The U.S. Court of Appeals for the District of Columbia Circuit vacated Securities and Exchange Commission rules adopted in 2010 designed to give shareholders the ability to nominate directors through corporate proxy materials.

The ruling agreed with the challengers – the U.S. Chamber of Commerce and the Business Roundtable (a group of blue-chip companies) – that the SEC “acted arbitrarily and capriciously for having failed once again…to adequately assess
the economic effects of a new rule.”

The SEC had approved the rules by a 3-2 vote in August 2010 after Congress authorized proxy access – procedures under which shareholders can get their nominees for corporate directors included in proxy materials issued by public companies – in passing the Dodd-Frank Wall Street Reform and Consumer Protection Act.

After business groups challenged decision , the SEC stayed the rules and the issue  was argued at the D.C. Circuit appeals court last spring.

The rules would have applied to shareholders owning at least 3% of a company’s total voting power and who had held their shares for at least three years.  Such holders would have been able nominate candidates for boards of directors via the corporate proxy materials, avoiding a costly and complicated separate proxy solicitation.

The three-judge panel’s decision said that because it concluded the SEC failed to justify the new rules, the court didn’t need to address the companies’ argument that the SEC arbitrarily rejected proposed alternatives to the proxy access rules.

Tom Donohue, president and CEO of  the U.S. Chamber, called the decision “a big win for  America’s job creators and investors.  We applaud the court’s decision to prevent special interest politics from being injected into the boardroom.” He said the decision “also sends a strong message that regulators need to meet their statutory requirement to clearly prove that the benefits of regulation
outweigh the costs.”

The business groups’ discussion of the decision is available here.

Meredith Cross, Director of the SEC's Division of Corporation Finance, said in a statement: "We are disappointed by today's decision striking down a rule that made it easier for shareholders to nominate a candidate to a company's board of directors. We are considering our options going forward. We note that our rule allowing shareholders to submit proposals for proxy access at their companies, which we adopted at the same time, is unaffected by the court's decision."

The appeals court panel said the SEC had “inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.”

The ruling also said that that SEC’s decision to apply the proxy access rule to investment companies “was also arbitrary.”

The court said there is “good reason to believe that institutional investors with special interests” – such as unions and pension funds -- would use the proxy access rules to advance their own issues and chided the SEC for “ducking serious evaluation of the costs that could be imposed” by shareholders representing special interests.

A number of shareholder groups including major institutional investors have sought proxy access as a way to address situations where, they believe, management and corporate boards have too cozy a relationship and too often ignore the interest of shareholders.

Regulators and rulemakers led the list of 100 most influential people affecting corporate governance in America’s board rooms in 2010, according to the National Association of Corporate Directors.

Administration officials on the list include President Barack Obama, David Axelrod, Rahm Emanuel and Valerie B. Jarrett.  Re-elected to the list were Sen. Christopher Dodd and Rep. Barney Frank, authors of the Wall Street Reform and Consumer Protection Law, and Securities and Exchange Commission Chairman Mary L. Schapiro.

The list, published in Directorship Magazine, is based on a survey of 15,000 public company directors and executives. The magazine doesn’t rank the 100 but instead selects several people each from a number of categories including regulators, directors, CEOs, governance policy makers, attorneys and professors.

Corporate directors in the top 100 include Dina Dublin (serving on the boards of Microsoft, Accenture, Pepsico); J. Michael Cook (Comcast, Burt’s Bees,  International Flavors and Fragrances);  Raymond J. Groves (Boston Scientific);  Bonnie G. Hill (Home Depot, AK Steel Holding, California Water Service Group, Yum! Brands); and Mellody Hobson (DreamWorks Animation, Estée Lauder, Starbucks).

CEOs who are also top 100 directors include Steven Ballmer of Microsoft, Rex Tillerson of ExxonMobil, Warren Buffet of Berkshire Hathaway, Steve Jobs of Apple, and Ellen Kullman of DuPont.

