On June 10, 2009, the U.S. Securities and Exchange Commission (the “SEC”) published for public comment proposed rules1 that will, for the first time, allow long-term shareholders to nominate up to 25% of the directors by placing them on the company’s proxy. If adopted, Proposed Rule 14a-11 has the potential to significantly reduce the estimated $368,000 expense that shareholders incur for sponsoring a director-election contest.2 The SEC also proposed eliminating Rule 14a-8(i)(8)’s election exclusion, which currently prohibits shareholders from submitting bylaw amendments addressing director-nomination procedures. Further, the proposal includes proxy rule exemptions and guidance that would allow nominating shareholders or groups to remain eligible for Schedule 13G. All told, the SEC proposal is a strong step towards facilitating the right of shareholders to nominate directors.
Although the proposal has certain flaws, the SEC proxy access proposal, if adopted, stands to benefit all shareholders but especially institutional investors such as union-related pension funds, which tend to be simultaneously invested in many public companies. Their investments will, either individually or collectively with those of other institutional investors, likely satisfy the proposed requirements to nominate directors on the company proxy. The ability to nominate and potentially elect directors in this fashion will change the dynamic between institutional investors and companies. Historically, management has been able to ignore institutional investors without fear of retribution because it controlled the board-selection process and SEC proxy rules limited shareholder options. However, the SEC’s recent proxy-access proposal offers large institutional investors a reasonable opportunity to nominate and potentially elect directors with significantly reduced costs. The mere fact of their potential board presence should promote a dialogue between institutional investors and management at public companies.
The following is a summary of the key requirements of Proposed Rules 14a-11 and 14a-8(i)(8), two proxy exemptions and guidance regarding Schedule 13G eligibility.
I. Proposed Rule 14a-11 Would Allow Shareholders to Nominate Directors
Companies Subject to Rule 14a-11
Rule 14a-11, which would permit shareholders to place director nominees onto the company’s proxy card, applies to any reporting company subject to Section 14(a) of the Exchange Act or any investment company3 registered under Section 8 of the Investment Company Act. Those companies would be required to include shareholder-director nominee(s) in the company proxy unless:
- State law or company governing documents prohibit shareholder nominations;
- The nominee’s candidacy or election would violate state law, company governing documents, federal law or stock exchange rules;
- The nominating shareholder or nominating shareholder group (“group”) has not satisfied the security ownership level4 requirement, continuously held those securities for at least one year from the date the nomination notice was submitted to the company and represented its intent to hold those securities through the election date;
- The nominating shareholder or group failed to timely file Schedule 14N (which provides details regarding the nominating shareholder or group and nominees) and all other required disclosures, representations and certifications by the date established by state law or company governing documents regarding the submission of director nominations. In the event there is no state law or company governing document deadline, the Schedule 14N must be filed with both the company and SEC no later than 120 days prior to the date the prior year’s proxy statement was mailed to shareholders;
- The nominating shareholder or groups’ representations and certifications in Schedule 14N were false and misleading in any material respect; or
- The nominating shareholder or group exceeded the 25% board director nominee limit.
No state currently prohibits shareholder director nominations and companies generally do not prohibit such nominations in their governing documents. But state law also allows companies to adopt a wide variety of governance procedures including with respect to proxy access. Generally, state law allows companies to condition governance procedures in ways that severely restrict shareholder rights. Common corporate governance conditions that limit shareholder rights including advance notice provisions, stock ownership requirements based on duration and amount, and information disclosure requirements. Comverse Technology Inc., incorporated in New York, is the first public company to adopt a proxy access bylaw.5
Shareholder Eligibility Requirements Under Proposed Rule 14a-11
Where a reporting company or registered investment company is subject to Rule 14a-11, a nominating shareholder or group must meet certain eligibility requirements to utilize Rule 14a-11. For example, the shareholder or group must beneficially own at least 1%, 3% or 5% of the company’s securities entitled to vote on the election of directors. The securities ownership percentage requirement is a sliding scale (see box) based on (1) market capitalization on the date the nominating shareholder or group submits notice on Schedule 14N of its intent to include a nominee(s) in the registrant’s proxy materials pursuant to Rule 14a-11; and (2) the nominating shareholder or group must have continuously held the securities for more than one year and must state that it intends on holding the securities through the meeting date. See Rule 14a-11(a)(3).
