Securities and Exchange Commission: Transforming Rule 14a-8 To Allow Shareholders Increased Voting Power

by Naureen Amjad October 31 2008, 15:51


While the decision of the Second Circuit Court of Appeals binds many public companies of that specific jurisdiction, the SEC must now decide whether to propose a clarifying change to Rule 14a-8(i)(8) ("the Rule"), binding all companies subject to Federal Securities Law and alleviating courts of difficult interpretation. A letter from shareholders to the Honorable Christopher Cox, requesting a return to the pre-1990 interpretation of the Rule, stressed an important distinction: ". . . between using a shareholder resolution as a back-door device to contest a specific election and using a shareholder resolution in order to change the rules for election so as to further the long-term interests of shareholders."[1] It is this distinction which also divides the opinions of Stephen Bainbridge, Margaret Blair and Lynn Stout on one side from those of Lucian Bebchuk. Bainbridge, Blair and Stout espouse theories such as "director primacy" and hold views opposing the shareholder primacy norm.[2] Their views appear to coincide with a decision against shareholder resolutions as a means to undermine a board’s power through elections. Their views appear to greatly differ from those of Bebchuk’s, who proposes allowing shareholders to alter "rules-of-the-game" decisions or else elect a new team of directors who will.[3] This report will use Bainbridge, Blair and Stout’s theories in support of an amendment seeking to expand the rule’s exclusions regarding shareholder proposals to limit shareholders’ input dealing with elections in general, while Bebchuk’s theories will be relied upon to amend the Rule in order to empower shareholders.[4] This assumption arises primarily from a grand simplification of both groups’ views: "director primacy" v. "shareholder primacy norm," respectively and this report will utilize their theories to weigh the arguments in favor and in opposition to an amendment.

II. Analysis

A revision to the Rule proposed by the SEC, if taking into account American International Group’s (“AIG”) arguments, would ultimately seek to reduce shareholders’ rights in initiating “permitted” changes to the bylaws.[5] The American Federation of State, County & Municipal Employees (“AFSCME”) submitted for inclusion in the 2005 proxy statement, a shareholder proposal requiring publication of shareholder-nominated candidates for director positions.[6] Rather than suggesting nominees for the purpose of opposing the nominating committee’s selection of candidates, the shareholder proposal was an attempt to alter procedures for elections in general, instead of causing a “contested contest” in a particular election. Additionally, if the proposal was included in the proxy statement, the board would have had an opportunity to state its reasons for opposition. The shareholder proposal appears not to be a unique one. The shareholder proposal appears quite similar to the one in AOL Time Warner Inc., in which case the SEC initially denied the company’s request for no-action relief in December of 2002, but then subsequently issued a No-Action letter, stating that there “appeared to be some basis” that a contested election could result.[7] The initial letter is one of many which are demonstrative of the SEC implementing its pre-1990 interpretation of the Rule, which the Commission now concedes as a “mistake.”

III. Rationale behind Increasing Shareholder Power

When analyzing Professor Bebchuk’s articles, it becomes apparent that he is in favor of reducing “substantial impediments facing shareholders when they seek to replace incumbent directors.”[8] Instead of relying on intervention by legislators and regulators, he is in favor of enabling shareholders themselves.[9] According to Bebchuk, allowing shareholders the ability to initiate special interest proposals would not give shareholders “blackmail power,” since proposals that were purely designed to advance special interests would not pass by a majority vote.[10] In other words, even if no revision was made to the Rule, nominated candidates who attempted to further their own interests would not garner favor, let alone election to the board. Bainbridge persisted in the fact that such shareholders would still maintain power over the board, due to the board’s uncertainty regarding which proposals would fail and thus, would be inclined to make concessions.[11] Using Bebchuk’s analysis, such concessions would be unnecessary as special interest resolutions (and nominees advancing them) have received little support in the past.[12] Bainbridge also offers the Panglossian argument, which would not promote an amendment in expanding the Rule to exclude any proposal touching upon any facet of elections.[13] Instead, such a theory would actually counter any sort of reform to the Rule, relying instead on the marketplace to produce its own optimal governance terms.[14] Such a standard contractarian approach, however does not explain why federal intervention has altered state laws with rules geared towards protecting investors.[15] Bebchuk explains that without the federal intervention of the last seven decades, shareholders would not have even been as empowered as they are currently.[16] Such a viewpoint does not further a need to amend the Rule to limit shareholders from nominating worthy candidates, but does provide justification in amending the Rule to specify allowing general election procedure information and excluding information regarding specific nominees for the purpose of causing contested elections.

