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The Securities and Exchange Commission has proposed changes to the federal proxy rules intended to facilitate shareholder nominations of directors.

The concept, often referred to as “shareholder access,” has been the subject of controversy, and proposed SEC rulemaking, since the early 1940s. This new iteration is the third time this decade that the SEC has tried to adopt rulemaking to implement a form of shareholder access.

There are two primary changes proposed by the SEC. The first change would add a new Securities Exchange Act of 1934 Rule 14a-11. This change would require a company to include in its proxy materials director nominees proposed by shareholders who satisfy ownership and certain other requirements, including that the nominating shareholder or group hold at least 1 percent of the stock of the company for at least one year. Second, the SEC has proposed an amendment to Rule 14a-8(i)(8) that narrows the circumstances under which a company may exclude proposals related to elections and nominations for directors.

If adopted, the SEC’s rules would subject nearly all US public companies to the cost of including shareholder nominees in proxy materials to stand for election against the director nominees recommended by the company’s board of directors. In this respect, the proposed rules are likely to have a significant impact on the director nomination process. We believe that they will also increase the number of contested elections in which shareholder nominees stand for election against those recommended by a company’s board of directors. Barring legislative changes, it is likely that the proposals will create challenging legal issues regarding the relationship between federal securities law and state corporate laws.

The proposed rules are set forth in a 250-page release entitled “Facilitating Shareholder Director Nominations.” You may read the release here. Comments on the proposal are due by August 17, 2009.

Background

The concept of shareholder access is not new. In 2003, the SEC proposed a version of proposed Rule 14a-11 setting forth detailed criteria for determining which, and under what circumstances, shareholders or groups would be entitled to propose director nominees, the number of nominees that they could propose and the process for making such nominations.

In 2007, the SEC proposed amending Rule 14a-8 to enable shareholders to include proposals on shareholder director nominations bylaws in company proxy materials when certain conditions were met. This would have effectively allowed shareholders to propose bylaw amendments that, if adopted, could result in contested elections.

These proposals generated widespread controversy. The SEC received thousands of comment letters and held numerous roundtable discussions on the subject. Shareholder groups have generally supported the adoption of rules to facilitate their ability to nominate directors, while companies and their advisors have generally opined that such requirements would, among other matters, impede the proper functioning of boards of directors, increase costs and cause inefficiencies.

The New Shareholder Access Proposal

As proposed, Rule 14a-11 would require companies to include in their proxy materials shareholder nominees for director, under the circumstances summarized below. The rule would apply to most companies subject to the SEC’s proxy rules, including investment companies and voluntary reporting companies. As proposed, the requirements of Rule 14a-11 would not apply to a company if applicable state law or the company’s governing documents prohibits shareholders from nominating candidates for the board of directors. However, as a result of certain proposed amendments to Rule 14a-8(i)(8), shareholders may have an expanded ability to propose removing such prohibitions from a company’s governing documents, as explained in greater detail below.

Shareholder Eligibility. In order to have its nominees included in a company’s proxy materials, the shareholder or group must beneficially own, continuously for at least one year as of the date it provides proper notice of the nomination:

• at least 1 percent of the company’s voting securities for “large accelerated filers” (generally companies with a public float of $700 million or more) or registered investment companies with net assets of $700 million or more;
• at least 3 percent of the company’s voting securities for “accelerated filers” (generally companies with a public float of $75 million or more but less than $700 million) or registered investment companies with net assets of $75 million or more but less than $700 million; or
• at least 5 percent of the company’s voting securities for “non-accelerated filers” (generally companies with a public float below $75 million) or registered investment companies with net assets of less than $75 million.

Limit on Number of Shareholder Nominees. A company may have to include in its proxy materials up to the number of nominees that represents 25 percent of the company’s board of directors. The rule includes detailed procedures in case a company receives more nominees that it is required to include in its proxy materials. If a board already includes a shareholder-nominated director elected under proposed Rule 14a-11 whose term extends past the date of the meeting for which the company is soliciting proxies, in the case of a classified board, such a director would count against this cap. If multiple shareholder nominees are proposed, the company will only be required to include in its proxy materials the first eligible nominee(s) for which it received proper notice.

Nominee Qualifications. Any person may be nominated under proposed Rule 14a-11, provided that his or her candidacy or board membership would not violate controlling state law, the company’s governing documents, federal law, or applicable rules of a securities exchange (other than exchange rules regarding director independence). Shareholder nominees must generally satisfy the objective criteria for “independence” under applicable exchange rules, but subjective independence determinations would not be required.

Filing Requirement for Nominating Shareholders. Shareholders who submit a nominee under proposed Rule 14a-11 would be required to file a notice on new Schedule 14N with the SEC and simultaneously to provide the schedule to the company. Schedule 14N requires disclosure of certain information regarding the nominating shareholder or group and any nominee that is comparable to the disclosure required in an opposition proxy statement in a contested election. The nominating shareholder or group must certify that it does not hold its voting securities for the purpose of or with the effect of changing control of the company or to gain more than a limited number of seats on the board. The Schedule 14N would be required not later than required by the company’s own advance notice provision, or, if there is none, 120 days before the anniversary of the company’s mailing of proxy materials for the previous annual meeting.