Based on the selections, Harvard University claimed bragging rights.  According to the Harvard Law School Forum on Corporate Governance and Financial Regulation blog, the Directorship 100 list includes twenty-seven individuals who are Harvard Law School faculty or fellows, guest Contributors to the blog, and/or Harvard Law School alumni – suggesting, the blog says, that Harvard and its governance program play  “a central role in the corporate governance landscape.”

Said Directorship Magazine:  “All members of the Directorship 100, regardless of how they arrived here, have power and influence. Some of it is new, some of it is long-standing.  Our modest job is to reveal those who exert the kind of influence that will permit the continued, if sometimes shaky, path that our system of capitalism is on, and the importance of corporate governance as a critical guidepost along the route.”

Given the green light by Congress, the Securities and Exchange Commission approved and released a long-awaited rule on proxy access — procedures under which shareholders can get their nominees for corporate directors included in proxy materials issued by public companies.

The SEC three times had made a run at proxy access rules, which include changes long sought by corporate governance activists, but hadn’t issued a final policy in the face of political and corporate resistance.  This year’s Dodd-Frank Wall Street Reform and Consumer Protection Act (Section 971) authorized the SEC to write the rules.

Under the new rule approved by the Commission, shareholders seeking access to corporate proxy  materials would:

--have  to own at least 3% of the total voting power entitled to vote at the meeting.
--be able to aggregate holdings to meet the 3% requirement.
--be required to have held their shares for at least three years.
--not be able to use the new rule "if they are holding the securities for the purpose of changing control of the company."
--be able to include one nominee or a number up to 25% of the board, whichever is greater. (If a board had three members, shareholders could nominate one; if a board had eight members, up to two nominees could be proposed).

The SEC said "'smaller reporting companies" would be subject to the rule only after a three-year phase-in period. Commission staff said the three-year delay would enable smaller companies to see how the rule works at larger companies and how it would affect them.  It would also let the commission determine whether changes in the rule might be required, the staffers said.

New rules generally take effect 60 days after publication in the Federal Register, SEC staff said.

The new rule -- called Rule 14a-11 -- requires shareholders to submit nominees no later than 120 days before the anniversary date of the mailing of the prior year proxy statement. Thus, if the rule becomes effective on Nov. 1, 2010, it would be available at companies that mailed their last annual meeting proxy statement no earlier than March 1, 2010.

Vote on Party Lines

As had been widely expected, the SEC acted on a 3-2 vote to adopt the new procedures, with Republican commissioners Troy Paredes and Kathleen Casey voting no.  Commissioner  Casey said the proposal represents “a series of arbitrary choices” that empower institutional shareholders “to the detriment” of individual shareholders and that the proposal is “likely to result in significant harm” to the economy.

Commissioner Parades protested that under the new rules, shareholders would be “unable to opt out” of the procedures “even if they want to,” and said it is at odds with state corporate law, particularly in Delaware.

SEC Chairman Mary Schapiro said shareholders should expect to see “dozens of instances of give and take” as the new rules take effect.  She called the proposal “rational, balanced and necessary” and pledged the SEC would prepare to make “prompt changes” to the rules if they seem appropriate.

Commissioner Elisse Walter said the proposal at last gives shareholders “a genuine alternative” in voting on directors.  The right to vote is meaningless, she said, if shareholders have no choice other than nominees presented by management.

Three Percent Rule

The 3% rule is a significant hurdle, making challenges at large companies such as International Business Machines or Exxon Mobil Corporation particularly difficult.  But pension, union and other large funds could pool their votes with other investors to offer candidates. (Congressional conferees turned down efforts by Sen. Christopher Dodd of Connecticut to include a 5% ownership threshold in the financial reform bill.)

Reacting to the proposal, the U.S. Chamber of Commerce said the SEC “is responding  to the campaign of a small group of special interest activist investors while ignoring the needs of the vast majority of investors who will never be able to use proxy access.”

