SEC adopts proxy access rules: prepare for changes to the director nomination process

Corporate Governance Alert

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

New Rule 14a-11 requires nearly all US public companies to include in their proxy materials director nominees proposed by shareholders who satisfy ownership and certain other requirements, including that the nominating shareholder or group has held at least 3 percent of the company’s voting power for at least three years.  The SEC has also amended Rule 14a-8(i)(8) to narrow the circumstances under which a company may exclude proposals related to elections and nominations for directors.

After three SEC rulemaking proposals in a decade, eliciting hundreds of comment letters, the SEC adopted the new proxy access rules just one month after the Dodd-Frank Wall Street Reform and Consumer Protection Act clarified the SEC’s authority to do so.  The new rules were adopted by a 3-to-2 vote, with two commissioners providing strong dissents. 

The rules will become effective 60 days after their publication in the Federal Register.  Because new Rule 14a-11 requires shareholders to submit nominees no later than 120 days before the anniversary date of the mailing of the company's proxy statement for the prior year, eligible shareholders will have the ability to submit nominees at companies that mailed their 2010 proxy materials in March 2010.

You may read the SEC’s 451-page adopting release, entitled “Facilitating Shareholder Director Nominations,” here.  

New proxy access Rule 14a-11

Rule 14a-11 requires companies to include in their proxy materials shareholder nominees for director under the circumstances summarized below. The rule applies to all companies that have a class of equity securities subject to SEC proxy rules, including investment companies, controlled companies and voluntary reporting companies.  However, for “smaller reporting companies” (generally, companies with a public float of less than $75 million), the effective date of the rule is delayed for three years.  The rule does not apply to companies that only have registered debt securities and, like the other proxy rules, does not apply to foreign private issuers.  Companies and their shareholders may not “opt out” or adopt more restrictive proxy access standards

A shareholder or group may not nominate a director candidate if applicable state or foreign law or the company’s governing documents (which the SEC release describes as including a company’s charter, articles of incorporation, certificate of incorporation, declaration of trust and/or bylaws, as applicable) prohibit shareholders from nominating candidates for the board of directors.  However, if state or federal law or the company’s governing documents merely impose more restrictive standards, such as a 10 percent ownership threshold, a shareholder or group who meets the requirements of Rule 14a-11 would be able to submit a nominee or nominees for inclusion in the company’s proxy materials pursuant to Rule 14a-11. 

Shareholder eligibility

In order to have its nominees included in a company’s proxy materials, the shareholder or group must hold, and must have held continuously for at least three years as of the date it provides proper notice on new Schedule 14N (discussed below), at least 3 percent of the voting power of the company’s securities.  The shareholder or group must thereafter continue to hold such securities from the date of the notice through the date of the meeting.  This uniform eligibility standard differs from the tiered 1, 3 or 5 percent standard (depending on the size of the company’s public float) that the SEC had proposed. 

For purposes of calculating 3 percent ownership, the nominating shareholder or a member of the nominating group must hold both voting and investment power of the securities.  Loaned securities are counted if the shareholder or a member of nominating group has the right to recall the loaned securities and will do so when notified that the shareholder or group’s nominee will be included in the company’s proxy materials.  Securities sold in a short sale that has not been closed out, and shares borrowed for purposes other than a short sale, are not included.

The nominating shareholder or group may not be holding any of the company’s securities with the purpose, or with the effect, of changing control of the company or to gain a number of seats on the board of directors that exceeds the maximum number of nominees that the company could be required to include under Rule 14a-11.  The nominating shareholder, group or any member of the group may not have any agreement with the company with respect to the nomination.  Nominating shareholders and groups should carefully consider their intentions and their eligibility to use Rule 14a-11, since the new rules will require certifications about these topics and impose liability on them under Section 14(a) of the Exchange Act for false or misleading statements.

Limit on number of shareholder nominees

Rule 14a-11 requires a company to include in its proxy materials at least one shareholder nominee and up to the number of shareholder nominees that represents 25 percent of the total number of company’s board of directors.  In the case of a classified board, the 25 percent limit is calculated based on the total number of board seats even if a lesser number are being voted on at the meeting.  Thus, a shareholder could nominate more than 25 percent of a class up for election in a particular year.  A shareholder-nominated director elected under Rule 14a-11 whose term extends past the date of the meeting for which the company is soliciting proxies counts against this cap, however.  In the case of a company that has multiple classes of voting securities entitled to elect a specified number of directors, a company will be required to include in its proxy materials for a nominating shareholder or group no more than the number of nominees that the nominating shareholder or group’s class is entitled to elect, subject to the 25 percent cap.

