Open Access

Discussion

In Search of Corporate Democracy

Any democracy is only as robust as its electoral process. But an election in which voters are given no choice of candidates and where negative votes have no meaning in the outcome hardly constitutes a democracy. Such is the process utilized for electing directors at U.S. corporations.

Harvard Law School's Lucian Arye Bebchuk observes, “In theory, if directors fail to serve shareholders, or if they appear to lack the qualities necessary for doing so, shareholders have the power to replace them. This shareholder power, in turn, provides incumbent directors with incentives to serve shareholders well, making directors accountable.” In practice, however, this safety valve of the corporate governance system is “largely a myth.” [1]

In the view of many shareholders, the current director election system simply creates self-perpetuating boards: incumbent members select nominees to fill vacancies and decide whether to re-nominate themselves. Thus, shareholders effectively have no meaningful choice among candidates, and the election process becomes mere ratification of the company's slate of nominees. Withholding votes from a board member can serve as a shareholder communication tool to express displeasure with a given director. But because directors are typically elected by a plurality (those nominees receiving the most votes win board seats), company nominees running unopposed are reelected.

Under current proxy rules, only candidates nominated by the board can appear in the company's proxy statement. A shareholder could technically nominate a candidate from the floor of the annual meeting, but, since most investors vote by mail, he is unlikely to succeed. Although some companies' bylaws outline procedures for shareholders to suggest possible candidates to board nominating panels, few of these individuals actually make it to the ballots as nominees. [2]Instead, shareholders wishing to nominate an alternative slate of candidates to run against management's must go through an expensive and time-consuming proxy solicitation process of their own (i.e., a proxy contest).

The concept of open or proxy access -- giving shareholders access to a company's proxy statement to nominate their own directors -- was first examined by the Securities and Exchange Commission (SEC) in 1942. The proposal, which was not adopted, would have allowed for up to twice as many candidates on the proxy as there were director seats to be filled. The SEC revisited the matter in 1977 and 1992, but ultimately focused on the development of nominating committees and their consideration of shareholder recommendations (1972) and on allowing for short-slate proxy contests by dissident shareholders (1992).

The 2002 accounting scandals and corporate failures that spurred sweeping regulatory reforms also reminded investors that, as owners of firms, they are ultimately responsible for director accountability and independence. Shareholder advocates rejuvenated the idea of direct proxy access to allow sizable shareholders to economically run their own board candidates using a company's proxy statement.

In 2003, the American Federation of State, County, and Municipal Employees (AFSCME) submitted binding resolutions at Citigroup, Sears, Roebuck, and Exxon Mobil and non-binding proposals at AOL-Time Warner, Eastman Kodak, and The Bank of New York, asking those companies to include in their proxy statement and on their proxy card a director nominee submitted by holders of at least three percent of the stock. Although the SEC ruled that such proposals could be excluded from companies' proxy statements because they related to director elections, the Commission promised to engage in a “top to bottom” review of the proxy rules governing what types of shareholder resolutions companies could rightfully exclude from their proxy materials.

Since its reemergence, the open ballot movement has received support from institutional investors and individuals, but has engendered opposition from some business groups. A September 2003 Harris Interactive survey sponsored by AFSCME found that 80 percent of 1,030 individual investors polled believed there should be a process allowing shareholders to nominate director candidates and that open elections would increase investor confidence. Ninety percent said companies should have to disclose more information about the direction nomination process. [3]

Mixed Signals from the SEC

In October 2003, the SEC proposed new rules to give significant, long-term shareholders a greater ability to include their director nominees in management's proxy statement. The rule was never adopted in the face of opposition by business groups, dissent within the SEC, and complaints that the process for allowing shareholders to nominate directors would be too complicated. The proposal entailed a two-step, two-year process. In the first year, one of two triggering events would have had to occur, demonstrating shareholder dissatisfaction with a company's proxy process:

• One or more directors at a company receive withhold votes of 35 percent or more of the votes cast, or
• A shareholder proposal asking for open access, which is submitted by holders of at least 1 percent of the shares (owned for at least one year), is approved by a majority of the votes cast.

If one of these conditions were met, then for the following two years the company would have been required to include in its proxy materials one or more board nominees proposed by holders of at least five percent of the shares (owned for at least two years). The number of shareholder nominees permitted would be dictated by the size of the board: one nominee for boards of eight or fewer directors, two nominees for boards of nine to 19 directors, and three nominees for boards having 20 or more directors.

In drafting the proposed rule, the SEC estimated that about half of U.S. listed companies have boards of eight or fewer directors, and half have boards or between nine and 19 directors. Approximately 42 percent of companies have at least one shareholder who would meet the five-percent ownership test to submit a board nominee. And about 50 percent of companies have two or more shareholders, each owning two percent or more of the shares for two years, who could aggregate their holdings in order to nominate a director. [4]

Similarly, for purposes of activating a triggering event, about 84 percent of listed companies have at least one institutional investor that would qualify to submit a binding open access proposal. And an SEC sample of 2,227 director elections in 2002 and 2003 found that about 1.1 percent of companies had total withhold votes in excess of 35 percent of the votes cast. (Alan Beller, then director of the SEC's Corporation Finance Division, estimated that 2 to 3 percent of companies had a director candidate who received withhold votes of 35 percent or more of the votes cast based on recent proxy results). [5]

The draft rule would have exempted foreign private issuers as well as Schedule 13-D filers (those shareholders seeking control of the company). Shareholders only intending to nominate directors under open access would have been permitted to use Schedule 13-G.

