TCS Daily

The SEC: From Bad to Worse?

By Stephen Bainbridge - August 12, 2004 12:00 AM

In October of last year, the SEC proposed a new rule that would permit shareholders to directly nominate directors of the corporations in which they have invested. As I detailed in my TCS column, Does the SEC Know When Enough Is Enough?, the proposal was seriously flawed. It was likely to impose significant indirect costs on corporations, without much in the way of countervailing benefits. (For more details, see my blog's archive of posts on the rule.)

As bad as the original proposal was, however, things may be about to take a turn for the worse.

The WSJ ($) reports that a "compromise" is in the works, under which:

"While details of the proposal are still being worked out, it would essentially allow shareholders to sit down with a company and agree on a person to replace a director who has been targeted by investors for removal. If an agreement couldn't be reached, shareholders would likely gain the right to nominate their own director the following year. The proposal may allow companies to bypass negotiating with investors if they agree to include shareholder-backed nominees on the ballot the following year."


(1) Which shareholders get to sit down with management? All of them, which can be in the millions, or just a select few? If a select few, how do we ensure that the interests of the few coincide with those of the many? How, for example, do we ensure that unions don't use the shareholder access rule for leverage in collective bargaining (as they often use the current shareholder proposal rule)? Or that social activists don't use it to promote a social agenda at odds with the profit-maximization interests of most shareholders?

(2) If adopted, the proposal may deter qualified individuals from being willing to serve as a member of the board. There will be a significant risk that activist investors will use the rule frequently and at numerous companies. Unlike the current system, under the rule, the activists will be targeting individual investors. Who would want to serve as a director if there is a significant risk one might be singled out for a smear campaign by unhappy investors? (Granted, the effect may only be at the margins, but many companies report that in light of the director liabilities created by Sarbanes-Oxley they are already having a hard time attracting independent directors.)

(3) The presence on the board of a single shareholder-approved director likely will have a highly disruptive effect on the board's decisionmaking processes. Granted, some firms might benefit from the presence of skeptical outsider viewpoints. The analogy to cumulative voting, however, suggests that such benefits will be rare. It is well-accepted that cumulative voting tends to promote adversarial relations between the majority and the minority representative. On such boards, the majority tends to resort to pre-meeting caucuses at which decisions are worked out. In addition, management tends to restrict the flow of information to such boards, out of concern that the minority will use confidential firm information for improper purposes. A chief indirect cost of the proposed compromise therefore will be less effective governance.

(4) Finally, and perhaps most disturbingly, there is still nothing in the reported compromise that would limit the rule to situations in which the targeted board is clearly dysfunctional. Instead, it apparently still applies to all public corporations, whether their internal governance is good, bad, or just indifferent. Hence, if enough shareholders are disgruntled, for whatever reason, they can force a vote. This makes no sense. The point of the rule, supposedly, is to restore investor confidence by ensuring good corporate governance. But if firms are well-managed why put them to the expense and bother of a shareholder nomination contest?

Several recent major SEC rules were adopted by a 3-2 vote, with SEC Chairman Donaldson (a Republican) siding with the Commission's two Democrats against his two fellow Republicans. It's been reported that Chairman Donaldson doesn't want to see that happen to this particularly controversial rule. Potential dissenters Glassman and Atkins thus may have significant leverage. If they can't use it to kill the proposal, they should use at the very least use it to emasculate the rule so that it does as little damage to corporate governance as possible.


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