On August 25, 2010, the Securities and Exchange Commission approved rules affording public corporation shareholders a federal right to have their nominees for election as directors included in the corporation's proxy materials.1 Prior to these rules, a public corporation's proxy statement, used to solicit shareholder votes in the election of directors, and the proxy cards distributed by a corporation to its shareholders and returned by them as the means of casting their votes, have only permitted shareholders to vote for or against the corporation's nominees for election as directors. As a result, a shareholder who has sought to nominate a candidate for election as a director has faced the burden of conducting his own proxy solicitation in opposition to the solicitation of the company.
Under new Rule 14a-11, shareholders or shareholder groups who have owned not less than 3 percent in voting power of the currently outstanding shares of the corporation for not less than three years can require that their nominees (up to 25 percent of the board) be included in the corporation's proxy statement and proxy card.2 In this way, shareholders will have the opportunity, on the card distributed by the corporation, to vote for persons other than management's nominees.
A shareholder seeking proxy access for a nominee must provide notice to the company on Schedule 14N (and file the Schedule 14N with the Commission) no earlier than 150 calendar days and no later than 120 calendar days before the anniversary of the date that the company mailed its proxy materials for the prior year's annual meeting.3 Schedule 14N must contain a variety of disclosures relating to the nominating shareholder or shareholder group and the nominee.
Advance Notice Bylaws
Many Pennsylvania public corporations currently have in place advance notice bylaws. Such bylaws typically require that a nominating shareholder provide to the company advance notice of the shareholder's intention to nominate a director, which notice must contain specified information concerning the nominating shareholder and the nominee. The notice is required to be delivered within a specified period of time, which, depending on the particular bylaw, may be calculated by reference to the anniversary date of the prior year's annual meeting of shareholders, or by reference to the anniversary date of the prior year's mailing of proxy materials for such annual meeting. Often the specified window period for timely advance notice and the required contents of the notice under a bylaw will differ from the window required for notice under Rule 14a-11 and the contents required by Schedule 14N. As a result, a valid federal proxy access notice under Rule 14a-11 may not satisfy the bylaw requirements for director nominations.
Some commentators, stating that Rule 14a-11 preempts all provisions in a company's governing documents, have recommended that corporations modify their advance notice bylaws to provide that they do not apply to nominations for which proxy access is sought under Rule 14a-11. Such action would except nominations for which proxy access is sought under Rule 14a-11 from all timing and content requirements generally applicable under an advance notice bylaw to shareholder nominations and other shareholder proposals.
Rule 14a-11 provides a federal proxy access right, regardless of any provision in a corporation's governing documents that would purport to restrict proxy access, or that would permit no proxy access at all. However, Rule 14a-11(b)(8) continues to recognize the primacy of state law by providing, as an eligibility requirement that must be met for proxy access, that the nominee's "candidacy, or if elected, board membership" may not "violate controlling...State law." As a result, state law that renders unlawful a particular nominee's candidacy, or if elected, board membership, will render such nominee ineligible for Rule 14a-11 proxy access.
The Pennsylvania Business Corporation Law (§1758(e)) provides that if the bylaws of a corporation provide "a fair and reasonable procedure for the nomination of candidates for election as directors, only candidates who have been duly nominated in accordance therewith shall be eligible for election." The negative corollary, made explicit by the word "only," is that by statute candidates who have not been duly nominated in accordance with such procedure shall not be "eligible for election." Within the meaning of Rule 14a-11(b)(8), the "candidacy or, if elected, board membership" of a candidate not duly nominated in accordance with such procedure would "violate controlling state law" as expressed in Pa. BCL § 1758(e), thus making the candidate ineligible for proxy access. The Pennsylvania statute requires that the procedure established in the advance notice bylaws be a "fair and reasonable" one. In many cases, we believe Pennsylvania counsel will be able to conclude that existing advance notice bylaws meet this requirement.
