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In probably its most controversial initiative regarding corporate governance in more than a decade, the Securities and Exchange Commission has proposed that shareholders at publicly held corporations be empowered to nominate a limited number of directors—between one and three depending on the size of the corporation’s board—by placing these nominees directly on the corporation’s own proxy statement. See Securities Exchange Act Release No. 34-48626 (Oct. 26, 2003). Although the triggering conditions that would authorize such nominations are still under SEC review and may be tightened, proposed Rule 14a-11 contemplates that one such trigger would be the decision of some percentage of the corporation’s shareholders to withhold consent from at least one of the company’s own nominees for its board of directors. Currently, the proposed percentage is 35%, but recent leaks to the press suggest that the SEC may move it up to 50% of all votes cast, excluding votes cast by brokers.

Even with this revision, the SEC proposals will be fiercely opposed by the usual bar associations and other corporate lobbyists, all of whom assert that the proposal will encourage a surge of “special interest” candidates and labor-backed proxy contests that would “unproductively” consume corporate resources. In contrast, most academics have regarded the SEC’s proposed rule as too “tame” and unlikely to be much used by cost-conscious institutional investors. Both sides, however, may have missed a hidden kicker in this rule that will shape its true impact.

A marathon of procedural steps under proposed rule

As the academics legitimately point out, shareholders dissatisfied with the performance of an incumbent board would have to run the following marathon of procedural steps under proposed Rule 14a-11: gather sufficient shareholder support to satisfy a triggering event under the rule (for example, secure the requisite “withheld consent” vote in the case of at least one management nominee); wait one year; then satisfy substantial ownership and holding-period requirements in order to nominate a director; bear the costs involved in persuading other shareholders to vote for their candidates; and win a majority vote for their candidates.

Arguably, this is a slow, costly process that produces few real benefits because the minority slate that might be so elected cannot change corporate policy. Actively trading shareholders, such as mutual funds, may be bored by the slow pace of such events, and in real crises-for example, HealthSouth, Tyco or WorldCom-when officers are indicted and the corporation is on the precipice of bankruptcy, earlier interventions are necessary if disaster is to be averted.

In this light, the critical question for the SEC is: If we build it, will they come? How often would shareholders use Rule 14a-11 if it were adopted as proposed? Here, one can start by looking at the recent data. Harvard Law School Professor Lucian Bebchuk has found that between 1996 and 2002, contested proxy solicitations totaled 215 and averaged about 30 per year. See Lucian Bebchuk, “The Case for Shareholder Access to the Ballot,” 59 Bus. Law. 43 (2003). Still, as he points out, the majority of contested solicitations did not involve attempts to replace the board with a new management team. About 25% involved nonelection issues, such as contests over bylaw amendments. Of those proxy fights that did focus on the election of directors, a majority involved a contest over the sale, merger or restructuring of the company. Once Bebchuk subtracted these cases and also cases involving very small firms having a market capitalization of less than $200 million, he reached the startling conclusion that “true” election contests averaged fewer than two a year between 1996 and 2002.

Arguably, this suggests that institutional shareholders would have little incentive to use an SEC rule that permitted them only to replace one or two directors. Even if the costs of such a contest are reduced by the proposed rule, one needs to identify real benefits to institutional investors before one can predict that they will use it.

But Rule 14a-11 does place real benefits within reach. The unrealized potential of the rule lies in its ability to enable institutions to realize some long-sought goals. Today, institutions regularly support shareholder proposals seeking to restrict the use of poison pills, to eliminate staggered boards or to curb excessive executive compensation. For example, a Georgeson & Co. study of the 2002 proxy season found that poison-pill rescission proposals received 59% of votes cast, while board-declassification proposals received 60% of votes cast. See Georgeson Shareholder, Annual Corporate Governance Review: Shareholder Proposals and Proxy Contests (2002). In short, when there is “money on the table” because a proposal would facilitate a takeover, institutional investors respond, even if many still do not support corporate-governance reforms in the abstract.

