The usual suspects are quite worried:
Shareholder Proposals Threatened by Financial Reform Bill the House Passedhttps://t.co/d704jUuihc pic.twitter.com/RmlZLLSGYV
— Consumer Reports (@ConsumerReports) June 12, 2017
Me? Not so much. I made the case for pruning the rule in my article Revitalizing SEC Rule 14a-8's Ordinary Business Exemption: Preventing Shareholder Micromanagement by Proposal (March 29, 2016). UCLA School of Law, Law-Econ Research Paper No. 16-06. Available at SSRN: https://ssrn.com/abstract=2750153:
As many courts and commentators have recognized, the SEC proxy rules seek to effectuate a scheme of “corporate democracy.”[1] SEC Rule 14a-8—the so-called shareholder proposal rule—is a central tool for accomplishing that goal.[2] In brief, the rule permits a qualifying shareholder of a public corporation registered with the SEC to force the company to include a resolution and supporting statement in the company’s proxy materials for its annual meeting.[3] To be sure, most of these proposals are phrased as recommendations,[4] but they nevertheless have become a powerful tool for influencing corporate decision making.[5]
The SEC’s efforts in this area are wholly inconsistent with the corporate governance structure created by state law. To be sure, the SEC and its supporters claim that the proxy rules simply make effective rights shareholders have under state law,[6] but in fact shareholder control rights under the latter are extremely limited.[7] Indeed, under state law, the shareholders’ “play an essentially passive and reactive role.”[8] Instead, decision-making authority is vested in the board of directors, which typically delegates much of that authority to corporate officers and employees.[9] As such, the corporation can hardly be described as a democracy.[10]
As I have argued elsewhere at book length, the separation of ownership and control is not a bug, but rather an essential feature of corporate governance.[11] Indeed, numerous commentators now accept that “corporate governance is best characterized as based on ‘director primacy.’”[12] In particular, there is growing agreement that “Delaware jurisprudence favors director primacy in terms of the definitive decision-making power, while simultaneously requiring directors to be ultimately concerned with the shareholders’ interest.”[13] Once again, it seems appropriate to recount the basic normative argument in favor of director primacy for the benefit of new readers, while keeping the statement as brief as possible and incorporating by reference works in which the argument is laid out in detail.[14]
As Kenneth Arrow explained in work that provided the foundation on which the director primacy model was constructed, all organizations must have some mechanism for aggregating the preferences of the organization’s constituencies and converting them into collective decisions.[15] These mechanisms fall out on a spectrum between “consensus” and “authority.”[16] Consensus-based structures are designed to allow all of a firm’s voting stakeholders to participate in decision making.[17] Authority-based decision-making structures are characterized by the existence of a central decision maker to whom all firm employees ultimately report and which is empowered to make decisions unilaterally without approval of other firm constituencies.[18] Such structures are best suited for firms whose constituencies face information asymmetries and have differing interests.[19] It is because the corporation demonstrably satisfies those conditions that vesting the power of fiat in a central decision maker—i.e., the board of directors—is the essential characteristic of its governance.[20]
Shareholders have widely divergent interests and distinctly different access to information.[21] To be sure, most shareholders invest in a corporation expecting financial gains, but once uncertainty is introduced shareholder opinions on which course will maximize share value are likely to vary widely.[22] In addition, shareholder investment time horizons vary from short-term speculation to long-term buy-and-hold strategies, which in turn is likely to result in disagreements about corporate strategy.[23] Likewise, shareholders in different tax brackets are likely to disagree about such matters as dividend policy, as are shareholders who disagree about the merits of allowing management to invest the firm’s free cash flow in new projects.[24]
As to Arrow’s information condition, shareholders traditionally lacked incentives to gather the information necessary to actively participate in decision making.[25] A rational shareholder will expend the effort necessary to make informed decisions only if the expected benefits outweigh the costs of doing so.[26] In light of the length and complexity of corporate disclosure documents, the effort incurred by shareholders in making informed decisions is quite high (as are the opportunity costs).[27] In contrast, the expected benefits of becoming informed are quite low, as most shareholders’ holdings are too small to have significant effect on the vote’s outcome.[28] Accordingly, corporate shareholders are rationally apathetic.[29]
