Federal Regulation of Securities dated Aug. 31, 2009, Sept. 18, 2009 and Jan. 19, 2010.
11 Delaware General Corporation Law Section 112; see also, Section 113 permitting bylaws to reimburse shareholders for costs incurred in a director election contest. See CA, Inc. v. AFSCME, 953 A.2d 227 (Del. 2008) (shareholders can adopt bylaws regulating process for election of directors).
12 Model Business Corporation Act Section 2.06; see 64 Bus. Law. 1157 (2009).
13 The bylaw and related commentary created and compiled by the ABA's Task Force on Shareholder Proposals can be found at the American Bar Association website at www.americanbar.org/aba.html.