Rather than the “first to nominate” standard the SEC had proposed, Rule 14a-11 requires a company to include in its proxy materials the nominee(s) of the nominating shareholder or group with the highest qualifying voting power percentage.  If that shareholder or group does not nominate the maximum number of nominees allowed under the 25 percent cap, the nominee(s) of the nominating shareholder or group with the next highest qualifying voting power percentage would be included, and so on, until the maximum number of nominees is reached or the company exhausts the list of eligible nominees. 

If a company agrees to include as a company nominee the nominee of the shareholder or group with the highest qualifying voting power percentage who is otherwise eligible under Rule 14a-11 to have its nominees included in the company’s proxy materials, a company may count such a nominee toward the 25 percent cap, provided that the nominating shareholder or group filed its notice on Schedule 14N before beginning communications with the company about the nomination.

Nominee qualifications

A shareholder or group’s nominee will not be eligible to be included in a company’s proxy materials if the nominee’s candidacy or, if elected, board membership would violate controlling federal law, state law, foreign law or applicable exchange rules (other than rules regarding director independence), and such violation could not be cured during the time period provided in Rule 14a-11.  Shareholder nominees must satisfy the objective criteria for “independence” under applicable exchange rules, but to the extent such rules require a subjective determination by the company’s board of directors or a group or committee thereof (for example, a requirement that the board of directors determine whether there is a material relationship between the nominee and the company affecting independence), the nominee would not be required to meet the subjective determination of independence as part of the shareholder nomination process.  The nominee also need not comply with a company’s own director qualification standards, although the nominating shareholder or group must disclose whether, to the best of its knowledge, the nominee meets any director qualifications set forth in the company’s governing documents.

  • Practice tip:  A shareholder or group’s nominee will not be “independent” under most stock exchange rules if the nominee only meets objective independence standards and not subjective independence standards.  For example, a nominee will not be independent under NYSE rules unless the company’s board of directors affirmatively determines that the person has no material relationship with the company, and a nominee will not be independent under NASDAQ rules unless the company’s board of directors affirmatively determines that the person does not have a relationship with the company that would impair the person’s independence.  Nominees who do not meet these standards may create challenging issues relating to compliance with applicable requirements for independent director membership on boards and committees.  Companies and nominating shareholders or groups may seek to address these issues through disclosure regarding the nominee.

Filing requirement for nominating shareholders or groups

A shareholder or group who submits a nominee under Rule 14a-11 must file a notice on new Schedule 14N with the SEC and simultaneously provide notice to the company.  Schedule 14N requires disclosure of certain information regarding the nominating shareholder or group and any nominee that is similar to, but somewhat more expansive than, the disclosure required in an opposition proxy statement in a contested election.  Schedule 14N also requires certain information relating to the nominating shareholder or group’s eligibility to rely on Rule 14a-11 and permits the nominating shareholder or group to include a statement in support of the nominee of no more than 500 words, which would be included in the company’s proxy statement.  The nominating shareholder or group must file Schedule 14N no earlier than 150 days, and no later than 120 days, prior to the anniversary of the mailing of the prior year’s proxy materials.

In Schedule 14N, the nominating shareholder or group must certify that it does not have a change in control intent, does not have an intent to gain more than the maximum number of board seats provided for under Rule 14a-11, that it and each of its nominees satisfies the applicable requirements of Rule 14a-11 and that the information set forth in Schedule 14N is true, complete and correct.  Nominating shareholders and groups should carefully consider their ability to make this certification, since they are subject to liability under Section 14(a) of the Exchange Act for false or misleading statements in Schedule 14N.

Unlike in the SEC’s proposed rules, companies may not exclude a nominee if any required representation or certification was false or materially misleading.  

Process for excluding shareholder nominees

Rule 14a-11 includes a process by which a company may exclude a shareholder nominee from its proxy materials if the company determines that the rule is not applicable to the company, the nominating shareholder, group or nominee failed to satisfy the eligibility requirements, or including the nominee would result in the company exceeding the 25 percent limit on the number of shareholder nominees.  The process sets forth rules and timelines regarding notifying the nominating shareholder or group of the exclusion determination, correcting certain deficiencies, notifying the SEC of the basis for an exclusion 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.

