SEC Proposes Significant Changes to Director Election Process for U.S. Public Companies
 
July 1, 2009
 
Laurie L. Green- Ft Lauderdale
Francois Janson- New York

On June 10, 2009, the Securities and Exchange Commission proposed new rules that would require all U.S. public companies to include in their proxy materials shareholder director nominees and shareholder proposals that seek to regulate the election of directors. With these amendments, the SEC hopes to facilitate the exercise by shareholders of their right to nominate candidates for election to the boards of public companies and their ability to shape the election process through shareholder action.

This release is a new effort by the SEC to reform the proxy process to facilitate director nominations by shareholders after an unsuccessful attempt in 2003 (the “2003 Proposal’). Thereafter, the SEC adopted rules expanding disclosure of nominating committee functions and shareholder communications with boards of directors, and four years later, rules facilitating the creation and use of electronic shareholder forums. In 2007, the SEC staff resumed its review of the proxy process, and concluded recently that the federal proxy rules might in fact constitute an impediment to the exercise of shareholders’ rights under state law to nominate and elect directors, and no longer achieved their true purpose of providing a replacement for an actual in-person meeting of shareholders. The staff is concerned that, in view of the erosion in investor confidence, shareholders’ inability to participate in the nomination of directors in the U.S. may result in a perceived lack of board accountability, and in turn may reduce the attractiveness of U.S. public companies to global investors.

To address these issues, the SEC is proposing new Rule 14a-11 to require companies to include in their proxy materials shareholder nominees and an amendment to Rule 14a-8(i)(8) to state that companies may no longer exclude from their proxy materials shareholder proposals seeking to make changes to their director election process.

Shareholder Director Nomination Rule

Noting that shareholders must typically undertake costly proxy contests to get their nominees elected, whereas management can access the company’s proxy materials and fund its solicitation from corporate assets, the SEC seeks to level the playing field by giving shareholders access to the company’s proxy materials.

Key Points

• All public companies listed or having equity securities registered in the U.S. (but not foreign private issuers) will be subject to these rules.
• The release sets forth a detailed process which companies and shareholders are required to follow to work through a nomination under the supervision of the SEC staff.
• Shareholder nominations must be permitted under state law and the company’s governing documents.
• Shareholder eligibility requirements ensure that the nominations are supported by large and long-term shareholders – the minimum ownership level required to make a nomination varies from 1% in large cap companies to 5% in smaller public companies, and shareholders will be entitled to aggregate their holdings to meet this threshold.
• The proposing shareholder may not seek to change control of the issuer and shareholder nominees must be independent.
• A new SEC filing is required when making a nomination (Schedule 14N).
• The first shareholder or group who satisfies the requirements of Rule 14a-11 and who also satisfies the required filings and notice to the company will be entitled to nominate the greater of one nominee or 25% of the directors of the board.
• Nominating shareholders may solicit participation of other stockholders to form a “nominating group” without triggering the requirement to file a full proxy statement. Members of the nominating group will, under certain circumstances, remain “passive investors” eligible to file ownership reports on Schedule 13G.

Rule Applies to Issuers Subject to the Proxy Rules

Proposed Rule 14a-11 would apply to all companies subject to the Exchange Act proxy rules, provided the relevant state law and the company’s governing documents do not prohibit shareholders’ nominations. Proposed Rule 14a-11 would not apply to foreign private issuers, who are exempted from the proxy rules, and companies that are subject to the proxy rules solely because they have a class of debt registered under the Exchange Act. In the event that the company’s governing documents do not permit shareholders to make nominations, the SEC is also proposing to allow shareholders to use the Rule14a-8 shareholder proposal procedure in order to seek the necessary changes to the governing documents.

Rule Immediately Available

The SEC proposes to make the shareholder nomination rule immediately available regardless of a company’s past corporate governance record. In its 2003 Proposal, the SEC subjected the availability of the shareholder nomination rule to two conditions designed to establish that allowing shareholder nominations was warranted because of a company’s poor governance record. The 2003 Proposal required a shareholder wishing to nominate candidates for directors to first obtain a shareholder vote in support of a proposal to allow such nominations at an annual meeting before it could nominate a candidate for election at the following annual meeting. Second, shareholder nominations were only permitted if one of the company’s nominees had received more then 35% withheld votes at a preceding annual meeting of shareholders. The SEC proposes to abandon these conditions, which would make the procedure available in any company for that company’s next annual meeting following the adoption of Rule 14a-11.

