The SEC's Proposed Shareholder Voting Rule

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This is the first issue of Financial Services Outlook, a new monthly publication of the Financial Market Deregulation project at AEI. The series will address current issues in financial services, including banking, insurance, and securities.

This first issue discusses the SEC’s hugely controversial proposal to enhance the ability of shareholders under limited circumstances to nominate directors of public companies. The proposal, we suggest, is controversial because the SEC has made no effort to provide a factual foundation for the proposed rule, accepting what are essentially anecdotes as the basis for its action. In addition, even assuming that anecdotes are a rational basis for an SEC regulation, the commission has not attempted to demonstrate why its intervention is necessary, or how this rule would change anything that is important or appropriate to change. The rule, we conclude, should be abandoned until the SEC meets these minimum requirements for regulatory action.

Last fall, the SEC published a proposed rule that would—under certain limited circumstances—permit shareholders of public companies to nominate one or two candidates as alternatives to the nominees of the company’s board of directors and management. The rationale for the rule, spelled out in the SEC’s accompanying release, is oddly vague. It never describes with specificity what the rule is actually supposed to accomplish, what shareholder rights it is intended to vindicate, what evidence the commission has assembled in support of the rule, or why the rule is necessary as an exercise of the commission’s regulatory authority. Instead, the rule is said to address cases where a company’s proxy process is “ineffective,” or shareholders are “dissatisfied,” or shareholder views have not been “adequately taken into account.”

What does the SEC mean when it is concerned about shareholders who are “dissatisfied,” or that a proxy process is “ineffective,” or that shareholders cannot participate “meaningfully” in the proxy process? Dissatisfied about what? Ineffective in what way? And meaningfully in what sense—political, economic, or emotional? To these questions, the SEC release provides no answers. It appears that the rule is designed to address general shareholder dissatisfaction—about anything—and thus reflects a new intrusion into the economic sphere of the culture of victimization that many have noted in American society in recent years. Now, it appears, shareholders are also victims—in this case of unresponsive corporations that will not listen or respond to their complaints.

Probably for this reason—public companies sense what is going on here—the proposal has been enormously controversial, provoking more letters of comment to the SEC than any proposal in recent memory, and stimulating the SEC to organize a daylong series of public roundtables where views pro and con could be aired in the presence of the members of the commission. At the roundtable, opponents of the proposal argued that it was not necessary, while supporters argued that it did not go far enough. The discussion at the roundtable did nothing to allay concerns that there was no basis for the rule other than the generalized sentiments expressed in the accompanying release. Indeed, it reinforced that conclusion.

No Factual or Regulatory Foundation

The roundtable comments exposed a major difference in the perceptions of those who favored and those who opposed the rule. The former group, which included representatives of public interest groups, public and private pension funds, and shareholder rights advocates, cited cases in which corporations ignored their requests for changes in corporate policies. Proponents of the rule connected this somehow to Enron and WorldCom, as though those cases of corporate fraud were the result of failure to be responsive to shareholders. The opponents argued that the Sarbanes-Oxley reforms—which included requirements for a majority of directors to be independent of management and for nominating committees of independent directors to choose the slate of directors who would be presented to shareholders at the annual meeting—should be given an opportunity to work before yet more regulatory requirements are added to those already in place. Thus, the dispute between the parties was completely hypothetical—the proponents arguing that non-responsiveness by corporations was rampant and unacceptable, and opponents contending that the problem, if it actually exists, has already been remedied by Sarbanes-Oxley.

Leaving aside the fact that the Sarbanes-Oxley reforms are likely to have a major impact on how directors are chosen and how they behave, and with all due respect to the SEC, statements by individuals or groups that corporations have in the past been “unresponsive,” or are not “accountable,” are not a sound or sensible basis for adopting a rule, especially one that—like the Sarbanes-Oxley Act itself—may have significant and adverse unintended consequences. There are two reasons for this. First, adopting a rule on the basis of anecdotal evidence that corporations are “unresponsive” or shareholders are “dissatisfied” is not a responsible way to perform the regulatory function. The SEC, given the power it has been delegated by Congress to promulgate rules (assuming of course that the SEC has the legal authority to adopt this rule, which is not entirely clear), should at least have studied what corporations are actually doing before proposing to fix a problem that might not actually exist to any significant degree.

