by Cydney Posner

The SEC has posted a new staff working paper, “Public versus Private Provision of Governance: The Case of Proxy Access,” reporting on a study conducted by the SEC’s  Division of Economic and Risk Analysis (DERA), of the “tradeoffs” between universal regulatory mandates and so-called “private ordering” in the context of proxy access. Is the study the first step in a reproposal of mandatory proxy access rules?

The study takes a look at the unique history of proxy access, which the SEC mandated for all public companies in 2010.  That rulemaking followed a very long and controversial history of efforts by the SEC to mandate proxy access. The SEC debated whether to institute proxy access in 2003 and 2007, but no rules were adopted. Fueled by concerns stemming from the economic crisis, in 2009, the SEC finally introduced a proxy access rule. (See this news brief.) The debate over proxy access was highly contentious, with proponents of proxy access emphasizing the need for accountability of boards, the importance of fair representation, implementation of shareholder rights under state law, the potential for improvements in director qualifications and board independence and other corporate governance benefits. On the other side, opponents raised concerns that shareholder-nominated directors could impede the proper functioning of companies and the collegiality of boards, cause inefficiencies, politicize board elections, represent only narrow single interests, make decisions that might not reflect the long-term interests of all shareholders or deter qualified directors who may be less than enthusiastic about facing an election contest.

The rule was successfully challenged by the U.S. Chamber of Commerce and The Business Roundtable, with the Court concluding that the SEC acted “arbitrarily and capriciously” in issuing the rule when it failed to provide an adequate cost/ benefit analysis. The WSJ characterized the opinion as a “sharp rebuke to the SEC, marking the fourth time in recent years the same court has thrown out an SEC rule based on similar grounds. (See these news briefs.)  At that point, the SEC elected not to contest the ruling  (see this new brief), and left it to companies and their shareholders to decide, through “private ordering,” whether to adopt proxy access and what the form of that access would be. (See this news brief.)

Interestingly, for several years after the rule was invalidated, there were a number of shareholder proposals for proxy access, but the anticipated flood of proposals had never really materialized.  Toward the end of 2014, however, that began to change. In November, NYC Comptroller Scott Stringer, acting on behalf of several New York City pension funds, submitted proxy access proposals to 75 companies.  The form of proposal was very similar to the SEC’s overturned rules, requiring a threshold of 3% ownership for three years, with shareholders having the right to nominate up to 25% of the board. (See this post.) For the 2015 proxy season, around 100 companies received proxy access proposals, and other advocates for proxy access urged companies to voluntarily endorse proxy access during the next six to eight months. (See this post.)  Moreover, average support for proxy access proposals was reported to be up significantly to over 60%. Of the 75 submitted by the NYC comptroller, 63 went to a vote, with 56% average support. Of the 63 proposals, 41 received majority support. It appeared that private ordering for proxy access had taken center stage.

However, for some proponents of proxy access proposals,  private ordering has had its limitations.  For example, sometimes it resulted in proxy access provisions adopted by companies that included restrictions viewed by some to be inappropriate, such as limitations on the ability of shareholders to aggregate their shares to reach the threshold ownership requirement or prohibitions on compensation paid to third-party nominees. A representative of the NYC Comptroller’s Office commented  that the stage was now set for the SEC to revisit a universal proxy access rule.

The DERA study compares how this market-based approach of private ordering is functioning relative to the alternative of a universal proxy access mandate.

The paper considered the relative strengths and weaknesses of the two approaches: a universal mandate could institute proxy access quickly and cost-effectively, bypassing problems typically associated with collective action, overcoming boards and management that oppose it and eliminating reliance on shareholder proponents, “whose interests may not be perfectly aligned with those of other shareholders and who thus might not target the firms at which shareholders collectively feel that proxy access would be most value-enhancing.”  However, a public mandate imposes a one-size-fits-all approach, while private ordering provides more flexibility for shareholders to pursue initiatives for proxy access at those  firms where it is expected to be “value-enhancing,” and allows for variability in the terms and conditions so that proxy-access provisions could be tailored to individual companies. The paper observes that, “overall, if the governance outcomes of private ordering are the result of value-maximizing contracts between all shareholders and management, then a private ordering process could give market participants the ability to reach a better outcome than the public alternative. However, the motivations of the shareholder sponsoring a proxy access proposal may not be directly aligned with those of other shareholders, and managerial discretion may affect the outcomes of private ordering, introducing potential frictions into this approach…. The fundamental question is whether private market forces, through the shareholder proposal process, would be able to realize (and perhaps surpass) the enhancements in shareholder value that could result from universally-mandated proxy access.”

The DERA working paper concluded that “private ordering may lead to a second best outcome.” With regard to shareholder proposals for proxy access, the study found that “proponents do not target primarily those firms that the market believes would have benefitted the most from mandated proxy access.” (The study identified these companies by using as a benchmark stock price returns reported at the time of the SEC’s announcement that it was staying the effectiveness of the proxy access rules, pending resolution of the litigation. The paper inferred that companies that the market believed would benefit more than others from mandated proxy access would be expected to have a lower return on the announcement of the stay.) The study also concluded that tailoring of proposal terms has been limited. Moreover, the study found, “management is more likely to challenge proposals at firms that stand to benefit more. Overall, [the study found] that private ordering creates value, but it may not efficiently deliver proxy access at the firms that need it most.” As a result, DERA concludes that the “dearth of tailored proposals and the lack of correlation between being targeted and the expected benefit of mandated proxy access suggest that the private process falls short exactly where it has the potential to deliver its biggest benefits over the universal mandate.”

The question then is whether DERA’s study was undertaken only to take advantage of the unusual history of proxy access to study private ordering versus universal mandates as an abstract matter, or whether the SEC is in fact considering a reproposal of a proxy access rule, with the DERA study constituting just part of the enhanced analytical justification.  Has the benefit of private ordering been to set the stage for universal proxy access, as the NYC Comptroller’s office indicated?   If so, will the 4th time be the charm?

Posted by Cydney Posner