SEC Chairman Mary Shapiro announced that the SEC is, as expected, revisiting the question of shareholder access to the proxy statement. Here speech is available here. Money quote:
The nation and the markets have recently experienced, and remain in the midst of, one of the most serious economic crises of the past century. This crisis has led many to raise serious questions and concerns about the accountability and responsiveness of some companies and boards of directors, to the interests of shareholders. These concerns have included questions about whether Boards are exercising appropriate oversight of management, whether Boards are appropriately focused on shareholder interests and whether Boards need to be more accountable for their decisions regarding such issues as compensation structures and risk management.
The trouble, of course, is that Board accountability is not a primary concern of the SEC. It is a concern of state corporate law.
Back in 2004, when the SEC last considered proxy access I published A Comment on the SEC Shareholder Access Proposal, to which I would refer those interested in a detailed legal analysis of shareholder access. For the benefit of readers to whom foonotes are abhorent, this seems an opportune moment to reprint my op-eds on shareholder access from the last go round:
Does the SEC Know When Enough Is Enough?
The Securities and Exchange Commission is now considering proposed regulations designed to allow shareholders to nominate directors and, moreover, to require the incumbent directors to place the shareholder's nominee on the company's own proxy statement and ballot, albeit under relatively limited circumstances. At first blush, the regulation strike many people as perfectly reasonable. After all, directors are elected by shareholders, so why shouldn't the shareholders be allowed to nominate directors?
This argument, however, fails to put the SEC proposal in context. The SEC's proposed regulations are just the latest in a continuing string of new corporate governance rules. Taken together, these new rules have significantly increased the regulatory burden on Corporate America. So let's step back and look at the SEC proposal in its proper context: the recent corporate scandals and the government's response.
Good for Government
History teaches that market bubbles are fertile ground for fraud. Cheats abounded during the Dutch tulip bulb mania of the 1630s. The South Sea Company, which was at the center of the English stock market bubble in the early 1700s, itself was a pyramid scheme. No one should have been surprised that fraudsters and cheats were to be found when we started turning over the rocks in the rubble left behind when the stock market bubble burst in 2000.
We all know the litany, of course: accounting scandals at Enron and WorldCom, to cite but two; insider trading at ImClone; alleged looting at Adelphia and Tyco; and so on. New York's attorney general, Elliott Spitzer has brought to light high profile problems calling into question the integrity of both stock market analysts and mutual fund managers.
Corporate scandals are always good news for big government types. After every bubble bursts, going all the way back to the South Sea Bubble, a slew of new laws have been enacted. Why? There is nothing a politician or regulator wants more than to persuade angry investors that he or she is "doing something" and being "aggressive" in rooting out corporate fraud. Look, for example, at how vigorously the SEC is trying to keep up with attorney general Spitzer.
Hence, it was entirely predictable that the shenanigans at Enron, WorldCom et al., coming after several years of steady decline in the stock market, would lead to regulation. Yet, how quickly we forget. Remember what Ronald Reagan said: "The nine most terrifying words in the English language are: 'I'm from the government and I'm here to help.'"
Costs Beginning to Mount
Like a cook who throws spaghetti at the wall to see if it's done, legislators and regulators have been throwing a lot of new rules at corporations to see what sticks: Sarbanes-Oxley, numerous SEC regulations, California's onerous corporate disclosure act, Spitzer's settlement with the analyst community, and countless law suits and indictments. Unlike the cook, who stops when the spaghetti is done, the lawmakers just keep throwing stuff at corporations without stopping to ask whether enough is enough.
The costs of all this regulatory activity are beginning to mount. Some companies, for example, will incur 20,000 staff hours to comply with just one SEC new rule -- a rule the SEC estimated would require only 383 staff hours per firm. According to a study by Foley Lardner, "Senior management of public middle market companies expect costs directly associated with being public to increase by almost 100% as a result of corporate governance compliance and increased disclosure as a result of the Sarbanes-Oxley Act of 2002 (SOX), new SEC regulations and changes to [stock] exchange listing requirements."
