The Securities and Exchange Commission is continuing its across-the-board onslaught aimed at remaking the standards of corporate governance in American business.
Working both inside the provisions of the Sarbanes-Oxley Act of 2002 (the draconian aspects of which are well-chronicled elsewhere), and in conjunction with actions by the self regulatory organizations (such as the stock exchanges and NASDAQ) that control the trading markets for larger public companies, the federal government for the first time has inserted itself deeply into the management process.
It is specifying the internal structures that public companies must maintain, as well as specific rules of behavior and standards of internal conduct applicable to senior executives. It is also defining responsibilities of attorneys to “report up the line” and police public company compliance with applicable law.
Consistent with this broad approach, the SEC on Aug. 8 proposed amendments to its proxy rules applicable to all public companies that would require proxy statement disclosure in two areas: how the nominating committee operates, and how shareholders may communicate with the board of directors on any issue.
Comments were due Sept. 15, and no doubt final regulations will be propounded before the upcoming proxy season. Aficionados of SEC–speak can access the SEC’s lengthy discussion of its proposals at www.sec.gov/rules/proposed/34-48301.htm.
Nominating Committee Disclosures
The proposed rules are designed to allow stockholders to evaluate their company’s board of directors and nominating committee, and to participate in making nominations. The proxy statement must include, among other things, a statement as to whether:
• the board has a standing nominating committee or similar committee (and if not, why not);
• the nominating committee has a charter and, if so, where it can be viewed (typically the company’s website);
• the nominating committee meets the “independence” listing of the self-regulatory organization (exchange or NASDAQ) over which the company’s securities are traded (if the company’s shares are not listed on an self-regulatory organization, the company must select one make disclosure as if its shares were in fact traded).
• the nominating committee has a policy concerning shareholder recommendations for directorships, a description of any such policy, and a description of procedures for shareholders making recommendations for nominations.
The proxy statement must also describe the minimum skill set required for board nominees, how the nominating committee itself identifies candidates, and whether it would evaluate shareholder-suggested candidates differently.
And for new directors, the statement must set forth from whom the original recommendation of the candidate came.
Fees paid to third parties for locating directors must be stated. Also, if a shareholder (or group) owning more than 3 percent of the company for at least one year has recommended a candidate, the statement must also indicate whether a committee has declined to endorse that nomination, the names of the recommending shareholders and the reasons for the committee deciding to withhold nomination.
Existing Practice Compared
These proxy nomination proposals are far broader than present Securities Exchange Act Rule 14a-8, by which security holders may cause proposals to be placed on the annual meeting agenda.
Among the specific reasons contained in Rule 14a-8 that would permit a company to exclude a shareholder proposal from its annual meeting agenda is that such proposal relates to an election for membership on the company’s board of directors.
Neither does this proposal impact Securities Exchange Act Rule 14a-4, which dictates the mechanical steps by which stockholder-suggested board candidates must express their consent to be named in the proxy statement and to serve if elected.
Nominating Committee Independence
The New York Stock Exchange and NASDAQ have proposed (but at this writing not yet adopted) revised listing standards, requiring member companies to maintain independent nominating committees. In its release discussing its proposed new proxy rules, the SEC notes that these SRO proposals, while desirable, “would not require nominating committees to consider security holder nominees or companies to make the disclosure” outlined above.
The cumulative effect of the SEC’s proposed rules and of the anticipated actions by the SROs controlling the trading markets will be that, as a practical matter, non-management controlled nominating committees of public companies will be driven to apply objective standards to their selections of board nominees, and to give significant consideration to shareholder suggestions.
It would be a brave (and foolhardy) public company that exercised its right to be non-responsive to the SEC’s implicit requirements, and to promulgate a proxy statement declaring (in effect) that (i) the company has no nominating committee; (ii) the company doesn’t want one because management wants to be in charge; (iii) the company applies subjective standards to its nominating process; and (iv) the company (presumably) couldn’t care less what its shareholders think.
The SEC also has proposed mandatory proxy statement disclosure concerning the process by which shareholders may communicate with the board. A company’s proxy statement must contain the following:
• whether there is a process for communicating with the board (and if not, why not);
• a description of such existing processes, including identification of those board members to whom communications may be sent;
• a description of any material action taken by the board during the preceding fiscal year resulting from such shareholder communications; and
• information concerning any screening that is applied to shareholder communications before those communications come to the board’s attention.
Today, the typical company website, under “investor relations,” invites shareholders to “communicate with the company” by sending an e-mail. As a practical matter, upon adoption of the new SEC rule, public companies of necessity will substantially upgrade this section of their websites to provide communication mechanics that will appear shareholder-friendly when described in the proxy statement.
Additionally, the NYSE has proposed a new listing standard that, if adopted, would require disclosure of a method by which stockholders can communicate directly and confidentially with the senior non-management director, or with all non-management directors as a group. Such a communications procedure might echo the compelled practice under Sarbanes-Oxley, by which audit committees are required to establish procedures for anonymous communications by employees of matters relating to accounting or auditing concerns.
There is little doubt that SEC-promulgated final rules addressing director nominations and stockholder communications with the board will substantially impact next proxy season’s activity.
Although these final rules may differ in some details from the SEC proposals described above, substantial intrusion by the SEC in these areas of corporate governance is to be expected. Together with the impact of Sarbanes-Oxley and the expansion of corporate governance requirements for listing by exchanges and inter-dealer quotation systems, the SEC’s efforts to recast corporate governance ground rules will make our next round of annual meeting proxy statements a more detailed and challenging exercise.
Stephen M. Honig is a member of Duane Morris’ corporate department, and is a resident in its Boston office. His practice includes counseling public companies in matters of SEC compliance and corporate governance. Mr. Honig acknowledges the assistance of Daniel Pierce, Esq. in the preparation of this article.