‘Substantial Implementation’ Will Backfire

‘Substantial Implementation’ Defense for Proxy Access Lite Under (i)(10) Will Backfire for Corporate Boards

Substantial implementation, that’s the deception companies have been arguing in order to obtain ‘no-action’ relief under SEC Rule 14a-8(i)(10) after implementing proxy access ‘lite.’ Law firms have been touting recent no-action letters released on February 12, with more in March  2016. It looks like a clear win for entrenched managers and directors for implementing only proxy access lite. In reality, such deception will cost companies more in legal fees and will reduce board discretion, since shareholders will increasingly file binding bylaw resolutions to obtain the same robust proxy access promised under vacated Rule 14a-8(i)(10).

The NYC Comptroller provided an example at NVR for all to see. Hundreds of such proposals will follow if substantial implementation no-actions continue for proxy access lite bylaws. In most cases such binding resolutions will be embraced by members of the Council of Institutional Investors, Institutional Shareholder Services, Glass Lewis and increasingly by mainstream mutual funds like BlackRock, SSGA, and ProFund Advisors. Genuine proxy access is a compelling shareholder right. Companies are going to lose this battle in the long-run if they fight it. In fact, the more they resist, the more likely they are to become the first targets for actual implementation.

Substantial Implementation: Rule 14a-8(i)(10) Background

Companies seeking to establish the availability of subsection (i)(10) have the burden of showing both the insubstantiality of any revisions made to the shareholder proposal and the actual implementation of the company alternative.[1]

Where the shareholder specifies a range of percentages (10% to 25%), Staff has generally agreed the company “substantially” implements the proposal when it selects a percentage within the range, even if at the upper end.[2] Likewise the Staff has found substantial implementation when the shareholder proposal includes no percentage[3] or merely “favors” a particular percentage.[4]

No-action letters granted by SEC Staff beginning March 12, 2016, carved out a new and unsubstantiated definition of “substantially implemented” without the benefit of a rulemaking, public comments, or review by the Commission.

Substantial Implementation: Proxy Access Background

The right to pursue proxy access at any given company was uncontroversial prior to 1990. In 1980 Unicare Services included a proposal to allow any three shareowners to nominate and place candidates on the proxy. Shareowners at Mobil proposed a “reasonable number,” while those at Union Oil proposed a threshold of “500 or more shareholders” to place nominees on corporate proxies. 

One company argued that placing a minimum threshold on access would discriminate “in favor of large stockholders and to the detriment of small stockholders,” violating equal treatment principles.

Early attempts to win proxy access through shareowner resolutions met with the same fate as most resolutions in those days – they failed. But the tides of change turned. A 1987 proposal by Lewis Gilbert to allow shareowners to ratify the choice of auditors won a majority vote at Chock Full of O’Nuts Corporation and in 1988 Richard Foley’s proposal to redeem a poison pill won a majority vote at the Santa Fe Southern Pacific Corporation.

However, in 1990, without public discussion or a rule change, the Staff began issuing a series of no-action letters on proxy access proposals. The SEC’s about-face may have been prompted by powerful boards and CEOs who feared that “private ordering,” through shareowner proposals, was about to begin in earnest.

That about-face was temporarily halted with the decision in AFSCME v AIG (2006). The court found the prohibition on shareowner elections contained in Rule 14a-8 applied only to proposals “used to oppose solicitations dealing with an identified board seat in an upcoming election” (also known as contested elections).

The more recent about-face by Staff on what constitutes substantial implementation for purposes of Rule 14a-8(i)(10) is similar to the reversal in 1990, which denied proxy access proposals altogether. Before February 12^th Staff concurred that companies, when substantially implementing a shareholder proposal, can address aspects of implementation on which a proposal is silent. However, Staff did not concur that substantial implementation could be accomplished with provisions that directly conflict with those included in the shareholder proposal.

Since the batch of SEC no-action letters issued on February 12^th contain no explanation of why SEC staff suddenly decided to reverse its long-standing interpretation, we can only speculate as to the reasons. However, many of those seeking the no-action letters granted beginning February 12^th argued that since their company had adopted proxy access bylaws similar to those adopted by most other companies that adoption, however weak, addressed the issue. The shareholder’s “essential purpose” had been achieved and substantial implementation had occurred. Nonsense!

