The SEC's Final Rules On Director Nominations And Shareholder Communications With Directors: Form Or Substance?

Editor: Please tell our readers something of your background and experience.

I have been at Willkie Farr since 1979 and became a corporate and securities law partner in 1986. I practice in the general corporate area, such as issuances of debt or equity securities by public and private companies, merger and acquisition transactions and the like. In recent years I have focused on real estate companies, like REITs and REOCs, but I have done deals in many other industries as well. I have a law degree from Bar Ilan University in Israel and an MBA in finance from New York University.

Editor: In November of last year the SEC promulgated final rules requiring expanded disclosure of a corporation's director nomination process. Can you give us an overview of this change?

The operative word here is disclosure. Essentially, that is what the final rules require. They mandate that companies disclose in some detail how their nominating process works and the standards by which nominees are selected. They also require disclosure of the procedures by which shareholders can communicate with boards of directors. These rules are the product of a study produced in mid-2003 by the SEC's Division of Corporate Finance, and it is important to note that the study's recommendations went far beyond the rules that to date have been adopted. There was, and continues to be, concern in the legal community that the SEC has not abandoned these additional items - sort of like waiting for the other shoe to drop. Among other things, these additional items would have required companies, for the first time and under narrow circumstances, to include in their proxy statements to shareholders candidates nominated by shareholder groups in opposition to candidates nominated by the existing board or its nominating committee. Needless to say, this idea has caused considerable consternation in board rooms across the country.

Some background to this. Today, a board-sponsored slate of candidates is presented to the shareholders for election. Shareholders who are unhappy with the slate can withhold their votes - which means that they can decline to vote "yes," but they can't actually vote "no." As a result, if the board's candidate wins only a handful of "yes" votes - he wins! To actually vote "no," the shareholder has to go through the proxy fight process and propose a competing slate of candidates, a very expensive and time-consuming proposition. The SEC study's proposal would have made it possible, for example, for five seats on the board to be contested by six candidates, not all of whom would be nominated by the board. This notion has not yet found itself into the rules, but whether it will, and when, is a matter of very intense speculation in the securities bar.

Editor: What prompted the SEC to address this issue now? Can you tie this into the recent corporate scandals and the enactment of Sarbanes-Oxley?

I think the SEC is simply taking advantage of the current climate - one that calls for increased scrutiny of corporate management and governing boards - to advance an agenda that has been percolating under the surface for some time. The notion of enhanced "shareholder democracy" has a long lineage, and some of the issues addressed by the SEC's study have been under review for years. There is a kind of cycle in this area that calls for the periodic visitation of how corporate directors are nominated and elected, and the climate resulting from the recent scandals is probably a fortuitous one, in the eyes of the SEC, for just such a visitation.

Editor: You mentioned the adoption of final rules with respect to the procedures by which shareholders may communicate with directors. What is the origin of this?

If I am a shareholder of a company, and I wish to go on record with my displeasure concerning some aspect of the business, I could simply write to the CEO or investor relations person. The new rules do not change anything in this regard. What is new is that companies must now disclose to shareholders whether they can also communicate directly with the directors and, if so, how to do it. I am not certain that this will change a lot of corporate procedures already in place, but it will now put a disclosure spotlight on those procedures. And, obviously, in today's climate, if a director gets a shareholder complaint, he is unlikely to just ignore it; he's more likely to raise it with the appropriate corporate personnel.

There is some concern that company boards will now be flooded with communications from disgruntled company employees or from simple kooks. Most companies have procedures in place to separate the wheat from the chaff. Remember, the rules require disclosure of how one can send a letter to the board; the rules don't require the board to read or respond to each letter.

Editor: In light of the recent corporate scandals it is increasingly difficult to find qualified independent directors willing to serve. What kind of impact are the new rules likely to have on this state of affairs?

It is becoming harder to find truly qualified independent directors, particularly those with strong financial backgrounds who can serve on or chair an audit committee. There is also pressure on boards to become more inclusive, with increased focus on gender- and race-based diversity. All this adds to the pressure on boards to locate, identify and have elected directors who are both qualified and independent. The new rules neither add to nor detract from that particular issue, in my view. They may, however, have an empowering effect on nominating committees and, through such committees, on boards of directors. For a very long time, it was the CEO who presented candidates to a rather passive nominating committee and board. The new rules may have the effect of encouraging the existing directors to be more critical of such candidates, perhaps even to put forward candidates of their own, and I think - if that does take place - it is a step forward. There is a delicate balance here; we want directors to have input into nominations, but we don't want companies run by committees.

Editor: How important is it to have third-party expertise available in the selection of director candidates?

I do not think you need an executive search firm to find qualified independent director candidates. To be sure, the pure "old boy network" should be a thing of the past because today's board is required to make an independent decision annually on the independence of each of its members. In addition, smart companies should recognize that a strong board is an extremely valuable resource. Board members with different areas of expertise and from different business and professional backgrounds enable the company to avoid pitfalls it may not be able to see if everyone on the board is cut from the same cloth. Today, company managements should understand that they need to have on their board both industry experience and skill sets from a wide range of industries and activities, including banking and finance, the securities industry, insurance, accounting and the law, and so on. They shouldn't be looking for gadflies, that's for sure, and I understand that being a friend of the CEO never hurts. But boards should look for candidates with experience and a skill set that can add real value.

Editor: Are these substantive changes in the area of corporate governance, or are they ?

That is a good question. I believe that there is a fundamental problem with the way governing boards carry out their responsibilities, and while I am not certain that I have a solution, I know that these rules we have been discussing do not address the problem. Boards are by definition reactive bodies. Their effectiveness is largely a function of what management chooses to share with them, and their ability to monitor what management does not choose to share is exceedingly limited. In too many cases, management holds back vital information from the board, and the board, in consequence, finds out what has been going on only long after the fact. While I wouldn't call the new rules "window dressing," to the extent that they focus on how a board is constructed, rather than how it functions in relation to the business which it is supposed to control, they are not addressing the heart of the problem.

Editor: After Enron and WorldCom it is difficult not to be in favor of more corporate democracy and transparency. Nevertheless, the pendulum has swung pretty far out in one direction. Is there some risk that American corporations might suffer at the hands of their global competitors?

I do not think so. If anything, we are still catching up to the rest of the world in terms of corporate democracy. Shortly before the Enron scandal broke, I was visited by a senior official of a foreign stock exchange and we debated the differing philosophies underlying the standards of corporate democracy in our respective jurisdictions. We agreed that the difference was this: the U.S. system puts a great deal of faith in the wisdom of the market, whereas the foreign systems rely upon a more paternalistic arrangement, with the government actively ensuring corporate democracy and transparency. I told her that I tended to trust the wisdom of the market - and, of course, Enron proved how wrong I could be, although to be fair, the recent scandal at the NYSE has shown that perhaps regulators are not above criticism either. But notwithstanding Sarbanes-Oxley and the other post-Enron regulations, we in the U.S. still tend as a matter of core philosophy to place great faith in the markets. So, even if events compel us to toughen our regulations, we have a long way to go before they appear tough by comparison with those of many foreign jurisdictions.

I would like to leave your readers with a final thought on the impact that rules, regulations and statutes have on corporate behavior. Long before the advent of Sarbanes-Oxley there were a number of highly-regarded companies with very independent and multi-talented governing boards. Among those companies were WorldCom and Enron. I do not believe that it is possible to legislate corporate morality. The rules provide, at best, a framework within which governing boards are supposed to function. That very probably does constitute a step in the right direction. It is by no means a complete answer.

Published March 1, 2004.