A Keystone of Capitalism
The Securities and Exchange Commission (SEC) shareholder proposal rule (”Rule 14a-8” or “the rule”) has proven to be one of the most critical shareholder rights for investors, retail and institutional alike, to protect their investments. Shareholders file proposals to ensure that companies are appropriately managing risk and disclosing the information investors need to inform investment decision-making and conduct adequate due diligence. Generally, investors file proposals to improve governance, increase transparency on issues relevant to investors, and to ensure that corporate leadership is acting in alignment with investors’ long-term interests. As such, the rule is aligned with the SEC’s mission to protect investors from, among other things, fraud, an unlevel informational playing field, and the extraction of private benefits from the firm by firm insiders.[1]
The rights to file and vote upon shareholder proposals are a keystone of American capitalism and corporate governance. While the Commission and Staff have fine-tuned the rule over the years, attempts to curtail shareholder rights have arisen every decade since the rule was promulgated more than 80 years ago. Prudently, these efforts have mostly been rejected by the Commission as well as Congress.[2]
About the Shareholder Proposal Rule
The shareholder proposal rule is grounded in the recognition that a company’s annual meeting is a crucial forum for companies–to provide transparency on certain important issues– and for investors–to elect directors and to advise the board and management on significant issues facing the company. It is a well-established and predictable process that provides significant benefits to companies and investors. Currently, there are procedural and substantive requirements that screen out inappropriate shareholder proposals, and require proponents to hold sufficient stake to merit their proposals’ consideration. As a result, legislative reforms are unnecessary and would be disruptive.
The shareholder proposal process provides important benefits to public companies and is not a significant burden. Over the last 80 years, the SEC shareholder proposal rule has encouraged many companies to adopt governance and disclosure policies that are today considered corporate best practice:
• Norms that improved accountability of directors, such as independent directors constituting a majority of the board and the annual election of directors by majority vote;
• Corporate disclosures that allow investors to assess and manage investment risks and evaluate a company’s resilience and sustainability into the future, for example its management of issues such as climate risk and boardroom diversity.
The Right of Shareholders to Engage on Issues of Consequence for Their Companies Must Be Protected
Environmental or social issues are appropriate for corporate annual meetings; it is a foundational and a long-standing right of shareholders to raise important issues of public debate or impact relevant to the future of their company.
There is no question as to whether corporations are impacted by social and environmental issues. By virtue of their resources and actions, corporations inherently do make decisions with significant social and environmental consequences and are also impacted by changing social dynamic and the environmental conditions within which they operate.
Rather, the question being asked is who deserves a voice in such decisions. Ultimately, boards and managers will make consequential choices, but the law provides that companies should not be insulated from valuable shareholder feedback and advice that is, in part, facilitated by the shareholder proposal process. The DC Circuit Court has made it clear that silencing shareholders on such issues cannot “be harmonized with the philosophy of corporate democracy” embodied in federal law.[3]
In respect of the role and discretion of management and board in running companies, SEC rules exclude proposals that merely address the day-to-day management of a corporation. In contrast, shareholders maintain a fundamental right to file and vote upon proposals on emerging issues relevant to the company’s future.
Ultimately, the rule allows shareholders to express their voice and opinions through voting. Well conceived proposals, compliant with SEC rules, are able to reach the proxy statement, but the ultimate test is the proxy statement as a marketplace of ideas. Significant voting support for a shareholder proposal is dependent upon investors’ understanding of whether the subject matter may affect value for investors, especially over longer time horizons.
Social and environmental proposals raise critical investor risk management concerns and often provide an early warning of issues that may ultimately prove to be highly material and even existential to a company.
To take one example: a 2013 shareholder proposal filed by the New York City Comptroller at Wells Fargo encouraged the company to establish a policy to recoup pay from executives whose conduct caused financial or reputational harm to the company. The proposal was never voted upon, because the company agreed to make the change after the proposal was filed. As a result, after the company settled charges in 2016 that it had improperly created 3.5 million unauthorized accounts, more than $180 million was clawed back from executives for failure to sufficiently prevent these problems.[4]
Proposals on climate risk are on a similar footing. A large portion of the market believes that climate change represents a significant financial risk, even an existential risk, to companies and the economy. Businesses will be transformed by the decarbonization of the economy and efforts to improve climate disclosure and performance are aligned with investor interests. Investors employ the shareholder proposal process to better understand how a company is evaluating and mitigating climate risks; for example, filing a proposal requesting companies to disclose its plans to address the physical and transitional risks presented by climate change. The economic risks to future retirees from corporate inaction to address climate risk is substantial. For instance, Swiss Re’s stress testing estimates that global GDP may be between 4% and 18% lower by 2050, depending on how successful we are in reducing GHG emissions. Efforts to block climate risk related shareholder proposals essentially attempt to force investors to invest as if climate change is not happening, and to ignore the risks to their companies and to the economy writ large. That is a dangerous and costly proposition.
