SEC Approves Rules Facilitating Shareholder Director Nominations

On August 25, 2010, the SEC adopted rules that will facilitate shareholders' nominations of director candidates to a company's board of directors, which is often referred to as "shareholder access" or "proxy access." New Rule 14a-11 allows shareholders satisfying certain conditions to include one or more director nominees in a company's proxy statement and on the company's proxy card. The rules also amend Rule 14a-8 to require that shareholder proposals to add certain procedures relating to director nominees to a company's governing documents be included in a company's proxy statement. The rules were adopted on a 3-2 vote of the commissioners.

To put shareholder access in perspective, directors of a public company are typically elected to its board of directors by its shareholders at an annual meeting of shareholders. The company sends a proxy statement in connection with the meeting that identifies the nominees for director who were recommended by the nominating committee of the company's board of directors. While it has always been possible for a shareholder to nominate his or her own nominees as candidates for the board (referred to as a "proxy contest"), the shareholder would have to file and mail a proxy statement to do so, which is expensive. In addition, the shareholder would have to list its nominees on a separate proxy card rather than being able to include them on the company's proxy card.

Under the new shareholder access rule, shareholders satisfying specified criteria can nominate directors and have those nominees included in the company's proxy statement, thereby reducing the expense of preparing their own proxy statement and clearing it with the SEC. In that event, the company must also include those shareholder nominees on a single "universal" proxy card which will list all nominees—those nominated by the board and by qualifying shareholders—rather than on two separate proxy cards.

Rule 14a-11 is not the exclusive means for a shareholder to nominate directors. A shareholder can still choose to file and mail a separate proxy statement by complying with the company's general advance notice bylaw requirements, which are less restrictive in terms of the stock ownership requirements, advance notice period and number of nominees.

Shareholder access will become effective 60 days after the SEC rules are published in the Federal Register, and will apply if the notice deadline is on or after that effective date. As described in more detail below, the notice deadline is generally 120 days before the date of mailing the prior year's proxy statement. For smaller reporting companies, there is a three-year delay before Rule 14a-11 becomes effective.

The SEC's adoption of shareholder access quickly followed congressional approval of the Dodd-Frank Act in July, which authorized the SEC to adopt shareholder access. This authorization resolved a concern about whether the SEC had statutory authority to adopt shareholder access. Although the chances of a successful legal challenge have been reduced by the Dodd-Frank Act, the two commissioners who voted against the rule identified at least one provision of the rule that one of them characterized as a "fatal flaw," which is the prohibition on opting out of shareholder access. The inability of shareholders to opt out of shareholder access, even if desired by shareholders holding a majority of the shares, arguably defeats the premise upon which shareholder access is based, which is empowering shareholders to invoke their state law rights.

Adoption of Rule 14a-11

Rule 14a-11 applies to companies that are subject to the proxy rules of the Securities Exchange Act of 1934, including investment companies and controlled companies.

Effective Date

Rule 14a-11 will become effective 60 days from the date the rules are published in the Federal Register. It will apply to a company for the 2011 proxy season if the 120-day deadline for giving notice of an intention to nominate directors under Rule 14a-11 is on or after the effective date of the rules. However, any company that is a "smaller reporting company" (generally defined as a company with a public float held by non-affiliates of less than $75 million) will not be subject to shareholder access until three years from the effective date of the rules.

Shareholder Eligibility/Filing Requirements

In order to nominate directors for inclusion in a company's proxy statement for a meeting of shareholders at which directors will be elected, the shareholder or group of shareholders must satisfy certain requirements:

Stock Ownership Amount—The nominating shareholder or group of shareholders must hold investment and voting power, either directly or through any person acting on their behalf, of at least 3 percent of the voting power of the company's securities entitled to vote on the election of directors at the meeting. Shareholders acting together can aggregate their shares to satisfy this stock ownership threshold. Securities loaned to a third party can be included in the calculation if they can be recalled and the shareholder will recall the loaned securities if any of the nominees will be included in the company's proxy materials. However, securities sold short and securities that have been borrowed do not count toward the threshold. In determining whether a shareholder or group holds at least 3 percent of the voting power of the company's securities, the shareholder or group can rely on the most recent 10-K, 10-Q or 8-K filed by the company containing that information unless the nominating shareholder or member of the group knows or has reason to know that the information is incorrect.

