SEC Quizzed on Proxy Rules
By L. Reed Walton, Staff Writer, and Ted Allen, Director of Publications

Chairman Christopher Cox of the Securities and Exchange Commission told lawmakers this week that the agency plans to issue proposed proxy rule changes by late July, in an effort to have final rules in place before the 2008 U.S. proxy season. 

Cox said the proposed rules would address non-binding shareholder resolutions and proxy access (i.e., the ability of long-term investors to nominate directors to appear on management proxy statements). As part of this process, the commission also is reviewing a proposed New York Stock Exchange rule to bar brokers from casting uninstructed shares in board elections.   

While Cox signaled that the SEC would not revive a draft 2003 proxy access rule that would apply to all companies, his comments suggested that the commissioners are still trying to reach an agreement on the issue. “We’re still actively engaged in discussions,” he said.  

Cox made his comments during a rare appearance by all five SEC commissioners before the House Committee on Financial Services. For almost four hours on June 26, lawmakers quizzed the SEC officials on various topics, including the competitiveness of U.S. capital markets, the ability of shareholders to sue bankers and others who help companies defraud investors, whether small companies should be subject to internal control reporting requirements, and a pilot program that requires advance commission approval of corporate fines.

While Cox said earlier that the SEC would issue a rule this summer, he was more definitive at the House hearing about the expected timetable. However, he declined to shed much light on the new rules during generally respectful questioning from lawmakers. Cox, a former Republican congressman from California, previously served on the financial services committee.  

Rep. Barney Frank, the Massachusetts Democrat who chairs the House panel, said the committee would hold a “full hearing” after the new proxy rules are proposed. “There is a lot of interest on the issue,” he noted.

The commission has struggled for years to reach a consensus on proxy access. The SEC, which abandoned the draft rule in 2005 amid corporate opposition, was forced to revisit the issue after a New York-based federal appeals court ruled in September 2006 that the agency improperly allowed American International Group (AIG) to exclude a proxy access proposal.

Shareholder advocates, who say that proxy access is needed to ensure board accountability, have urged the SEC to clarify that investors may continue to file access resolutions at specific companies. Access proposals received 45 percent support at UnitedHealth and 43 percent at Hewlett-Packard this year. An access proposal filed by a dissident investor will be on the ballot July 16 at Cryo-Cell International, a small-cap firm in Florida.

Corporate interests have argued that proxy access is not necessary, given the various reforms already adopted by many companies, such as majority voting in board elections. 

During the hearing, several Democratic lawmakers spoke in favor of proxy access. “This is an issue of great significance,” Rep. Frank noted, according to the Associated Press. Another lawmaker said he would be concerned if the SEC adopts a high economic threshold that would bar most shareholders from participating. Rep. Brad Sherman from California observed that “the world has not caved in” after the SEC stopped granting corporate “no action” requests to omit access proposals following the AIG ruling. 

Noting that the AIG decision applies only to one section of the country, Cox said, “we need to make sure that there’s one rule for the whole country, that everyone understands it, and that we have it in time for the next proxy season,” he said.

Annette Nazareth, one of two Democratic commissioners on the SEC, noted her support for the commissioners to address the issue. “I would want action on proxy access as soon as we can,” she said.

It appears that Cox is leaning toward allowing shareholders to pursue access proposals at specific companies, instead of proposing a universal rule that applies to all issuers. “I share your concerns about imposing a federal set of detailed rules on what is a matter of state law,” Cox told lawmakers. “A national bylaw is not an approach I would favor.”  
 
Shareholder Proposals
When asked by Rep. David Scott of Georgia about the utility of non-binding (or precatory) shareholder proposals, Cox recalled the arguments made by proponents and critics at three agency roundtables in May.

While some companies view these proposals as a “nuisance” and a distraction, Cox acknowledged: “they’re non-binding, and therefore there is a limit to the distraction that [they] can provide.”

While Cox didn’t reveal his views on whether stricter filing requirements are needed, he did say that the SEC is studying the feasibility of electronic shareholder forums. “We want to make sure we have healthy communication at all times with companies,” he said.
 
