Friday Editorial: Prognosticating on the Proxy Rules

The SEC has now held three roundtables touching upon the relationship between the proxy rules and state law.  It is the case that the proxy process, rather than the actual meeting, is where shareholder matters in public companies are decided.  The meeting itself is an anachronistic formality.  At the same time, however, the proxy process is regulated almost entirely by the Commission (with a slight assist from the exchanges).  

Let’s assess the consequences of these rules.

First, most shareholders cannot afford the expenses associated with drafting a proxy statement and distributing it to even a rump group of owners.  The inability to solicit renders meaningless the right to make nominations or proposals at the shareholder meeting.  As a result, the requirement that a solicitation be accompanied or preceded by a proxy statement effectively denies these shareholders the rights typically afforded under state law.  

To the extent Rule 14a-8 allows the shareholder to include the proposal in management’s proxy statement, the costs associated with this regulatory burden are largely avoided, effectively allowing them to exercise their state law rights.  Access to management's proxy statement does not mean a free process.  Non-management shareholders still must incur costs to the extent they want to publicize their efforts or actively engender support from other shareholders, costs that will not be reimbursed.  But each exception to Rule 14a-8 effectively makes the cost of entry prohibitive by forcing shareholders to incur the costs of a solicitiation, effectively denying them their state law rights.  This is particularly true with respect to proposals concerning the election of directors and those that purport to interfere with the activities of the board of directors.  

Second, some shareholders have the ability to pay the costs of drafting a proxy statement but not the costs of distribution to all shareholders. As the Commission has noted, non-management shareholders need not solicit all shareholders:

• "Soliciting persons other than the issuer are not subject to the requirements of Section 14(c). Thus, unlike the issuer, they have no obligation to furnish an information statement to shareholders from whom no proxy authority is sought. As a result, soliciting persons can limit the cost of a solicitation by soliciting proxies only from a select group of shareholders, such as those with large holdings, without furnishing other shareholders with any information."

This encourages insurgent shareholders to cherry pick the recipients of the proxy materials.  Most likely they would go to shareholders with larger holdings.  As a result, not all shareholders receive information on the insurgent nominees or proposals.  Shareholder with small holdings, therefore, may receive materials only from management and are, therefore, not completely informed when executing their proxy.    

Third, some shareholders can afford the costs of drafting proxy statements and even the costs of distribution but know that the efforts will quickly become public and engender a hostile response from management.  To take advantage of secrecy, the shareholders may, at least in companies with reasonably concentrated share ownership, opt to take over the board without using the proxy rules. They could do so by forming a group to oust management (which may require the filing of a Schedule 13D) shortly before the meeting and solicit no more than 10 shareholders. See Rule 14a-2(b)(2). This would preserve secrecy and not allow management much time to respond. It would also result in the denial of information about the efforts of the insurgents to most shareholders. This is what occurred in connection with the takeover of Take-Two. 

Back in the 1980s, some bidders found the constraints of the tender offer rules so severe that they would terminate the offer and “sweep the street,” that is buy the shares concentrated in the hands of the arbitrageurs. See SCM v. Hanson, 774 F.2d 47 (2nd Cir. 1985).  The proxy rules are moving in a similar direction. Given the costs and restrictions involved, it will increasingly be the case that insurgents will look for ways to avoid the regulatory framework, with the ultimate consequence that shareholders will be denied the information they need to make informed decisions.

The solution?  In developing the proxy rules, the Commission should recognize that these requirements are not just disclosure provisions.  They are the mechanism by which shareholders may or may not exercise their state law right to nominate directors or propose bylaws.  As such, they should not be viewed as a form of administrative largess.  This militates against the use of broad exceptions that deny shareholders access to the proxy statement, including those governing the use of management's proxy statement for proposals concerning the election of directors.  It also may require an approach that allows shareholder access to management's proxy statement, with state law having the burden of deciding which proposals are appropriate for shareholders to bring.