Stock Ownership Duration—The minimum amount of securities used to satisfy the ownership threshold described above must have been continuously held for at least three years as of the date of submitting the notice of intent to use Rule 14a-11. In the case of a nominating shareholder group, each member must have held the securities counted toward the threshold for at least three years. In addition, the nominating shareholders must continue to own the qualifying securities through the date of the meeting at which directors will be elected, and provide disclosure as to whether or not they intend to continue their ownership after the election of directors, which may be contingent upon the outcome of the election. Similar to the current process for proving stock ownership for purposes of shareholder proposals under Rule 14a-8, nominating shareholders who are not "registered" holders must provide a written statement from the "record" holder, dated within seven calendar days prior to the notice on Schedule 14N, verifying the amount of securities owned and that the securities satisfying the ownership threshold have been continuously owned for at least three years, or by providing a copy of a Schedule 13D or 13G or Form 4 or 5 demonstrating the required ownership.

No Change of Control Intent; No Agreements with the Company—As a condition to use Rule 14a-11, the nominating shareholders may not be holding the company's securities with the purpose or effect of changing control of the company or gaining more seats on the company's board than is permitted under Rule 14a-11. In addition, the rule requires that neither the nominating shareholders nor the nominees may have a direct or indirect agreement with the company regarding the nominations prior to making the related SEC filing.

Deadline for Notice—The nominating shareholders must provide notice to the company of their intent to use Rule 14a-11 no earlier than 150 days and no later than 120 days prior to the anniversary of the mailing of the prior year's proxy statement. If the company did not hold an annual meeting during the prior year or if the date of the meeting changes more than 30 days from the prior year, the company will need to file a Form 8-K, under new Item 5.08, after the company determines the anticipated meeting date disclosing the due date for shareholder nominees under Rule 14a-11, which must be a reasonable time before the company mails its proxy materials.

Schedule 14N Filing Requirement—The nominating shareholders must file with the SEC a notice of intent to nominate directors on Schedule 14N on the same day the notice is provided to the company. The Schedule 14N must be amended to reflect any material change, including any withdrawal of a nominating shareholder or nominee and the reasons for the withdrawal. The nominating shareholders, and not the company, will be liable for any statement in the notice. The notice on Schedule 14N must include, among other things:

• The name and address of the nominating shareholder or each member of the nominating shareholder group;

• The amount and percentage of voting power of the company's securities entitled to be voted by the nominating shareholder or group and the ownership of those securities for at least three years, including any required verification;

• Biographical or other information about the nominating shareholder or group and the shareholder nominee(s), similar to the disclosure currently required in a contested election;

• The nature and extent of the relationships between the nominating shareholder or group, the nominee and/or the company or any affiliate of the company;

• Whether or not the nominee(s) satisfy the company's director qualifications if any (as set forth in the company's governing documents) and objective independence requirements of applicable national security exchanges;

• Certifications that, after reasonable inquiry and based on the nominating shareholder's or group's knowledge, the eligibility requirements applicable to the nominating shareholder or group and the nominee(s) have been satisfied;

• A statement that the nominating shareholder or group will continue to hold the qualifying amount of securities through the date of the meeting and a statement with regard to the nominating shareholder's or group's intended ownership of securities following the election of directors (which may be contingent on the results of the election);

• An optional statement in support of each shareholder nominee, not to exceed 500 words per nominee; and

• The address of any website on which the nominating shareholders may publish soliciting material.

The Schedule 14N must be amended within 10 days after announcement of the final results of the election to provide information about continued stock ownership.

Nominee Requirements

Nominee Eligibility—A company will not be required to include a shareholder's director nominee whose candidacy or, if elected, board membership would violate controlling state or federal law, or the applicable standards of the stock exchange on which the company's securities are listed (other than subjective independence requirements) if the violation cannot be cured within 14 calendar days of notice from the company. There are no restrictions on the relationships between the nominees and the nominating shareholders. The company cannot require nominees to comply with other eligibility qualifications or expectations set by the board, but could explain in the company's proxy statement the extent to which nominees do not satisfy the company's qualifications.

Shareholder Access Process Requirements

Company Response to Schedule 14N—If a company intends to include a nominating shareholder's nominees, the company must provide notice to the shareholder postmarked or transmitted electronically no later than 30 calendar days before it files its definitive proxy materials.

Failure to Satisfy Requirements—Companies are not required to include nominees if all eligibility requirements have not been satisfied. If a company determines that it may exclude a nominee, it must provide a notice to that effect to the nominating shareholder within 14 calendar days after the deadline for nominees under Rule 14a-11. The shareholder must respond within 14 calendar days after receipt of the deficiency notice to cure the defect (if it can be cured). If the company still believes that it may exclude the nominees, the company must provide notice of this fact to the SEC no later than 80 calendar days before filing its definitive proxy statement. The company may also submit a no-action request to the SEC no later than 80 calendar days before filing its definitive proxy statement to get the SEC's informal view about whether the company can exclude a nominee. If the only deficiency is a supporting statement that exceeds 500 words for a nominee, the company must include the nominee, but can exclude the supporting statement. The company may not exclude a nominee on the basis that the company believes the Schedule 14N contains materially false or misleading statements because the nominating shareholder, not the company, has liability for those statements. The company can refute the statements in its soliciting materials and the statements will be subject to the SEC's proxy contest review procedures.

