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There is a strong push in U.S. corporate governance to increase shareholder power to nominate directors. For example, Walt Disney removed Michael Eisner from his chairmanship, and MCI instituted new rules to solicit director nominations. The Securities and Exchange Commission, mindful of this groundswell, undertook a review of the shareholder proxy voting process and its impact on director nominations. The result was two significant proposals: one that would increase corporate disclosure about the nomination process, and another that requires companies sometimes to include shareholder nominees in their proxy statements. Unfortunately, the SEC’s proposal concerning shareholder access to management’s proxy statement is laden with complex requirements and unnecessary restrictions. The SEC needs to change its approach: It should take steps — using the technological developments of the Internet — to permit all shareholders to nominate directors. THE PROXY PROBLEM Typically, any shareholder may nominate directors from the floor of an annual or special meeting. Delaware courts have upheld bylaws that require advance submission of nominees. This approach may work effectively for small, closely held companies where a majority of voting shareholders can be present at the meeting. In the public company arena, however, elections no longer functionally occur at a meeting — they are decided as a result of the proxy voting process. Under the current system, anyone seeking to elect directors must distribute a proxy statement and card to all shareholders. Management uses the corporate treasury to pay the expenses for its own candidates, but a shareholder has to use his own funds. In a proxy contest, if the insurgent group wins, it can have the board vote to pay its expenses. But repayment will not occur where shareholders elect a single director. The costs, along with the limited prospect of success for shareholder nominations, make it unlikely in most instances that shareholders will nominate candidates to the board. The SEC’s proposal attempts to solve this problem by providing that, in some limited cases, shareholders can include their nominee in management’s proxy materials. The effect is to allow free distribution of information about shareholder nominees, eliminating some of the costs associated with a solicitation. In many ways, this proposal is nothing new. The SEC has long granted shareholders access to management’s proxy statement. A rule allowing shareholder proposals has existed since the 1940s (although not where it involved the election of directors). The pending proposal reflects the SEC’s desire to improve the quality and independence of the board of directors while at the same time preventing disruption that could occur from a truly open shareholder nomination process. Inclusion of too many nominees would cause management to incur increased expense in the form of longer proxy statements and higher mailing costs. Further, the business community and many of its legal advisers believe that giving security holders access to company proxy materials could turn every election of directors into an open contest, which could discourage some qualified board members from agreeing to appear on a company’s slate of nominees. More important, facilitating access for shareholders serious about electing nominees would cause management to spend valuable time (and corporate assets) campaigning against these candidates. Taking officers and directors away from business activities is no small cost for corporations. Also, there is real potential for a contentious atmosphere within the boardroom should shareholder nominees be elected. Directors nominated by the board presumably will meet any necessary qualifications, both in terms of expertise and disposition. No such guarantee will exist for shareholder directors. Moreover, shareholder directors may see themselves as having an obligation to be harder on management proposals, thus increasing dissent in the boardroom and making management of the company harder. FLAWED SOLUTION The proposed solution, while something of a step forward, will result at best in infrequent shareholder nominee inclusion in management’s proxy materials. Under the proposed rule, shareholders will have the right to add nominees into management’s proxy statement only if shareholders withhold 35 percent or more of the votes for a single director, or if shareholders pass a proposal that requires management to put in place a system for accepting shareholder nominees. Neither is likely to occur often. Withholding votes for a director will rarely trigger the requirement. The SEC noted in the release that only 1.1 percent of companies over a two-year period had 35 percent of votes withheld. Even this percentage overstates the number of times withholding will likely occur under the proposed rule. Withholding votes traditionally has had no consequence since no matter the number withheld under a plurality voting system, directors are still elected. Thus, investors can withhold their vote as a form of protest, an entirely symbolic act. Under the SEC proposal, withholding votes will have far greater consequences. The action will potentially trigger an obligation on management to implement a system of allowing shareholder access to the proxy statement for director nominees. Withholding votes will be perceived as far more hostile to management, making it less likely that institutional investors will do so. Similarly, problems exist with statistics published by the SEC. First, data published by the SEC seems to overstate the number of proposals that receive a majority of votes cast. The SEC suggests that somewhere around half of the proposals get a majority of votes cast. Published articles do not support this number. More important, the percentage of all successful shareholder proposals cannot be used as an indication of the number of shareholder nominee proposals that will pass. Further, shareholder nominee proposals are unique. Most shareholder proposals that pass are nonbinding, which gives management less incentive to oppose them. This will not be true of a proposal to require inclusion of shareholder