As the person who drafted the specific terms of the template used in each of the proposals where Staff granted no-action letters, I assure you the essential purpose was not to obtain watered-down versions of proxy access. An earlier proxy access proposal template was purposefully revised to ensure the form of proxy access obtained would closely align with the essential elements defined by the SEC’s vacated Rule 14a-11. Substantial Implementation would require each condition specifically highlighted in the proposal to have been met by any board adopted bylaw seeking exemption under (i)(10).

Substantial Implementation: Origins of the Industry Standard

As many company letters seeking no-action point out (I use Amazon.com as an example):

Proxy access is a complex issue. Because proxy access creates an entirely new right that implicates the interaction of state law nomination processes, Commission proxy rules, the intricacies of the beneficial ownership and proxy voting processes, and corporate governance considerations, bylaws implementing proxy access must address numerous substantive and procedural issues. This complexity was reflected in the text of the Commission’s proxy access rule, Rule 14a-11 under the Exchange Act, which was 6,374 words long, counting “instructions” included in the rule but not counting the length of Schedule 14N or other rules that were adopted or amended at the same time that Rule 14a-11 was adopted.

Virtually all of the 487 words comprising the Proposal and its brief supporting statement consist of an extensive list of proxy access terms requested by the Proponent.

The proposal’s terms did not focus on 3% held for 3 years, as seems to have been the case by Staff granting no-action letters. It would be a lot easier and clearer if proponents could just reference the SEC’s vacated Rule 14a-11 and request boards implement proxy access as close as practical to that vacated rule within the limitations of the existing regulatory framework. In California, all regulations must meet the “clarity” standards of the Administrative Procedure Act and they are reviewed by the Office of Administrative Law for compliance to those standards. Apparently federal regulations are too vague to be cited in proposals, even regulations that have not been vacated. 

For example, on March 30, 2012 Staff issued a no-action letter on Dell, which included the following:

There appears to be some basis for your view that Dell may exclude the proposal under rule 14a-8(i)(3), as vague and indefinite. In arriving at this position, we note that the proposal provides that Dell’s proxy materials shall include the director nominees of shareholders who satisfy the “SEC Rule 14a-8(b) eligibility requirements.” The proposal, however, does not describe the specific eligibility requirements. In our view, the specific eligibility requirements represent a central aspect of the proposal. While we recognize that some shareholders voting on the proposal may be familiar with the eligibility requirements of rule 14a-8(b), many other shareholders may not be familiar with the requirements and would not be able to determine the requirements based on the language of the proposal. As such, neither shareholders nor Dell would be able to determine with any reasonable certainty exactly what actions or measures the proposal requires. Accordingly, we will not recommend enforcement action to the Commission if Dell omits the proposal from its proxy materials in reliance on rule 14a-8(i)(3). (Dell, March 30, 2012, https://www.sec.gov/divisions/corpfin/cf-noaction/14a-8/2012/jamesmcritchie033012-14a8.pdf)

If proponents cannot cite federal rules for something as simple as eligibility requirements, we certainly cannot cite a vacated Rule 14a-11 to describe the features that should be contained in proxy access bylaws. Instead, for the 2015 proxy season most proxy access advocates filed fairly generic proposals, describing little more in the way of specifics than that shareholders must hold 3% of the company’s common stock for at least 3 years.

The primary objective last year of many shareholder advocates was to begin a tidal wave of proxy access adoptions, even flawed adoptions, to get the process rolling. Quality was not as important as quantity. At large early adopting companies, such as Citigroup, I was willing to withdraw proposals even where boards limited shareholder groups to 20 and allowed access to 20% of the board or 2, whichever was greater. Other proponents agreed to even more unfavorable terms.

After we knew we had significant momentum, many of us tried to get back to the provisions of the vacated Rule 14a-11 when negotiating with companies. However, knowing the history of no-action decisions under Rule 14a-8(i)(10) and especially after Staff granted no-action relief to General Electric, it was obvious that proposals with little specificity were vulnerable to being watered down.