“The more communication, the better,” Cox told lawmakers. “We’re looking for a cost-effective means that doesn’t interfere with the running of the company.”

The commission has acted three times since 1970 to revise Rule 14a-8, which governs shareholder proposals. In 1998, the SEC backed away from stricter limits on resubmitted proposals after companies objected to another provision that would have allowed investors who own more than a 3 percent stake to override no-action decisions by agency staff.   

Broker Votes
Democratic Rep. Melvin Watt of North Carolina asked Cox about the proposed NYSE rule and voiced concern that broker votes enabled a CVS/Caremark director to win election in May. Watt noted that investor advocates and North Carolina Treasurer Richard Moore have asked the company to provide more information on how broker votes were cast, but they were “stiff-armed.”

Cox explained that some smaller companies would be unable to meet quorum requirements without broker votes. He said this concern will be “in the mix” as the commissioners consider broker votes and other proxy issues, and he noted that the SEC may conduct a separate rulemaking to address the NYSE rule.    

Broker votes do account for a significant percentage of the shares in U.S. companies. About 85 percent of exchange-traded securities are held by brokers and banks on behalf of their clients, according to the SEC. Traditionally, brokers have cast those shares in favor of management nominees, prompting the Council of Institutional Investors and other shareholder advocates to describe the practice as “ballot-box stuffing.”
 
U.S. Competitiveness
Rep. Paul Kanjorski, a Pennsylvania Democrat, asked Cox about complaints by business groups that the Sarbanes-Oxley Act is discouraging foreign companies from entering American capital markets.

“I don't think the sky is falling,” Cox said. “All around us, there’s more competition.” At the same time, he noted that U.S. markets are still attracting foreign companies. “We’re on pace to have the most foreign listings in the U.S. since 1997.”

Commissioner Paul Atkins offered a different view. “There is no doubt that regulatory costs do discourage issuers from coming to the U.S.,” he said. While he agreed that some companies are attracted by U.S. legal protections, Atkins said, “others can be repelled if regulations are not in balance.”

Securities Litigation
The lawmakers expressed widely divergent opinions on securities class-action lawsuits. Several Democrats praised the SEC’s recommendation that the U.S. government submit a brief in support of investors in an upcoming Supreme Court case on “scheme liability” (i.e., whether shareholders should be able to sue bankers, vendors, and other “secondary actors” who help companies engage in fraud.) The outcome of that case may affect the efforts of Enron investors to recover billions of dollars from three of the company’s former underwriters.

The case, known as Stoneridge Investment Partners v. Scientific-Atlanta, produced a rare SEC split under Cox. He joined with the agency’s two Democratic commissioners to vote for filing a brief to support investors. The Office of the Solicitor General, which represents federal agencies, decided not to back investors after hearing opposition from the Treasury Department, the Federal Reserve, and White House officials, according to news reports.  

Noting that the Solicitor General represents the government, not just the SEC, Cox said it’s not uncommon for other agencies to have different views on a Supreme Court case. He said the SEC was within its rights to make its recommendation, “given our charter and our responsibilities” to protect investors. Cox defended his vote by noting, “I thought it was important to be consistent” with the 2004 position that the agency took in the Homestore litigation, where investors claimed that AOL Time Warner helped the company inflate its revenues.    

Rep. Frank praised the SEC’s position in Stoneridge and distinguished that case from other securities law disputes, such as the recent Tellabs decision, where the Supreme Court tightened pleading standards. Frank said he supports efforts to require more evidence of fraud, but he opposes the elimination of a whole class of scheme liability claims. 

Atkins and Commissioner Kathleen Casey, who voted against the Stoneridge recommendation, said the liability standards detailed in the agency’s brief were too vague. “It’s important to have a test that draws a clear line,” Atkins noted.  

Meanwhile, several Republicans denounced the SEC’s recommendation. Rep. Richard Baker of Louisiana said the agency’s position is a “clear and present danger” to U.S. capital markets. Rep. Tom Price of Georgia warned of “settlement extortion” by plaintiffs’ lawyers, noting that there have been $43 billion in securities settlements in the past decade.    

