By Michael Schmidt, CFA 

More than a year after its introduction, the Securities and Exchange Commission (SEC) has officially adopted its proposed change to the federal proxy process in what it claims will “facilitate the rights of shareholders to nominate directors to a company’s board.” This decision was not passed unanimously by the SEC, but was passed nonetheless on Aug 25, 2010. The decision was significant, as it means that shareholders, regardless of size, can potentially have a direct effect on the proxy process and the composition of their companies’ boards.

The proxy process change is one of many ideas the SEC has put in motion to present itself as a more investor-friendly agency and to combat some of the negative views expressed by the public in recent years.

There seems to be widespread acceptance of this proxy process change among investors, which may impact small companies the most. The change may eventually mean more to them than they yet realize, because it could potentially have a larger impact on the board composition of small companies than large companies. This change allows anyone, whether an individual or group, with at least a 3% investment stake in a company to place their own choice for board seat candidates on proxy materials that will go out to shareholders. This change varies dramatically from the current process in which investors must essentially wage a war at their own expense to get their candidates on the ballot. This is one of the most significant changes the SEC has made to the proxy process in almost 30 years and does not come without dissension.

Some who oppose this change, including two of the five voting SEC members, argue that large shareholders with an agenda can use this opportunity to manipulate companies  for their own benefit rather than that of all shareholders.  Others feel a “one size fits all” solution may lead to increased expense in compliance to all registered companies.  Mr. Russ Weigel III, a former SEC attorney, stated, “I cannot say that I am a fan of increased regulation that creates additional compliance duties with little upside for corporate America. The only scenario that I can see where this rule is of benefit to anyone is in the context of the company having a widely disparate shareholder base where a 3% shareholder’s interests may be of some influence on management.”

While there seems to be plenty of dissenting opinions on this ruling, there is really no way to tell until it goes through a complete proxy cycle, which could start in early 2011 for mid- to large-cap companies first.

The Current Process:

As has been the process for many years, current board members can nominate new board candidates, and this information is passed along to investors in the proxy materials. During the nomination period, shareholders have little or no say in the process, and their choices for board nominations have little or no chance of getting on the ballot prior to proxy release. Most investors, including institutional holders, find it more convenient to vote for the candidate presented to them in the proxy materials rather than attend the annual shareholder’s meeting and vote personally. In fact, most investment groups have dedicated teams for this purpose alone.

Since shareholders, in most situations, have to attend shareholder meetings to nominate their own candidates, you don’t have to be anti-big business to see the apparent flaws in the current system.  There is and has been a sort of “old boy” network going on in corporate America, and many boards have been criticized for this – in particular, those companies that have failed or gone through significant financial problems or scandals under the so-called watchful eyes of board members. In the defense of current boards, the current system legally allows board members to take on these often lucrative seats in multiple companies and in some cases sit back and vote with management and not get too involved. The process by nature creates an almost disinterested party, as there is not much incentive for independent boards to get very involved as board members, and it makes it easier to just vote with management.  In addition, board members are rarely held directly responsible for company failures and scandals. Part of this is due to the fact that their powers to actually run the company are limited and after their term they just move on to the next appointment.   

What this means for all parties involved, including small-cap investors

Since this adopted change excludes what the SEC considers “smaller reporting companies” (those with less than $75M in float, or if not able to calculate float, those with less than $50M in annual revenues) for three years, the new policy will have a temporary mid- to large-company bias at first.  Once the change has endured a few cycles of feedback and revisions, smaller companies should be able to participate as well. This could have similar implications to how someone with the means and political agenda is able to become an elected public official, often referred to as “buying the election”. While the SEC has imposed rules as to who can be nominated, and although a nomination in no way guarantees appointment, imagine how an influential one or more newly nominated board members could be.  Here are a few examples:

• More frequent turnover for board members as shareholders are offered more voting options
• If elected, shareholders’ interests could theoretically be represented on boards with significant influence
• Boards could have dramatic changes in their composition, from the typical career board member to members who have direct interest in the company’s long-term plans
• Increase in the comfort level of those investors who have blamed some corporate boards for failures, scandals, and involvement in the recent financial crisis
• The introduction of a voice from someone who would not normally even be considered for a board appointment

While the implications have grand scale positive indications, the dissenters and opposition to this change have reasonable concerns, such as:

• An increase in administrative and legal costs to all companies, as this will eventually be a one-size-fits-all change
• The risk of abuse: even with significant government oversight and the requirements of SOX, if a company’s intention is to bend the rules, deceive, or cook the books, no board has the power to much more than question management’s practices. A well-organized fraud will always be difficult to detect from the board level.
• Too much power in too little hands – currently the composition of boards is designed to create a diversified panel of people from various backgrounds and affiliations. If enough investors in a small company are successful, they could in theory take over a board.

There seem to be enough positive reactions from investors and their advocates to understand why the SEC has made this change. The change to the proxy process will inevitably heighten awareness of board composition, provide more transparency to the entire process, provide opportunities for change in the construction of traditional boards, and help investors of all size stakes know where to direct their anger or praise rather than just blaming the system.