Many commentators argue that the rise of institutional investors radically changes the foregoing analysis, arguing that such investors have greater abilities to gather information and superior incentives to do so vis-à-vis retail investors.[30] There is no doubt that institutional investors—or, more precisely, a subset thereof—have become more active in corporate governance.[31] Yet, many classes of institutional investors remain mostly passive or, at best, followers.[32] In addition, important classes of the most active institutions—most notably government and union pension funds—have strong incentives to pursue private benefits at the expense of other investors.[33] Finally, as discussed below, hedge fund activism increasingly tends to entail micromanagement of decisions they are poorly equipped to make.[34]
In sum, the public corporation succeeded in large part because it provides a hierarchical decision-making structure well suited to the problem of operating a large business enterprise with numerous employees, managers, shareholders, creditors, and other inputs. [35] In such an enterprise, someone must be in charge: “Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success.”[36] As we have seen, that someone is the board of directors, not the shareholders.[37]
Strong limits on shareholder control are essential if that optimal allocation of decision-making authority is to be protected.[38] This includes both limits on direct shareholder decision making and limits on shareholder oversight of the board, because giving shareholders a power of review differs little from giving them the power to make management decisions in the first place.[39] As Arrow explained:
Clearly, a sufficiently strict and continuous organ of [accountability] can easily amount to a denial of authority. If every decision of A is to be reviewed by B, then all we have really is a shift in the locus of authority from A to B and hence no solution to the original problem. [40]
In principle, Rule 14a-8 contains protections designed to prevent it from being used as a tool for effectuating a shift in the locus of corporate decision making from the board to the shareholders. As the D.C. Circuit explained, the rule’s drafters recognized that “management cannot exercise its specialized talents effectively if corporate investors assert the power to dictate the minutiae of daily business decisions.”[41] Accordingly, the Rule contains several eligibility requirements designed to ensure that shareholder proponents have some minimum amount of skin in the game.[42] In addition, the Rule contains 13 substantive bases for excluding a proposal.[43]
The substantive ground for exclusion most directly relevant for present purposes is Rule 14a-8(i)(7), which permits exclusion of proposals relating to ordinary business operations.[44] This exemption is intended to “to relieve the management of the necessity of including in its proxy material security holder proposals which relate to matters falling within the province of management.”[45] Specifically, Rule 14a-8(i)(7) permits exclusion of a proposal that “seeks to ‘micro-manage’ the company by probing too deeply into matters of a complex nature upon which shareholders, as a group, would not be in a position to make an informed judgment.”[46]
[1] See, e.g., Med. Comm. for Human Rights v. Sec. & Exch. Comm'n, 432 F.2d 659, 674 (D.C. Cir. 1970), vacated as moot, 404 U.S. 403 (1972) (noting “the concepts of corporate democracy embodied in the proxy rules”); Frank D. Emerson & Franklin C. Latcham, Further Insight into More Effective Stockholder Participation: The Sparks-Withington Proxy Contest, 60 Yale L.J. 429, 430 (1951) (citing the proxy contest at The Sparks-Withington Company as providing “examples of how the SEC's proxy rules in general promote ‘corporate democracy’”); Note, Disclosure of Payments to Foreign Government Officials Under the Securities Acts, 89 Harv. L. Rev. 1848, 1855 (1976) (“The Securities Exchange Act also reflects an intent to promote shareholder democracy in its authorizing the SEC to regulate proxy solicitation.”
[2] See Daniel E. Lazaroff, Promoting Corporate Democracy and Social Responsibility: The Need to Reform the Federal Proxy Rules on Shareholder Proposals, 50 Rutgers L. Rev. 33, 37 (1997) (arguing that “the SEC has attempted to strike the difficult balance between enhancing corporate democracy through Rule 14a-8 and preventing undue harassment of, or interference with, the primary profit-making function of American business”); cf. Frank H. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law 85-86 (1991) (arguing that Rule 14a-8 is actually an “anti-democratic device”).
[3] For a more detailed overview of Rule 14a-8 and its various requirements, see Stephen M. Bainbridge, Corporate Law 294-302 (3rd ed. 2015).
[4] SEC Rule 14a-8(i)(1) allows the corporation to exclude from its proxy statement any proposal that “is not a proper subject for action by shareholders under the laws of the jurisdiction of the company's organization.” 17 CFR § 240.14a-8(i)(1). In a note on that provision of the Rule, however, the SEC takes the position “most proposals that are cast as recommendations or requests that the board of directors take specified action are proper under state law. Accordingly, [the SEC] will assume that a proposal drafted as a recommendation or suggestion is proper unless the company demonstrates otherwise.” Id.
[5] See Thomas Lee Hazen & Lissa Lamkin Broome, Board Diversity and Proxy Disclosure, 37 U. Dayton L. Rev. 39, 45 (2011) (observing that “the shareholder proposal rule has proven a powerful tool for shareholders desiring to voice concerns”).