While Bebchuk appears to be in favor of shareholder nominated candidates, he proposes procedural requirements in assuring that holding and owning requirements are met and limits resubmission of defeated proposals.[17] In demonstrating options to the board, he explains that “when confronted by a challenger running on a platform of adopting value-enhancing change … management would likely be able to win by … pledging to initiate the promised change.”[18] Not only would this discourage challengers from initiating a proxy contest in the first place, but provides little justification for amending the Rule. The SEC’s concern in proposing an amendment to the Rule is to make sure the board retains its control and so as not to allow shareholders’ nominees to cause contested elections; however, this is hardly a concern considering electoral challenges to the board’s candidates are currently negligible.[19]

IV. Rationale behind Limiting Shareholder Power

Utilizing Bainbridge’s rationale, limiting shareholder proposals like AFSCME’s through an amendment would seem inevitable, as he considers this the “majoritarian default.”[20] Such a default rule assumes shareholders to be “rationally apathetic” and lacking incentive to actively participate in decision-making.[21] Bainbridge’ reasoning does not take into account those shareholders, such as AFSCME’s who desire to initiate change to the bylaws. Instead, Bainbridge assumes most shareholders will passively acquiesce to candidates proposed by the board.[22] While it is true that activist institutional investors were not previously the norm, due to the length and complexity of disclosure documents, it is apparent that informed shareholders are now trying to get more involved, and it is necessary to clarify what their particular rights are in terms of elections. However, Bainbridge notes that active investor involvement in corporations would disturb the very essence of practicality: “centralization of essentially non-reviewable decision-making authority in the board.”[23] In his opinion when managers do put their own interests before shareholders it is simply for fear of being voted off the board and such a situation permits resistance to proxy contest reform.[24] This justification, however, is difficult to reconcile since shareholders may still vote on the removal of directors, without attempting to reform the proxy contest.[25] Bainbridge’s view regarding shareholders is best depicted through one rather controversial statement: “Shareholder voting is properly understood not as a primary component of the corporate decision-making structure, but rather as an accountability device of last resort, to be used sparingly, at most.”[26]

Turning now to Blair and Stout’s article, it is clearly in favor of management with somewhat more complex theories than Bainbridge’s. Instead of focusing on the usual struggle between the board and shareholders, Blair and Stout study a team production model comprised of shareholders, management, employees and even creditors.[27] It is this team which the board, as a “mediating hierarchy,” is designed to protect, and not the shareholders interests alone. Such a theory dispels the board as agents of shareholders and defines the board as the “trustees” of the team. Such a theory supports allowing an amendment to the Rule in favor of the board, if the amendment would also benefit other members of the team; however, this would be a drastic change from current thought, which focuses on the shareholder primacy norm. This “trustee” rationale appears somewhat similar to the business judgment rule in that it would argue the board was acting in good faith when serving the team and such an argument cannot normally be successfully contested.[28] As boards are often thought to know more about what ails their respective corporations than courts, an amendment to the Rule in favor of the board would most likely not be countered by shareholders, since the board could use the business judgment rule as its defense. While it has often been suggested that “shareholder delegation of decision-making authority to the board is in the shareholders’ best interests” in regards to efficiency and sound judgment, boards must consider the rise of informed and outspoken shareholders. And even if by chance these intelligent shareholders nominate a sub-par nominee to the board, according to Bebchuk, such a nominee would never even gain majority vote and could be kept from re-appearing in the next year’s proposal by failing the “two meeting rule.”[29] However, when the board acts as a “trustee” towards shareholders, as well as other employees on the “team,” it does not treat shareholders any different from those who are mere staff employees. If this were the case in practice, both employees of corporations as well as creditors, would be allowed voting rights. One potential issue with such a scheme would be mass confusion regarding the differentiation between debt and equity and the fact that bondholders are given priority through fixed payments, whereas shareholders are traditionally given voting rights as owners of the corporation. In such a scheme, creditors would be given the best of both worlds (voting/ ownership rights and fixed payments), leaving shareholders owning perhaps ten percent of the company, without much to show. Such chaos may cause shareholders to remove themselves from the “team” and seek higher opportunity costs elsewhere.