Some groups had urged the SEC to permit “private ordering” of proxy access procedures — letting companies establish their own procedures to create proxy access under Delaware and other state corporate regulations.  Across-the-board rules, they argued, aren’t always appropriate. And a number of companies urged the SEC to permit shareholders to opt out of proxy access procedures.

Opponents gave the SEC a number of objections to proxy access.  Richard Templeton, chairman, president and chief executive of Texas Instruments, said the process “would promote a focus on short-term interests and could result in what are essentially annual proxy contests...distracting management and board attention from the creation of long-term shareholder value.”

Legal Challenges Likely

Challenges to the rules seem likely.  Bloomberg recently reported that the U.S. Chamber of Commerce has retained Eugene Scalia of the law firm Gibson, Dunn & Crutcher (and son of U.S. Supreme Court Justice Antonin Scalia) to “review the forthcoming SEC rules for a potential legal challenge.” The Chamber’s Center for Capital Markets Competitiveness says “...the SEC has failed to demonstrate a compelling need for this rule-making or how capital markets will be made more efficient by its adoption.”

Some companies have found the best defense is a good offense — engaging major shareholders to see if some middle-ground resolution is possible short of a board challenge.  Indeed, Weil, Gotshal & Manges LLP corporate partner Holly Gregory has advised companies to “Know who your large owners are — the top twenty or thirty shareholders — and consider whether to reach out to them in advance of the next meeting to find out what their concerns are, especially with regard to board composition and executive compensation.”

And, she adds, “Ensure that investor relations personnel are well-versed on institutional investor and proxy advisor positions on ‘hot button’ issues — as well as the company’s rationale where its approach departs from these positions.”

Proxy battles can also be expensive, notes writer Julie Connelly in Corporate Board Member magazine (Third Quarter 2010) in an article titled “Proxy Access: Worth Little More Than a Hill of Beans.”

Proxy battles entail legal fees, proxy-solicitation costs, and, in some cases, payments to prospective board candidates.  Indeed, there’s general agreement that finding candidates to serve on board is getting more difficult, given increased demands on a director’s time and exposure. To help identify potential board candidates, the pension fund of the California Public Employees’ Retirement System, the nation’s largest in terms of assets, is creating a "Diverse Director Database.”

J. W. Verret, an assistant professor of law at George Mason University’s law school, has been thumbing his nose at proponents of proxy access with a series of “16 defenses” he is proposing for boards of directors to thwart the expected SEC proposal. (One example: if shareholders can nominate a quarter of the board, give decision making to an Executive Committee of the Board made up of the other 75%.)

Editor's Note 8/25/2010: This article has been updated from an earlier version to reflect the outcome of the SEC vote and to incorporate additional comments.

Correction 8/30/2010: This article has been updated from an earlier version to correct a reporting error with regard to advice given to companies by Holly Gregory of Weil, Gotshal & Manges LLP.

The Securities and Exchange Commission wants some help with its bulging agenda.

The agency faces a deluge of new rule-making tasks, many tied to the recently enacted Dodd-Frank financial reform legislation.

SEC Chairman Mary Schapiro

To jump-start the process, SEC Chairman Mary Schapiro is loosening up the procedures to gather public comment. “We are expanding our process beyond what is legally required,” she said in a July address to the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness. “We are inviting public comment even before the various rules are proposed and before the official comment periods have begun.

“We have created a series of e-mail inboxes—that can be accessed at www.sec.gov -- so that anyone interested can easily weigh in.”

All submissions on the comment system will be posted on the Commission’s web site with personal identifying information included.

The new arrangement comes with some ground rules, which the SEC chairman called “best practices.”  The SEC staff will “try to meet with any interested parties who seek to meet with us,” she said, but it may have to limit the number of meetings and will limit multiple meetings with the same party.  The staff will ask persons requesting meetings to provide in advance an agenda of intended topics for discussion; participants will be encouraged to submit written comments to the public file.  And,  she said,“I expect we will hold public hearings on selected topics.”