  • Practice tip:  Given the timelines in the process, a company should consider requesting staff no-action relief with regard to all nominees that it believes are excludable at the outset and asserting all available bases for exclusion with respect to such nominees at that time.  Note that a company could decide not to request no-action relief with respect to nominees of smaller shareholders because it plans to include the nominee(s) of the shareholder with the highest qualifying ownership percentage in its proxy materials.  However, the company should keep in mind that one or more of such nominee(s) may later withdraw or be disqualified, perhaps due to sales of shares or other changes in circumstances.  If one or more of these nominees is no longer standing for election, the company would be required to include an otherwise eligible nominee submitted by the shareholder or group with the next highest qualifying ownership percentage.  Thus, a late withdrawal or disqualification of one or more nominees could open the door for the nomination of another nominee who might otherwise have been excludable if the company had timely sought no-action relief with regard to the next potential nominee.

Related amendments to proxy rules and Schedule 13G filing requirements

In connection with new Rule 14a-11, the SEC also amended other rules, including existing exemptions from proxy rules and beneficial ownership reporting requirements, intended to compliment and facilitate the new proxy access regime.

Rule 14a-8(i)(8)

Rule 14a-8 allows a qualifying shareholder to submit a proposal at a shareholder meeting, although Rule 14a-8(i)(8) historically allowed 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.”  This so-called “election exclusion” historically permitted companies to exclude shareholder-proposed proxy access bylaw amendments.

The SEC has amended Rule 14a-8(i)(8) to prevent companies from excluding a proposal seeking to establish a procedure in a company’s governing documents for the inclusion of one or more shareholder nominees for director in the company’s proxy materials.  Additionally, if a company’s governing documents prohibit shareholder nominations, shareholders could seek to amend the provision by submitting a shareholder proposal under Rule 14a-8.  New Rule 14a-8(i)(8) permits a company to exclude a shareholder proposal if it:

  • Would disqualify a nominee who is 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
  • Seeks to include a specific individual in the company’s proxy materials for election to the board of directors, or
  • Otherwise could affect the outcome of the upcoming election of directors

A shareholder proposal could also be excluded under other provisions of Rule 14a-8, such as if its implementation would cause the company to violate any state, federal or foreign law to which it is subject or if the proposal or supporting statement was contrary to any of the SEC’s proxy rules.

Proxy solicitation exemptions

The SEC also adopted two exemptions from the proxy solicitation rules intended to facilitate certain shareholder communications in connection with proxy access.  These include exemptions to enable shareholders to engage in limited solicitations, including oral solicitations, to form nominating shareholder groups and to engage in solicitations in support of their nominees without disseminating a proxy statement.  These amendments limit written communications to specified information and require filings with the SEC under cover of Schedule 14N. 

Inclusion of a shareholder nominee in the company’s proxy materials will not require the company to file a preliminary proxy statement, provided that the company is otherwise qualified to file in definitive form. In this regard, the inclusion of a shareholder nominee will not be deemed a solicitation in opposition.

Nominating shareholder Section 14(a) liability

As noted above, a nominating shareholder and each member of a nominating shareholder group would be subject to liability under Section 14(a) of the Exchange Act 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 it reproduces in its proxy statement, and such information would not be incorporated by reference into any filing under the Securities Act, Exchange Act or Investment Company Act, except to the extent that the company specifically incorporates that information by reference.  The SEC indicates that it will consider such information to be the company’s own statements for anti-fraud and civil liability purposes if the company “otherwise adopt[s] the information as its own,” although it does not expressly state this in the rules.

New Form 8-K triggering event

Since Rule 14a-11 imposes shareholder nomination deadlines tied to the mailing of a company’s proxy statement in the prior year, the SEC has also adopted a new Form 8-K triggering event with respect to any company that did not hold an annual meeting the previous year or that has “changed” the date of its annual meeting by more than 30 calendar days from the date of the previous year’s meeting.  Under new Item 5.08 of Form 8-K, such a company will be required to file a Form 8-K within four business days after the company determines the “anticipated meeting date,” disclosing the date by which a nominating shareholder or group must submit a notice to include a nominee in the company’s proxy materials pursuant to Rule 14a-11, which date must be a reasonable time before the company mails its proxy materials for the meeting.   

  • Practice tip:  The SEC did not indicate what constitutes a company determination of an “anticipated meeting date,” but did indicate that a late filing would result in a company not being current or timely for purposes of form eligibility and the resale of securities.  To avoid the loss of Form S-3 and Form S-8 eligibility, it will be important for a company to establish a clear record of its determination of the meeting date, such as by timely reflecting the determination in resolutions adopted by the board of directors (which generally fix an actual, not “anticipated,” meeting date).  In addition, note that a “changed” meeting date would include both an advanced and a delayed meeting date, consistent with Rule 14a-5(f), which currently requires similar disclosure on Form 10-Q regarding changed meetings.  In this regard, companies should note that Rule 14a-5(f) has not been deleted in the SEC’s new rules.  Accordingly, the new Form 8-K requirement is in addition to the existing obligation to report on the earliest possible Form 10-Q the “new meeting date” when the next annual meeting is advanced or delayed by more than 30 calendar days.