[6] See Roosevelt v. E.I. DuPont de Nemours & Co., 958 F.2d 416, 421 (D.C. Cir. 1992) (stating that Congress intended that the SEC’s proxy rules “bolster the intelligent exercise of shareholder rights granted by state corporate law”).
[7] See Dooley, supra note 5, at 181 (explaining that shareholders “have no authority to initiate action on such fundamental questions as whether the corporation shall setts its assets, merge with another firm or, under most statutes, even amend its charter”).
[8] Id.
[9] See supra notes 6-8 and accompanying text (discussing the board of directors’ governance role).
[10] See supra note 3 and accompanying text (noting the undemocratic nature of the corporation).
[11] See generally Stephen M. Bainbridge, The New Corporate Governance in Theory and Practice (2008) (describing the corporate governance model known as director primacy).
[12] Larry Ribstein, Why Corporations?, 1 Berkeley Bus. L.J. 183, 196 (2004). See generally Jean Jacques du Plessis et al. Principles of Contemporary Corporate Governance 9 (2d ed. 2011) (“Until very recently, the ‘shareholder primacy model’ and ‘stakeholder primacy model’ of corporate governance have been the most prominent models, but Stephen Bainbridge, in his excellent work, The New Corporate Governance in Theory and Practice, analyses these theories and provides some exciting new perspectives on corporate governance models by expanding on the ‘director primacy model’ that he developed recently.”); Seth W. Ashby, Strengthening the Public Company Board of Directors: Limited Shareholder Access to the Corporate Ballot vs. Required Majority Board Independence, 2005 U. Ill. L. Rev. 521, 533 (“Although theorists have long debated how to best describe the public company, a new theory of the firm has emerged that appears more complete than its predecessors: Professor Stephen M. Bainbridge’s model of director primacy.”).
[13] Kevin L. Turner, Settling The Debate: A Response To Professor Bebchuk’s Proposed Reform Of Hostile Takeover Defenses, 57 Ala. L. Rev. 907, 927–28 (2006). Turner goes on to note that “the Delaware jurisprudence, while not explicitly affirming ‘director primacy,’ does implicitly leave the directors to make decisions with shareholders expressing their views only in specific and limited situations.” Id. at 928.
[14] As a critic of the director primacy model observed, “the exigencies of law review scholarship entail repeating the same argument in multiple articles before going on to apply that argument to specific topics.” Brett McDonnell, Professor Bainbridge and the Arrowian Moment: A Review of The New Corporate Governance in Theory and Practice, 34 Del. J. Corp. L. 139, 141 (2009). Accordingly, as Michael Paulsen observed in a similar situation, “[t]he result is a certain amount of borderline-self-plagiarism, for which I hereby apologize—and which this general footnote hopefully mitigates to the extent necessary ….” Michael Stokes Paulsen, The Priority of God: A Theory of Religious Liberty, 39 Pepp. L. Rev. 1159 1162 n.5 (2013).
[15] See Kenneth J. Arrow, The Limits of Organization 68-69 (1974) (discussing organizational decision making).
[16] Id.
[17] See Michael P. Dooley & E. Norman Veasey, The Role of the Board in Derivative Litigation: Delaware Law and the Current Ali Proposals Compared, 44 Bus. Law. 503, 520 (1989) (arguing that the “decisional default rules of partnership law, which emphasize the partners' equal rights to participate in the management of the business, closely resemble Arrow's Consensus model”).
[18] See Arrow, supra note 60, at 69 (providing examples of authority-based decision-making structures).
[19] See McDonnell, supra note 59, at 154 (“Consensus works where all team members have identical interests and identical information.”).
[20] See id. (“In a large corporation, no major constituency group comes close to achieving identical interests or identical information.”); see also Dooley & Veasey, supra note 62, at 520 (explaining that “the statutory scheme of centralizing corporate authority in the board and relegating the stockholders to a passive role is intended to economize on the costs of decisionmaking within the firm”).
[21] See generally Iman Anabtawi, Some Skepticism About Increasing Shareholder Power, 53 UCLA L. Rev. 561, 579-93 (2006) (setting out a number of ways in which shareholders' interests may conflict). In addition to Arrow’s information and incentive criteria, an Authority-based decision-making structure is essential to the public corporation due to the collective action problems inherent in attempting to involve many thousands of decision makers, which necessarily prevent shareholders from operating the corporation by consensus. See Jana Master Fund, Ltd. v. CNET Networks, Inc., 954 A.2d 335, 340 (Del. Ch. 2008) (noting that, “with ownership diffused among so many holders, there exists a problem of collective action”).