It may be possible in a particular case for a nominating shareholder to cure any asserted noncompliance with an advance notice bylaw; however, it is not certain that this would be possible in every case.4 Based on the analysis outlined above, in a case of uncured noncompliance with an advance notice bylaw, a company may be able to seek no-action treatment from the Commission on the basis of ineligibility under Rule 14a-11(b)(8). The basis for excluding the nominee would rely on a matter of Pennsylvania law, and thus under Rule 14a-11(g) would require a supporting opinion of counsel expert in Pennsylvania law. If no-action treatment were not granted, the company may determine to include the nominee in its proxy materials.5 In such event, the company would be able to include proxy statement disclosure that the nomination violated the company's advance notice bylaw, and, in an appropriate case, a statement that the nomination would be ruled out of order if presented at the annual meeting, with the result that the candidate would not be elected.
None of these actions-seeking to exclude the nominee from the proxy materials on the grounds of violation of an advance notice bylaw; disclosing in the proxy materials that the nomination is invalid as a matter of state law under the bylaw; or ruling the nomination out of order as a matter of state law, as violative of the advance notice bylaw, and declaring the nominee not elected as a matter of state law regardless of vote-will be possible if the company takes action to amend its advance notice bylaw to exclude Rule 14a-11 nominations from its coverage. Of course, if a company determined to leave its current advance notice bylaw unchanged, it would retain the ability to waive compliance with the bylaw in the case of a particular Rule 14a-11 nomination if the board determined that to be desirable.
Where a company has an advance notice bylaw currently in existence, the failure to take action to change the bylaw to exclude Rule 14a-11 nominations from its coverage is unlikely to attract any adverse attention from activist shareholders or other adverse publicity. The status quo would simply be maintained, and no public disclosure of the absence of a change would be required.
Director Qualification Bylaws
The Pennsylvania Business Corporation Law (§ 1722(a)) authorizes a corporation to prescribe in its bylaws qualifications for directors. However, most public corporations have historically not adopted such bylaw provisions. Prior to Rule 14a-11, shareholders have nominated candidates for election as directors only in the unusual case of a proxy contest; ordinarily director nominations have been made by a corporation's nominating committee and its board of directors. Many corporations have adopted director qualification guidelines for use by nominating committees in selecting individuals to be candidates for election. Although such guidelines do not have the prescriptive force of director qualification bylaws (that is, it would not be unlawful for a person not meeting the guidelines to serve as a director), most corporations have found such guidelines to be an effective means of providing direction for the decisions of the nominating committee. With such guidelines in place, most corporations have not felt a need to include prescriptive director qualification provisions in the bylaws.
Rule 14a-11 removes the burden of conducting a separate proxy solicitation for shareholders or groups that meet its requirements. In addition, the new amendments to Rule 14a-8(i)(8) open the door to shareholder proposals, which will be required to be included in the company's proxy statement for a shareholder vote, to create proxy access rights for shareholders with less restrictive ownership requirements than Rule 14a-11's requirement of ownership of 3 percent of the shares for three years.6 The share ownership requirements for a shareholder to introduce such a proposal and seek to have it included in the proxy statement are de minimis.7
Under new Rule 14a-11 and under a regime of expanded proxy access that may be proposed and approved by shareholders,8 it will be more likely than in the past that shareholders will nominate candidates for election as directors. These nominating shareholders or groups will not be bound by guidelines that the company may have adopted for its nominations, and will not owe a fiduciary duty to the corporation with regard to their selection of candidates.
Consequently, these new rules may provide an impetus for corporations to review director qualification guidelines that they have previously adopted, and ascertain whether the guidelines or a variant of the guidelines should be included in the corporation's bylaws as prescriptive legal requirements for the holding of the office of director.
Director qualification guidelines currently in place tend to be worded in general terms. Guidelines will typically include language to the effect that persons to be nominated as candidates for election as director must possess the highest level of personal and professional integrity, and must have a history of sustained experience and accomplishment, in having served in a leadership role in companies of similar size and complexity to the subject company, or in government, finance, accounting, law, higher education or other fields. Such guidelines also may require that the nominee be able to devote sufficient time to fulfill his responsibilities as a director. Also, such guidelines will usually require that the nominee should represent all shareholders and not any special interest group or constituency. Guidelines may also include maximum (or more rarely, minimum) age requirements.