Blair and Stout hold an interesting view on derivative suits in that they do not give rights to shareholders per se, but to the corporation itself. In other words, shareholders are not given rights to sue for themselves, but for the corporation or “team” to whom case law finds fiduciary duties to be owed.[30] The explanation offered by the two professors that the business judgment rule negates the shareholder primacy norm, thus negating the board’s status as an agent, seems to be a reason for empowering shareholders. Since according to such a theory, the board does not owe any fiduciary duties, such as the duty of loyalty to the shareholders, they must resort to amending bylaws and nominating candidates who will look out for their interests. Such theories if proposed to the shareholders themselves, would cause great concern and would force the shareholders into taking on an “everyone-for-himself” sort of approach to survive. I think the appropriate question that arises in anyone’s mind at this point is, “why give shareholders any rights regarding the election process at all?” To which Blair and Stout have prepared an answer: to act as a mere safety net in extreme misconduct situations.[31] What these scholars appear to be conclusively stating is that shareholders’ voting rights are of such little value that they are unlikely to influence outcomes; but, if this is true, then why not allow shareholders the satisfaction in thinking they are nominating candidates to the board, while in actuality no real threat of overthrow could arise?

V. Recommendation

My primary recommendation to the SEC would be to amend the Rule by in favor of expanding shareholders’ rights in regards to elections. I believe an amendment would be a more efficient alternative than to force controversial proposals to be resolved in lengthy lawsuits. Cases such as Bebchuk v. CA, Inc. and Gen. Datacomm Indus., Inc. v. State of Wis. Inves. Bd. have already demonstrated courts’ unwillingness to review unripe situations and this provides an even greater incentive to corporations to rely on internal problem-solving.[32] This way, boards would be bound by the new clearly-stated Rule and would most likely be deterred from attempting to circumvent the law by soliciting a No-Action letter from the SEC. It would be inefficient for a board to attempt to deny the plainly-written text of the Rule in hopes that the SEC would revert to the pre-1990 interpretation. I strongly concur with the views of the Second Circuit Court Judge, Wesley, in AFSCME v. AIG.[33] The court opined that “an agency’s interpretation of an ambiguous regulation made at the time the regulation was implemented or revised should control unless that agency has offered sufficient reasons for its changed interpretation.”[34] The Rule’s last revision in 1976 was pretty clear in stating the all election-related proposals would not be excluded. This is seen through the exceptions the SEC clearly stated it was not excluding: cumulative voting rights, general qualification for directors and political contributions to the issuer.[35] All of these seem to “relate to an election,” but were permitted in the 1976 interpretation. While the SEC stated that based on the 1976 interpretation, shareholder proposals could be excluded under the election exclusion if they resulted in an “immediate election contest,” a shareholder proposal establishing a process to wage a future election contest would be far from immediate. Rather, it is unknown whether a contested election would even result in the future. However, the SEC seems to have altered the interpretation without any reasoning in 1990 and even then appeared uncertain of the new interpretation, as evidenced by its wavering application through 1998. While it is true that the SEC applied the original interpretation for approximately sixteen years, it can be easily changed so long as some reason is stated beyond mere “mistake.”

We must look at the general purpose of the Rule which appears to have been to allow certain election-related proposals, while excluding those that might result in a contest. Under such a proposed purpose, it seems counterintuitive to refuse proposals such as AFSCME’s, without also excluding the exceptions stated above. These exceptions are very important in that they demonstrate the Commission’s original intent when promulgating the Rule and are indicative of a drastic change in policy from the one in place for sixteen years.

My recommendation would seek to allow general proposals such as AFSCME’s even if ultimately resulting in a contest and exclude proposals intentionally waged to trump the board. While it is important to extend rights to the shareholders of a corporation, such rights must not be limitless. Allowing shareholder proposals on any election-related factor would be far too broad, while excluding the right to contribute to the election process entirely would be too limiting. This would ultimately be a fact-intensive inquiry. Investors need a mechanism with which to replace incumbent directors and such a mechanism will force the directors to make decisions with the shareholders in mind. I am opposed to an amendment to the Rule which would prohibit all information dealing with an election. While the SEC might appear to be satisfied with such an amendment, their real concern seems to be with shareholders’ ability to wage election contests without undertaking a full-blown proxy solicitation.[36] Even though the SEC is justified in thinking that shareholders may be able to bypass full disclosure regarding their nominees by placing such information in a proposal, there is no solid basis for the SEC to believe so. There is no reason to believe that simply because shareholders would have the option of nominating candidates that they would no longer use a proxy to vote for the board’s candidates, or to believe that the shareholder proposal would become a way to “beat the system” so to speak. It would be safe to assume that those eligible of nominating candidates (3% shareholders of a year) would be sophisticated business persons capable of following the same disclosure rules which would apply to the board.