Shareholder Eligibility Requirements

To qualify for shareholder nominations under Rule 14a-11, a nominating shareholder (or nominating group) is required to have a minimum stock ownership level tiered according to company size, as follows:

• 1% of the voting securities for large accelerated filers (companies with a worldwide market value of $700 million or more)
• 3% for accelerated filers (companies with a worldwide market value of $75 million or more but less than $700 million)
• 5% for non-accelerated filers (companies with a worldwide market value of less than $75 million).

Each shareholder seeking to make a nomination under the rule (alone or as a member of a group) would be required to have owned the required amount of securities for at least a year from the date of the notice of nomination and to represent that such shareholder intends to hold the securities through the date of the meeting. A nominating shareholder or group would be required to state their intent with respect to continued ownership of their shares after the election. The procedure would be reserved for shareholders who did not acquire and do not hold their securities for the purpose or with the effect of changing control of the company.

Shareholder Nominee Requirements

A company could exclude from its proxy materials any nominee who, if elected, would cause the company to violate applicable laws or its governing documents, and such violation could not be cured. A company may not impose additional requirements in its governing documents as a condition to including in its proxy materials nominations made through Rule 14a-11.

Nominees would be required to meet the objective criteria of independence set forth in the relevant or generally applicable national securities exchange rules for directors (other than audit committee members). The subjective element of the definition of independence would not have to be satisfied.

To limit the risk that companies could encourage shareholders to nominate supportive nominees to block future unwelcome nominations, the SEC proposes that a nominating shareholder or group be required to represent that no relationships or agreements exist between the nominee, or the nominating group, and the company and its management. Negotiations to determine whether the shareholder nominee could receive the support of management (if they are unsuccessful) or whether the company is required to include the nominee in its proxy materials would not disqualify a nominating shareholder or group.

Unlike the 2003 Proposal, the proposed rule does not include limitations on relationships between the nominating shareholder or group and the nominee. Employees or executives of shareholders would therefore be eligible to be nominated under Rule 14a-11. The staff believes that fiduciary duties under applicable state law would ensure that a nominee would act on behalf of the corporation and not any particular shareholder or group of shareholders.

The release also clarifies that a nominating shareholder would not become an affiliate of a company merely by virtue of nominating a candidate for election as a director.

The maximum number of nominees that shareholders may nominate through the Rule 14a-11 procedure would be capped at one director for boards with seven or less members and at 25% of the full board for larger boards. This limitation would be applicable on an ongoing basis (any existing shareholder nominee would count against the limitation) to prevent shareholders from using this procedure for control purposes. If competing nominations are made by more than one shareholder or group, proxy access would be allocated on a first-in basis regardless of the relative ownership levels of the shareholders. The company would be required to include all qualifying nominees in its proxy materials up to and including the total number permitted by the rule.

New Schedule 14N

In order to make a nomination under Rule 14a-11, a shareholder or group would be required to send the company and file with the SEC a shareholder notice on Schedule 14N by the advance notice deadline for shareholder proposals set forth in the company’s governing documents or, where no such provision is in place, no later than 120 days before the date the company mailed the proxy materials for the prior year’s annual meeting.

The notice would include disclosure of the type that nominating shareholders would be required to provide in a proxy contest. The disclosure would enable the company and the SEC to assess whether the proponents meet the shareholder eligibility and other requirements of the Rule. In particular, the notice would contain the following disclosure:

• the name and address of the nominating shareholder or, if a nominating shareholder group is filing the Schedule 14-N, of each member of the group
• information regarding the amount and percentage of securities beneficially owned and entitled to vote at the meeting
• a written statement from the record holder of the shares beneficially owned by the nominating shareholder confirming that the shareholder continuously held the securities for at least a year
• a written statement of the intent of the nominating shareholder(s) to continue holding the requisite number of shares through the shareholder meeting at which directors are elected
• a certification that the shares are not held for the purpose of, or with the effect of, changing the control of the issuer or gaining more than a limited number of seats on the board of directors

