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The Securities and Exchange Commission (SEC) has been active this year in the areas of corporate democracy and the nomination and election of directors. After an examination of its current proxy regulations, the SEC in August proposed a rule that would require significant additional disclosures about companies’ nominating committees, the director-nomination process, and how shareholders may communicate with directors. On Oct. 8, the SEC voted unanimously to propose a rule that would require companies, under certain circumstances, to include shareholders’ nominees for director in the company proxy materials. (A Webcast of the meeting is available at www.sec.gov/news/openmeetings.shtml. The text of the proposal was posted on the SEC’s Web site on Oct. 14 at , www.sec.gov/rules/proposed/34-48626.htm.) The debate among investors and shareholder activists, who support these initiatives, and the business community and its legal advisors, who view the proposals with much trepidation, has already been intense. A company is not now required to include in its proxy materials any shareholder nominees for director; it only must describe its own candidates. Required disclosures about nominating committees are limited. Shareholders generally have the right under state law to make nominations, but those candidates have virtually no chance of success unless the shareholders prepare their own proxy materials at their own expense and solicit proxies in favor of their nominees. Despite the SEC’s intermittent consideration of these issues for more than 60 years and several significant changes in the related disclosure and election rules, the SEC has never before proposed to give shareholders access to the company proxy machinery. In mid-April of this year, the SEC asked its staff to examine current proxy regulations and develop possible changes to improve corporate democracy. In response, the division of corporation finance produced its July 15 “Staff Report: Review of the Proxy Process Regarding the Nomination and Election of Directors.” See www.sec.gov/news/studies/proxyrpt.htm. The staff report noted a need to improve the existing proxy process in two areas. The division of corporation finance recommended first that the SEC propose new requirements for increased disclosure in company proxy materials relating to nominating committees and the company’s procedures for allowing shareholders to communicate with board members. Second, it recommended that the SEC propose new proxy rules that would allow shareholders to place their nominees in a company’s proxy materials, subject to certain limitations. The SEC has now proposed rules for public comment on both these topics. The proposed disclosure rule On Aug. 8, the SEC released a proposed rule that would require significant additional disclosures in company proxy statements. See www.sec.gov/rules/proposed/34-48301.htm. Some of these disclosures seemed relatively innocuous, such as whether there is a nominating committee, and if so, whether it has a charter, what the charter provides, whether the committee’s members are independent and whether it pays any third party to assist in identifying or evaluating prospective candidates. Proposed disclosures that provoked more comment related to specific minimum qualifications and specific qualities or skills that the committee believes are necessary for directors to possess, specific standards for the overall structure and composition of the board, the committee’s process for identifying and evaluating nominees, and the issue of whether the committee evaluates a nominee recommended by a security holder differently from other nominees. Investors generally supported these disclosures as they provided a more complete view of the nominating process and of how investors might participate in it more effectively. Business interests’ objections Some business representatives were critical, arguing that there are a huge number of qualities and skills that would be beneficial, and the resulting disclosure may likely be a generalized boilerplate list of little value in actually understanding the nominating process. Further, they suggested that checklists of specifics were not reflective of how committees actually dispatch their responsibilities. Committees, business argues, need significant flexibility in their evaluation of candidates, and in their policies and procedures that are broad and sufficiently general to deal with many diverse circumstances. A disclosure proposal attracting even more attention would require a company whose nominating committee rejected a nominee recommended by a person or group that had been a 3% shareholder for at least a year to disclose the names of the shareholders who recommended the candidate and the specific reasons why the committee did not make the nomination. Investors and activists liked the concept, but generally thought that the ownership threshold should be lower than 3%. Businesses and the bar were highly concerned that disclosures about rejected candidates could inhibit the development and functioning of the nominating process by chilling committee discussions, encouraging the board to accept lesser candidates to avoid a public relations war over a rejection and subjecting the board to second-guessing by people who lacked all of the information available to the board. Further, they suggested that the process of judging individuals is inherently subjective, involves many intangibles and does not lend itself to itemized lists of specifics. They were also concerned about the prospect of litigation if the candidate or his sponsoring shareholder took exception to the reasons for the rejection. The bulk of the many supporters of the proposal believed that it represented only a first step before a shareholder-access rule. Business and its advisors, on the other hand, believed that enacting the disclosure and access proposals may have significant negative consequences. Many of them thought that the SEC should let more time pass to evaluate the effects of the Sarbanes-Oxley Act, the numerous recent related SEC rules and the proposed rule changes at the major securities exchanges before making fundamental changes to the proxy process. Further, they suggested that the cumulative effects of these rules could make desirable candidates less willing to serve on corporate boards. Shareholder access rule There has been skirmishing over the proposed disclosure rule, but the real war will be waged over shareholder access. On Oct. 8, the SEC voted to propose a rule that in certain circumstances would require public companies to include in their proxy materials the names and other information about shareholder nominees for election as director. See www.sec.gov/rules/proposed/34-48626.htm. One of two triggering events-which the SEC believed would provide an indication that a company had been unresponsive to shareholder concerns-would have to occur for the procedure to apply. One triggering event would be when at least one of the