On August 25, 2010, the Securities and Exchange Commission (SEC) adopted rules that will require companies to include in their proxy materials certain shareholder-nominated board of director candidates. Under new Rule 14a-11, a shareholder or group of shareholders owning at least 3% of the outstanding voting power of the securities entitled to be voted on the election of directors of a public company for the prior 3 years will have the right to include in the company’s proxy statement shareholder-nominated candidates for up to 25% of the board of directors, but no less than one director.
Presently, while shareholders may nominate their own directors consistent with state law and an issuer’s governing documents, shareholders are not entitled to include their director nominees in the company’s proxy materials. Instead, a dissident shareholder would need to prepare and distribute its own proxy materials, resulting in a proxy contest. Due to the difficulty and expense involved in waging an independent proxy contest against a slate of management-nominated directors, shareholder-nominated directors have been relatively infrequent.
Twice before, the SEC had tried to institute proxy access rules, but was unable to do so because of company opposition and questionable authority on which to take such measures. The recently enacted Dodd-Frank Act specifically granted the SEC the authority to issue rules permitting shareholders to use proxy solicitation materials provided by an issuer for purposes of nominating individuals to serve on boards of directors.
This is only the most recent of a number of rule changes and trends in recent years that are changing the dynamics of director elections. Over the past several years, there has been a strong trend for corporations to adopt bylaws requiring a majority of votes cast to be in favor of election of a director for the director to be elected. In addition, the recent amendment of NYSE Rule 452 means that brokers are no longer able to vote absent instructions from owners in uncontested elections.
A more complete description of the requirements and allowances of the new rules is set forth below.
For a shareholder or group of shareholders to be eligible to include a nominee in the company’s proxy materials pursuant to Rule 14a-11, they must have continuously owned 3% of the voting power of the company’s stock for the three years prior to providing such notice, and must continue to own the 3% through the shareholder's meeting. This differs from the proposed rule, which proffered a 1%/3%/5% sliding scale of ownership based on company size, and only a one-year holding period.
The percent of a company’s stock held by a nominating shareholder is calculated with reference to the voting power of all stock entitled to vote in the election of directors. Thus, where there are multiple classes of stock entitled to vote for the board, the determination should be made based on all voting stock, not only the class of stock owned by the nominating shareholder. Stock that is not subject to the proxy rules, such as nonvoting stock or a class of privately-held stock entitled to elect a separate board seat, would not be included in the determination of percentage holdings. In addition, for stock to count towards the 3% threshold, the shareholder must have both investment and voting power of the stock. Thus, borrowed stock and short sold stock will not count towards the threshold; however, loaned stock may count if the shareholder has the right to call the stock back and makes an undertaking to do so upon being notified that the nominee will be included in the company’s proxy materials.
In addition, the shareholder or group of shareholders may not hold the company’s securities with the intent of changing control of the company or gaining a number of seats on the board in excess of the number of seats that a company would be required to include under Rule 14a-11. The shareholder must also not have an agreement with the company regarding the nomination, and must provide notice on new Schedule 14N as described below. The new rules do not restrict resubmissions of director nominees the following year in the event a shareholder’s nominee fails in an earlier bid to get elected.
Number of nominees that may be included
Generally, shareholders may nominate the greater of 25% of the board (rounded down) or one director, based on the total number of board seats. If more than one shareholder nominates directors that would cause the number of nominated directors to exceed the allowed amount, then the shareholder with the highest percentage of holdings would have its nominees included. This differs from the proposal, which gave preference on a first-come, first-served basis.
The number of board seats for which a shareholder can nominate directors is calculated based on the full size of the board regardless of whether the board is classified or there is a shareholders’ agreement in place entitling certain holders to elect certain directors. In situations where there are multiple classes of stock and shareholders of each class are only permitted to elect a portion of the full board, the number of directors that a shareholder of any one class will be entitled to elect will be based upon the number of director seats the class of shares held by that nominating shareholder is entitled to elect. For instance, if a corporation with two classes of stock outstanding (Class A and Class B) has a 12-person board of directors and a structure that permits Class A shareholders to vote only for two Class A directors, the maximum of number of shareholder nominees that could be included on the company’s proxy statement is two, notwithstanding the 25% limitation in other cases.