[22] See Anabtawi, supra note 66, at 578 n.76 (explaining that “differences of opinion over how to maximize shareholder value” is a source of “shareholder division”).
[23] See Martin Lipton & William Savitt, The Many Myths of Lucian Bebchuk, 93 Va. L. Rev. 733, 744-46 (2007) (explaining why shareholders often have different time horizons for maximization).
[24] See Anabtawi, supra note 66, at 578 n.76 (explaining that shareholders can have differing “preferences for income versus growth and tax status”).
[25] See Keith N. Hylton, An Economic Theory of the Duty to Bargain, 83 Geo. L.J. 19, 77 (1994) (“Both the excessive cost of keeping all the shareholders informed and the individual shareholders' “free rider” incentive to let the other shareholders bear the costs of participating in corporate affairs induce rationally apathetic shareholder behavior towards corporate decisions.”).
[26] See Jana Master Fund, Ltd. v. CNET Networks, Inc., 954 A.2d 335, 340 (Del. Ch. 2008) (“Individual investors have too little ‘skin in the game’ to rationally devote the time and energy necessary to keep themselves aware of the details of the corporation’s performance or to campaign for corporate change.”).
[27] Zohar Goshen, Shareholder Dividend Options, 104 Yale L.J. 881, 902 (1995) (observing that “the costs of shareholder voting include the cost of informing shareholders and opportunity costs”).
[28] Patrick J. Straka, Executive Compensation Disclosure: The SEC's Attempt to Facilitate Market Forces, 72 Neb. L. Rev. 804, 835 (1993) (arguing that small shareholders' costs will outweigh the benefits of making an informed decision).
[29] See Jana Master Fund, 954 A.2d at 340 (observing that “most shareholders are rationally apathetic”).
[30] See, e.g., Lee Harris, The Politics of Shareholder Voting, 86 N.Y.U. L. Rev. 1761, 1785-86 (2011) arguing that “institutional investors ... do not need shorthand to sort through information that may be expensive, or otherwise difficult, to procure. Rather, these institutions have the resource, the ability, and the duty to stay apprised of the content of shareholder proposals.”); Joseph W. Yockey, On the Role and Regulation of Private Negotiations in Governance, 61 S.C. L. Rev. 171, 181 (2009) (“Through their large holdings, institutional investors are thought to be able to overcome the rational apathy problem presented by diffuse individual shareholders.”); cf. Jill E. Fisch, Class Action Reform Lessons from Securities Litigation, 39 Ariz. L. Rev. 533, 540-541 (1997) (arguing institutional investors are better situated that retail investors to monitor corporations).
[31] See Pamela Park, Corporate Governance 2013: Shareholder Activists Demand Voices in the Boardroom and Changes to Corporate Strategy, Westlaw Corp. Gov. Daily Briefing, 2014 WL 241758 (Dec. 26, 2013) (“Shareholder activists took an increasingly prominent role in corporate governance this year, as companies in a whole range of industries faced pressure from hedge funds and institutional investors to make leadership and strategic changes.”).
[32] See Roberta Romano, Less Is More: Making Institutional Activism A Valuable Mechanism of Corporate Governance, 18 Yale J. Reg. 174, 179 (2001) (“The fact that in contrast to public pension funds, private pension and mutual funds do not engage in activism has been explained by the competitive nature of the industry, or more pejoratively, as cost-conscious private funds' free-riding on the expenditures of activist public funds.): Anna Sandor, Leveraging International Law to Incentivize Value-Added Shareholding: Why Foreign Sovereign Wealth Funds Still Matter and How They Can Improve Shareholder Governance, 46 Geo. J. Int'l L. 947, 961 (2015) (“Other institutional investors, such as mutual funds, are similarly critiqued for their penchant for passive investment.”).
[33] See Romano, supra note 77, at 231-32 (discussing incentives of managers of such funds to pursue private benefits).
[34] See infra Part II.
[35] Given the collective action problems inherent with such a large number of potential decision makers, the differing interests of shareholders, and their varying levels of knowledge about the firm, it is “cheaper and more efficient to transmit all the pieces of information to a central place” and to have the central office “make the collective choice and transmit it rather than retransmit all the information on which the decision is based.” Arrow, supra note 60, at 68-69.
[36] Id. at 69.