The utility of shareholder proposals for institutions is constrained, however, by the fact that most are usually precatory in nature. This is because SEC Rule 14a-8, which authorizes shareholder proposals, requires the proposal to be a “proper subject” for shareholder action under state law. For some time, doubt has existed over whether a shareholder-adopted, mandatory bylaw amendment that seeks to restrict the board’s control over the poison pill or executive compensation was a “proper subject” for shareholder action under state law. See Coffee, “The Bylaw Battlefield: Can Institutions Change the Outcome of Corporate Control Contests?,” 51 U. Miami L. Rev. 605 (1997). In consequence, the SEC has generally (and timidly) permitted companies to omit mandatory shareholder proposals, cast as bylaw amendments, from their proxy statements.

But this doubt over the legitimacy of bylaw amendments has been recently resolved in a way that may create powerful incentives for institutional shareholders to elect a single director to the corporate board. In Hollinger Int’l Inc. v. Black, 2004 Del. Ch. Lexis 13 (Feb. 26, 2004), the Delaware Chancery Court faced an effort by a controlling shareholder to use a bylaw amendment to prevent a rebellious board from selling corporate assets or adopting a poison pill so as to block his intended sale of his control block in his corporation. Specifically, Lord Conrad Black, the indirect majority shareholder in Hollinger International, adopted a bylaw amendment by majority shareholder consent that provided in effect that any significant board action required a unanimous vote. Because Lord Black was both a board member and the majority shareholder, the effective result was to give him a minority veto over any sale of significant assets. In response, Hollinger International sued, alleging that such a bylaw amendment violated the Delaware General Corporation Law.

After a trial, Vice Chancellor Leo Strine initially found the bylaw amendment to be consistent with the Delaware General Corporation Law. Although he noted that “there has been much scholarly debate about the extent to which bylaws can . . . limit the scope of managerial freedom a board has, e.g., to adopt a rights plan, there is a general consensus that bylaws that regulate the process by which the board acts are statutorily authorized.” Id. at 154. Relying in part on Frantz Mfg. Co. v. EAC Industries, 501 A.2d 401 (Del. 1985), which upheld a similar unanimous attendance and vote requirement for board action, Strine left no doubt that such bylaws “may pervasively and strictly regulate the process by which boards act.” Id. at 159 n.136. Nonetheless, he then held the specific bylaw adopted by Black to be “inequitable,” based on long-standing Delaware precedents holding that “inequitable action does not become permissible simply because it is legally possible.” Id. at 160; see Schnell v. Chris-Craft Industries Inc., 285 A.2d 437 (Del. 1971).

The real impact may be on bylaw amendments

Thus, although the specific bylaw was enjoined, the message of the Hollinger case is that similar bylaws are enforceable. Conduct that would be inequitable for a controlling shareholder, particularly one that had earlier breached his fiduciary duties to the firm’s minority shareholders, would not be inequitable for widely dispersed, noncontrolling institutional shareholders. The unappreciated significance of Hollinger lies in the powerful new weapon it hands shareholders in their continuing tug-of-war with corporate managements. If institutions can elect a single director to a board, they can also adopt a bylaw amendment that, at least in the case of Delaware corporations, required unanimous board consent for the adoption or modification of a poison pill, for awards of executive compensation that institutions deem excessive or for other sensitive matters. In the past, the first step in this scenario-the election of the single director-would have been prohibitively expensive for the institutions. But, under proposed Rule 14a-11, this step would cost little and could be combined with the proposed bylaw amendment in the same proxy statement.

Potentially, the combination of Hollinger and proposed Rule 14a-11 alters the balance of power between boards and shareholders. Institutions that would be indifferent to electing a single director to a corporation’s board might eagerly support a campaign to curb the use of a poison pill, to restrict defensive tactics or to preclude dilutive stock issuances to management. Thus, both sides may have missed the forest for the trees in evaluating the likely impact of proposed Rule 14a-11. Rather than encouraging meaningless election contests for “gadfly” or “special interest” directors, the rule could enable institutional investors to pressure managements to realize economic value. Once this is recognized, the proposed rule will only become more controversial-and more important.

John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and director of its Center on Corporate Governance.

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