The SEC, the Election of Directors, and a Proposal to Reduce the Rights of Shareholders

We are discussing the backdating cases in Delaware and will resume tomorrow.  The topic has been overtaken by events. 

Yesterday the Wall Street Journal published a story indicating that the Commission was considering a rule proposal that would permit shareholders to submit proposals under Rule 14a-8 to regulate the election of directors.  From the description of the proposal, the SEC will be violating the cardinal rule of corporate governance:  Do no harm (see Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure)  No matter how it is pitched, the proposal, if adopted, will effectively deny shareholders their rights under state law to make proposals concerning the way directors are elected. 

Recall that the SEC had, in the past, allowed companies to exclude from their proxy statements proposals that related to the election of directors.  The position was upended by 2nd Circuit in AFSCME.  The decision overturned the Commission's attempt to allow for the exclusion of a proposal submitted by AFSCME to Hewlett Packard.  The proposal, if adopted, would have required HP to include in its proxy statement nominees received from certain large shareholders.  

As reported by the WSJ, the SEC apparently is considering an amendment to Rule 14a-8 that would overturn portions of the Second Circuit's decision.  Specifically, the SEC would permit the proposals but only if made by shareholders holding 5% or more of the company's stock.  In other words, these types of proposals will be limited to the largest shareholders (or, presumably, groups of shareholders).  

What is the problem with establishing a 5% threshold?  Two things.  First, the requirement effectively negates a shareholder right that exists under state law.  Second, for large public companies, it is very difficult to meet.  

With respect to state law, shareholders have the right to propose bylaws, including ones that would require management to include their nominees in the proxy statement.  Trying to exercise this right by making a proposal at a shareholder meeting is a non-starter, at least in the case of large public companies.  Rule 14a-4(c) of the proxy rules allows management to solicit proxies and to vote the proxies against any proposals that come up at the meeting.  Any shareholder trying to exercise this right, therefore, would see it voted down because of the proxies accumulated by management.   

To have any chance at adoption, therefore, shareholders must circulate the proposal before the meeting and seek their own proxies.  But this is, as we have noted, an expensive process, one that few shareholders can afford.  Moreover, the expense is a result of the regulatory system imposed by the SEC.   

Rule 14a-8 mitigates the costs caused by the Commission's regulatory system by allowing shareholders to including their proposals in management's proxy statement.  The draft rule under consideration by the SEC would, however, allow only the largest shareholders to have the right to include a proposal about the election of directors in management's proxy statement.  In other words, the draft rule would allow the class of shareholders most able to pay the costs of a proxy solicitation to have a free ride while denying those least likely to be able to afford the costs the same right.  The proposal effectively denies the vast majority of shareholders the right to exercise their state law right to make certain types of shareholder proposals.    

And how many shareholders would be able to make use of this authority?  In large public companies, not many.  Wal-Mart is the largest company in the Fortune 500, with Exxon-Mobile second.  Wal Mart has, according to its most recent 10-K, 4,124,451,341 shares of common stock; Exxon-Mobile?  5,693,398,774 shares of common stock.  To make a proposal under the draft rule would require shareholders to own more than 205 million shares of Wal Mart (at around $47 a share, this would require ownership of and more than $9 billion in shares), 280 million shares of Exxon-Mobile (at around $86 a share, this would require more than $24 billion).  How many shareholders meet those requirements?  In Wal-Mart, other than the Walton Family, none.  In Exxon-Mobile?  Apparently none.

In other words, for large public companies, this would be a very difficult threshold to overcome, requiring shareholders to incur the costs associated with organizing groups of shareholders willing to publicly oppose management (a group of 5% or more of the voting shares of the company would most likely be required to disclose its existence in a Schedule 13D).  

The SEC can pretend that it is extending rights to shareholders but the facts demonstrate otherwise.  Concerned about shareholder rights and democracy?  Let all shareholders eligible to use Rule 14a-8 include any proposal permissible under state law, including those affecting the election of directors, and allow informed shareholders, rather than bureaucratic edict, determine whether the provision should be implemented.