The only mandatory cost associated with the shareholder proposal rule is for the issuer to publish a proposal limited to no more than 500 words in the proxy. In contrast to these minimal printing costs, the issues elevated by shareholder proposals, including environmental or social proposals, often reflect risks that could amount to billions of dollars of liability or reputational damage, or alternatively, opportunities with the potential for increased profitability. The value of the shareholder proposal process to companies and their investors far exceeds the cost.
The Commission has responded to Company and Investor Feedback and the Process is Now Efficient and Predictable for All
The Commission’s ordinary business rule, Rule 14a-8(i)(7), allows companies to exclude shareholder proposals focusing only on the day-to-day operations of the corporation. Such day-to-day decision-making is reserved to the discretion of the board and management. Shareholder proposals are reserved for the significant issues facing a company, which is why SEC rules and Staff guidance do not allow exclusion of shareholder proposals raising significant policy issues.
Under Chair Gensler, the Commission’s staff issued Staff Legal Bulletin 14L, which repealed certain subjective criteria for ordinary business added during the preceding years, and focused the question of a “significant social policy issue” on whether a proposal addresses an issue of significant social impact. The change aligns with the interests of shareholders as it has become clear that issues of major social or environmental impact are likely to affect a company’s bottom line in the near- or long-term and can impact the prospects for diversified investors in the broader economy whose portfolio-wide value can be significantly undercut by externalities.[6]
Because of Staff Legal Bulletin 14L, issuers and proponents have greater predictability as to whether or not the SEC will exclude a particular proposal. In 2023, we estimate that this resulted in a 30% drop in no-action challenges by issuers, which represents a reduction in costs to companies and investors associated with those challenges. More predictability means that shareholders can ensure proposals are in compliance with the rules, and issuers save money by not spending corporate funds on subjective and highly debatable legal challenges. Despite claims that the Staff Legal Bulletin 14L opened the floodgates for proposals, this year the Staff continued to allow exclusion of proposals based on companies’ ordinary business and micromanagement assertions in no action requests.[7]
We have heard outsized and exaggerated claims that the number of shareholder proposals facing companies is massively expanding. At most, about 20% more shareholder proposals reached corporate proxy statements in 2023. In the context of the broader market, that is not a significant increase. The majority of public companies still do not receive any shareholder proposals. On average, 13% of Russell 3000 companies received a shareholder proposal in a particular year between 2004 and 2017. In other words, the average Russell 3000 company can expect to receive a shareholder proposal once every 7.7 years. For companies that receive a shareholder proposal, the median number is one per year.[8]
In short, the shareholder proposal rule is functioning as intended. There is not an explosion of inappropriate shareholder proposals as a result of the new staff legal bulletin, but instead clarity for investors seeking to protect their assets.
The House Financial Services preliminary committee report on ESG inaccurately states that the SEC eliminated “the requirement for proposals to be relevant to a company’s business.”[9] To the contrary, shareholder proposals are required to be relevant to companies, and are excludable if they are not. The existing and continuing relevance rule, Rule 14a-8(i)(5), permits a company to exclude a proposal if it relates to operations which account for less than five percent of the company's total assets at the end of its most recent fiscal year, and for less than five percent of its net earnings and gross sales for its most recent fiscal year, and is not otherwise significantly related to the company's business. An activity that might comprise a minor part of the company’s business financially is still “significantly related” to the company’s business if the activities in question pose a threat to the company in other ways.
Much has been made of the staff legal bulletin’s elimination of the “nexus” test. “Nexus” refers to a vague and redundant relevance test added by SEC staff that went far beyond the rules established by the Commission that already require a proposal be relevant to a company. The nexus concept attempted to further probe the relevance of a social policy issue to a company; in reality, the nexus test has neither good grounding in the Commission’s promulgated rules and releases, nor any objective means of determination.[10] From the standpoint of investors, the removal of the subjective, nexus test in Staff Legal Bulletin 14L constituted welcome relief, and enhanced the ability of proponents to predictably draft proposals that would meet the criteria of the rule and avoid exclusion.[11]
In short, the existing relevance rule is functional and recommendations to restore a nexus or materiality test amount to recommendations to fix something that isn’t broken, and serving only to reintroduce subjectivity and unpredictability to SEC staff decision making.