In addition, the nominating shareholder or group would be required to make certain representations and disclosure regarding compliance with the shareholder eligibility requirements of the rule, as follows:

• a representation that the nominating shareholder or group is eligible to submit a nominee under Rule 14a-11
• a representation that the nominee’s election would not violate applicable laws or the company’s governing documents
• a representation that the nominee meets the objective criteria for independence under the applicable rules of a national securities exchange or national securities association
• a representation that the nominating shareholder has no agreement with the company concerning the nominations
• a statement that the nominee consents to be named in the company’s proxy statement and to serve on the board if elected
• a statement that the nominating shareholder intends to continue to own the requisite number of shares through the date of the meeting
• disclosure concerning the nominee that would be required to be included in a Schedule 14A (biographical information, legal proceedings, transactions and relationships with the company)
• disclosure concerning the nominating shareholder or group of shareholders that would be required to be included in a Schedule 14A in a contested election
• disclosure concerning the nature and extent of the relationships between the nominating shareholder or group of shareholders and nominee and the company and any affiliate of the company
• a supporting statement (which may not exceed 500 words)

The Schedule 14N would need to be amended promptly if there is any material change in the information previously submitted. The nominating shareholder or group would also be required to file a final amendment to its Schedule 14N within 10 days of the final results of the election to disclose its intent with regard to continued ownership of their shares.

Nomination Process

The release sets forth a detailed process which companies and shareholders are required to follow to work through a nomination under the supervision of the staff. The procedure is modeled after the existing procedure for excluding shareholder proposals under Rule 14a-8. The principal steps are as follows:

• A company must inform a nominating shareholder or group within 14 days of receipt of a notice of nomination whether it has reasons to believe that it may disregard the nominations.
• The nominating shareholder or group must respond within 14 days of receipt of the company’s notice of deficiency and would be given an opportunity to cure certain eligibility or procedural deficiencies affecting the nominations.
• If the company wishes to exclude the nomination, it must request a determination of no-action from the SEC no later than 80 days prior to filing its definitive proxy statement (and include an opinion of counsel stating the basis for such exclusion).
• The nominating shareholder or group may submit a response to the company’s notice to the SEC within 14 days of receipt of a copy of the company’s request to the SEC.
• The staff may provide its views to the company and the nominating shareholder or group informally before issuing a formal response to the no-action request.
• The company must inform the nominating shareholder or group no later than 30 days before filing its definitive proxy statement whether it intends to exclude the nominations.

To view the SEC’s release timeline, click on this link.

New Limited Exemption for Preliminary Communications Among Shareholders

The SEC proposes to adopt a limited exemption from the prohibition against solicitations made prior to filing a proxy statement to facilitate communications among shareholders in connection with Rule 14a-11 nominations. The proposed exemption would allow shareholders who are seeking to make such a nomination, but do not own the required ownership percentage, to solicit other shareholders to form a nominating group. The exemption would only be available for written communications limited to the content permitted by Rule 14a-11 and filed with the SEC. Oral communications would not be exempt. In addition, communications made in connection with nominations made outside of proposed Rule 14a-11, such as nominations made pursuant to state law and the company’s governing documents, would not be exempt. Each written communication could only include the following:

• a statement of the shareholder’s intent to form a nominating shareholder group in order to make a nomination under the rule
• a statement describing the proposed nominee or, if no nominee has been identified, the proposed characteristics of the nominee whom the shareholder intends to nominate
• the percentage of shares that the shareholder or group beneficially owns
• the means by which shareholders may contact the soliciting party

Any written soliciting material distributed to shareholders would have to be filed with the SEC on Schedule 14A no later than the date the material is first published.

The staff states that this new exemption will be in addition to the existing exemption for solicitations of less than 10 shareholders, which is intended to allow shareholders to “test the waters” prior to launching a formal solicitation, and the exemption for communications that take place in an electronic shareholder forum.