Chairman Schapiro highlighted five areas among the “many topics on our plate”:

OTC Derivatives. The new law brings oversight to the over-the-counter derivatives market, and new rules will address capital and margin requirements, mandatory clearing, operation of executive facilities, business conduct standards for swap dealers and public transparency for transactional information.

Fiduciary Duty. The new law calls for a study of existing standards of care for broker-dealers and investment advisers. Currently, she noted, “there’s a difference between a broker and an adviser” and an investor “can be treated differently based on who they’re getting their investment advice from.”  Advisers are supposed to put the interest of clients before their own, while broker-dealers are supposed to make “suitable” recommendations.

After the study is finished, she noted, “we will have the authority to write rules that would create a uniform standard of conduct for professionals who provide personalized investment advice to retail customers.”

Hedge Funds advisers will have to register with the SEC.

Corporate Disclosure. “We will be adopting many rules in this area – especially in the area of executive compensation.” Under the new act, advisory say-on-pay votes will be required at all companies at least once every three years. And shareholders will also have a say on golden parachute payments to executives.

Companies will be required to calculate and disclose median total compensation of all employees and the ratio of CEO compensation to that of employees

New rules will address standards of independence for compensation committees and for conflict of interest standards when retaining compensation consultants. And rules will establish that brokers cannot vote on compensation matters.

Chairman Schapiro said she intends to have new rules concerning shareholders’ ability to nominate director candidates in effect “in time for the 2011 proxy season.”

Credit Rating Agencies. The new law requires rulemaking on disclosure, controls, conflicts of interest and analyst training, as well as on preventing sales and marketing considerations from influencing credit ratings.

Photo by talkradionews, via Flickr

Listen to Gillespie as he discusses the issues with Michael Connor in a Business Ethics podcast. You can download an MP3 file of the interview with John Gillespie here.

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BOOKS: Money for Nothing: How the Failure of Corporate Boards Is Ruining American Business and Costing Us Trillions

by John Gillespie and David Zweig

Reviewed by Michael Connor

If you’re one of the many trying to determine where blame might lie for the financial and economic crises of the last two years, John Gillespie and David Zweig would suggest you look in the corporate boardroom. Their new book - Money for Nothing: How the Failure of Corporate Boards Is Ruining American Business and Costing Us Trillions – is rich with unfortunate detail:

• Stanley O’Neal, former CEO and president of Merrill Lynch, was paid $48 million in salary and bonuses in 2006, in large part because of the firm’s apparent success in selling mortgage-backed securities.   When the company’s failures made headlines, O’Neal was allowed by his board to “retire” with an exit package worth $161.5 million.  Within three months, O’Neal was back in a boardroom, “this time as a director of Alcoa, serving on the audit committee and charged with overseeing the aluminum company’s risk management and financial disclosure.”
• Countrywide Financial, a leader in the subprime mortgage market, paid each of its directors from $344,988 to $538,824 in 2006, more than twice the average for the five hundred largest U.S. corporations, while CEO Angelo Mozilo himself made $48 million, not including gains on stock options. In the two years prior to the housing market crash, independent board members cashed out more than $24 million in stock gains.
• The board of Lehman Brothers included “a theatrical producer, the former CEO of a Spanish-language television company, a retired art-auction company executive, a retired CEO of Halliburton, a former rear admiral who has headed the Girl Scouts and served on the board of Weight Watchers International, and until two years before Lehman’s downfall, the 83-year-old actress Dina Merrill.”  In a September 2008 conference call, Lehman CEO Dick Fuld told analysts: “I must say the board’s been wonderfully supportive.”  Four days later Lehman filed for bankruptcy.  Lehman shareholders, represented by the board, lost more than $45 billion.