If adopted, the SEC's shareholder access proposal would significantly add to that regulatory burden. A review of contests in the late 1980s found that insurgents spent an average of $1.8 million and incumbents an average of $4.4 million. Those costs are almost certainly much higher today, but let's use them as a baseline. Assume that a company faces a shareholder nominee every three years. Assume further that a shareholder nomination contest costs one-third what a full proxy contest costs. On those assumptions, each public corporation would face annualized costs of about $500,000. Using the 10,000 actively traded U.S. companies in the Compustat database as a proxy for the number of companies potentially subject to the rule, we can estimate an aggregate annual cost of $5 billion. Of course, I may be overestimating the number of contests and the cost of each contest. Remember two things, however: (1) I'm using 1980s era cost estimates and (2) the SEC grossly underestimated the cost of complying with Sarbanes-Oxley.
A more conservative estimate might use data about shareholder proposals under current SEC regulations. According to the SEC's own figures, the cost per company of including a shareholder proposal in the proxy statement is $87,000. ISS tracked 1,042 shareholder proposals at public corporations during the 2003 proxy season, which gives us total corporate expenditures on shareholder proposals of $90,654,000.
Either way, there can be no doubt that giving shareholders access to the proxy statement to nominate directors is going to be expensive. Plus there are all the indirect costs. Companies are already having a hard time attracting independent directors. The shareholder access proposal likely will make that search even harder. Why would somebody be willing to serve on the board if he or she might be the one singled out to be ousted?
Disrupting Successful Boards
The election of a shareholder representative also will disrupt the delicate internal dynamics that make boards successful. Its effect will be analogous to that of cumulative voting, which allows minority shareholders representation on the board. Experience with cumulative voting suggests that it often leads to pre-meeting caucuses by the majority and a reduction in information flows to the board as a whole. In turn, this results in adversarial relations between the majority and minority board members, which interferes with effective board governance.
Is it clear that the benefits of shareholder access will exceed these costs? Why, for example, should you and I have to subsidize some activist or gadfly who wants some free publicity?
If the SEC could figure out a way to limit the proposal to situations in which the board is clearly dysfunctional, these concerns might less important. The problem is that the SEC rules apply to all public corporations, whether their internal governance is good, bad, or just indifferent. As currently drafted, a shareholder would be allowed to put its nominee on the corporation's proxy if one of two triggering events occurred:
· A shareholder puts forward a proposal to authorize shareholder nominations, which is then approved by the holders of a majority of the outstanding shares; or
· Shareholders representing at least 35% of the votes withhold authority on their proxy cards for their shares to be voted in favor of any director nominated by the incumbent board of directors.
Nothing in either trigger limits the rule to the Enrons of the world. If enough shareholders are disgruntled, for whatever reason, they can force a vote. This makes no sense. The point of all these reforms, supposedly, is to restore investor confidence by ensuring good corporate governance. But if firms are well-managed why put them to the expense and bother of a shareholder nomination contest? Just as a good cook eventually stops throwing spaghetti at the wall, it is time for the regulators to stop, take a deep breath, and stop throwing new reforms at Corporate America. Let's wait and see how the first couple of rounds of reform play out before imposing yet more burdens on corporations in our still precarious economic environment. In October of last year, the SEC proposed a new rule that would permit shareholders to directly nominate directors of the corporations in which they have invested. As I detailed in my TCS column, Does the SEC Know When Enough Is Enough?, the proposal was seriously flawed. It was likely to impose significant indirect costs on corporations, without much in the way of countervailing benefits. (For more details, see my blog's archive of posts on the rule.) The WSJ ($) reports that a "compromise" is in the works, under which:
As bad as the original proposal was, however, things may be about to take a turn for the worse.
"While details of the proposal are still being worked out, it would essentially allow shareholders to sit down with a company and agree on a person to replace a director who has been targeted by investors for removal. If an agreement couldn't be reached, shareholders would likely gain the right to nominate their own director the following year. The proposal may allow companies to bypass negotiating with investors if they agree to include shareholder-backed nominees on the ballot the following year."