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Note the reference to a “Schedule 14N” in the preceding paragraph. This schedule is new, but similar to the existing Schedule 13G that must be filed by the beneficial owners of more than 5% of a Section 12 registered equity security. Schedule 14N also requires certain proxy contest disclosures detailed in Schedule 14A. All told, Schedule 14N has extensive disclosure requirements and its proper completion requires the understanding and application of five related rules: Rule 14a-18, Rule 14a-19, Rule 14n-1, Rule 14n-2 and Rule 14n-3.
When and What a Shareholder Must File to Include Its Nominee in Proxy Materials
If a shareholder or group is seeking to compel the inclusion of director nominee(s) in the company proxy materials, the nominating shareholder or group must file a Schedule 14N with the company and the SEC at least 120 days6 prior to the date that proxy materials were mailed the prior year. See Rule 14a-11(a)(4), Rule 14a-11(c), Rule 14a-18, Rule 14a-19 and Rule 14n-1.
As expected, there is significant repetition between the rules and Schedule. However, part of the overlap is due to the distinction between a federal proxy rule nomination and state law or company-governing-document nominations. Specifically, Rule 14a-18 applies to federal proxy rule nominations pursuant to Rule 14a-11. Otherwise, nominations pursuant to state law or company governing documents are covered by Rule 14a-19. In either case, Rules 14a-18 and 14a-19 have numerous similarities, including:
- A requirement that Schedule 14N be filed by the date specified in the company’s advance notice bylaw provision or, absent such requirement, no later than 120 days before the date the company mailed its proxy materials for the prior year’s meeting.
- A statement from the nominee that he or she consents to being named in the company’s proxy statement and proxy and, if elected, will serve on the company’s board of directors.
- Disclosure about the nominee as would be provided in response to the disclosure requirements of Items 4(b), 5(b), 7(a), (b) and (c) of Schedule 14A.
- Disclosure about the nominating shareholder or each member of the group as would be required in response to the disclosure requirements of Item 4(b) and 5(b) of Schedule 14A.
- Legal proceedings disclosure regarding the nominating shareholder or each member of the group for the last five years consistent with Item 401(f) of Regulation S-K.
- Instructions that detail look-through requirement to determine who must provide disclosure for items 4 and 5 above.
- Relationships between nominating shareholder or group and nominee and company and affiliates, including (1) direct or indirect material interests in any contract or agreement, (2) any material pending or threatened litigation, and (3) any other undisclosed material relationship.
- Website address on which nominating shareholder or group may publish soliciting materials.
Compare Rule 14a-19(a) through (f) with Rule 14a-18(e) and (g) through (k).
Rule 14a-18, the federal proxy rule nomination procedure, is more demanding than Rule 14a-19, the state law or company governing document nomination procedure, because the former requires these additional items:
- A representation that, to the knowledge of the nominating shareholder or group, the nominee’s candidacy or, if elected, board membership would not violate controlling state law, federal law or exchange rules.
- A representation that the nominating shareholder or group satisfies the conditions of Rule 14a-11(b).
- A representation that the nominee(s) meets the objective criteria for “independence” of the national securities exchange or national securities association rules applicable to the company.
- A representation that neither the nominee nor the nominating shareholder or any member of the group has an agreement with the company regarding the nomination.
- A statement that the nominating shareholder or group intends to continue to own the requisite shares through the date of the meeting of shareholders. Additionally, the nominating shareholder or group must provide a statement with respect to continued ownership after the election.