Unfortunately, in the annals of modern corporate governance, those are not isolated cases.  Gillespie (an investment banker who has worked at Bear Stearns, Lehman Brother and Morgan Stanley) and Zweig (a journalist who has worked at Time Inc. and Dow Jones), put forth an abundance of evidence to support the stereotype of a modern-day corporate director – typically an over-compensated, under-challenged former corporate executive (or former government official) who never argues with management and votes to reward CEOs and senior executives with multi-million dollar salaries and bonuses even as the companies themselves all-too-often spiral into oblivion, damaging the lives of real people, including employees and shareholders.

The subject is truly anger-inducing, and rest assured Money for Nothing will make you angry (or reinforce your existing anger) about the current state of corporate governance.  But if policy-makers and the business community are going to set a corrective course for the 21^st century corporation, it’s critical that we get beyond the anger and begin to pick apart issues while creating new definitions for accountability.  Money for Nothing succeeds at that as well.

(Listen to Money for Nothing co-author John Gillespie on a Business Ethics podcast.  You can download an MP3 audio file of the program here.)

Defining the Job

Corporate directors have existed, and been criticized, for hundreds of years; forty years ago  Harvard Business School professor Myles Mace characterized them as “nothing more or less than ornaments on the corporate Christmas tree.”   More recently – in the wake of scandals at Enron, WorldCom, Tyco and others - the Sarbanes Oxley Act of 2002 introduced a number of reforms aimed at improving the effectiveness of boards for U.S. companies.

In fairness, most large global enterprises consider governance a top priority - IBM and Coca-Cola are among those that come to mind – and work hard to improve the performance of their boards.  And these days, especially with the threat of litigation, directors who take their jobs seriously can sometimes confront a formidable task.  Increasingly, report executive recruiters, the best director candidates don’t want the job.

Perhaps most disconcerting for directors themselves, Gillespie and Zweig suggest, is the intense public debate about the role of corporate governance in the modern-day corporation.  Should directors be encouraging management primarily to increase shareholder value?   If so, how important are near-term profits and short-term stock performance?   What about long-term sustainability of the enterprise? And how does one incorporate the many demands of multiple stakeholder groups, including employees, local communities and a panoply of activist groups dedicated to particular causes?   Juggling those priorities requires directors with a far-sighted mind-set and ethical core that allows for day-to-day constancy and the ability to make difficult decisions amidst extraordinary circumstances.

In Search of Solutions

The authors recommend a number of solutions aimed at changing boardroom culture. The most radical might be the creation of a new class of directors – “public directors” – an idea first proposed in the 1930’s by William O. Douglas, then head of the Securities and Exchange Commission (and later a U.S. Supreme Court Justice) and adopted more recently by some experts in governance.  Public directors would be identified as such by a government entity, independent of the company, and constitute a minority of the board.  To ensure objectivity, the authors suggest, independent directors might even be paid independently, maybe by an assessment on large companies or even publicly.

Other suggestions include creating a director training consortium; insisting on greater diversity of board members; imposing term limits; limiting directors to serving on three or fewer boards; and requiring that directors “put skin in the game.”  This latter recommendation, which has been proposed before (by governance expert Charles Elson and others) would require directors to have a “meaningful percentage” of their net worth invested in companies they serve – maybe to 6 percent, depending on the number of directorships they hold.

Probably the biggest check on board behavior, though, is the power of shareholders.  Among other recommendations, the authors suggest allowing shareholders to call an Extraordinary General Meeting in which a majority of those voting may remove directors.  It’s a practice allowed in the United Kingdom and other countries, but difficult to imagine being implemented in the U.S.

Despite the horror stories they report, in their final analysis Gillespie and Zweig seem reasonably optimistic about the future. “Boards can play the single most effective role in advancing the future opportunities and prosperity of our families, our communities, and our country,” they write. “If we expect and demand more of them, they will rise to that challenge and answer that call.”