Company nominees that were added at the request of a shareholder after filing a Schedule 14N will be counted against the number of directors that may be nominated; however, nominees that a shareholder negotiates to include without the filing of a Schedule 14N would be counted as company nominees. In addition, shareholder-nominated directors that remain seated on a classified board will be counted against the number of directors that may be nominated. For instance, if a board has six directors staggered so that two directors are elected each year, if one of the sitting directors was elected through the new proxy access rules, then the company would not be required to include a shareholder nominee under Rule 14a-11 until that director is up for reelection. On the other hand, if a shareholder-nominated director is elected and then is nominated by the company in a subsequent election, that candidate would not count against the number of shareholder-nominated directors that must be included in the company’s proxy materials.
If a nominee is disqualified or withdraws prior to the printing of the proxy statement, then the company would be required to include the next eligible shareholder nominee, if one exists, that otherwise would not have been included in the company’s proxy materials, in the order of priority based on the percentage holdings of the nominators. The company would not be required to include a substitute nominee once the company has started printing its proxy statement.
A nominee may be excluded from the company’s proxy materials if the election of such nominee would violate state law, federal law, or the rules of the national securities exchange on which the company’s securities are listed. In addition, the nominee must meet the objective independence standards of the national securities exchange on which the company’s securities are listed that are applicable to directors generally. The nominee need not meet the company’s director qualification requirements, although the nominator would be required to disclose on Schedule 14N whether the nominee does meet those qualification requirements. In addition, the nominee need not be independent from the shareholder or group of shareholders nominating the candidate.
This requirement may create certain issues relating to a company’s board and committee composition. First, the nominee need not meet any subjective independence standards of the company, such as a determination by the board or nominating committee that the director is independent. If the nominee does not meet those requirements, then the nominee may be unable to serve on committees required to be comprised of all independent directors. Second, the nominee must only meet the standards applicable to boards generally, and not standards applicable to certain committees. For instance, if the election of a shareholder nominee causes the company’s audit committee financial expert to not be re-elected, then the company might not be able to meet the standards imposed by the national securities exchange on which it is listed. While the company may not exclude a nominee on such a basis, it may state in the proxy statement that a certain director should be re-elected because failure to do so would cause the company to no longer be in compliance with such standards.
In addition, companies may seek no-action letters from the SEC staff with respect to any determination to exclude a shareholder nominee or other shareholder proposal relating to proxy access. The SEC has assured the public that it will dedicate enough resources to this to ensure that any disputes are resolved before proxy materials are distributed.
Procedure for nominations and exclusions
For a shareholder to have its nominee included in the company’s proxy materials, it must submit its nominee to the company no earlier than 150 days before and no later than 120 days before the one-year anniversary date on which the proxy statement was first mailed out to shareholders in the prior year. This differs from the proposed rule, which would have given deference to a company’s advance notice bylaw provision, if any.
If a company determines that it will include a shareholder nominee, the company must notify the nominating shareholder no later than 30 days before the company files its definitive proxy statement. If the company determines that it will exclude the shareholder nominee, then it must notify the SEC of its decision no later than 80 days before the company files its definitive proxy statement, and must notify the nominator no later than 14 days after the last date on which shareholders may submit nominees. The nominator would then have 14 days to cure any defects.
