Unfetter the Shackle: Promoting Shareholder Involvement in Corporate Governance Through Proxy Mechanism

• Publication year: 2016

Unfetter the Shackle: Promoting Shareholder Involvement in Corporate Governance through Proxy Mechanism

Zhiyuan Liu

UNFETTER THE SHACKLE: PROMOTING SHAREHOLDER INVOLVEMENT IN CORPORATE GOVERNANCE THROUGH PROXY MECHANISM

Introduction

From time to time, scholars argue that the role of corporate law is to guarantee that shareholders have adequate information to participate intelligently in the securities market, or to empower them to make changes to the corporation's internal structure.¹ As an important mechanism to realize these goals, proxy rules serve to ensure that the shareholders receive sufficient information about corporate matters and are afforded the opportunity to act as they wish on the matter.²

State statutes and case law provided the initial foundation for the emergence of proxy rules. But state laws merely empowered proxy voting, instead of regulating its mechanics, and case law rarely addressed problems of shareholder access.³ As a gap-filler, a set of rules under Section 14 of the Securities Exchange Act of 1934 has been playing a major role in constructing the proxy mechanism.⁴ Federal proxy rules apply if a company has securities listed on a national securities exchange, has a class of equity securities held by 500 or more shareholders, and total assets exceeding $10 million,⁵ or is a registered investment company or a public utility holding company.⁶ Thus, this essay limits the discussion to the proxy rules applicable to these types of companies, most of which are not likely to be small. Since the ownership interests in these "big" companies are scattered and discrete, more elaborate proxy solicitation is required.⁷ However, there have always been focus points among various proxy approaches, and the current legal system has made certain choices when determining to what extent the proxy should be utilized in the hands of shareholders. This essay will identify the commonly used

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approaches, analyze how shareholders can make use of these measures, and discuss the factors that impact the development of important proxy mechanisms toward a more pro-shareholder direction.

I. Modern Proxy Mechanism and Its Typical Form

The modern federal proxy rules start from the Securities Exchange Act of 1934 ("1934 Act"),⁸ and are imposed in detail by accompanying Securities and Exchange Commission regulations.⁹ The term "proxy" refers to a document that authorizes a designated person to vote the shareholder's shares with respect to the matters and in the manner specified in such document.¹⁰ Normally proxy solicitation takes place at least once a year for board elections and other important corporate issues.¹¹ In most cases, the existing directors nominate the slate of candidates and the company sends information to the shareholders through "proxy materials"—usually comprising a proxy voting card and a proxy statement—so those shareholders have information to vote their shares.¹² As a result, the board of incumbent directors constantly takes control of the proxy process, whereas individual shareholders have little say in determining the election.¹³ Several reasons contribute to this imbalance. First, the incumbent directors and management make proxy proposals and frequently the only votes that count are the votes cast in favor of the names on the proxy.¹⁴ Furthermore, companies often have a staggered board, which means only one-third of board seats are up for election each year.¹⁵ Finally, shareholders have to incur significant costs, but do not receive reimbursement

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from the corporation, while the board can charge its full expenses to the company.¹⁶

Nonetheless, shareholders who desire to input their advice to the annual meeting can achieve the goal by means of shareholder proposal. Rule 14a-8 of the Securities Exchange Act provides that eligible shareholders are entitled, at no cost to themselves, to include proposals in board's proxy materials.¹⁷ But in addition to the eligibility issue and certain procedural hurdles set forth by the rule, shareholders may encounter the company's, in essence the board's, refusal if the proposal's subject matter falls within one of the listed grounds for exclusion.¹⁸ Not surprisingly, director election is among the exclusionary reasons and the relevant clause bars shareholders from intervening in the election in any form, including putting a specific individual in the company's proxy materials for election to the board of directors.¹⁹ To exclude a shareholder proposal, a company must submit a "no-action" request to the SEC before it files definitive proxy materials.²⁰

