As noted in thecorporatecounsel.net blog, last week, the Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce held an event discussing corporate governance and possible reforms. Both SEC Chair Jay Clayton and Corp Fin Director Bill Hinman were interviewed on stage and previewed a number of potentially important developments regarding, among other topics, proxy advisory firms and shareholder proposals.
Chair Clayton stayed true to his consistent theme of focusing on protection of long-term retail investors, who provide about 70% of the funds in the market. His goal is to ensure that the rules work to drive long-term value for those investors. He also observed that there was no denying the shift that had taken place in the stage at which companies decide to go public. Years ago, companies went public to raise funds for investment in the company; now they go public—at a much later stage—primarily for liquidity. In that regard, his efforts were also focused on encouraging more companies to go public earlier in their lifecycles, so that more retail shareholders were able to participate in investing at the growth stage. He then identified several areas that he thought needed to be addressed:
- Proxy plumbing: Are the votes counted really the votes submitted? The system is fairly antiquated and needs to reconsidered. How can the accuracy, transparency and efficiency of the proxy voting and solicitation system be improved?
While the potential remedies were not discussed at this presentation, this topic was taken up at great length at the proxy process roundtable in 2018, as well as at an earlier meeting of the SEC’s Investor Advisory Committee. One roundtable panelist observed that the current system of share ownership and intermediaries is a byzantine one that accreted over time and certainly would not be the system anyone would create if starting from scratch. There was broad agreement that the current system of proxy plumbing is inefficient, opaque and, all too often, inaccurate. For example, the Securities Transfer Association found that, out of 183 meetings its members had tabulated in the past year, 130 had overvoting problems. Although most were ultimately reconciled, the question remained as to why the overvoting occurred. Anecdotally, panelists described instances of overvoting, delays in counting of registered shares, breaks in the chain of custody leading to separation of necessary documentation and resulting disqualification of votes, and shares not counted because of conflicts on the face of the omnibus proxy. So the question was: should the SEC start over from scratch with a complete overhaul or were there approaches that could repair the existing system? On that issue, there was no agreement. As framed by the first panelist, “do we have the willpower” to reinvent the system? (See this PubCo post and this PubCo post.)
- Shareholder proposals and the shareholder engagement process: Reporting on the most recent proxy season, Hinman noted that the most common shareholder proposals related to ESG, with executive compensation coming in second. As in the recent past, Corp Fin agreed in no-action responses that about one-third of the proposals could be excluded from proxy statements. About one-half were withdrawn, presumably reflecting an agreement following engagement between the company and proponent. That data—plus that fact that during the month-long government shutdown, the ball seemed to keep rolling without SEC intervention—has triggered some rumination at the highest ranks about the possibility of really revamping the process so that perhaps, like other no-action requests that are submitted, Corp Fin would not respond to every no-action request submitted to exclude a shareholder proposal. Requests based on difficult topics, such as the “ordinary business” exclusion, would likely receive a response. But if the request were ordinary course and there were no value to be added in a response, perhaps Corp Fin would not provide a formal response at all? Of course, the staff would still need to figure out how to monitor whether the process was working. But hopefully, with the SEC out of the way, the result would be more engagement between companies and shareholders. After all, Clayton, noted, the rules were designed to facilitate shareholder engagement—dialogue is good.
What’s not at all clear is how companies and shareholders would respond. Will companies be reluctant to exclude all but the most obviously excludable proposals without SEC staff confirmation? Or would they take the opposite approach? Would proponents whose proposals were excluded in the absence of a no-action response from the staff head straight for the courts?
Recourse to the courts on issues related to shareholder proposals, while not exactly common, does have a history. In 2019, for example, the NYC Comptroller sought to have a manufacturer of aerospace components adopt a policy related to climate change. After the company sought no-action relief from the SEC staff—and before even submitting a response to the SEC or receiving a response from the staff—the proponent pension funds filed suit in the SDNY seeking to enjoin the company from soliciting proxies without including the shareholder proposal and declaratory relief that the exclusion of the proposal violated Section l4(a) and Rule l4a-8. Then, on December 7, the NYC Comptroller’s office wrote to the SEC that it would not respond to the company’s November request for no-action because the pension funds had separately commenced a lawsuit against the company seeking declaratory and injunctive relief “that would ensure the… shareholder proposal is included in the proxy solicitation materials. The company apparently decided that this was not a battle worth fighting. By letter dated December 28, 2018, in the midst of the government shutdown, the company advised Corp Fin that it was withdrawing its request for no-action relief and would be including the proposal in its 2019 proxy materials. (See this PubCo post.)
But it’s not just large asset managers and pension funds like the NYC Comptroller that are willing to participate in court fights. You might recall that, in 2014, three companies facing shareholder proposals from John Chevedden et al., a prolific shareholder activist, adopted a “direct-to-court” strategy, bypassing the SEC no-action process. In each of these cases, Mr. Chevedden fought back and the court handed him a victory, refusing to issue declaratory judgments that the companies could exclude his proposals. (See my News Briefs of 3/18/14, 3/13/14 and 3/3/14.) See also this PubCo post about litigation regarding a shareholder proposal requesting adoption of a policy regarding the sale of high-capacity firearms.