company’s nominees for the board of directors for whom the company solicited proxies received “withhold” votes from more than 35% of the votes cast at an annual meeting of securityholders. The other event would be when a majority of votes were cast in favor of a shareholder proposal-submitted by a 1% securityholder or group that had held their shares for one year-requesting that the company become subject to the access procedure. Companies that become subject to the procedure would be required for two years to include in their proxy materials the names of securityholder nominees for election as director if the nominating securityholder or group had been a 5% shareholder for two years, had reported its ownership on Schedule 13G and had an intent to maintain that ownership through the election meeting. Securityholders could not use the process if they sought to change or influence control of the company or if the relevant state law did not allow them to make nominations. Nominees must satisfy any applicable objective independence standards of a national securities exchange or a national securities association. Prohibited relationships Further, the nominee cannot be a member of, or be an employee, executive officer, director or affiliate of any member of, the nominating shareholder group. Additionally, the nominee may not recently have received consulting or advisory fees from or have certain other relationships with the nominating securityholder. The nominating securityholder can have no direct or indirect agreement with the company regarding the nomination of the nominee. The number of shareholder nominees a company would be required to include in its proxy materials or have on its board would range from one, if its board was eight or less, to three, if its board was 20 or more. If a company receives more nominees than it is required to include, the nominees would be those put forward by the nominating securityholder with the largest ownership. Debating the pros and cons Many businesses fear that if shareholders have easy access to the corporate proxy machinery, every annual election of directors may turn into a proxy contest with the enormous disruption and distraction from running the business that a proxy contest has historically entailed. With the proposed rule, businesses may now wonder if they will have two layers of proxy contests: one every time a 1% shareholder submits a proposal for the company to become subject to the access rule, and another the next year if the proposal passes. Business interests have also noted that nominating committees have a fiduciary duty to act in the best interest of the company. Nominating shareholders have no such duty to the enterprise, and many institutional investors may have duties to their own constituents to act in the constituents’ best interests. Businesses and the bar therefore contend that shareholder access could result in the election of special-interest or single-issue directors and create Balkanized and dysfunctional boards. This, in turn, would act as an additional deterrent to board service by highly qualified candidates. While the prohibitions on certain relationships between a candidate and the nominating shareholder may rule out some single-issue directors, shareholders may be able to effectively seek out unrelated, but extremely sympathetic, candidates. Business accordingly believes it is imperative to have triggers that target companies only when there is real ineffectiveness in the proxy process and that do not sweep in a broad range of issues. The investors’ arguments Investors and activists do not share these views. They argue that if management is competent and responsive, it should have no fear of opposition candidates and should not be distracted by them. Additionally, they state that institutional investors are at most “reluctant activists,” and that there is no evidence they would rush to exercise their new rights or embark on an election contest unless it were necessary to bring a wayward company back into line. Further, shareholders’ candidates cannot be elected unless they get more argue that special-interest or single-issue directors are unlikely to prevail. Finally, because they believe special-interest directors are unlikely, they suggest that shareholder candidates would generally share the same goals as the other directors, including enhancing shareholder value. Therefore, election of shareholder candidates may well not produce board discord. Hence they believe that triggers should be limited and permit quick action by shareholders when the need arises. Some prominent institutions had argued before the rule was proposed that a two-step process that took two years was too long, and would not allow them to act in time to stop any perceived problem before the problem became intractable. To some extent, the investors’ overall position seems to be based on a construct that shareholders are owners, directors are their agents and if the directors are not doing what the shareholders want, something must be amiss. The more traditional model, however, is that directors, once elected, have a duty to the corporation and should act using their own best judgment, whether or not that might be how the shareholders would vote if asked. Issue of SEC authority Some commentators have asked whether the SEC is moving too far toward substantive regulation of the director-election process with these proposals. The question is more than philosophical. It affects whether the SEC actually possesses the authority under the Securities Exchange Act to adopt these rules. The access rule was clearly drafted to avoid the issue to the extent possible, and in the Oct. 8 open meeting, SEC General Counsel Giovanni Prezioso stated his belief that the agency had sufficient authority to proceed with the rule-making. The issue of authority will doubtless be raised again in the comment process, however. The SEC is keenly aware of the contentious nature of the topics in its proposals and their importance. Almost half the substance of the proposing release for the shareholder access rule is requests for comments on specific aspects of the proposal, an amount that is perhaps unprecedented. Further, in order to ensure that all parties have sufficient time to prepare and submit their comments on the proposal, the comment period will last until Dec. 22, a significantly longer period than usual. The fervor with which companies and investors advocate their positions during that period and their anxiety about the ultimate result will only escalate, because as Commissioner Harvey Goldschmid stated in the Oct. 8 open meeting, “We are in the process of shifting the balance of power between corporate managements and shareholders.” See www.sec.gov/news/speech/spch100803hjg.htm. R. Daniel Witschey Jr. is a partner at Houston’s Bracewell & Patterson, where he practices corporate and securities law. John R. Brantley, another partner at the firm, provided insightful suggestions for this article.

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