Why Proxy Access Is Harmful to Corporate Governance
Sharfman, Bernard S., Journal of Corporation Law
Traditionally, the nomination of directors has been under the control of the board of directors and its nominating committee.1 In this role, the board is to evaluate the characteristics of the existing management team and incumbent board members and the challenges and opportunities facing the corporation and then take these factors into consideration when nominating director candidates.2 However, this traditional function of the board is now being challenged by new federal legislation and recently promulgated Securities and Exchange Commission (SEC) rules that support providing co-responsibility for this function with shareholders.
Section 971 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)3 amended Section 14(a) of the Securities Exchange Act of 1934 (Exchange Act) to permit the SEC to adopt rules that will allow shareholders access to a public company's4 proxy solicitation materials for purposes of nominating their own directors. That is, certain shareholders would gain the ability to place their director nominees alongside the board's slate of director nominees in the company's proxy card and proxy statement (proxy access). In response, the SEC promptly issued Rule 14a-11.5
A key aspect of Rule 14a-11 was that it required proxy access at all publicly traded companies. Public companies were not allowed to opt-out of the proxy access rules.6 This one-size-fits-all approach to corporate governance is much reviled among corporate law scholars and practitioners who believe that a very important reason why corporate law is wealth enhancing is because it allows for private-ordering.7 That is, company officials and investors are in a much better position to determine the optimal corporate governance arrangements of their company than public officials.8 In addition, federally mandated proxy access eliminates the benefits of our federalist system from this area of corporate governance.9 As Justice Brandeis so eloquently stated many years ago, "a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country."10 The proxy process will be less effective without state experimentation because, even if proxy access can be argued to be good for corporate governance, there is good reason to believe that Rule 14a-11 was not the optimal default rule.11
The imposition of a mandatory regime of inefficient corporate governance rules as provided for in Rule 14a-11, no matter what the will of the majority of shareholders or the individual needs of a particular firm, is wealth reducing.12 This suggests that a better approach to proxy access would have been to provide public companies the option to opt-in13 or at least opt-out of Rule 14a-11. Nevertheless, the SEC was quick to embrace mandatory proxy access.
Why the SEC would so quickly embrace rules that have a wealth reducing effect is a reflection of the growing political power of those that support mandatory proxy access. This is evidenced by the inclusion of Section 971 in the Dodd-Frank Act, even though there are no facts to support the argument that proxy access will enhance financial stability,14 and the changing make-up of SEC Commissioners from a Republican to Democratic majority, the political party which is strongly supported by the most vigorous advocates of proxy access, unions, and public pension funds.15
Enhancing the political support for proxy access has been the ongoing and growing shareholder empowerment16 movement.17 This movement has been fueled by the growing dominance of institutional investors in the investment of publicly held stock, helping to reduce investors collective action costs,18 which in turn has been fueled by a reduction in the collective action costs of institutional investors through the use of shareholder advisory services such as Institutional Shareholder Services;19 the increasing ability of activist hedge funds to raise large pools of funds so as to seek significant positions in public companies;20 perhaps, most importantly, the SEC's ideological support of shareholder interests,21 which has led to the liberalization of communications between shareholders with respect to proxy voting,22 elimination of discretionary broker voting for the election of directors,23 and required disclosure of proxy voting by investment companies;24 and the newfound ability to use the populist argument that shareholders must take a more active role to constrain reckless risk-taking by corporate managers in order to prevent another financial crisis. …