As anticipated, the Securities and Exchange Commission recently adopted changes to the federal proxy rules utilizing authority given to it under the Dodd-Frank Wall Street Reform and Consumer Protection Act enacted in July 2010. The new rules effectively facilitate the existing state law right of shareholders to nominate and elect directors.
New Rule 14a-11 under the Securities Exchange Act requires an issuer to include in its proxy materials the names of persons nominated for director by a shareholder, or group of shareholders, holding at least 3 percent of the issuer's voting stock. The issuer's proxy materials must include certain information concerning the nominating shareholder, or group of shareholders, and its director nominees. Before adoption of this rule, shareholders who wanted to nominate their own directors had to incur the expense of preparing and distributing their own proxies. (Note: For ease of reading, any references below to a "shareholder" include both an individual shareholder or a group of shareholders.)
A shareholder is not eligible to include its nominees unless it holds at least 3 percent of an issuer's voting stock and has held the shares for the three-year period prior to notifying the issuer of its proposed nominees. The nominating shareholder must own the shares through the date of the shareholder meeting at which the nominees are to be elected. Additionally, director nominees must be "independent" under applicable exchange rules.
To nominate a director, the nominating shareholder must file a Schedule 14N with the SEC. The schedule must contain specified information concerning the nominating shareholder and its proposed director nominees. The nominating shareholder must include a statement that it does not hold the subject shares with the intent of changing control of the issuer or gaining more director seats than the rules permit. The rules prohibit a shareholder from nominating more than one director, or 25 percent or more of the issuer's total number of directors, whichever is greater. In many cases, a shareholder will be able to nominate only one director.
A nominating shareholder must file Schedule 14N no earlier than 150 days, and no later than 120 days, prior to the anniversary of the date on which the issuer mailed its proxy materials for the prior year's annual meeting. If more than one shareholder files a qualifying Schedule 14N, the issuer must include in its proxy materials only the director nominees of the shareholder with the highest voting power percentage. Contrary to the SEC's proposed rule, the first shareholder to file a Schedule 14N does not necessarily get its nominees included in the issuer's proxy materials unless it has the highest voting power percentage among the filing shareholders.
The SEC also amended Rule 14a-8 under the Exchange Act, which governs when an issuer must include shareholder proposals in its proxy materials, to permit qualifying shareholders to require an issuer to include in its proxy materials proposals for amendment to the issuer's governing documents regarding director nomination procedures. Without this rule, issuers were free to exclude from their proxy materials shareholder proposals relating to director nomination procedures. By requiring issuers to include these proposals, the new rule effectively promotes contested director elections. In its adopting release, the SEC clarified that shareholder proposals to amend an issuer's governing documents with respect to director nomination procedures cannot undermine Rule 14a-11. Issuers, therefore, may exclude proposed amendments that under Rule 14a-11 are contrary to the proxy rules.
For most issuers, the new rules take effect for the 2011 proxy season. For smaller reporting companies, however, the SEC has delayed effectiveness of the rules for three years. In advance of the applicability of the new rules, issuers should review their governing documents and address any issues posed by the new proxy scheme.