Problems: (1) Which shareholders get to sit down with management? All of them, which can be in the millions, or just a select few? If a select few, how do we ensure that the interests of the few coincide with those of the many? How, for example, do we ensure that unions don't use the shareholder access rule for leverage in collective bargaining (as they often use the current shareholder proposal rule)? Or that social activists don't use it to promote a social agenda at odds with the profit-maximization interests of most shareholders? In the Wall Street Journal, Robert Pozen recently proposed that the Securities and Exchange Commission should adopt two new rules to empower shareholders: "First, the SEC should allow shareholders of a public company to propose in its proxy statement a bylaw disqualifying any director nominee who receives less than a majority of the votes cast from being renominated at the company's next election. If approved, the bylaw would permit such a director to be seated after an uncontested election because there are no competing candidates. In the next election, however, such a director could not be nominated again for a seat on that company's board. ... "Second, instead of risking investor confusion by combining company and shareholder candidates in the same proxy statement, the SEC should help reduce the costs of making a separate solicitation of proxies for a minority of directors running for office: a "short list" rather than a full slate of nominees. Under current SEC rules, proponents of a short list must incur enormous expense by mailing proxy statements to every company shareholder. To reduce these costs, the proponents of a short list should be allowed to publish their proxy statements on the Internet, according to a task force of the American Bar Association. Internet publication would reach most company shareholders, small and large, especially if the company's Web site included a Web address for the materials of the short list proponents. Pozen is a very serious and influential fellow -- chairman of MFS Investment Management, former member of the President's Commission to Strengthen Social Security, former associate general counsel of the SEC, and so on -- so anything he recommends is likely to get a serious hearing in Washington. Unfortunately, these are both very bad ideas. If adopted, the short list proposal would significantly increase the prospect of a divided board of directors. As with all minority representation schemes, such as cumulative voting or codetermination, the resulting divisions within the board of directors will significantly reduce the board's effectiveness. Granted, some firms might benefit from the presence of skeptical outsider viewpoints. It is well-accepted, however, that cumulative voting tends to promote adversarial relations between the majority and the minority representative. The likelihood that cumulative voting will results in affectional conflict rather than cognitive conflict thus leaves one doubtful as to whether firms actually benefit from minority board blocks. The likelihood of disruption in effective board processes is confirmed by the experience of German firms with codetermination. German managers sometimes deprive the supervisory board of information, because they do not want the supervisory board's employee members to learn it. Alternatively, the board's real work is done in committees or de facto rump caucuses from which employee representatives are excluded. As a result, while codetermination raises the costs of decision making, it seemingly does not have a positive effect on substantive decision making. The likely effects of electing a short list therefore will not be better governance. It will be an increase in affectional conflict (as opposed to the more useful cognitive conflict). It will be a reduction in the trust-based relationships that causes horizontal monitoring within the board to provide effective constraints on agency costs. It will be the use of pre-meeting caucuses and a reduction in information flows to the board. In sum, it will be less effective governance. Expanding the Federal Role Both of Pozen's proposals are also problematic because they would represent a significant and unwarranted expansion of the federal role in corporate governance. In particular, variants on his first proposal, relating to a requirement that directors be elected by majority vote, are currently being actively debated in state legislatures around the country and among the drafters of the American Bar Association's influential Model Business Corporations Act. For over 200 years, corporate governance has been a matter for state law. Even the vast expansion of the federal role begun by the New Deal securities regulation laws left the internal affairs and governance of corporations to the states. As the US Supreme Court explained in CTS Corp. v. Dynamics Corp., 481 U.S. 69 (1987): "It ... is an accepted part of the business landscape in this country for states to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares." Indeed, the Court opined that "[n]o principle of corporation law and practice is more firmly established than a State's authority to regulate domestic corporations." It thus is state law that determines the rights of shareholders, "including ... the voting rights of shareholders." The basic case for federalizing corporate law rests on the so-called "race to the bottom" hypothesis. States compete in granting corporate charters. After all, the more charters the state grants, the more franchise and other taxes it collects. According to the race to the bottom theory, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders. The