[37] See supra notes 3-6 and accompanying text (discussing allocation of decision-making authority within the corporation).
[38] If the foregoing analysis has explanatory power, it might fairly be asked, why do we observe any shareholder voting rights at all? For a discussion of that question, explaining why corporate law allows only shareholders to participate in corporate decision making (to the limit extent it does so) and not other constituencies, see Stephen M. Bainbridge, The Case for Limited Shareholder Voting Rights, 53 UCLA L. Rev. 601, 603-16 (2006).
[39] See John D. Donovan, Jr., Derivative Litigation and the Business Judgment Rule in Massachusetts: Houle v. Low, Boston B.J., Nov./Dec. 1990, at 22, 27 (observing that “the power to review constitutes the power to decide”).
[40] Arrow, supra note 60, at 78.
[41] Med. Comm. for Human Rights v. SEC, 432 F.2d 659, 679 (D.C. Cir. 1970), vacated as moot, 404 U.S. 403 (1972).
[42] See generally Palmiter, supra note 18, at 886 (“Many of the rule’s access conditions seek to ensure an orderly solicitation process so that shareholder proposals do not choke the company-funded proxy mechanism or interfere with management’s solicitation efforts.”). For example, Rule 14a-8(b)(1) limits eligibility to use the rule to shareholders who have owned at least 1% or $2,000, whichever is less, of the issuer’s voting securities for at least one year prior to the date on which the proposal is submitted. 17 CFR § 240.14a-8(b)(1) (2015). Rule 14a-8(c) provides that a shareholder may only submit one proposal per corporation per year. 17 CFR § 240.14a-8(c) (2015). There is no limit to the number of companies to which a proponent can submit proposals in a given year, however, nor is there any limit on the number of proposals a company may be obliged to include in its proxy statement. See Bainbridge, supra note 48, at 296 (discussing eligibility requirements under the Rule).
[43] See 17 CFR § 240.14a-8(i) (2015) (setting out substantive bases for excluding a proposal); see generally Palmiter, supra note 1812, at 888 (explaining that the substantive exemptions “of Rule 14a-8 filter out vexatious, illegal, deceptive, and unintelligible proposals.”). If the registrant believes the proposal can be excluded from its proxy statement, it must notify the SEC that the registrant intends to exclude the proposal. See 17 C.F.R. § 240.14a-8(j)(1) (2015) (“If the company intends to exclude a proposal from its proxy materials, it must file its reasons with the Commission no later than 80 calendar days before it files its definitive proxy statement and form of proxy with the Commission.”). A copy of the notice must also be sent to the proponent. Id. If the SEC staff agrees that the proposal can be excluded, it issues a so-called no action letter, which states that the staff will not recommend that the Commission bring an enforcement proceeding against the issuer if the proposal is excluded. See generally Donna M. Nagy, Judicial Reliance on Regulatory Interpretations in SEC No-action Letters: Current Problems and a Proposed Framework, 83 Cornell L. Rev. 921 (1998) (describing the no action process). On the other hand, if the staff determines that the proposal should be included in management’s proxy statement, the staff notifies the issuer that the SEC may bring an enforcement action if the proposal is excluded. Whichever side loses at the staff level can ask the Commissioners to review the staff’s decision. After review by the Commissioners, the losing party can seek judicial review by the United States Circuit Court of Appeals for the District of Columbia, but these reviews are very rare. See Med. Comm. for Human Rights v. SEC, 432 F.2d 659, 666 (D.C. Cir. 1970) (discussing appellate review of SEC review of a staff determination). If management is the losing party at the staff level, it typically acquiesces in the staff’s decision. If the proponent loses at the staff level, the proponent typically seeks injunctive relief in federal district court. See, e.g., Amalgamated Clothing and Textile Workers Union v. SEC, 15 F.3d 254, 257 (2d Cir. 1994) (holding that a proponent who believes that the registrant improperly excluded a proposal may seek judicial in a federal district court).
[44] 17 CFS § 240.14a-8(i)(7) (2015) (permitting exclusion of a “proposal [that] deals with a matter relating to the company's ordinary business operations”).
[45] Notice of Proposed Amendments to Proxy Rules, Exchange Act Release No. 4950, (Oct. 9, 1953).
[46] Apache Corp. v. New York City Employees’ Ret. Sys., 621 F. Supp. 2d 444, 451 (S.D. Tex. 2008) (quoting Amendments to Rules on Shareholder Proposals, 63 Fed. Reg. 29106, 29108 (May 28, 1998)).