Process for Excluding Shareholder Nominees. The proposed rule includes a process by which a company can exclude a shareholder nominee from its proxy materials if the company determines that (a) the rule is not applicable to the company, (b) there has not been compliance with the requirements of the rule, or (c) that any representation required to be included in Schedule 14N is false or misleading in any material respect. The proposed process sets forth rules and timelines regarding notifying the nominating shareholder or group of the exclusion determination, correcting certain eligibility or procedural deficiencies, notifying the SEC of the basis for an exclusion determination and of any shareholder response to the determination, obtaining a no-action letter stating the SEC staff’s informal views regarding the exclusion and notifying the nominating shareholder or group of the company’s final decision about including or excluding the shareholder nominee.

Other Proposed Rule Changes

The SEC has also proposed changes to other rules and regulations, including existing exemptions from proxy rules and beneficial ownership reporting requirements, that may be affected by the new proposed procedures.

• Rule 14a-8(i)(8)

Existing Rule 14a-8 allows a qualifying shareholder to submit a proposal at a shareholder meeting, although existing Rule 14a-8(i)(8) allows management to exclude such a proposal if it “relates to a nomination or an election for membership on the company’s board of directors . . . or a procedure for such nomination or election.” The SEC staff has interpreted this so-called “election exclusion” to permit companies to exclude shareholder access bylaw amendments.

The SEC has proposed amending Rule 14a-8(i)(8) to require companies to include in their proxy materials proposals to amend, or request an amendment to, a company’s governing documents regarding nomination procedures or disclosures related to shareholder nominations, provided the proposal does not conflict with proposed Rule 14a-11.

Proposed Rule 14a-8(i)(8) would permit a company to exclude a director nomination proposal in certain circumstances, including that the proposal:

• Would disqualify a nominee standing for election;
• Would remove a director from office before his or her term expired;
• Questions the competence, business judgment or character of one or more nominees or directors;
• Nominates a specific individual for election, other than pursuant to Rule 14a-11, an applicable state law provision, or a company’s governing documents; or
• Otherwise could affect the outcome of the upcoming election of directors.

Unlike the prior proposed changes to this rule, the current changes do not impose any additional ownership requirements beyond those already required by this rule. If the SEC adopts Rule 14a-11 in substantially the form proposed, it is likely that the significance of Rule 14a-8(i)(8) would be greatly diminished.

• Related amendments to proxy rules and Schedule 13G filing requirements

The SEC also proposed a number of related amendments intended to facilitate shareholder access, including amendments to enable shareholders to engage in limited solicitations to form nominating shareholder groups and engage in solicitations in support of their nominees without disseminating a proxy statement. Under the proposed changes, inclusion of a shareholder nominee in the company’s proxy materials would not require the company to file a preliminary proxy statement, provided that the company was otherwise qualified to file directly in definitive form. In this regard, the proposed rules make clear that inclusion of a shareholder nominee would not be deemed a solicitation in opposition.

Furthermore, a nominating shareholder and each member of a nominating shareholder group would be subject to liability for any statement that is false or misleading that is included in a company’s proxy materials, either pursuant to the federal proxy rules, an applicable state law provision, or a company’s governing documents as they relate to including shareholder nominees for director in company proxy materials. In addition, a company would not be responsible for such shareholder-provided information, unless the company knows or has reason to know that the information is false or misleading, and such information would not be incorporated by reference into any filing under the Securities Act of 1933, as amended, the Exchange Act, or the Investment Company Act of 1940, as amended, unless the company specifically determines to incorporate such information by reference into a filing.

In addition, the SEC has proposed amendments to allow beneficial owners of more than 5 percent of a company’s securities to file short-form beneficial ownership reports on Schedule 13G rather than Schedule 13D, regardless of activities in connection with a nomination under proposed Rule 14a-11.

SEC officials have noted that they would like to adopt the final rules in time for the 2010 proxy season. Given the intense debate surrounding shareholder access issues, however, it remains to be seen whether the SEC can meet that aggressive schedule.

Shareholder Access Proposal Likely to Elicit Heated Debate

The SEC’s new shareholder access proposal is almost certain to elicit extensive debate. The SEC has acknowledged that there are “competing concerns” and “long-held and deeply felt views” in opposition of shareholder access, and in its 250-page proposing release it summarizes several of these concerns.

While the SEC has characterized its proposal as designed “to remove impediments the federal proxy rules create to shareholders’ exercise of their rights to nominate and elect members of boards of directors,” those who oppose new shareholder access rules contend that it is not immediately obvious that compelling nearly all US public companies to incur the cost of including shareholder nominees in proxy materials, to stand for election against those recommended by a company’s board of directors, is or ought to be a shareholder right.

With other shareholder access proposals on the table or in the works, from currently proposed federal statutory changes in this area, pending rulemaking proposals by stock exchanges on related topics such as discretionary voting, the recent adoption of state law innovations on shareholder access, and increased voluntary company adoption of shareholder access bylaws, the debate again promises to be a heated one. While it remains to be seen whether the SEC will attempt to take action on the proposal in time for 2010 proxy season, we will continue carefully monitoring relevant developments to help public companies plan for their potential impact.