United States: SEC Proposes Rules on Shareholder Access to Director Nomination Procedures

The proposed rule stems from a report published on July 15, 2003 by the Division of Corporation Finance of the SEC. The report recommended changes to the proxy rules regulating the nomination and election of directors in response to a request from the SEC. On August 8, 2003, the SEC proposed the first of two sets of recommended rule changes: new disclosure rules requiring greater disclosure of (a) public company committee processes and (b) the processes by which stockholders may communicate with the directors of companies whose stock they hold. Proposed Rule 14a-11 and related proposed amendments to other rules are the second set of recommended changes stemming from the July 15, 2003 report. Proposed Rule 14a-11 is designed to address what the SEC believes to be a failure of the current rules to allow significant shareholders to have a voice in the director nomination process where there is evidence of stockholder dissatisfaction with the election process.

Currently, Exchange Act Rule 14a-8 provides a mechanism by which stockholders may submit proposals to be included in a company’s proxy statement, but SEC rules do not provide a formal mechanism for a stockholder to nominate a candidate for director. Hence, as a practical matter, stockholders may vote a proxy only for those director candidates nominated by the company or withheld their votes for those candidates. Further, if the company elects directors by a plurality rather than a majority of votes, even a stockholder’s "withhold" vote is meaningless because each company nominee receiving at least one vote will be elected. Rule 14a-11 is designed to give stockholders a formal voice in the director nomination process, but only after the occurrence of certain triggering events that, according to the SEC, indicate that the company has not been responsive to stockholders.

Rule 14a-11 would apply to all companies that are subject to Exchange Act proxy rules, including investment companies registered under Section 8 of the Investment Company Act. A company incorporated in a state in which state law prohibits stockholders from nominating a candidate for director, however, would not be subject to Rule 14a-11. In addition, a company whose governing documents prohibit stockholders from nominating director candidates would not be subject to the Rule¹. The SEC is seeking comment on whether Rule 14a-11 should apply only to those companies subject to accelerated deadlines for filing Exchange Act reports pursuant to Exchange Act Rule 12b-2 and investment companies, as opposed to all companies subject to Exchange Act proxy rules.

In order for a stockholder to be able to nominate a candidate for director under proposed Rule 14a-11, one of two triggering events must occur:

• At least one of the company’s nominees for the board of directors receives "withhold" votes from more than 35% of the votes cast in an election of directors at a stockholders’ annual meeting (occurring on or after January 1, 2004); or
• An eligible stockholder² submits a Rule 14a-8 proposal providing that the company become subject to the stockholder nomination procedure to a vote of stockholders at their annual meeting (occurring on or after January 1, 2004), and the proposal receives more than 50% of the votes cast on that proposal at that meeting.

The SEC has asked for comment on a potential third triggering event (although it is not part of the rule as proposed), whereby a Rule 14a-8 proposal submitted by an eligible stockholder for a vote at an annual meeting of stockholders received more than 50% of the votes cast on the proposal and the board of directors of the company failed to implement the proposal within a certain timeframe thereafter. This triggering event would apply to both mandatory and precatory stockholder proposals.

If one of the triggering events occurs, the subject company would be required to inform its stockholders through disclosures in its Form 10-Q or 10-QSB (or 10-K or 10-KSB if the triggering event took place in the fourth quarter of the company’s fiscal year) that the stockholder nomination procedure had been triggered.

Once a triggering event has occurred, the procedure remains active for each annual or special meeting held through the annual meeting in the second calendar year following the calendar year in which the triggering event occurs. During this period, a company would have to include a stockholder’s nominee in its proxy materials where the stockholder (or group of stockholders) and the nominee meet certain additional requirements. The stockholder or stockholder group would be eligible to submit a nomination under Rule 14a-11 if it:

• beneficially owns (and has owned, for two continuous years), either individually or in the aggregate, more than 5% of the company’s shares that are eligible to vote in the election of directors at the next annual stockholders’ meeting (or, in lieu of such an annual meeting, a special meeting);
• intends to continue to own those shares through the date of the annual or special meeting;
• is eligible, as to the stockholder or each member of the stockholder group, to report beneficial ownership on Schedule 13G, rather than Schedule 13D, in reliance on Exchange Act Rule 13d-1(b) or (c); and
• has filed a Schedule 13G reporting its beneficial ownership before or on the date of the submission of the nomination to the company, which Schedule 13G must include a certification that the stockholder or stockholder group has held more than 5% of the appropriate class of the company’s securities for at least two years.

Once a stockholder or stockholder group qualifies to nominate a candidate for director, the stockholder may nominate more than one candidate depending on the size of the company’s board, as set forth in the chart below. 

 If more than one stockholder or group of stockholders qualifies to nominate a candidate for director, the stockholder or group of stockholders with the greatest beneficial ownership interest seeking to nominate a candidate may nominate all of the candidates that the company is required to include.