nominees in management’s proxy materials, and management will likely actively oppose such proposals. Additionally, in the absence of a secret ballot, management will know which shareholders supported the proposal, reducing support. As a result, only a small percentage of these types of proposals will pass. The likelihood of success for a shareholder nominee proposal is further limited by the SEC’s proposal that to be eligible to submit proposals regarding nominees, a shareholder (or group) has to own at least 1 percent of the shares. This is a substantially higher threshold than is currently required for the submission of shareholder proposals. Under SEC rules, proposals must be submitted by shareholders who own the lesser of 1 percent or $2,000 of stock for one year. The proposed rule requires that the proposal be submitted by a shareholder (or group) who owns more than 1 percent and has held the shares for at least two years. For the vast amount of shareholders, the costs of complying with the proxy rules preclude any realistic exercise of the power. OTHER OBSTACLES Even if shareholders can surmount these difficulties and succeed in having management put a structure in place to accept shareholder nominees, additional barriers exist, limiting the likelihood of success. Specifically, only a shareholder (or group of shareholders) owning more than 5 percent of the shares for at least two years could submit proposals. The SEC conceded that, in the area of shareholder proposals, submissions by shareholders meeting these requirements were rare. Moreover, the shareholders must not have any interest in acquiring control. The requirement of significant share ownership disenfranchises most shareholders. The two-year holding period is also hard to justify, particularly given the attendant requirement that shareholders have no intent to acquire control. Moreover, the ban on shareholders interested in acquiring control essentially eliminates those investors most likely to spend the additional funds necessary to elect the nominee. Allowing only passive investors to submit a nominee essentially eliminates those shareholders most likely to make effective use of the new structure. Further, the proposal drastically restricts the nominees who can be submitted by shareholders, through the imposition of qualification requirements. Under the proposal, shareholder nominees must be independent under the definition contained in a rule of a self-regulatory organization. A nominee may not have “a direct or indirect agreement with the company regarding the nomination” (a requirement designed to prevent management shareholders from using the process). And the nominee cannot be part of the group that proposed him or her. The nominee cannot be a nominating shareholder or an immediate family member of a nominating shareholder (or, in the case of an entity, an executive officer or director). Nor can a nominee have been an employee of a nominating shareholder during the prior calendar year. The nominee also cannot have engaged in any business relationship with any nominating shareholder within the prior year or have certain control relationships. Thus, shareholders submitting nominees cannot simply pick the person they think best for the board. Instead, they have to navigate around a series of qualifications not imposed on management’s nominees. Finally, the number of nominees is limited. The flaws in the proposal arise out of a fundamental ambiguity about its purpose. In effect, the SEC has proposed a rule that would require management to participate in its own demise. To succeed, shareholder nominees in most cases will need to defeat a management nominee. Moreover, they will likely be viewed as more antagonistic to incumbent management. Yet under the proposal, management must facilitate shareholder participation. The SEC’s approach to this dilemma has been to drastically limit the instances where management will in fact confront this risk. REMOVING THE RESTRICTIONS A better solution would be to remove the myriad of restrictions imposed on shareholders and allow all of them to have meaningful opportunities to nominate directors. With management taken out of the middle of the process, the solution is straightforward. Allow any shareholder who wants to nominate a director to meet the proxy statement/card distribution requirement by posting materials on the Internet. Shareholders wanting to make a nomination need to get into the hands of shareholders a proxy statement and proxy card. Drafting the proxy statement and card will involve some expense to shareholder nominators, as they will incur the expense of creating a Web page and obtaining necessary legal advice. But this serves as a valuable check on the process, by reducing non-meritorious nominations. Shareholders wanting to vote for one of the directors nominated through this approach could download a proxy card, include relevant identification, and send it to the identified recipient. With respect to record owners, brokers could construct a Web page with identical information but include voting instructions instead of a proxy card. Moreover, to the extent both systems provided for return of information by e-mail, shareholders would not even have to incur the cost of mailing. Management could be required to provide notice of the Web sites of any shareholder nominee that posted the material at least 120 days before the distribution of the proxy statement and that met the requirements of the proxy rules. The approach would require some electronic security, though the sort used by banks and financial institutions should suffice. The approach would allow all shareholders to nominate directors without management in the middle, and would reduce the problems inherent in the current proposal, which leaves the right to nominate directors largely empty for most shareholders. J. Robert Brown Jr. is the associate dean for academic affairs and a professor at the University of Denver College of Law. Celia R. Taylor is an associate professor at the law school, where she teaches securities regulation. They can be reached at [email protected] and [email protected], respectively.

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