On May 19, 2009, Senator Charles Schumer introduced his much publicized and expansively titled Shareholder Bill of Rights Act of 2009 (the “Bill”). In a little over 11 pages, the Bill seeks to dramatically reshape a number of longstanding practices of US publicly traded corporations, essentially federalizing a number of areas that have traditionally been the province of states and stock exchanges.
In this memorandum, we summarize and analyze the proposed provisions. In the final analysis, we believe that the vast majority of the proposals are best left to states and stock exchanges. Nevertheless, we also believe that recent trends indicate that wholesale rejection of some of the principles embodied in the Bill is inadvisable. In the last two years, many companies have taken steps to enhance their responsiveness to shareholders, either voluntarily or as a result of shareholder action. In addition, the State of Delaware recently amended the Delaware General Corporation Law to permit, but not require, shareholder access to proxy statements for director nominees. The Corporate Committee of the American Bar Association is considering similar changes to the Model Business Corporations Act. As discussed below, we believe that these events indicate that shareholders’ voices have been heard and call into question the need for federal legislation in these particular areas of public company governance.
We also note that on May 20, 2009, the Securities and Exchange Commission (the “SEC”) held an open meeting to discuss its proposed rule to provide shareholders with access to company proxy statements for director nominees. This is the SEC’s third proposal on this topic and, as on past occasions, it has failed to attract unanimous support from SEC Commissioners, with two voting against the rule proposal and three voting in favor. The SEC’s proposal is briefly discussed below and will be the subject of a separate client alert once the text of the proposed rule is released.
The Bill would give shareholders a non-binding, advisory vote on executive compensation at any annual or special meeting at which “compensation disclosure” is required under the SEC’s proxy rules. Since compensation disclosure is required at any shareholder meeting where a benefit plan in which directors and officers can participate is adopted or amended, the say-on-pay requirement would also apply, for example, to a special meeting to approve an amendment to an equity compensation plan to permit the repricing of underwater options in which directors or executive officers may participate.
Bills mandating say-on-pay were introduced in 2007 in the Senate by then-Senator Barack Obama and in the House by Representative Barney Frank. The bills have not yet been adopted by Congress. Say-on-pay achieved further momentum when mandated in the American Recovery and Reinvestment Act of 2009 (the “ARRA”) for companies receiving TARP funds. The Bill improves on the provisions for TARP recipients in the following ways. First, it allows for a one-year phase-in after enactment of the Bill rather than providing for immediate implementation. This is an important change because, if say-on-pay is to provide any meaningful benefit to shareholders, compensation committees need to be able to communicate with, and solicit input from, large shareholders during the year preceding a shareholder vote. Second, the Bill attempts to address the overly-broad requirement in the ARRA that companies should hold a say-on-pay vote at every annual or “other” meeting at which compensation disclosure was required.1 However, Senator Schumer’s bill is still overly broad because it would require, for example, a say-on-pay vote in connection with a business combination where compensation disclosure with respect to individuals who will continue to serve as directors and executive officers is required to be included in the proxy. A say-on-pay vote in the context of a business combination seems unnecessary, particularly in light of the specific proposal regarding compensation paid in connection with business combinations described below. We believe that this type of transaction should be excluded from the say-on-pay requirement and that the Bill should provide the SEC with authority to create other exceptions from the requirement based on the type of company and transaction involved.
The Bill would also give shareholders a non-binding, advisory vote on any agreement or understanding related to compensation based on, or related to, a merger, acquisition, or similar transaction, in a proxy solicitation that was not previously subject to a say-on-pay vote of stockholders. The persons subject to this requirement are confusingly referred to in the Bill as “principal executive officers.” The requirement presumably is supposed to refer to named executive officers who are already subject to routine “say-onpay” votes under the Bill. The shareholder approval requirement has a one-year phase-in like the regular say-on-pay vote.
The Bill requires the SEC to promulgate rules implementing say-on-pay votes within one year following its enactment.
Say-on-pay has to date been implemented by only a small number of companies in the United States. It therefore remains to be seen whether it is effective in increasing communication between compensation committees and shareholders. We note that increased adoption of majority voting in many ways obviates the need for a say-on-pay vote since a withhold vote from compensation committee members is now a more effective method of indicating dissatisfaction than was previously the case. Nevertheless, of all of the proposals in the Bill, say-on-pay seems the one most likely to garner support.
The Bill would require the SEC to promulgate rules allowing a shareholder who has held at least one percent of the voting securities of a company for at least two years preceding the date of the next scheduled annual stockholders meeting to include director nominees in the company’s proxy statement.2 On May 20, 2009, the SEC Commissioners approved a rule proposal to permit proxy access rules for shareholders. Therefore, on the face of it, the Bill does not serve a substantive purpose and, in fact, its proposed ownership thresholds conflict with those being proposed by the SEC, as outlined below. Nevertheless, Congressional authorization of SEC rulemaking on proxy access does serve another purpose: it significantly lowers the risk of a successful challenge to the constitutionality of any future SEC rules in this area. Absent Congressional authorization, it could be argued that board nomination procedures fall among a category of activities relating to corporations and corporate governance that are quintessentially state-law governed. However, there is more certainty that, under the Constitution’s Commerce Clause, Congress may authorize the SEC to regulate certain aspects of corporate governance for public companies.