In addition, to the extent that the some dissatisfaction on the part of shareholders has been found to exist, the SEC should explain what aspects of shareholder dissatisfaction public companies are required to remedy. Is there some reason that a public company should be legally obligated to be responsive to a shareholder about, say, the company’s environmental policies, or its plans to put a plant in China? If so, then the SEC should say so. But it is not satisfactory to say that shareholders should have some inchoate right to nominate one or more directors simply because they are generally “dissatisfied.” For the reasons outlined below, companies will generally be responsive to their shareholders; but if they are not, the SEC must articulate a reason why it should exercise its regulatory authority to penalize non-responsiveness. This the commission has not done, and as a regulatory agency with authority delegated by Congress, it has at the very least an obligation to do so.

Why Is Intervention Necessary?

Even in the doubtful case that the SEC has a sound regulatory basis for making any rule on this subject—and we will never know this until the SEC tells us what that basis is—there is a serious question of whether any regulation is necessary to achieve these purposes. If the reasons advanced in support of the rule at the roundtable reflect the commission’s own rationale for adopting the rule, the process should be abandoned. Ultimately, both the justifications presented by the rule’s supporters and the discussion by the SEC in its accompanying release reflect a confusion about the role of shareholders in a corporation, the role of boards of directors, and the ways that change can actually be brought about in public companies. This is probably understandable when it arises from the groups that favor the rule. It is surprising and troubling when that confusion extends to the SEC itself, which has the power to compel significant changes in how public companies operate and seems uncritically to have accepted the weak rationale of the proponents.

The first confusion seems to arise from a conflation of the idea of the shareholder as a voter at a corporation’s annual meeting and the idea of a citizen as a voter in a democracy. This should not require restatement, but the purpose of the voting process in a democracy is to establish a mutually acceptable way of resolving the many conflicts that arise among the members of a society—who is to be taxed, and for how much; who is to receive services, and to what degree; and what are to be the society’s priorities among the myriad possibilities. As many have noted, democracy is not necessarily the best system for resolving these conflicts, but it is the only system that everyone can accept as fair.

We pay attention to the responsiveness of governments because in general it is extremely difficult for citizens to change how they are governed by changing their country of residence. Expatriation may entail leaving families and employment, learning a new language, and great expense. None of these problems exist for shareholders who are dissatisfied with how their corporations are governed. Shareholders can remedy dissatisfaction with governance or non-responsiveness simply by selling their shares.

It was remarkable how little discussion at the roundtable focused on the shareholder’s ability to adopt this course, or on the effect it would have on the corporations subject to such selling pressure. Yet corporations do not treat this possibility lightly. They spend large sums on shareholder relations, knowing perfectly well that shareholder dissatisfaction can lead directly to lower stock prices, higher capital costs, and ultimately the loss of income or employment for management. But this obvious incentive—which clearly makes most corporations highly responsive to shareholder requests—did not seem to be sufficient to overcome the idea that some corporations failed to be adequately responsive to the groups whose representatives spoke at the roundtable.

Sadly, it seemed that a majority of the commission was willing to take anecdotal tales and allegations as a sufficient basis for adopting the rule despite the virtual certainty that if shareholders were really dissatisfied they had a powerful weapon—the sale of the shares—with which to discipline the boards and managements of non-responsive companies. In effect, then, the SEC is about to make a rule that would impose a kind of penalty on corporations for not doing what they have a strong incentive to do anyway.