Number of Nominees—Companies are required to include in their proxy statements nominees who, together with any continuing directors who are serving multi-year terms for which they were elected pursuant to Rule 14a-11, represent up to 25 percent of the board, or in any event, at least one director. If multiple eligible nominees in excess of the 25 percent maximum are nominated by shareholders, the nominating shareholder or group with the highest percentage of the company's voting power will be entitled to have its nominee(s) included. If shareholders are only entitled to elect a subset of the full board due to voting rights related to separate classes of stock, the maximum number of nominees that can nominated under Rule 14a-11 is based on the number of directors that can be elected by the class of stock held by the nominating shareholder. In the case of a company with a classified board, the calculation is based on total board size, not the size of the class currently up for election. Any nominees submitted by the nominating shareholders with the highest qualifying voting power percentage who the company agrees to include as board nominees after the filing of the Schedule 14N will count toward the 25 percent as long as communications with the company regarding the nominations did not commence before the Schedule 14N was filed. This change was adopted in the final rule to avoid discouraging companies from voluntarily nominating candidates submitted by shareholders in settlement of a proposed proxy contest. The number of shareholder nominees that may be included in the company's proxy statement is not affected by a proxy contest waged by shareholders outside of Rule 14a-11. Rather, nominees submitted pursuant to Rule 14a-11 will be in addition to any nominees or slates of nominees proposed by other shareholders through traditional proxy contests. However, a shareholder relying on Rule 14a-11 to submit nominees may not also engage in a non-Rule 14a-11 solicitation. Accordingly, the concept of a "universal proxy" will only be available for a nominating shareholder relying on Rule 14a-11.

Withdrawing or Disqualified Nominee—If a nominating shareholder with the highest qualifying voting power percentage withdraws or is disqualified, the company must include the nominees from the nominating shareholder with the next highest qualifying voting power percentage, not to exceed the 25 percent aggregate maximum. If a nominee withdraws or is disqualified, the company must include any alternate nominees submitted by the qualifying shareholder or, if none, the nominees submitted by the nominating shareholder with the next highest qualifying voting power percentage, not to exceed the 25 percent aggregate maximum. Once a company has commenced printing of its proxy materials, the company is not required to include substitute nominees, but rather can delete the disqualified or withdrawn nominees.

Inclusion in Company Proxy Statement—If the company determines to include a nominating shareholder's nominees, the company must include certain specified information about the nominee and the solicitation. The company must also include any nominees submitted under Rule 14a-11 on the company's proxy card and allow shareholders to vote on each nominee (including the company's nominees and the shareholders' nominees) separately. The company may clearly designate nominees as board nominees or shareholder nominees but cannot have a box permitting shareholders to vote on the company's nominees as a group. Inclusion of a shareholder nominee under Rule 14a-11 will not require the filing of a preliminary proxy statement by the company.

Although certain of the Rule 14a-11 procedural requirements are similar to current Rule 14a-8, it differs in other respects. For example, the nominating shareholders are not required to attend the meeting at which their nominees are voted on and there is no limit on the number of times a qualifying shareholder can submit nominees or a nominee can be nominated simply because a particular nominee failed to be elected or receive a certain number of votes.

Related Changes to Proxy Solicitation and Beneficial Ownership Reporting Rules

To facilitate Rule 14a-11, the SEC adopted exemptions, subject to certain requirements, from the proxy solicitation rules to enable shareholders to communicate with each other to coordinate proposed nominations and garner support for shareholder nominees so long as the shareholders do not seek to act as proxies or furnish or request a proxy or other form to elect nominees or revoke proxies for board nominees. Similarly, the SEC adopted an exception from the Schedule 13D filing requirements so that shareholders seeking to form a group solely for the purpose of nominating directors under Rule 14a-11 or soliciting activities in connection with a Rule 14a-11 nomination (including related solicitations in opposition to board nominees) will not lose the eligibility to file on Schedule 13G. No changes to the Section 16 reporting requirements or Rule 144 affiliate definition were adopted.