Rep. Ed Royce of California cited the concerns about frivolous litigation raised in a report by U.S. Senator Charles Schumer and New York Mayor Michael Bloomberg. Royce and 15 other Republican lawmakers have asked the SEC to prepare a report on the costs and benefits of securities lawsuits. 

In a June 22 letter, the lawmakers asked the agency to examine settlements and detail the transaction costs--including attorneys’ fees--that decrease the value of shareholders’ investments. The letter also asked the SEC to address if there are sufficient legal protections to deter “professional plaintiffs,” and whether there is a need for a “pay-for-play” ban on political contributions by plaintiffs’ lawyers to government officials who oversee public pension funds. Finally, the SEC was asked to recommend whether private settlements should be coordinated with Fair Fund distributions by the agency.    

Royce asked the SEC to complete that report by the end of the year. Cox said the agency would produce the report, and he appeared receptive to the suggested pay-for-play ban. 

Cox was asked by several Democrats about whether the SEC was considering a proposal to allow companies to mandate the arbitration of investors’ claims. In response, Cox said, “we have no pending proposal” to do so, repeating comments that he made to a Senate panel in May.  

Litigation Levels Remain Steady, Study Finds
By Ted Allen, Director of Publications

While federal securities lawsuits declined to a record low in 2006, the overall level of shareholder litigation remained steady as investors filed more than 100 derivative lawsuits in state court over alleged stock-option backdating, according to a study by PricewaterhouseCoopers (PwC).

Last year, shareholders filed federal securities cases against 106 firms and brought 108 state derivative actions against corporate officers, according to PwC’s “2006 Securities Litigation Study.” This total exceeds the overall number of cases (173) filed in 2005 and is just under the annual average of 218 since 2002.

“Despite an apparently waning number of federal securities litigation class actions, there is no evidence of a downward trend in shareholder activism,” the study’s authors concluded.

As the study explained, many investors chose to file derivative lawsuits--instead of federal securities cases--over stock option irregularities because many of those firms did not experience significant share price declines. Shareholders also filed 20 federal cases over alleged backdating.

“The lesson for companies, therefore, appears to be that they should not assume that minimal or no shareholder loss translates into no litigation,” the PwC authors wrote.

The PwC study’s inclusion of the state derivative claims differs from the approach taken by litigation studies done by NERA Economic Consulting, and Cornerstone Research with Stanford University Law School. Those reports focused on the decline in federal cases. 

The study also found that institutional investors are continuing to play a prominent role in securities litigation. Public pension funds and other institutions served as lead plaintiffs in 52 cases that netted $5.8 billion in settlements that were disclosed in 2006. That sum was more than 94 percent of the total $6.17 billion in settlements announced last year.

The study projects that large institutional investors will be appointed lead plaintiffs in 56 percent of the new cases filed in 2006. Institutions have increased their participation significantly since 2002, when they served as lead plaintiffs in 22 percent of new cases. While most of these participating institutions are public or union pension funds, the study also noted the role of mutual fund managers such as Centurion Securities and Fortis Investment Management.

Fewer large firms were sued in federal court last year. According to the study, Fortune 500 companies were defendants in 11 percent of the new cases, down from 15 percent in 2005. If state derivative cases are included, Fortune 500 firms were defendants in 12 percent of the 214 cases filed in 2006.

Technology companies continue to face the most lawsuits; those firms were defendants in 31 percent of the new federal cases, the study found. Most of those cases included allegations of option backdating or improper revenue recognition.

The PwC study also found that more audit committee members are being sued. Last year, audit panel members were sued in 8 percent of the new federal cases, as compared with 2 percent in 2005 and the 4 percent average since 2002. However, other corporate officers still are more likely to be targeted by investors. CEOs were defendants in 97 percent of the federal cases, while chief financial officers were defendants in 82 percent of those lawsuits. Both percentages are consistent with historical trends.