Schedule 13G/D and Section 16 Issues

The staff advises shareholders seeking to make a Rule 14a-11 nomination to consider their obligations under Regulation 13D and Section 16. Regulation 13D requires any shareholder (or group) who is the beneficial owner of more than 5% of the shares of a public company to file a beneficial ownership report on Schedule 13D with the SEC, unless the shareholder is permitted to file on Schedule 13G because it is a qualified institutional investor or it owns less than 20% of such shares and does not hold any shares for control purposes. The staff believes that the formation of a group solely for the purpose of making a nomination under Rule 14a-11 would not make a 5% nominating shareholder or group lose its eligibility to file on Schedule 13G, and proposes to add a carve-out covering Rule 14a-11 activities in the instructions regarding Schedule 13D. This carve-out would not extend to communications or other actions by shareholders in connection with nominations made pursuant to state law or a company’s governing documents. Concerning Section 16, the staff believes that, because the ownership thresholds for Rule 14a-11 nominations are well below 10%, it does not anticipate a need to create a carve-out for groups established for this purpose.

Application of Proxy Rules to Shareholder Nominations

The release clarifies that shareholder nominations will not be deemed to be solicitations in opposition and therefore will not trigger the filing and disclosure requirements applicable to shareholders’ proxy contests. Upon receipt of a valid nomination, a company would be required to include the names of the nominees and supporting statement as well as to present the nominees in an impartial manner on its card. The release provides that companies would not be liable for such statements but that nominating shareholders would be subject to the prohibition against misleading statements contained in Rule 14a-9. A notable difference from normal practice would be that companies would not be permitted to provide shareholders with the ability to vote for or to withhold authority to vote for the company nominees as a group, but rather would be required to provide that each nominee be voted upon separately.

The parties would be free to solicit outside of the proxy statement subject to any filing requirement applicable under the proxy rules. The proposed rule would avoid the need for the nominating shareholder or group of shareholders to file its own proxy statement in order to be allowed to solicit in favor of its nominees, so long as such shareholder or group is not soliciting authority to act as proxy for other shareholders and does not furnish or request a proxy card. Any written communication made for such purpose would need to be filed with the SEC on Schedule 14A on the date of first use and include the following:

• the identity of the nominating shareholder or group and a description of their interests in the company, by security holdings or otherwise
• a prominent legend advising shareholders that a shareholder nominee will be included in the company’s proxy statement and to read the proxy statement when it becomes available

Shareholder Election Proposal Rule

The SEC proposes to amend Rule 14a-8, the rule that requires companies to include a qualifying shareholder proposal in their proxy statement, to facilitate its use by shareholders in connection with the director election process. Until now, companies could exclude proposals that relate to a director nomination or election, or a procedure for nomination or election. The SEC now proposes to narrow this exclusion to a few limited situations.

The proposed amendment would enable shareholders to require companies to include in their proxy statement proposals that would amend a company’s governing documents regarding director nomination procedures or disclosures related to such nominations, provided the proposal complies with the other requirements of Rule 14a-8 and does not conflict with Rule 14a-11. As proposed, the rule would allow shareholders to make binding proposals to provide other means for director nominations than the nomination process already contemplated by Rule 14a-11, but could not be used to impose more onerous requirements for shareholders to make nominations in reliance on Rule 14a-11.

No additional disclosure requirement would be triggered by the use of Rule 14a-8 as proposed, so long as the proponent does not make any nomination. However, if the proponent made a nomination once the proposal has been adopted or pursuant to a separate right under state law or the company’s governing documents to have shareholder nominees included in the company’s proxy statement, proposed Rule 14a-19 would require that the proponent file a shareholder notice on Schedule 14N including disclosure similar to what would be required in an election contest. The company would include this disclosure in its proxy statement.

The SEC proposes to continue to allow companies to exclude proposals on certain limited grounds under existing interpretations which would now be codified in Rule 14a-8. A 14a-8 proposal would continue to be excludable if it would disqualify a nominee, remove a director from office before the end of such director’s term, questions the competence of a director, nominates a specific individual for election or would affect the outcome of the upcoming election.

Looking Forward

Although the proposed rules are very controversial, in light of the recent financial crisis and recent reform proposals from congress, it is likely that all or some portion of the proposed rules will be adopted. However, given the numerous questions posed in the release and expected litigation challenging the SEC’s authority to adopt the proposed rules, it is unclear whether the proposed rules will be adopted in time for the 2010 proxy season. The comment period ends August 17, 2009.

For more information, contact:

Francois Janson
212.513.3266 | francois.janson@hklaw.com

Laurie L. Green
954.468.7808 | laurie.green@hklaw.com

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