The general language of director qualification guidelines reflects the reality that an assessment of an individual's qualifications to serve as a director of a public corporation is often not easily capsulized in a formulaic test. As a result, these guidelines do not normally set forth bright line rules that are capable of objective determination.
As part of the development of language for a prescriptive bylaw qualification provision, companies may wish to review their existing qualification guidelines to determine whether additional specificity is possible without a substantial loss of flexibility. However, meaningful qualifications probably will not be able to be expressed in completely objective terms. Nevertheless, adoption of a director qualification bylaw, even one that may not be easily capable of bright-line determinations, can provide the board with baseline criteria that could constitute an important tool in dealing with shareholder nominations, particularly in egregious situations. In particular, in a proper case, if the board was convinced that a particular nominee did not meet the stated bylaw qualification requirements, disclosure could be included in the proxy materials that the person would not be seated as a director, regardless of the voting outcome. In the Adopting Release, the Commission acknowledged that where a company's governing documents establish certain qualifications for director nominees that, consistent with state law, would preclude the company from seating a director who does not meet these requirements, this matter should be disclosed in the proxy materials where such a nominee has been included.9
Under Pa. BCL § 1504(a), a director qualification bylaw may be adopted by the board of directors without shareholder approval, subject to the ability of shareholders to vote to change the board's action. Prior to adopting such a bylaw, a company will want to carefully consider the likely reaction of activist shareholders, and seek to develop qualification language that will be least likely to provoke an adverse reaction. Obviously, the adoption of such a bylaw will be unpalatable if it leads to adverse publicity and results in a targeting of the corporation by activists, by provoking nominations of candidates for election, or litigation challenging the validity of the bylaw, or both.
Most director qualification guidelines currently in place at public corporations use criteria that are noncontroversial, and would be viewed by most reasonable observers as entirely proper in the consideration of nominees. To the extent that new bylaw provisions follow the substance of existing guidelines, such that the provisions simply incorporate requirements for all nominations that previously applied only to company nominations, it may be possible to conclude that the adoption is unlikely to provoke any serious public relations difficulties or activist shareholder reactions.
The qualification requirement could be couched in a way that could bolster an argument in a no-action request to the Commission staff that a nominee's failure to meet the requirement should result in exclusion of the nominee from the proxy materials pursuant to Rule 14a-11(b)(8). The Commission's discussion of director qualification bylaws in the Adopting Release focused on provisions of the type that would simply express a qualification that a person must meet in order to serve as a director. The Commission stated that such provisions as a matter of state law may bar seating a nonqualifying person as a director, but do not bar the nomination or election of such person, and therefore should not bar inclusion of a nominee in the company's proxy materials under Rule 14a-11.10
However, it would be possible to express the qualification requirements in the bylaws by stating them, not simply as criteria that a person must meet in order to serve as a director, but as criteria that must be met in order for a person to be validly nominated as a director. A bylaw requirement that specified, as part of procedures for nomination of candidates for director, that to be validly nominated, a person must meet the qualification requirements necessary to seating the person as a director, would appear to be a "fair and reasonable procedure for the nomination of candidates" within the meaning of Pa. BCL § 1758(e). As a result, only those nominated in accordance with the procedure would be eligible for "election as directors" under Pa. BCL § 1758(e).
This type of bylaw provision could permit the company to invoke the eligibility requirement of Rule 14a-11(b)(8) and contend in a no-action request that a particular nonqualified person's candidacy and, if elected, board membership would violate controlling state law, making him ineligible for inclusion in the proxy materials. Given the typical breadth of qualification language, the determination of a lack of qualification may often be sufficiently uncertain in the staff's view so that no-action treatment will not be forthcoming; however, it may be valuable to couch a bylaw qualification provision in terms that relate to nomination procedures, so as to preserve the possibility of making the argument.
As discussed above, the public reaction to such a bylaw is likely to be dependent upon the nature of the bylaw qualifications stated, how evidently reasonable they are, and how closely they track existing criteria expressed in director qualification guidelines. Language making the qualifications a prerequisite for a valid nomination, as opposed to a prerequisite for service as a director, is probably unlikely to draw separate attention.