In the case of General Electric, the company implemented proxy access with the same ownership threshold, holding period, and cap on shareholder nominees as requested by the proposal but GE added a group limit of 20 shareholders. That was consistent with prior decisions under Rule 14a-8(i)(10) because the shareholder proposal was silent on the issue of group size limits.

To remedy the situation, several of us began submitting proposals with greater specificity, including provisions to deny group caps, ensuring a minimum of two directors, and ensuring that restrictions that do not apply to other board nominees should not be imposed on shareholder nominees. This strengthened our hand in negotiations and we were able to win better terms for an agreement to withdraw.

Substantial Implementation: Staff Drops a Bomb, Reinterpreting Rule 14a-8(i)(10)

The positive negotiating position that came with extra specificity of terms in proxy access proposals largely evaporated after February 12^th when Staff issued no-action letters that appear to have found that the only essential provisions to proxy access bylaws are 3% of shares held for 3 years. Contrary to prior no-action opinions, Staff ignored the fact that shareholder proposals specified various other terms: 25% of the board, no group limitations, etc.

Substantial Implementation: Democracy Takes One Step Forward, Two Steps Back

Last year the SEC took a small step in the right direction after my appeal of a no-action decision involving Whole Foods Market and howls of protest from more influential shareholders, led the SEC Chair White to call for a review of (i)(9) and an end to “gaming” the system. After seeking comment and suspending no-action opinions on that subdivision, Staff Legal Bulletin No. 14H (CF) was issued to clarify the exclusion under subdivision (i)(9) applied only “if a reasonable shareholder could not logically vote in favor of both proposals.”

Now Staff is apparently ‘protecting’ shareholders from having to compare bylaws adopted by boards of directors, in response to shareholder proposals, with the terms requested by the shareholder. Would that task be too confusing for shareholders? Staff declares ‘substantial implementation’ of proxy access even where dramatic differences occur between what is specifically requested and what has been granted. Isn’t this the same ‘gaming the system’ that Chair White warned against last year?

Before the suspension and clarification of (i)(9) last year, Staff had begun allowing issuers to omit shareholder proposals from the proxy and include their own, if their proposals were on the same subject. At least shareholders got to vote on the changes proposed by management.

Since SLB 14H and the February 12^th no-action letters, SEC Staff has essentially announced a new game in town. Boards are now being advised that when their company receives a proxy access proposal, they can simply adopt language on their own. You do not need approval from shareholders. If the board adopts proxy access that allows shareholders with 3% of common stock held for three years to nominate a director, you have met their “essential” purpose. Therefore, the shareholder proposal can be omitted. Since boards do not even have to put bylaws up to a vote by shareholders, any remnant of direct democracy is eliminated. Gaming the system has become even easier than it was before SLB 14H.

SEC Revolving Door

If Chair White were to suspend no-action opinions based on Rule 14a-8(i)(10) and call for a review of the history of that subdivision, Staff would find a very similar situation to what they found in investigating the evolution of how (i)(9) was interpreted. Starting out narrowly, Staff gradually widened the exemption far beyond its original intent.

J. Robert Brown, a member of the SEC’s Investor Advisory Committee has already done much of this review in his Comment Letter on Rule 14a-8(I)(10), Securities & Exchange Commission, June 18, 2015 (June 18, 2015). See U Denver Legal Studies Research Paper No. 15-26.

Substantial Implementation: The Way Forward Without Gaming the System

There is an easy remedy to restore some semblance of accountability to shareholders. Go back to Staff’s interpretation of Rule 14a-8(i)(10) as it existed before February 12^th.

Fortunately, no-action letters “reflect only informal views” and do not set precedent. Included with many no-action letters is the following statement: “SEC staff reserves the right to change the positions reflected in prior no-action letters.” I hope Staff will do so, but am not holding my breath.

Substantial Implementation: Inclusion of Group Nomination Limits

Companies typically argue this provision, “which places a twenty-shareholder limit on the size of a nominating group, achieves the essential purpose of this aspect of the Proposal by ensuring shareholders are able to use the proxy access right effectively…” As evidence of its efficacy, companies note: “a twenty-shareholder nominating group is a widely embraced standard among companies that have adopted proxy access.” That is evidence of the provision’s popularity, not its efficacy.