To introduce their nominees into the director election, many shareholders would mount a "proxy fight" or "proxy contest." Generally, proxy contests are used to replace board members where a serious dispute exists about the current management's policies, competence, or integrity, and where sufficient shareholder dissatisfaction provides reasonable grounds for a prospective success in an electoral challenge against the incumbent board.²¹ To initiate a proxy contest, a shareholder who wishes to nominate a candidate other than the ones proposed by the incumbent board should separately file his own proxy statement and solicit votes from other shareholders.²² Although proxy contests may seem like an optimal measure to remove an unwanted director from the board, this often requires significant funding and additional social resources.²³ Typically, for an "insurgent" shareholder or shareholder group to succeed in a proxy contest, the shareholders need to either hold sufficient shares that are entitled to vote, or persuade enough other shareholders to vote for their nominee, so that they have a better chance to obtain majority votes in the

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upcoming election.²⁴ For example, as one of the rare successes,²⁵ John D. Rockefeller won his fight with the management of the Standard Oil Company of Indiana mainly because of his relatively large ownership stake, his ability to fund the fight, and his own standing in the community.²⁶

Additionally, shareholders launching a proxy contest have to deal with various defensive tactics adopted by the board, including the classic anti-takeover strategy, "poison pill," which sometimes creates obstacles for shareholders to gather enough shares.²⁷ This allows existing shareholders, excluding the dissenting shareholder who has acquired sufficient shares, to purchase more discounted shares, and thereby allowing investors to make instant profits while the shares held by the dissenting shareholder are diluted.²⁸

Apparently, the modern proxy system has created many impediments to shareholder participation via proxies. In summary, two major legal barriers impair dissenters' ability to let their voice be heard effectively: (1) the indirectness of the shareholder intervention, due to separate filing requirements independent from a management-initiated proxy;²⁹ and (2) obstacles to owning a meaningful stake of shares, which leads to the dispersion of the ownership interest and less incentives for shareholders to act collectively as a group.³⁰

II. Rule-making Effort in Promoting Shareholder Involvement

Since the SEC started handling the proxy access issue, numerous institutional and individual investors have suggested that granting long-term shareholders a meaningful choice directors is the most important proxy reform to be considered.³¹ In response to complaints by shareholders and academics that the proxy rules impose excessive costs on proxy campaigns, the SEC has

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made efforts in proposing rule changes that would reduce those costs and enhance shareholder access.³²

Perhaps one of the boldest attempts by the SEC was its changes to Rule 14a-11 in 2010. Based upon the rationale that long-term significant shareholders should have a means of nominating candidates to the boards of the companies that they own,³³ the SEC adopted the new rules which required companies to provide shareholders the opportunity to have their nominees included in the company proxy materials sent to all shareholders.³⁴ Meanwhile, SEC's proposed rules also permit shareholders to use shareholder proposals to amend fundamental corporate documents and to create rules for them to propose director nominees in proxy materials.³⁵ To have their nominees included in the proxy materials, shareholders should own at least three percent of the total voting power of the company's securities and are entitled to vote on the election of directors at the annual meeting, though they will be able to aggregate holdings to meet this threshold.³⁶ They also will be required to have held their shares for at least three years and will be required to continue to own at least the required amount of securities until the date of the meeting at which directors are elected.³⁷

The new rules essentially bridged a shortcut for shareholder involvement in board elections because shareholders can directly include their nominees at the beginning of the proxy process and the corporation is required to do so.³⁸ To some extent, the inclusion of shareholder director nominees has nullified the exclusionary ground in shareholder proposal rules that the company can use to exclude the shareholder's request to put a specific candidate in the proxy material. However, the new rules cannot fully replace proxy contests from the perspective of seeking control, due to limits on the number of nominees a

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shareholder can include in the proxy material,³⁹ and such shareholder will lose eligibility if he or she is holding the securities for the purpose of changing control of the company.⁴⁰ The rule does not apply if applicable state law or company's governing documents "prohibit shareholders from nominating a candidate for election as a director."⁴¹ It appears that the SEC's reform of this particular rule in the Act echoes Black's proposition of "institutional voice," which will allow a certain number of shareholders to collectively have...