Another confusion reflected in the proposed rule is the bland acceptance of the notion that shareholders are the “owners” of a corporation and thus have all the rights that owners of property may generally exercise. This proposition, which was thrown about promiscuously at the roundtable, is a vast oversimplification. Shareholders certainly have rights in a corporation—to participate in a portion of its cash flows and to elect the directors—but it is incorrect as a matter of law to analogize them to owners. Most state corporate laws, which spell out the rights of shareholders and define the authority of corporations, say that the management of a corporation is vested in the board of directors. Some corporate laws have special provisions that, if exercised in the proper way, allow shareholders to take control of the management of a corporation in lieu of the board of directors, but this is not the general rule. In fact, in assessing their powers, shareholders are much closer to trust beneficiaries than they are to owners; in effect, shareholders are trust beneficiaries with the power to elect the trustees.

Thus, it is incorrect to suppose that shareholders have an unlimited right, as though they were owners, to direct the affairs of their corporations. The board of directors is the organization with the authority under law to do this, but—like trustees—they owe fiduciary duties to the corporation and only indirectly to the shareholders. Under these circumstances, it is difficult to understand what shareholder rights the SEC is vindicating through this proposed rule. Although the SEC created a 107-page document describing the reasons for the proposed rule, it never answers this question. It seems to assume, along with the supporters of the rule, that shareholders have the right to direct the affairs of the corporations in which they are invested, and to the extent that these rights are being ignored by corporations it is appropriate for the SEC to intervene. Like the question of whether companies are in fact unresponsive to their shareholders, the commission seems never to have considered the necessary question of whether shareholders have the right to require their corporations to be responsive to shareholders.

Can the Proposed Rule Achieve Anything?

Finally, there is the issue of whether the rule—even if it had a sound factual and regulatory basis—can be effective in changing anything worth changing. There is no question that corporations—like every other institution in society—must be subject to criticism and reform. However, one of the characteristic elements of corporations is that their managements and operations can be changed quickly and effectively when shareholders and outsiders have the incentive to do so.

During the 1980s, financing mechanisms were developed that enabled dissident shareholders and outsiders to acquire control of corporations and bring about real reform in how they carry on their activities. Sleepy companies that were failing to use their assets effectively were acquired by takeover specialists, who either broke them up and sold off their pieces at a profit or installed new management and profited from the increases in shareholder value that resulted. Soon boards of directors understood that unless they and the company’s management were operating the company’s assets for the benefit of the shareholders they were in jeopardy of a takeover, and this instilled a sense of concern about creating shareholder value that still exists on boards of directors. Unfortunately, with the support of state legislatures and court decisions, many managements were able to protect themselves from challenge through such artificial anti-takeover devices as poison pills and staggered boards, which eventually brought hostile takeover activity to a virtual halt in the 1990s.

Nevertheless, the lesson of the earlier period is clear: there is a way to bring about real change in how corporations operate, and that is by making it easier for dissident shareholders or outsiders to acquire control of companies that are not creating economic value. If the SEC’s proposed rule had been directed at this purpose, it would at least have had a comprehensible rationale, but it was not. If one of the SEC’s stated reasons for the rule had been that it was intended in part to overcome the restrictions on takeovers arising from changes in state laws, or from the adoption by public companies of poison pills or staggered boards, then one might say that at least the SEC has recognized how economically relevant change is brought about.

But the rule is explicitly designed only to permit shareholders to elect one or two directors to a corporation’s board—a number perhaps sufficient to get a “non-responsive” company to answer shareholder mail, or per- haps to pay more attention to the environment when it sites its manufacturing facilities—but clearly insufficient to change the way the company or its management goes about creating shareholder value.

Indeed, this frames the deficiencies of the proposed rule, and the reason it is so controversial. If it were genuinely intended to achieve reform of public companies in an economically relevant sense—by providing a mechanism for ousting unproductive or failing boards and managements—no one could reasonably object to it. But instead, the rule appears, at best, to provide a mechanism to harass boards and managements, and—at worst—a vehicle to force public companies to accept the objectives of interest groups with noneconomic policy agendas.

Peter J. Wallison is a resident fellow at AEI.

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