Legislative Reforms Are Unnecessary and Would Disrupt Capital Market Relationships
We note that Congress is considering legislation that would significantly diminish shareholder rights and should therefore be of grave concern to all shareholders and fiduciaries.
Some of the legislative proposals would allow issuers to write their own bylaws governing the types of shareholder proposals that could be considered at a company’s annual meetings. Setting aside the question of whether companies would do so over the objections of shareholders, it should be evident that transforming what is currently an efficient and time-tested set of rules into a complicated web of company bylaws would neither be in investor or company interests. It could well divert shareholder concerns into more disruptive fights including books and records requests, shareholder litigation, “vote no” campaigns and contested Director elections.
Conclusion
Shareholder democracy is part of the fabric of American capitalism. In our free enterprise system, investors have the freedom to take risks to grow and sustain their investments, supported by essential rights in the governance of corporations. Shareholder proposals are a time tested, fundamental right of shareholders to hold investee boards and managers accountable on the issues that investors believe will matter for the long term. The resultant dialogue, engagement, education and reforms are a source of vigor and dynamism for American corporations.
No legislators of any political orientation should knowingly support “reforms” that would curtail the rights and freedoms of retail and institutional shareholders or attempt to substitute political judgments for the analytical processes of professionals in the financial markets. The legislative initiatives which appear as a “solution” in search of a problem.
[1] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2282103
[2] An exception was the 2020 rulemaking promulgated by the Commission which has significantly raised filing and resubmission thresholds. In 2020, the Commission, responding to comments from issuers, adopted new steeper thresholds for filing and resubmission of shareholder proposals. The prior rule allowed any shareholder with over $2000 in company shares held for at least a year to file a proposal; the new rule increased the required “skin in the game” by requiring that if the shareholder only held shares for a year they would need to hold at least $25,000 in shares; smaller shareholders holding only $2,000 are now required to hold their shares for at least three years before filing a proposal. The thresholds to resubmit a proposal in subsequent years after a vote were also raised significantly. The prior rule required 3% voting support on a first vote, 6% on a second vote and 10% on a third year and subsequent votes. In contrast the new rule requires 5% the first year, 15% the second year and 25% the third year.
[3] Medical Comm. for Human Rights v. SEC, 432 F.2d 659, 680-81 (D.C. Cir. 1970).
[4] The New York Times has noted that prior attempts to roll back shareholder proposal rights would have blocked the clawback proposal. https://www.nytimes.com/2017/06/16/business/wells-fargo-clawback-fair-choice-act-shareholders.html
[5] For example, the Staff sought out the opinion of the company’s Board of Directors (in addition to their lawyers) as to whether or not the proposal addressed ordinary business, and offered multiple new avenues and hooks for companies to argue ordinary business on almost any proposal. This resulted in proliferation of lengthy no action requests prepared by company lawyers attempting to fulfill the extensive criteria set forth by the Staff.
[6] Judicial and Commission interpretations affirm that shareholders have a legitimate and compelling interest in being heard on these matters. As the D.C. Circuit Court of Appeals has noted, “the clear import of the language, legislative history, and record of administration of section 14(a) is that its overriding purpose is to assure corporate shareholders the ability to exercise their right — some would say their duty — to control” important corporate decisions. Medical Comm. for Human Rights v. SEC, 432 F.2d 659, 680-81 (D.C. Cir. 1970).
[7] Corporate lawyer Marc Gerber discussed this trend in exclusion of numerous proposals this year in a recent blog post. https://corpgov.law.harvard.edu/2023/07/08/shareholder-proposal-no-action-requests-in-the-2023-proxy-season/
[8] Council of Institutional Investors, “Frequently Asked Questions about Shareholder Proposals” Accessible at: https://www.cii.org/files/10_10_Shareholder_Proposal_FAQ(2).pdf
[9]ESG Working Group, House Committee on Financial Services “Preliminary Report on ESG Climate Related Financial Services Concerns,” Page 15, (June 23, 2023) accessible at: https://financialservices.house.gov/uploadedfiles/hfsc_esg_working_group_memo_final.pdf
[10] https://corpgov.law.harvard.edu/2021/12/23/sec-resets-the-shareholder-proposal-process/ The nexus rule promoted the proliferation of complex company no-action challenges, spawning an opportunity for companies to make extended subjective and philosophical arguments to the SEC staff regarding the absence nexus.
[11] Clearly, the existing relevance rule continues to apply and to bear on the types of issues that are being raised as a cause for bringing back “nexus”. A proposal that merely seeks a general corporate plebiscite on a social or ethical issue on which the company has no impact or involvement would be unlikely to pass the Rule 14a-8(i)(5) test of being “otherwise significantly related to the company’s business”.