The SEC has once again been put at the center stage of a long-standing dispute regarding the role of shareholder proposals in corporate governance and social activism. This fractious issue will once again be debated in the fall, following delivery of a congressionally-mandated SEC study. Under the National Securities Markets Improvements Act, adopted in October 1996, the SEC is required to submit a report by October 11, 1997 to Congress on the effects of the SEC's shareholder proposal rules on companies and proponents. Further SEC action or a congressional response is likely.
Past As Prologue
Since 1942, companies subject to the Federal proxy rules have been required to include in their proxy statements shareholder proposals and supporting statements which any shareholder owning more than a nominal number of shares intends to present at an annual meeting of shareholders. Under the Federal regulations, such a proposal may be omitted under a number of exclusions, including most frequently proposals which relate to the ordinary business operations of the company or relate in only a de minimus way to the company's business. If the company desires to omit a proposal it must provide notice to the proponent and to the SEC. The SEC staff typically responds to the notice with either a "no-action" position- meaning that the Commission staff will not take enforcement action against the company if it omits the proposal- or a letter stating that the SEC staff cannot take such a position because it believes that the proposal may not be properly omitted under the exclusion, although the SEC staff is permitted to express no position. Regardless of the position taken by the staff, both the company and the proponent can take the issue to the courts. Since most proponents and companies are unwilling to face the costs of litigation, the SEC staff view is frequently followed.
Although there are thirteen exclusions to the shareholder proposal requirement, the most frequently debated exclusion is for those proposals that deal with the ordinary business operations of the company. This exclusion was adopted in 1954 to "relieve management of the necessity of including in its proxy material security holder proposals which relate to matters falling within the province of management."
Following the original adoption of ordinary business exclusion, companies were usually successful in omitting social advocacy proposals. Fearing that this exclusion was being interpreted too broadly, in 1976 the Commission solicited comments on three proposed ways of dealing with the ordinary business exclusion. First, the Commission proposed narrowing the exclusion so that it would only permit the omission of a proposal dealing with a "routine, day-to-day matter relating to the ordinary business operations of the company." Second, it proposed replacing the exclusion with one which would exclude all proposals which the board of directors would not be required to act upon. Third, it proposed eliminating the exclusion altogether. In the end, the SEC rejected all three proposals, choosing to retain the exclusion but suggesting that it be interpreted "in a somewhat more flexible manner than in the past."
The SEC staff, in apparent response to the Commission's call for a more flexible interpretation, narrowed its view of the ordinary business exclusion to require companies to include proposals which "have significant policy, economic or other implications inherent in them." Under this interpretation, social activists, usually from the left, used the shareholder proposal process to advance a number of causes including affirmative action, adoption of the MacBride Principles relating to employment practices in Northern Ireland, withdrawal from doing business in South Africa prior to the end of Apartheid, and adoption of environmental codes of conduct. However, in 1992 the Commission staff, responding to a no-action request from Cracker Barrel Old Country Stores, conceded that the social-policy distinction was unworkable.
In reviewing a request to exclude a shareholder proposal urging the adoption of an affirmative action policy for homosexuals, the SEC staff ruled that shareholder proposals concerning a company's employment policies and practices for the general workplace tied to a social issue would no longer be viewed as removing the proposal from the realm of the ordinary business operations of the company. In so ruling, the staff noted that the distinctions recognized in the past by the staff in determining whether a given proposal raises significant policy questions are "characterized by many as tenuous, without substance and effectively nullifying the application of the ordinary business exclusion to employment related policies." The SEC later extended the logic of Cracker Barrel to shareholder proposals in non-employment-related areas, such as proposals which urged companies to cease doing business in Burma.
Following the SEC no-action letter in Cracker Barrel, the proponent of that affirmative action proposal, the New York City Employees Retirement System (NYCERS), filed suit against the SEC claiming that the SEC's reversal of its prior no-action positions that social policy issues raised otherwise ordinary business proposals out of the exclusion violated provisions of the Administrative Procedure Act. After loosing in the Federal District Court in a decision written by Judge Kimba Wood, the SEC ultimately prevailed in the NYCERS APA suit in the Second Circuit Court of Appeals, but for the two and one-half years the litigation was pending the SEC refused to provide no-action relief under the ordinary business exclusion.