Amendment of Rule 14a-8

The SEC also adopted amendments to narrow the scope of the exclusion in Rule 14a-8(i)(8) relating to the election of directors. Shareholders meeting certain eligibility requirements have historically been able to submit a shareholder proposal to be included in the company's proxy statement; however, proposals relating to the election of directors have not been permissible. As amended, shareholder proposals that seek to establish a procedure in the company's governing documents for the inclusion of one or more shareholder director nominees in a company's proxy materials may not be excluded under Rule 14a-8(i)(8). Companies will, nonetheless, be entitled to exclude proposals that would disqualify a nominee who is standing for election, remove a director from office before the end of his or her term, question the competence, business judgment or character of one or more nominees or directors, seek to include a specific individual in the company's proxy materials for election to the board of directors or otherwise affect the outcome of the upcoming election of directors. As a result, the shareholder access rights afforded under Rule 14a-11 will not be exclusive, and shareholders may seek to impose lower (but not higher) stock ownership and holding period thresholds and broader (but not narrower) access rights to nominate directors. 

Practical Steps to Consider

When it comes to fighting a proxy contest, the best defense may be a good offense. The SEC rules generally foreclose any opportunities for imposing limitations or restrictions on shareholder access rights through the company's governance documents. As a result, changes to corporate bylaw or governance guidelines are not required. However, companies should consider the following steps to prepare for, or possibly even avoid, a proxy contest:

Review Composition of Board of Directors and Any New Nominees

• Under recent SEC rules, companies are required to disclose the qualifications, skills and experience that each director and nominee brings to the boardroom. Companies should carefully review that disclosure against any internally adopted criteria/guidelines for directors to make sure that the company is in compliance with its own objectives. Companies should also compare the qualifications of current directors against key strategic areas within the company, such as financial complexity, international operations, regulatory requirements, etc., to make sure that board members, as a group, bring experience relevant to the company's operations. Reviewing the company's risk factors against the skills directors have to analyze and address those risks can also be helpful in identifying director qualifications that may be important to shareholders. To the extent that the current board composition is not aligned with the company's current business, the nominating committee should seek out additional board talent or consider other changes.
  
• Boards should review and, if necessary, enhance the director evaluation process. Proxy contests often result in personal attacks on individual directors and their qualifications. Companies will want to make sure that directors are not subject to scrutiny for poor performance due to low attendance at board meetings, questions about independence or failure to comply with company guidelines.
  
• Nominating committees should enhance their procedures for reviewing and assessing director candidates, including directors standing for re-election and candidates proposed by shareholders. In addition, nominating committees should continually review possible additional director candidates in the event of an unexpected resignation or retirement.
  
• Boards should review all governing documents, including committee charters and governance guidelines, to ensure consistency on nomination process and director qualifications.

Engage in Meaningful Self-Evaluation of Corporate Strategy and Governance

• Companies should proactively engage in meaningful evaluation of corporate strategy and corporate governance structures. By reviewing analyst reports, industry information, data about competitors and input from shareholders, boards should consider strategic changes, such as growth strategies, acquisition/divestiture opportunities and shareholder return mechanisms (dividends, stock repurchases, etc.). Boards should conduct regular reviews of strategic alternatives and assess the risks of proceeding or not proceeding, as the case may be, with those alternatives. This will enable the Board to explain the steps that it has taken and reasons for choosing to pursue or not pursue certain courses of action if it perceives that a proxy contest was intended to force the pursuit of those strategies.
  
• Similarly, regularly reviewing corporate governance best practices, in terms of general and industry-specific benchmarking, to understand areas where the company may be viewed as lagging best practices will help identify areas for change or allow the board to articulate the reasons for deviating from current trends. 

Enhance Communication With Shareholders

• Companies should review avenues for shareholder communication and consider the appropriate level of proactive shareholder engagement that allows the board to exercise its business judgment with an understanding of shareholder concerns and while in possession of shareholder feedback. Adding a routine report from senior management and investor relations personnel at board or committee meetings regarding discussions with shareholders and other constituents may help keep the board informed.
  
• Companies should also review and enhance clarity in routine shareholder communications, such as periodic SEC reports, the proxy statement and press releases, to make sure that shareholders understand what the company is communicating with respect to key issues, such as financial condition, business opportunities and executive compensation.

Be Prepared for a Proxy Contest

• Companies should discuss with their boards in advance the import of the new proxy access rules, including the increased likelihood of proxy contests, the possible expense and effort involved in such contests and the likely level of involvement of directors and officers in such contests. Such preparation will better enable the directors and officers to assess whether to oppose, or compromise with respect to, shareholder nominees in the event of such nominations.
  
• Because of the increased likelihood of proxy contests and the relatively short time periods under Rule 14a-11 for assessing nominees and determining how to respond, such as whether to communicate or negotiate with the nominating shareholder, it is important for companies to identify advisors to contact ahead of time—proxy solicitation firms, public relations firms and legal counsel—to formulate a response and strategy should a proxy contest arise.

Companies may want to review and, if necessary, revise governance/nominating committee and board meeting schedules to ensure that a meeting will be held around the applicable Schedule 14N notice time so that the company can consider an appropriate course of action in case such a notice or other shareholder proposal is received.