Schedule 13G filing

The SEC also adopted amendments to permit beneficial owners of more than 5 percent of a company’s securities to file short-form beneficial ownership reports on Schedule 13G (assuming the person is otherwise eligible to file on Schedule 13G, such as an institutional or less-than-20-percent investor without a control intent), rather than on Schedule 13D, for activities undertaken solely in connection with a nomination under Rule 14a-11.  However, any activity other than those provided for under Rule 14a-11, such as urging a board to consider strategic alternatives, would make the exception inapplicable, and the exception would not apply to activities in connection with a nomination outside of the Rule 14a-11 process, such as pursuant to applicable state or foreign law or a company’s governing documents.  

The SEC explicitly declined to provide guidance as to whether a nominating shareholder group constitutes a “group” for purposes of Section 13 or Section 16 of the Exchange Act or an “affiliate” under the securities laws.  Accordingly, nominating shareholders need to continue to analyze these issues under existing rules and interpretations based on all relevant facts and circumstances.

Practical considerations regarding proxy access and company bylaws

The new proxy access rules will apply to the 2011 proxy season and will immediately present challenging issues for companies.  In beginning to plan for the impact of the new rules, one important area for most companies and shareholders to consider is how the new proxy rules will interact with the company’s bylaws.  A few specific bylaw considerations raised in the SEC release include:

  • The relationship between proxy access and advance notice bylaws. The SEC takes the view that Rule 14a-11 will apply whether or not a company’s governance documents purport to include more restrictive standards.  The SEC also acknowledges that state or foreign law or company governance documents may establish procedures and standards for proxy access regimes that shareholders may use as an alternative to Rule 14a-11.  Similarly, when a shareholder or group is ineligible to use Rule 14a-11, perhaps because it has a change in control intent or an intent to gain more than 25 percent of the board, the shareholder or group may continue to choose to conduct a traditional proxy contest.  In these circumstances, and with respect to other types of shareholder proposals, advance notice bylaws continue to play an important role.

    In light of the continuing relevance of advance notice bylaws in regulating director elections and other business proposed by shareholders, companies should take a fresh look at advance notice bylaws to ensure that there is a clear and effective mechanism for (1) identifying business that shareholders intend to bring before a meeting (including director nominations), (2) obtaining the information the company regards as necessary to evaluate the proposal and to make informed recommendations about it to shareholders (including whether the nominee is qualified), and (3) ensuring the person introducing business actually is a qualifying shareholder of the company.  Companies should have state of the art advance notice bylaws for director nominations and shareholder business.  Further, companies should consider revising their advance notice bylaws to resolve any ambiguities created in light of the new rules.
  • Meeting attendance requirements.  Unlike Rule 14a-8, Rule 14a-11 does not require a nominating shareholder or group to appear at the meeting to present its nominee.  The SEC indicates that state law, and presumably bylaws adopted in accordance with state law, controls what happens if a candidate is not nominated at a meeting because the person supporting the candidate does not attend the meeting or make other arrangements.  Some bylaws require a shareholder to attend the meeting and formally introduce any business the shareholder proposes be conducted at the meeting, including a director nomination.  Companies may wish to review their bylaws with respect to attendance requirements.  
  • Director qualification standards.  Rule 14a-11 permits an otherwise eligible shareholder or group to access a company’s proxy even if its nominee fails to satisfy a company’s qualification requirements at the time of nomination and election.  The nominating shareholder or group must disclose whether, to the best of its knowledge, the nominee meets such requirements, if any, set forth in the company’s governing documents.  Many companies set forth their director qualification standards in nominating policies or committee charters, and not in the company’s governing documents.  Companies may wish to consider amending their bylaws to include key director qualifications applicable to all directors.
  • Bylaw and committee charter review.  Companies should carefully review their bylaws and their nominating committee charters and consider whether to revise any provisions that may be ambiguous or cause confusion in light of the new proxy access rules. 

 

We would be pleased to help you consider the new proxy access rules and how they may affect your company.  Please feel free to contact us with any questions.

 

Andrew D. Ledbetter

 

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