In order to be nominated by an eligible stockholder under proposed Rule 14a-11, a nominee is required to meet certain qualifying standards, mainly related to independence. Specifically, the stockholder nominee must not:

• violate state or federal law or the rules of any national securities exchange or association by virtue of being either a candidate or a director;
• be, or be the immediate family member of, the nominating stockholder or a member of the nominating stockholder group;
• if the nominating stockholder or any member of the nominating stockholder group is an entity, have been, or have an immediate family member who has been, an employee of a nominating stockholder during the then-current calendar year or the immediately preceding calendar year;
• have accepted or have an immediate family member who has accepted, any consulting, advisory, or other compensatory fee from the nominating stockholder or any member of the group of nominating stockholders or any affiliate of any such holder or member, during the then-current calendar year or the immediately preceding calendar year;
• be an executive officer, director (or person fulfilling similar functions) of the nominating stockholder or any member of the nominating stockholder group, or of an affiliate thereof;
• control the nominating stockholder or any member of the nominating stockholder group;
• be out of compliance with the applicable standards for director independence of a national securities exchange or association; or
• have a direct or indirect agreement, or be nominated by a stockholder who has an agreement, with the company regarding the nomination of the nominee.

Once a triggering event has occurred, if both the nominating stockholder and the candidate being nominated meet all of the applicable eligibility requirements, the stockholder would be required to provide notice to the company at least 80 days before the date that the company mails its proxy materials for the election for which the stockholder is intending to submit a nominee or nominees. The nominating stockholder also would be required to file with the SEC a copy of the notice sent to the company. The required notice to the company would include a statement from the nominee consenting to be named in the company’s proxy statement and to serve on the board if elected, as well as certain other information about the compliance of the nominating stockholder and the nominee with Exchange Act Rules. Finally, the notice would include a representation that:

• the nominating stockholder is eligible to submit a nominee under Rule 14a-11;
• the nominee meets the independence criteria set forth in rules of a national securities exchange or association;
• no prohibited relationship exists between the nominee and the nominating stockholder or the nominating stockholder group;
• neither the nominee nor the nominating stockholder (or any member of the nominating stockholder group) has a direct or indirect agreement with the company regarding the nomination of the nominee;
• the nominating stockholder or each member of the nominating stockholder group is eligible to report its security ownership on Exchange Act Schedule 13G in reliance on Exchange Act Rule 13d-1(b) or (c); and,
• the nominating stockholder or stockholder group holds more than 5% of the appropriate class of the company’s securities, as reflected in Schedule 13G of the nominating stockholder or group, has held such shares continuously for at least two years, and intends to continue to own those securities through the date of the applicable election of directors.

Once the company receives notice from a stockholder intending to nominate a director, the company would be required to determine whether the nominating stockholder complies with Rule 14a-11 and whether or not the nominee satisfies the related requirements for nominees. The company would not be required to include a stockholder nominee if:

• the company is not subject to Rule 14a-11;
• the nominating stockholder has not complied with the requirements of the procedure;
• the nominee does not meet the requirements of the procedure;
• any representation required to be included in the stockholder’s notice to the company is materially false; or
• the company has received more nominees than it is required to include by proposed Exchange Act Rule 14a-11 and the nominating stockholder or stockholder group is not the largest beneficial owner of securities as compared with other qualifying nominating stockholders.

If the company determines that it is not required to include a candidate in its proxy materials for one of the reasons listed above, it would be required to promptly notify the nominating stockholder and explain the bases for its determination in writing. The company would still be required to disclose in its proxy materials that a stockholder nomination was submitted and the reasons for the company’s determination that the nomination had not met the requirements of Rule 14a-11.

If the company determines that it is required to include a candidate in its proxy materials, the company would be required to notify the nominating stockholder and state whether or not the company intends to include information supporting its own candidates or opposing the stockholder candidate(s). If the company includes in its proxy materials a statement supporting its nominees and/or opposing the stockholder’s nominee(s), it would also be required to give the nominating stockholder the opportunity to include a statement in support of the stockholder’s candidate(s)³. The company would be permitted to identify whether each candidate was nominated by the company or a stockholder and recommend a vote for or against such candidates without triggering the requirement to include a statement from the stockholder nominee in the proxy materials.

Exchange Act Rules 13a-11, 13d-1, 14a-4, 14a-5, 14a-6, 14a-8, 14a-12, 15d-11 and 16a-1, Schedules 13G and 14A, and Forms 8-K, 10-Q, 10-QSB, 10-K and 10-KSB under the Securities Exchange Act of 1934 would also be amended as part of the proposed rules. The significant rule changes include:

• Rules 14a-3 to 14a-6(o), 14a-8 and 14a-10 to 14a-15 would not apply to communications among stockholders for the purpose of forming a stockholder group, provided that the communication is either made to a limited number of stockholders or is to an unlimited number of stockholders but contains limited content.
• Rules 14a-3 to 14a-6(o), 14a-8 and 14a-10 to 14a-15 would also not apply to solicitations by a stockholder in favor of its nominee, provided that the stockholder does not seek the power to act as proxy for another stockholder, and provided that each written communication contains certain specified information.
• The SEC is also proposing to revise the categories of persons eligible to report their ownership on Schedule 13G to include those stockholders who acquire or own a company’s securities in connection with a nomination, soliciting activities or election of a nominee under the Rule 14a-11, noting that those stockholders should not be deemed to have a purpose or effect of changing or influencing the control of a company solely by virtue of making the nomination or engaging in soliciting activities.
• The definition of a 10% owner for Section 16 purposes would be amended to exclude a Rule 14a-11 nominating security holder group.

The SEC’s release, which contains greater detail about proposed Rule 14a-11, including certain amendments and issues raised by the SEC for consideration that are not discussed in this memorandum, is available on the SEC’s web site at: http://www.sec.gov/rules/proposed/34-48626.htm.

The SEC has requested comments on the above proposals, and issuers who have strong views about any aspect of these proposals are urged to comment. Comments related to the proposals must be submitted to the SEC by December 22, 2003.