In addition, Clayton noted that the thresholds for resubmission of shareholder proposals had not been revised since 1954. That, Hinman observed, was a different era, when it was much more difficult for a proposal to gain momentum. The ownership threshold of $2000 for initial submissions of proposals dated to 1998. Here, however, Hinman cautioned that it was important for smaller shareholders to continue to have a voice, so a low ownership threshold may continue to be available but paired with a longer period of retention. Don’t be surprised to see new rulemaking proposals on the submissions and resubmission thresholds. That should please the Chamber, which has been an advocate for raising those thresholds (See this PubCo post.)
- The role of proxy advisory firms: It was clear from the proxy process roundtable that many asset managers rely heavily on proxy advisory firms. (See this PubCo post.) And neither Clayton nor Hinman took issue with that reliance to the extent that it was limited to functions like the heavy lifting of review and crunching of data to achieve economies of scale. The real question, however, was whether that reliance may have gone too far? Many shareholders count on asset managers to fulfill their fiduciary duties by exercising their best judgment in voting. Just what does that fiduciary duty entail? Expect to see more guidance that revisits the extent to which an asset manager can outsource and still fulfill its fiduciary obligation to consider votes in the particular context of each company, where necessary.
In addition, proxy advisory firms rely on exemptions from the proxy rules to avoid having to distribute their own full proxy statements. Corp Fin may be considering some new guidance or rulemaking that conditions that exemption on these firms’ constructive engagement with companies, allowing companies to review and respond to the firms’ reports prior to their release. That approach might give companies a fair shot at raising concerns about the recommendations, and especially about errors and incomplete or outdated information on which a recommendation is based. That change would also make it easier for asset managers to appreciate the issuers’ views. (See this PubCo post and this PubCo post.)
A case for more comprehensive reform of the proxy advisory industry was presented in this 2018 proxy season survey from Nasdaq and the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness. There, they observe that ISS and Glass Lewis control 97% of the industry, making them “de facto standard setters for corporate governance in the U.S.” However, they argue, they are plagued by conflicts of interest that affect their objectivity, adopt a one-size-fits-all approach, are unwilling to “constructively engage with issuers, particularly small and midsize issuers that are disproportionately impacted by proxy advisory firms,” lack transparency regarding the development of recommendations, and are prone to making analytical errors but unwilling to address them. These problems, they contended, were “often cited as a challenge to the willingness of businesses to go and stay public.” Regulators and legislators have taken some initial steps in overseeing the proxy advisory firms, but, they argued, more reform was needed. CCMC and Nasdaq conducted the survey during the 2018 proxy season including responses from 165 companies. The theme, they contended was that there had been few improvements: “Companies are bringing more issues to the attention of proxy advisory firms, but they still find it difficult to engage in constructive discussions that lead to better informed voting recommendations. Conflicts of interest still pervade the industry, and many report a lack of transparency into how recommendations are developed.”
To encourage companies to go and stay public while maintaining investor protection, Corp Fin is seeking to eliminate unnecessary burden in the rules, such as the recent proposal regarding financial statements of acquired companies. (See this PubCo post.) Clayton stressed that the SEC’s rules should help shareholders understand how management and the board run the company—the SEC needs to guard against a disclosure system that drives how the business is run. (So much for that old SEC standby—regulation by humiliation, which tends to compel companies to take the action rather than explain to shareholders why they haven’t.) One example the two officials discussed in that regard were stock buybacks, which has recently been the subject of much criticism. (See this PubCo post and this PubCo post.) The SEC may regulate the mechanics, but not the basic decision of whether to conduct a buyback. Moreover, the SEC emphasizes disclosure—how does the compensation committee take buybacks into account in determining whether performance metrics have been met? In the Liquidity section of MD&A, why did the company choose to conduct a buyback? But the SEC does not preclude the conduct.
Last, board diversity was also addressed. Hinman noted that there was a tension surrounding board diversity disclosure—disclosure versus privacy. Corp Fin resolved that tension in a recent CDI interpreting Reg S-K Items 401 and 407 by looking to “self-identified” diversity characteristics and consent to disclosure.
In the CDIs, to the extent those self-identified diversity characteristics were considered by the board or nominating committee in assessing whether the person’s “experience, qualifications, attributes or skills” were the right fit for the board, Corp Fin expects the discussion required by Item 401 to include, among other things, “identifying those characteristics and how they were considered.” In addition, the description of diversity policies under Item 407 should “include a discussion of how the company considers the self-identified diversity attributes of nominees as well as any other qualifications its diversity policy takes into account, such as diverse work experiences, military service, or socio-economic or demographic characteristics.” (See this PubCo post.)