At the SEC’s open meeting on May 19, 2009, the Staff of the Division of Corporation Finance outlined their proposal for shareholder access to company proxy statements for director nominees. The proposal falls into two broad parts. First, new proposed Rule 14a-11 would allow shareholders who have held a specified percentage of a company’s shares to include director nominees for up to 25 percent of the company’s board of directors in the company’s proxy statement. The ownership percentage threshold would be one percent for a large accelerated filer, three percent for an accelerated filer and five percent for a non-accelerated filer.3 A shareholder would be required to certify that it was not seeking control of a company and, if proposals to nominate directors in excess of 25 percent of the board members were received, precedence would be given to those proposals received first. The interaction of the proposed rules with state corporation laws remains to be seen. For example, on the one hand, the Staff stated that the right to include shareholder nominees in a company’s proxy statement would exist only if permitted under the law of a company’s state of incorporation and the company’s governing documents. On other hand, assuming such inclusion is permitted, it appears as if the thresholds in Rule 14a-11 could be overridden by any state or company-specific thresholds. Second, it is proposed that Rule 14a-8 be amended to enable shareholders to include a proposal in a company’s proxy statement regarding the procedures for the nomination and election of directors provided that such proposal does not conflict with proposed Rule 14a-11. This would enable shareholders to include proposals to facilitate nominations under Rule 14a-11 if permitted under state law.
The Bill would require the SEC to promulgate rules within one year of its enactment prohibiting any national securities exchange from listing the securities of a company that does not comply with the following standards contained in the Bill. These rules would be required to provide an opportunity to cure any violation and may also provide for exemptions.
Separation of Chairperson and CEO roles. The Chairperson of a company must (i) be an “independent director” under the exchange’s rules and (ii) not previously have served as an executive officer. The Bill does not limit the length of the look-back or contain any exception for service as an interim executive officer. If the Bill is adopted, we would expect the SEC to provide for this and other reasonable exceptions in its rules.
More importantly, however, we fundamentally question the wisdom or need for this separate requirement. The NYSE already requires companies to have a lead independent director if the roles of Chairperson and CEO are combined. Experience indicates that a lead independent director adds the necessary balance to board proceedings and provides an independent point of contact for board members and shareholders alike. In addition, shareholder proposals to separate the CEO and Chairperson roles, together with pressure from large institutional shareholders and proxy advisors, have led to a significant decrease in the number of companies with a combined CEO/Chairperson. In 1998, 16 percent of S&P 500 companies separated the CEO and Chairperson roles, compared to 39 percent in 2008. We therefore question the need for federal legislation to address this issue.
Annual election of directors. Each director must be subject to annual election. This proposed requirement seeks to prevent the use of a classified board where only a portion—usually one third—of the directors are elected annually. While the proposal appears to be directed at increasing accountability for corporate boards, it is an extremely blunt tool for doing so. First, a large number of companies have declassified the boards in recent years as a result of shareholder demands, thereby calling into question the need for federal legislation to address this issue. Second, in 2007 approximately 7.4 percent of US listed companies, representing 9.4 percent of total US market capitalization—including some of the most prominent companies in the United States—had dual-class stock whereby founders or insiders, for every share they hold, have multiple votes compared to the public. The Bill does not address this situation, nor does there seem to be a reasonable way to do so.
Ultimately, shareholders of companies with dual-class stock have made a choice to invest in such companies. Arguably, the same is true of shareholders of companies with classified boards. Third, the term of office for directors is more clearly a subject for state corporation laws than federal law. Fourth, annual director elections would likely require many companies to amend their certificates of incorporation, which requires a shareholder vote. It is unclear what happens if shareholders do not approve such an amendment. The certificate of incorporation is a contract between the company and its shareholders, the amendment of which is governed by state law requirements. How much effort would a company have to go to in order to have an amendment approved? Would those companies whose shareholders fail to approve an amendment have to be delisted? The Bill assumes that all shareholders want the same thing, but experience shows this is not the case.
Majority voting. Each director in an uncontested election must be elected by a majority of votes cast. Plurality voting is only permitted in contested elections. If a director is not elected by a majority in a uncontested election, that director must tender his or her resignation, and the board must accept that resignation within a reasonable period to be determined by the SEC. This last provision is to prevent “holdovers” whereby a director who does not receive a majority of votes continues in office until his or her resignation is tendered to, or accepted by, the board, or until another election is held.
It should be noted that the case for federal legislation does not seem compelling in this case either. Shareholders have enjoyed considerable success persuading companies to implement majority voting. Currently, over 60 percent of Fortune 500 companies have implemented majority voting policies either of their own volition or after having lost a shareholder proposal. Changing the vote requirement from what is provided in state corporation laws leads down a slippery slope. If director vote requirements can be federalized, why not merger vote requirements or any other future “hot button” issues?
Risk committee. Each company is required to establish a risk committee consisting entirely of independent directors within one year after the SEC promulgates rules regarding the establishment of such committees (which it is required to do within one year after the Bill is enacted). Many companies already combine a risk function with their audit committees. Others, in industries that require considerable focus on risk management, such as banks and insurance companies, have long had the practice of establishing separate risk committees. Ultimately, most companies will likely elect to combine the risk function with their existing audit committees. It will be interesting to see, however, if the SEC’s rules implementing such requirement limit the purview of the committee to financial risk, or if it will have a broader mandate with which many audit committee members may not be comfortable.
The last two years have resulted in a shift in the relationship between management and shareholders. Shareholders first systematically attacked and largely dismantled antitakeover provisions (such as staggered boards and poison pills), and then enhanced their ability to effect change at a corporation (through majority voting and the ability to call special meetings). More recently, shareholders have directed their attention to executive compensation practices (through say-on-pay resolutions and simply withholding votes from compensation committee members). All of these developments call into question the need for federal involvement in public company governance.
There is a risk that, if passed, the Bill will fundamentally shift the balance of power to a point where each annual meeting will turn into a contested election battle and become disruptive to the operation of the company’s business. Ultimately, this could force boards to take a short-term view in order to survive from year-to-year, rather than taking the longer-term view that legislators, regulators and shareholders have been advocating.