- Any statement in support of the shareholder nominee(s), which may not exceed 500 words, if the nominating shareholder or group elects to have such statement included in the company’s proxy materials.
Compare Rule 14a-18(a) through (d), (f) and (l) with Rule 14a-19.
Item 6 of Schedule 14N requires nominating shareholders or groups to provide Rule 14a-18 disclosures, representations and statements. Similarly, Item 7 of Schedule 14N mandates that nominating shareholders or groups provide Rule 14a-19 disclosures, representations and statements.
Schedule 14N’s cover page and its Items 1 through 3 disclosures are similar to what Schedule 13G requires,7 including core information such as the identity of the nominating shareholder or each member of the group and the amount and percent of securities owned by the nominating shareholder or each member of the group.
Beyond this core information, the major remaining requirements of Schedule 14N are the Item 5 statement of ownership and Item 8 certification. Item 5(a) requires the nominating shareholder(s) to document their ownership of the requisite amount of securities. If the shareholder(s) are record owners a simple confirming statement is required. Otherwise, bank or brokerage statements attesting to the shareholder(s)’ ownership should be submitted with the schedule. If the shareholder has filed a Schedule 13D, Schedule 13G or Form 3, 4 or 5 those documents may be attached or incorporated by reference.
In addition, the shareholder must prove that he has continuously held the securities for more than one year. See Item 5(a) of Schedule 14N. Further, the shareholder(s) must provide a written statement that they intend to continue to own the requisite shares through the date of the meeting of shareholders and intent with respect to continued ownership after the election. See Item 5(b) of Schedule 14N.
Finally, Item 8 of Schedule 14N requires nominating shareholder(s) to certify no control intent. Specifically, the schedule requires the following verbiage:
By signing below I certify that, to the best of my knowledge and belief, the securities referred to above are not held for the purpose of or the effect of changing control of the issuer of the securities or to gain more than a limited number of seats on the board.
Signatures and Item 8 certifications are required by each filing person or their authorized representative.
Exclusion Process Regarding Nomination Submissions
Rule 14a-11(f) sets forth the process by which eligibility issues relating to shareholder nominations will be determined. The process is similar to the existing Rule 14a-8 shareholder proposal process. Surprisingly, the SEC estimated that only 20% of the shareholder nominations would be challenged by companies,8 and that 90% of the shareholder nominations would be included in the company proxy materials.9 The following is required to challenge a nomination:
- Once a nominating shareholder has submitted its Schedule 14N to the company and SEC, the company has 14 calendar days to consider and challenge the nomination. See Rule 14a-11(f)(3).
- The company must provide the nominating shareholder(s) an explanation of the basis for determining that it may exclude the nominee(s). See Rule 14a-11(f)(4).
- The nominating shareholder has 14 calendar days after receipt of the exclusion notice to cure or correct any deficiencies identified by the company. See Rule 14a-11(f)(5).
- Generally, neither a nominee nor the members of the nominating shareholder group may be changed to remedy identified deficiency. See Rule 14a-11(f)(6). However, inadvertent excess nominees may be remedied. Companies seeking to exclude nominations must submit a notice to the SEC at least 80 calendar days prior to filing its definitive proxy materials. See Rule 14a-11(f)(7). The notice must: (1) identify the nominating shareholder or each group member, (2) identify the excluded nominee(s), (3) include an explanation of the basis for excluding the nominee(s) and (4), if applicable, include an opinion of counsel supporting state law claim as basis for exclusion. See Rule 14a-11(f)(8).
- The company has the burden of proof for any exclusion under Rule 14a-11. See Rule 14a-11(f)(9).
- The company must provide the nominating shareholder or group with a copy of its notice to exclude simultaneously with the SEC filing. See Rule 14a-11(f)(10).
- The nominating shareholder or group may submit a response to the company’s notice to the SEC. Such response must be filed with the SEC no later than 14 calendar days after the nominating shareholder or group’s receipt of the company notice. The shareholder or group must simultaneously provide the company with a copy of the response filed with the SEC. See Rule 14a-11(f)(11).