In early 2005, the SEC dropped consideration of the draft rule amid opposition from business groups and two of the agency's Republican commissioners. Before the 2005 proxy season, the agency's staff allowed American International Group (AIG) and several other companies to exclude access proposals filed by AFSCME and other investors that were modeled after the SEC's draft rule. After AFSCME sued over the exclusion of its proposal at AIG, a federal appeals court ruled in September 2006 that the SEC had improperly allowed the company to omit the proposal. The court faulted the SEC for failing to explain why the agency changed its interpretation of SEC Rule 14a-8 after 1990 to allow the omission of access proposals. After the court's ruling, the agency said it would address the issue at hearings in October and December, but those discussions were delayed after the commissioners failed to reach a consensus on the issue. As of early January 2007, the SEC had not issued new guidance on whether access proposals may appear on corporate ballots.

In July 2007, the SEC issued for public comment two competing draft rules on proxy access. One rule would have required investors to hold at least a 5 percent stake and meet new disclosure standards to file access bylaw proposals. The second draft rule essentially blocked investor access to the proxy altogether. In November, a short-handed commission voted 3-1 to support the limiting measure, thereby allowing the SEC staff to resume granting corporate “no action” requests to exclude shareholder access proposals. The decision has been denounced by Democratic lawmakers, state pension funds, and, labor investors, who warn of potential litigation should companies omit shareholder access resolutions from their 2008 proxies.

Better Disclosure of the Nomination Process

The SEC adopted rules in late November 2003 to improve disclosure of companies' director nomination process. This included information on:

• Whether the company has a separate nominating committee and, if not, the reason why and who determines nominees for director;
• Whether the members of the nominating committee are independent;
• The company's process for identifying and evaluating director candidates;
• Whether the company uses a third party search firm to identify director candidates;
• Minimum qualifications for director nominees;
• Whether the company considers shareholder nominees and the process for their consideration;
• Whether the company has rejected candidates nominated by shareholders.

Companies would also be required to disclose information on shareholder communications with directors, including:

• Whether the company has a process allowing shareholders to communicate with board members and, if not, why not;
• The procedures for communications between shareholders and directors;
• Whether such communications are screened and, if so, how; and
• The company's policy on director attendance at annual meetings and the number of directors who attended in the previous year

Criticisms of Open Access

While corporations generally support expanded disclosure of their director nomination processes, many fear that open access could turn ordinary annual meetings into de facto proxy fights and undermine the role of board nominating committees. Opponents cite these risks: disruptive annual meetings; an influx of special interest directors resulting in balkanized, dysfunctional boards; and deterrence of qualified directors from seeking board service. Martin Lipton and Steven Rosenblum point to the experience of the past 20 years where unions, social activists, gadflies, and public pension funds that are subject to political pressures have dominated the SEC Rule 14a-8 process in their submission of shareholder resolutions. [6] Robert Pozen argues that other institutional investors, such as mutual funds, have historically been reluctant to become activists. [7]

Corporate groups such as the Business Roundtable prefer that the SEC give the governance reforms from the Sarbanes-Oxley Act and the self-regulatory organizations (SROs) a chance to take effect before launching additional regulations.

Despite objections within the corporate community, several companies have been adopting their own forms of ballot access, either voluntarily or involuntarily. Apria Healthcare Group, for example, allows owners who hold at least 5 percent of its shares for two years to nominate two director candidates per year. Nominees receiving less than 25 percent of the vote are barred from re-running for four years. [8] Other firms, such as Hanover Compressor, Enterasys Networks, and Homestore, are introducing or considering some form of open access in conjunction with settlements to shareholder lawsuits or bankruptcies.

Voting on Open Access Proposals

Proxy access is an evolving issue for regulators and the market at this time. Opening the proxy ballot to shareholder-nominated candidates could prove to be an important avenue for promoting greater corporate accountability. Nevertheless, it is a mechanism that nominating shareholders should use responsibly and only in justifiable circumstances.

In 2007, UnitedHealth Group, Hewlett-Packard, and Cryo-Cell International each received a proxy access proposal. All three resolutions received significant shareholder support, with the resolution at Cryo-Cell, a small-cap biotech company, receiving 53.4 percent support.

In assessing shareholder proposals asking companies for open access--either binding proposals or non-binding proposals--ISS will consider the proponent's rationale for targeting the given company and the ownership threshold proposed in the resolution. Evidence of board oversight or accountability issues would be grounds for supporting the resolution.

Such issues may include lack of responsiveness to shareholders (such as failing to implement majority-supported shareholder proposals), inadequate board and key committee independence, egregious compensation practices, accounting and financial irregularities, and other concerns where there may similarly be reason to withhold from or vote against directors. In the case of binding resolutions, ISS will also examine the reasonableness of the ownership threshold promulgated by the sponsor that would qualify shareholders to nominate directors.