As part of the new rules, the SEC created a new form, referred to as Schedule 14N, which a shareholder or group of shareholders nominating a director or directors must file on EDGAR at the same time that notice of the nomination is provided to the company. Schedule 14N will include, among other items:
- the name and address of each shareholder in the nominating group;
- the amount and percentage of voting stock owned by each holder in the nominating group;
- the period of continuous ownership of the voting stock;
- if the securities are held in street name, a written statement of the registered holder of the shares verifying beneficial ownership of the shares by the nominees;
- biographical and other information for the nominees and the nominators, similar to disclosures currently required in a contested election;
- statements of whether the nominee meets the company’s director qualification requirements and that, to the nominator’s knowledge, the nominee meets the objective criteria for independence of the exchange rules applicable to the company;
- disclosures about the nature and extent of the relationships between the nominator, the nominee, and the company or its affiliates;
- a certification that there is no intent to effect a change of control of the company or acquire greater than the number of board seats the holder would be permitted to nominate under the new rule;
- certifications that the shareholder will continue to hold the stock through the meeting and otherwise meet the requirements of Rule 14a-11, and that the nominee or nominees satisfy the requirements of Rule 14a-11;
- a statement as to intent regarding continued ownership of the stock after the meeting;
- any oral statements made in order to form an ownership group; and
- a statement of up to 500 words in support of each nominee.
Since Schedule 14N needs to be filed on EDGAR, shareholders that otherwise do not have EDGAR filer codes should be careful to obtain filer codes prior to submitting its notice to the company, so that they may comply with the timing requirements of this rule.
Shareholder proposals relating to proxy access
In conjunction with Rule 14a-11, the SEC is also amending Rule 14a-8(i)(8), which currently allows companies to exclude from its proxy statements shareholder proposals that relate to nominations or procedures for nominations of directors. Under the revised rule, a company would only be able to exclude proposals to disqualify a director nominee; to remove a sitting director from office; that question the competence, business judgment, or character of a nominee or director; to exclude a nominee from the company’s proxy materials; or to affect an upcoming election of directors.
As revised, shareholders would be able to make a number of proposals that companies previously were able to exclude. For instance, to the extent permitted by Rule 14a-11, a shareholder could propose modifications to procedures that make it easier for a shareholder to include a nominee in the company’s proxy materials. In addition, a shareholder could propose bylaw amendments that shareholder nominees constituting greater than 25% of the board could be included in the company’s proxy materials. If such bylaw passes and is enacted, shareholders could nominate directors on a company’s proxy statement either through the procedures set forth in the amended bylaws or through Rule 14a-11.
Shareholder solicitations and liability
Under the new rules, the SEC added two exemptions pursuant to which a shareholder may solicit other shareholders in connection with a shareholder nominee without being subject to the full proxy rules. Shareholders may make solicitations in order to (a) form an ownership group or (b) make statements in favor of shareholder nominees or against company nominees, limited in manner prescribed by the rule. Soliciting material generally would need to be filed under cover of Schedule 14N no later than the date of first use.
Shareholders will have liability for material misstatements and omissions of material fact from Schedule 14N or provided for inclusion in the proxy statement. The company will not have liability for such statements. In addition, shareholders will not lose eligibility to file an abbreviated beneficial ownership form on Schedule 13G solely by reason of nominating directors under the new rule, although there is no exclusion from Section 16.
New Form 8-K requirement
The SEC is also adding a new Form 8-K requirement relating to shareholder director nominations. Under new Item 5.08, if the date of a company’s annual meeting has been changed by more than 30 days from the date of the prior year’s meeting, the company must disclose the date by which a nominating shareholder must submit the notice on Schedule 14N. This disclosure must be provided within four business days after the company determines its new annual meeting date. Failure to comply with this item will result in a loss of Form S-3 eligibility, so companies that significantly alter their meeting dates in 2011 should establish control procedures to capture this new requirement.
Exclusions and delayed effectiveness for smaller reporting companies
Effectiveness of Rule 14a-11 is deferred for three years with respect to smaller reporting companies. Also, companies that are only reporting by virtue of having registered debt are exempt from the rules. Finally, companies not otherwise subject to the proxy rules, such as foreign private issuers and companies without elected boards, are excluded from Rule 14a-11. All other companies, including investment companies, must comply with the new rules and may not opt out.
Effectiveness of the new rules
The new rules will become effective 60 days after publication in the Federal Register, which will result in them becoming effective sometime in late October or early November. Since shareholder notice must be provided at least 120 days in advance of the date on which the company sent out its proxy statement last year, this means the new rules essentially would not be effective for the 2011 proxy season for companies that sent out last year’s proxy statement earlier than sometime in late February or early March, depending on the timing of publication of the new rules in the Federal Register.