- The SEC staff may provide its views to the company and nominating shareholder or group. See Rule 14a-11(f)(12).
- Companies are required to provide notice to the nominating shareholder or group no later than 30 calendar days prior to the mailing of the definitive proxy materials whether the nominee(s) will be excluded. See Rule 14a-11(f)(13).
II. Proposed Amended Rule 14a-8(i)(8) Would Allow Shareholders to Propose Director-Nomination Bylaws
The SEC is proposing to amend Rule 14a-8(i)(8) to allow shareholders to propose director nomination bylaws or amendments to a company’s governing documents that affect director nomination procedures. This amendment, if adopted, will reverse a long-standing SEC position allowing companies to exclude any shareholder proposal that implicated director elections.
As proposed, Rule 14a-8(i)(8) would only allow companies to exclude shareholder director nomination bylaw proposals that:
- Disqualify a nominee who is standing for election;
- Remove a director from office before his/her term expires;
- Question the competence, business judgment, or character of one or more nominees or directors;
- Nominate a specific individual for election the board of directors, other than pursuant to Rule 14a-11, state law or company’s governing documents; or
- Otherwise would affect the outcome of the upcoming election of directors.
The SEC’s proposing release makes it clear that Rule 14a-8(i)(8) bylaws cannot conflict with Rule 14a-11 nominations or applicable state law. Therefore, shareholders may propose director- nomination procedures that are less stringent than Rule 14a-11 (e.g., a lower ownership threshold, shorter holding period or, possibly, a greater number of director nominees). However, the SEC indicated that director-nomination bylaws have limits, such as when they “result in an election contest between a company and shareholder nominees without the important protections provided by the disclosure and liability provisions otherwise provided for in the proxy rules.” It is unclear whether the SEC will provide further guidance regarding the limits on nomination bylaws.
III. New Proxy Rule Exemptions for Nominating Shareholders
The proposing release includes two new proxy rule exemptions to facilitate shareholder nominations. One is designed to make it easier to form a shareholder group. The other liberalizes the solicitation process for the group seeking support for their nominees. Both require public filing with the SEC on the date of first use. Proposed Rule 14a-2(b)(7), the exemption for group formation, has several substantive requirements and limitations. To qualify for the exemption that permits shareholders interested in forming a nominating group to approach other shareholders without violating the proxy rules, one must:
- Put in writing a shareholder’s intent to form a Rule 14a-11 nominating group;
- Limit the written statement of each soliciting shareholder’s intent to form a nominating shareholder group in order to nominate a director under Rule 14a-11;
- Identify, and a brief statement regarding, the potential nominee(s) or, where no nominee(s) have been identified, the characteristics of the intended nominee(s), if any;
- Disclose the percentage of securities that each soliciting shareholder beneficially owns or aggregate percentage owned by any group to which the shareholder belongs; and
- Disclose the means by which shareholders may contact the soliciting party.
In addition, the written notice must be sent to the national securities exchanges where the securities are listed and registered. It is important, however, to note that if a nominating shareholder or group limits its solicitation to ten persons or less such solicitation is exempt from the proxy rules and need not comply with proposed Rule 14a-2(b)(7).
The exemption for nominee(s) supporting solicitations, Proposed Rule 14a-2(b)(8), also has substantive requirements and limitations. These include:
- The soliciting party does not, at any time during the solicitation, seek directly or indirectly, the power to act as proxy for a shareholder and does not furnish or request a form of revocation, abstention, consent or authorization;
- Each written communication includes the identity of each nominating shareholder and a description of his direct or indirect interests, by security holdings or otherwise;
- A prominent legend in clear, plain language advising shareholders that a shareholder nominee is or may be included in the company’s proxy statement and to read the company’s proxy statement when it becomes available because it includes important information. If the proxy statement is publicly available so state and encourage shareholders to read that document because it contains important information. The legend also must explain to shareholders that they can find the company’s proxy statement and other relevant documents at no charge on the SEC website; and
- Any soliciting material published, sent or given to shareholders must be filed with the SEC on the date of first use and copies sent to each national securities exchange where the securities are listed and registered.