problem is that the race to the bottom theory makes no economic sense and is unsupported by the empirical evidence. Basic economic common sense tells us that investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not lend to such firms without compensation for the risks posed by management's lack of accountability. As a result, those firms' cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from adopting excessively pro management statutes. The empirical research bears out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time. A study by Yale law professor Roberta Romano of corporations changing their domicile by reincorporating in Delaware, for example, found that such firms experienced statistically significant positive stock price gains. In other words, reincorporating in Delaware increased shareholder wealth. This finding strongly supports the race to the top hypothesis. If shareholders thought that Delaware was winning a race to the bottom, shareholders should dump the stock of firms that reincorporate in Delaware, driving down the stock price of such firms. As Romano found, and all of the other major event studies confirm, there is a positive stock price effect upon reincorporation in Delaware. (For a good summary of the research, see Roberta Romano, The Advantage of Competitive Federalism for Securities Regulation.) Additional support for this conclusion is provided by state takeover regulation. Compared to most states, which have adopted multiple anti-takeover statutes of ever-increasing ferocity, Delaware's single takeover statute is relatively friendly to hostile bidders. An empirical study of state corporation codes by Harvard law professor John Coates confirms that the Delaware statute is the least restrictive and imposes the least delay on a hostile bidder. Given the clear evidence that hostile takeovers increase shareholder wealth, this finding is especially striking. The supposed poster child of bad corporate governance, Delaware, turns out to be quite takeover-friendly and, by implication, equally shareholder-friendly. According to the Supreme Court's CTS decision, the country as a whole benefits from the fact that this area is regulated by the states rather than the federal government. As Justice Powell explained, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis pointed out many years ago, "It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country." So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead may lead to more efficient corporate law rules. In contrast, the uniformity imposed by rules like those proposed by Pozen will preclude experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed -- no "laboratory" of federalism. Instead, we will be stuck with rules that may well be wrong from the outset and, in any case, may quickly become obsolete. In conclusion, the SEC should promptly toss Pozen's proposals into the circular file. This is an area best left to the states.
(2) If adopted, the proposal may deter qualified individuals from being willing to serve as a member of the board. There will be a significant risk that activist investors will use the rule frequently and at numerous companies. Unlike the current system, under the rule, the activists will be targeting individual investors. Who would want to serve as a director if there is a significant risk one might be singled out for a smear campaign by unhappy investors? (Granted, the effect may only be at the margins, but many companies report that in light of the director liabilities created by Sarbanes-Oxley they are already having a hard time attracting independent directors.)
(3) The presence on the board of a single shareholder-approved director likely will have a highly disruptive effect on the board's decisionmaking processes. Granted, some firms might benefit from the presence of skeptical outsider viewpoints. The analogy to cumulative voting, however, suggests that such benefits will be rare. It is well-accepted that cumulative voting tends to promote adversarial relations between the majority and the minority representative. On such boards, the majority tends to resort to pre-meeting caucuses at which decisions are worked out. In addition, management tends to restrict the flow of information to such boards, out of concern that the minority will use confidential firm information for improper purposes. A chief indirect cost of the proposed compromise therefore will be less effective governance.
(4) Finally, and perhaps most disturbingly, there is still nothing in the reported compromise that would limit the rule to situations in which the targeted board is clearly dysfunctional. Instead, it apparently still applies to all public corporations, whether their internal governance is good, bad, or just indifferent. Hence, if enough shareholders are disgruntled, for whatever reason, they can force a vote. This makes no sense. The point of the rule, supposedly, is to restore investor confidence by ensuring good corporate governance. But if firms are well-managed why put them to the expense and bother of a shareholder nomination contest?
Several recent major SEC rules were adopted by a 3-2 vote, with SEC Chairman Donaldson (a Republican) siding with the Commission's two Democrats against his two fellow Republicans. It's been reported that Chairman Donaldson doesn't want to see that happen to this particularly controversial rule. Potential dissenters Glassman and Atkins thus may have significant leverage. If they can't use it to kill the proposal, they should use at the very least use it to emasculate the rule so that it does as little damage to corporate governance as possible.