The Council of Institutional Investors, whose members hold more than $3 trillion in assets actually researched the evidence and found the following (Proxy Access: Best Practices, August 2015):

We note that without the ability to aggregate holdings even CII’s largest members would be unlikely to meet a 3% ownership requirement to nominate directors. Our review of current research found that even if the 20 largest public pension funds were able to aggregate their shares they would not meet the 3% criteria at most of the companies examined.

CII’s position is generally consistent with the view of the SEC. In 2010, the SEC considered, but rejected imposing a cap on the permitted number of members in a nominating group. The SEC found that individual shareowners at most companies would not be able to meet the minimum threshold of 3% ownership for proxy access unless they could aggregate their shares with other shareowners.

In contrast to typical adopted ‘lite’ bylaws, our proposal seeks to allow nomination by “a shareholder or an unrestricted number of shareholders forming a group.” There is obviously an infinite difference between limiting shareholder groups to 20, instead of an unlimited number.

Companies typically admit this provision is an essential element but argue a twenty-shareholder group is a widely embraced standard. They provide no evidence that this standard meets the essential purpose of the provision, which is to allow shareholders to combine together in groups to achieve the required holdings.

In permitting the exclusion of proposals, Rule 14a-8 imposes the burden of proof on companies. See Rule 14a-8(g). Companies have typically cited no evidence, only fashion. Why is fashion weighed more heavily by SEC Staff than evidence? Could it have something to do with where they hope to work after leaving the SEC?

Substantial Implementation: Number of Nominees

Our proposal seeks to allow shareholders to nominate one quarter of the directors then serving, or two, whichever is greater. However, ‘lite’ bylaws provide that shareholder-nominated candidates cannot exceed 20% of the number of directors in office.

Although both one quarter and 20% often yield two nominees with the current board sizes, companies fail to meet an essential element of the proposal, which would ensure a more substantive proportion of shareholder nominees allowed on the proxy even if the number of directors changes.

Substantial Implementation: Conclusion

The series of no-action letters issued by Staff beginning February 12, 2016 are anomalous in their interpretation of what constitutes substantial implementation and what constitutes the essential elements of my proxy access template. The essential elements of the proposal are the specifications called out in the proposal. Even company letters appear to agree to that, despite the no-action letters issued by Staff on February 12,

If I am building a house and specify in the contract that the furnace must meet an annual fuel-utilization-efficiency (AFUE) rating of 95% but the contractor installs one with an 80% AFUE rating, they have not met the essential terms of the contract. Based on the anomalous no-action letters of February 12^th, if Staff were issuing an informal opinion on substantial implementation, they would apparently argue the quality of the furnace does not matter. They arbitrarily deem only a roof and walls to be essential elements of a house.

Under Rule 14a-8(i)(10) boards are free to adopt elements that do not conflict with those requested in a shareholder proposal. If a proposal specifies a range, boards can select a percentage at the high end. Unless specified, boards can round down to the nearest whole number instead of rounding up to arrive the appropriate number of shareholder nominees for a specified percentage of the board. However, boards were not entitled under Rule 14a-8(i)(10) to round an infinite number of shareholders forming a group down to 20. That was not substantial implementation… until February 12th.

The anomalous no-action letters issued on February 12 provides no evidence why 3% of shares is considered an essential element to proxy access but being able to cap the number allowed to form a group is not. There is a world of difference between a group of twenty, which research by the Council of Institutional investors concludes cannot be reached by its members at most companies, and an unlimited group. One set of bylaws can actually be implemented; the other cannot.

If I had more money, I’d sue the SEC for action very similar to AFSCME v AIG. Unfortunately, my pockets are shallow, not deep.

Substantial Implementation Will Backfire

Substantial Implementation: March 12 No-Actions Will Backfire

Entrenched boards and managers who think they have won by gaming the system with unworkable proxy access bylaws will find only temporary ‘relief’ from shareholder action by filing for an exemption under Staff’s newly defined definition of ‘substantial implementation.’ We will be back next year and every year after that if necessary. Binding bylaw resolutions are much more prescriptive than precatory proposals. Gaming the system is likely to come back to haunt you because your hands will be tied when those resolutions pass… and they will.