Certainly, both exemptions provide some relief to nominating shareholders’ or groups’ efforts to exercise the fundamental right to nominate and possibly elect director nominees.
IV. Nominating Shareholders Eligible for Schedule 13G
Even though Rule 14a-11’s stock ownership requirements are generally below the Section 13(d) threshold of more than 5% of a Section 12 registered equity security, the SEC expects a certain number of nominating shareholders and groups to exceed 5%.10 Therefore, nominating shareholders and groups that in aggregate exceed 5% would be required to file either a Schedule 13D or, if eligible, Schedule 13G.
Historically, the SEC considered the act of nominating directors evidence of a control intent. Therefore, shareholders who nominated directors were ineligible for Schedule 13G, which requires passive investment. The proposing release changes this historical SEC approach to control by allow nominating shareholders or groups to be eligible for Schedule 13G. This position is based on Rule 14a-11’s certification of no control intent by the nominating shareholder or group over the issuer. This certification is similar to the Schedule 13G passive investor certification. In addition, Rule 14a-11 and Schedule 14N requires nominating shareholders to certify they are seeking “no more than a limited number of seats on the board.”
It is important to note that nominating shareholders or groups may not be eligible for Schedule 13G if they pursue a nomination under state law or company governing documents. The SEC based this distinction on the possibility that nominating shareholders may not be required to limit the number of board nominees, certify a lack of intent to change control or gain more than a limited number of board seats as required by the Rule 14a-11.11
In addition, if a nominating shareholder is elected pursuant to Rule 14a-11, he or she “would most likely be ineligible to continue filing on Schedule 13G because of [her] ability as a director to directly or indirectly influence the management and policies of the company.”12
The SEC’s proxy access proposal is a strong step towards facilitating the shareholder’s right to nominate directors. Rule 14a-11 will allow certain long term shareholders to nominate up to 25% of the directors by way of the company proxy. This new rule should reduce the cost to shareholders of nominating a director. In addition, eliminating Rule 14a-8(i)(8)’s election exclusion, proxy rule exemptions and Schedule 13G guidance will encourage shareholders to exercise the shareholder franchise.
The proposal has flaws, but the SEC proposal certainly enhances the rights of shareholders. Once the rule is made final (assuming that it will be), we would expect to see a significant increase in the nomination of director candidates by shareholders.
Regardless, if adopted, the SEC proxy access proposal benefits all shareholders but especially institutional investors such as union-related pension funds. These large pension funds tend to be simultaneously invested in many public companies and have worked for decades to establish a dialogue with public companies and their management. Proxy access should make management more responsive to institutional investors who, individually or collectively, have the ability to nominate and elect directors.
To a lesser extent, proxy access will also benefit social-issue and activist investors. Social-issue investors generally promote issues, such as diversity or global warming and corporate policies fostering those issues rather than nominating directors. Typically, social-issue investors do not have as large an investment in a company as do the large pension funds. It is possible that social-issue investors may utilize proxy access in order to make it more difficult for companies and/or their fellow shareholders to ignore their concerns.
Activists investors, on the other hand, are generally motivated primarily by potential value, and proxy access may be useful in providing a less expensive avenue into the boardroom. However, certain aspects of proxy access are problematic for activists. For example, the “race-to-the-mailbox” test used in the rule to determine which shareholder or group is permitted to use the company’s proxy for their director nomination would create uncertainty in an activist’s approach to a particular company. In addition, the activist may want to nominate more directors than the 25% cap imposed by Rule 14a-11. Lastly, Rule 14a-11 limits the ability to solicit proxies and prohibits shareholders from seeking a change in control. Based on the foregoing, large pension funds could be expected to be the primary beneficiaries of SEC’s proxy access proposal.