While the SEC has resumed granting no-action positions based on Cracker Barrel, social activists were able to include in last October's National Securities Markets Improvements Act a requirement that the SEC study "whether shareholder access to proxy statements pursuant to . . . the Securities Exchange Act of 1934 has been impaired by recent statutory, judicial, or regulatory changes; and the ability of shareholders to have proposals relating to corporate practices and social issues included as part of proxy statements."
Proposals to Reform the Shareholder Proposal Process
Several of the SEC Commissioners have expressed views on the shareholder proposal process. The principal advocate of reform is Commissioner Steven Wallman, who has put forward his own proposal. Acknowledging that the social policy exception to the ordinary business exclusion "reflects the futility of efforts by a federal agency not equipped to serve as a trier of fact or arbitrator of social or business policy to make the judgments required by the [Federal proxy rules,]" Wallman's proposal would address the problem by eliminating the ordinary business exclusion entirely, along with the exclusion for proposals which relate to de minimis operations, but would: limit the number of proposals carried at company cost to three; with the proposals selected by lot by a company's independent auditors or other independent third parties; raise the shareholder eligibility threshold to require the proponent to have held at least $12,500 worth of stock for two years or $2,500 worth of stock for five years (as opposed to the current requirement of $1,000 worth of stock for one year); and provide an exception to the numerical cap of three proposals for those proponents that individually or as a group hold at least five percent of the outstanding voting stock.
While Commissioner Issac Hunt is keeping an open mind on the subject, his preference would be to get the SEC to get out of the process, noting that the SEC "[doesn't] do anything to develop expertise in the area."
Not surprisingly, the social activists are urging the reversal of Cracker Barrel. Without making specific public proposals, the Interfaith Center on Corporate Responsibility solicited its members to write the SEC and Congress to "support the right to be heard as social investors." A number of shareholder rights groups have also entered the fray in order to press for more shareholder democracy and better corporate governance. For example, the Investor Rights Association of America urged the SEC to go beyond its current rule to allow groups of investors holding at least 5% of a company's shares access to company proxy statements to nominate at least one independent director.
The SEC Questionnaire
In response to the National Securities Markets Improvements Act's mandate, the SEC posted a fourteen page questionnaire on its web site, seeking input from shareholder proponents, companies, and other interested parties. In announcing the publication of the questionnaire, Chairman Arthur Levitt urged the public to participate in the survey by stating "Everything is on the table. We are looking for new ideas, including those that could fundamentally change the way we administer the shareholder proposal process."
The SEC questionnaire asked sixty-six questions, many of which offer the respondent the opportunity for a narrative response. Responses to the questionnaire were due by April 7, 1997. According to the SEC staff, there were 322 responses to the questionnaire, the results of which are presented being analyzed.
Among the issues on which the Commission solicited comment, participants were asked to comment on a number of alternative proposals. One would allow each company to create its own shareholder proposal process (that is for deciding which proposal should be included or excluded), which process would then be approved or disapproved by shareholders rather than being subject to a Federal rule. Another would allow each state to set up its own shareholder proposal rule that would apply instead of the SEC rule. Still another would limit the maximum number of shareholder proposals that a company could include in each proxy statement without regard to the subject matter of the proposal so long as they were consistent with State and Federal law.
The SEC also sought comment on the mechanical process to be employed in submitting shareholder proposals. As suggested by Commissioner Wallman, the SEC sought comment on whether to increase the amount of shares a shareholder is required to own in order to submit a proposal or to adopt a system in which a company would be required to include only those proposals where the proponent has obtained the endorsement of a certain number of his or her fellow shareholders.
The SEC staff has only begun to analyze the responses to the questionnaire. The early analysis is that many believe the current system is flawed but there is no consensus in how to fix it. Without a major securities bill under substantial consideration, Congressional action is unlikely this term. However, it is virtually certain that the SEC study and the results of the questionnaire will generate substantial commentary and more fireworks at the Commission.
Mr. Galda is a partner at Buchanan Ingersoll and serves as Vice Chairman for Programs.