An action plan for managing proxy access
Strategizing before the rules go into effect will help family-controlled businesses to respond effectively.
Approximately one third of the Fortune 500 can fairly be described as family-controlled companies, and while family members in these companies usually are not the majority stockholders in a technical sense, in many cases they still maintain a significant degree of control through positions on the board of directors. This level of control has assuaged family members’ fears that the company would become unable to adhere to the family’s strategic vision and the guiding principles of the founder.
However, the world has been changing. Among the other changes made by the Dodd-Frank Act, proxy access has been adopted. Under the controversial new rules, shareholders will have the ability to nominate directors and solicit votes for their candidates via the company’s annual proxy statement. The proxy access changes were slated to take effect on Nov. 15, 2010, but in light of recent litigation challenging the new rules, the Securities and Exchange Commission has decided to stay the rules for the time being.
Once the new proxy access rules become effective, they are expected to have a wide-reaching effect, particularly because sitting directors will be more vulnerable to being ousted by dissident shareholders. Many families have relied on incumbent directors to promote their vision and goals for the company. In the past, an incumbent director could take comfort in knowing that reelection was almost certain, as only management had access to the proxy machinery. However, with the ability of minority shareholders to use the company’s proxy statement in a contested election, the likelihood that the family will be able to control such elections has been reduced.
Overview of the proxy access rules
While shareholder nominations will probably increase under the new rules, shareholders will still face significant challenges in trying to unseat a sitting director with one of their nominees. Waging a successful proxy contest has historically been prohibitively expensive and time-consuming for almost all shareholders. Under the new rules, the challenges, though still significant, are likely to be less difficult.
Shareholders who (individually or as a group) have owned at least 3% of the company’s voting securities for three years or more will be eligible to submit a nominee for director. These shareholders will be able to require a company to include in its proxy materials information regarding nominees for up to 25% of the directors (but at least one). For companies with staggered boards, the 25% calculation applies to the total board, not just the number of directors up for election at a particular meeting.
Shareholders will be required to provide to the company specific information about their nominees at least 120 days before the anniversary of the mailing date of the prior year’s proxy statement (but not sooner than 150 days before that anniversary date). The required disclosures, which must also be publicly filed, include the amount and percentage of securities owned, the length of ownership, biographical information about the nominee and a statement in support of the nominee of up to 500 words. The disclosures must also state whether the nominee meets any eligibility requirements that the company has specifically adopted for directors and that the shareholder or group is not holding any securities with the purpose or effect of changing control of the company or seeking more than the maximum number of board seats than it would be permitted to nominate under the rules. All of this disclosure, including the supporting statements, must be published in the company’s proxy statement.
Effect on family businesses
Until now, company proxy statements included only management’s nominees for directors, giving an incumbent board a huge advantage in any election context, which often has discouraged shareholders from challenging incumbent directors. The new rules will shake up the proxy process and cause a lot of anxiety for families who count on their board seats to give them effective control. Without a guaranteed reelection of directors who support the family’s vision, families may be more vulnerable to losing board control to minority shareholders with different agendas, including the possible sale or breakup of the company.
Additionally, smaller family--controlled businesses may be more at risk for shareholder director nominations because it is easier to own 3% of a smaller business. However, if the business is a “smaller reporting company” as defined by the SEC (i.e., less than $75 million of public float), it will have three years before the proxy access rules apply to it.
Recent proxy contests at publicly traded family-controlled businesses such as Barnes & Noble and the Hyatt Hotel Group are examples of shareholder activism that have been disruptive within a company. However, companies do have choices with these new rules. While some companies have reacted to shareholder nominations with hostility, families and boards may want to consider whether this is the appropriate response when proxy access is the norm.
The proxy access rules reflect a policy judgment by Congress—urged on by many shareholder groups—that minority shareholders should have more of a say in how public companies are run. Families will have to balance these shareholders’ interests against their own vision for their companies. Nominations by significant shareholders who have held the company’s stock for at least three years may be worth considering.
If your family board and corporate board of directors have not yet done so, now is the time to discuss and consider whether your family business is going to resist or embrace the change. But in any event, having an action plan for the board and company is critical to ensure a smooth transition to the new rules, before the first shareholder nominations are received.
What to do right now
1. Know your shareholders. The first step in managing the new proxy access rules is to know your larger shareholders. Families should work with management and the incumbent directors of their companies and take the time now to understand their shareholder base. They should determine who owns 3% or more of the outstanding shares and then meet with them to find out their concerns and questions.
Monitoring the shareholders goes hand in hand with communication. Companies should evaluate their shareholder communications and investor relations processes. Boards that engage in a continuing dialogue with significant shareholders and institutional investors should have advance notice of those investors’ intentions, so that they do not wake up to a surprise nomination. A proxy battle should not be the first time the shareholders hear directly from the board.
2. Evaluate board performance and composition. The family should encourage its sitting directors to reflect on their own performance and composition. Here are some questions the board should ask:
• Does the board act transparently?
• Are conflicts of interest minimized and fully disclosed when they occur?
• Does the board act promptly on performance and corporate governance issues?
• Does the board conduct regular self-evaluations?
• Is the board aware of the investors’ actual perspectives and concerns regarding the company?
Reflection on the makeup and size of the board may also be appropriate. Sitting directors should already be discussing the requirements and needs for the board, including whether new blood is needed. They might consider whether long-standing directors have become too chummy with management and if the company would benefit from more diversity of thought or background.
More fundamentally, the family and the board should come to terms with whether increased shareholder participation is a good thing. The new rules embrace a different way of thinking about how boards should be composed and how directors should be chosen, and the family will want to work with the board and management to build a consensus as to what their combined position will be.
3. Consider bylaw amendments. Along with evaluating how the board works, family businesses should review their bylaws to determine if the company should adopt amendments to update advance notice and nomination provisions or to include director qualifications.
Family businesses may wish to change their advance notice period to match the new proxy access rules window of between 150 and 120 days before the mailing date of the prior year’s proxy statement. Additionally, companies should consider whether to include director qualifications in their bylaws.
4. Respond to Schedule 14N filings. Some shareholders who plan to submit a director nomination may work with other shareholder groups to reach the 3% threshold. In order to form a nominating group, the shareholder will have to file a notice on Schedule 14N at the start of communication with other shareholders, as well as copies of any written communications. While the board should be communicating with shareholders even before a Schedule 14N filing, the family should still monitor any early Schedule 14N filings closely. This is an opportunity for the family and the board to engage with the soliciting shareholder to understand and potentially address the shareholder’s concerns, before the group submits a director nomination and triggers an election contest.
Family businesses will be affected by the proxy access rules. To minimize disruption in the day-to-day operations of the business, the family and the incumbent board should create a game plan of next steps. Taking a thoughtful approach to the new rules and avoiding knee-jerk reactions will put your family business in a better position to avoid a dissident nomination, and to manage if and when a shareholder nomination is received.
The time leading up to the effectiveness of the rules should be used to develop and implement an action plan as described above. Reflecting and strategizing now will enable the family to respond appropriately to shareholder nominations in the future.
Doug Raymond is a partner in the Corporate and Securities Group at the law firm Drinker Biddle & Reath LLP (www.drinkerbiddle.com). This article was written with assistance by Ena Lebel, an associate in the firm’s Corporate and Securities Group.