Utilizing the approach that many still take, (despite the theory espoused by Lynn & Stout) shareholders and the board are involved in a principal-agent relationship. It may be argued that the board has actual authority to engage in only those actions which would benefit the shareholders and the implied authority to make secondary decisions leading to the success of the shareholder primacy norm principle. It is already well known that the board holds control regarding the state of incorporation or reincorporation and amendments to the charter. Shareholders also understand that their initiated bylaw amendments may not set solid rules, nor force the board to do anything. However, shareholders must be afforded the opportunity to at least have their proposals included in the proxy statement, along with those of the board. Shareholders derive their primary power from their right to vote. Currently it is one of a reactive nature, allowing shareholders to react to the nominees presented by the board instead of bringing forth their own. Cases like Stahl v. Apple Bancorp, Inc.[37] provide a key example of a board simply working around shareholders’ desires, by postponing a key meeting in which a proxy contest regarding election procedures was to be discussed. It is such tactical strategies taken by boards which necessitate allocating initiative rights to shareholders. Currently, shareholders live and work by the board’s schedule, but hopefully by an amendment to the Rule, shareholders can prove their ability to contribute to the corporation. In applying Bebchuk’s words, we see that “a reform that provides shareholders with the power to make rules-of-the-game decisions would lessen the need for other corporate law reforms.”[38] Without such a reform to give shareholders incentive to participate in the corporations they “own,” there will constantly be need for outside intervention, leading to a self-fulfilling prophecy that shareholders are merely passive bystanders.

[1] Letter from Peter Montagnon, Director of Investment Affairs, Association of British Insurers, to Christopher Cox, Chairman, Securities and Exchange Commission (Oct. 16, 2006) (on file with the SEC).

[2] Margaret Blair & Lynn Stout, A Team Production Theory of Corporate Law, 85 Va. L. Rev. 247 (1999); Stephen Bainbridge, Director Primacy and Shareholder Disempowerment, 119 Harv. L. Rev. 1735 (2006).

[3] Lucian Bebchuk, Case for Increasing Shareholder Power, 118 Harv. L. Rev. 833 (2005); Letting Shareholders Set the Rules, 119 Harv. L. Rev. 1784 (2006).

[4] SEC Rule 14a-8(i)(8) (2006).

[5] Del. Code Ann. tit. 8, § 109(a).

[6] AFSCME v. AIG, Inc., 2006 WL 2667941 (2d Cir. 2006).

[7] No-Action Letter from the SEC, AOL Time Warner Inc., 2003 WL 942784 (2003).

[8] Bebchuk, Set the Rules, supra note 3, at 1785.

[9] Id.

[10] Bebchuk, Increasing Power, supra note 3, at 1799.

[11] Bebchuk, Set the Rules, supra note 3, at 1800.

[12] Id.

[13] Id. at 1805.


[15] Id.

[16] Id.

[17] Bebchuk, Increasing Power, supra note 3, at 871-72.

[18] Id. at 871.

[19] Id. at 856.

[20] Bainbridge, supra note 2, at 1742.

[21] Id. at 1751.

[22] Id.

[23] Id. at 1749.

[24] Id. at 1740.

[25] Del. Code Ann. tit. 8, § 141(k).

[26] Bainbridge, supra note 2, at 1750.

[27] Blair & Stout, supra note 2, at 253.

[28] Smith v. Van Gorkom, 488 A.2d 858 (Del. Sup. Ct. 1985) (providing an exception to the general belief that the business judgment rule is air-tight).

[29] Bebchuk, Increasing Power, supra note 3, at 1871.

[30] Blair & Stout, supra note 2, at 293.

[31] Id. at 312.

[32] Bebchuk v. CA, Inc., 902 A.2d 737 (Del. Ch. 2006); Gen. Datacomm Indus., Inc. v. State of Wis. Inv. Bd., 731 A.2d 818 (Del. Ch. 2006).

[33] See AFSCME, supra note 6.

[34] Id.

[35] Adoption of Amendments Relating to Proposals by Security Holders, Exchange Act Release No. 34-129999, 41 Fed. Reg. 52,994, 52,998 (Nov. 22, 1976).

[36] See AFSCME, supra note 6.

[37] Stahl v. Apple Bancorp., 579 A.2d 1115 (Del. Ch. 1990).

[38] Bebchuk, Increasing Power, supra note 3, at 844.

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