2006 was a better year for foreign issuers. Thirteen foreign firms were sued in U.S. courts last year, down from 19 in 2005 and a record 30 in 2004, the PwC study found. Most of the 2006 cases were filed against non-European issuers, including five firms based in Bermuda and two Canadian companies. Overall, about 1 percent of the 1,200 foreign issuers in the U.S. were sued last year, a rate that is comparable to the 1.2 percent of domestic companies that were sued.

However, foreign firms still are agreeing to significant settlements. Nortel Networks of Canada agreed to $2.2 billion in settlements last year, while Royal Dutch Shell announced a $352.6 million accord with European investors in April.

A longer version of this article appears in the June 2007 issue of the SCAS Alert, a publication of ISS’ Securities Class Action Services unit. 

Global Roundup

EU Presses Forward on Shareholder Rights
The European Commission, the executive arm of the European Union, has formally adopted an EU-wide directive on ensuring the rights of shareholders, and is now seeking comment on a proposed supplement to the directive to address stock lending and other concerns.

Brussels announced June 12 that the European Council had formally adopted its directive, dubbed Fostering an Appropriate Regime for Shareholders' Rights, which was first proposed in January 2006. The EU parliament approved a draft of the bill in February after modifications to the original proposal.

“These new rules will mean that shareholders, no matter where they are located in the EU, can have their say about the way companies are run and can hold management accountable,” EC Internal Market and Services Commissioner Charlie McCreevy said in a statement. “This is good news for all shareholders, for the integration of EU financial markets, and for the economy as a whole.”

According to EC officials, the directive helps ensure that investors will have “timely access to … relevant information” ahead of a general meeting of shareholders, and will simplify the “means to vote at a distance.” For example, the directive sets a minimum notice period of 21 days for most shareholder meetings, which can be reduced to 14 days where “shareholders can vote by electronic means and the general meeting agrees to the shortened convocation period.” The provision, notably, differs from the original January 2006 proposal, which called for 30 days’ notice for all meetings.

The directive also calls for the publication of proxy materials via the Internet at least 21 days before the meeting, and for the disclosure of vote results via the issuer’s Web site.

Additionally, the new rules allow for the submission of proposals at special meetings for holders of more than 5 percent of a company’s outstanding common stock. The draft rules, however, included the 5 percent threshold as well as a potentially more modest limit allowing holders of stakes worth at least €10 million ($12 million) to file resolutions.

In a bid to ease concerns over share-blocking--whereby companies can freeze the trading of to-be-voted shares in the days leading up to a shareholder meeting--the directive includes a requirement for companies to use proxy voting record dates. Governance observers note, however, that holders of a company’s stock on the date of record can vote their shares even if the stock is later sold before the meeting date. That flexibility may stimulate greater hedge fund activism at European companies, critics of the system contend.

The EC is now pressing ahead with a supplement to the directive that would address lingering investor concerns such as those tied to proxy material disclosure and stock lending. Officials are now seeking comment on a number of potential proposals including one concerning the language of publication for proxy materials. EC officials note that while companies are allowed to post proxy materials in multiple languages in addition to that of the home market, few to date are doing so. “This means that communication costs for issuers are low but information costs are high for actual and potential cross-border shareholders,” the commission notes.

The EC is now asking interested parties whether companies should be required to make available proxy materials “in a language customary in the sphere of international finance,” unless shareholders decide otherwise. Officials say they are mindful of the potential burden for smaller issuers, and would consider allowing companies to opt out of such a requirement based on size and the level of foreign investor holdings.

Comments on stock lending also are being sought. The practice has been scrutinized in recent years, EU officials say, over concerns that some investors actively borrow stock so they can influence voting at shareholder meetings. Consequently, the commission intends to ask whether borrowed shares should be kept from voting, except in those cases where the voting rights are exercised in accordance with instructions of the lender.

Comments on the commission’s proposals, which can be sent by e-mail, are due by July 27. --Subodh Mishra

In Brief

Commissioners Adopt Mandatory E-Proxy Rules
The Securities and Exchange Commission has adopted new e-proxy rules that require large companies to offer Internet delivery of proxy materials to all shareholders starting in January.

The amendments are in addition to an earlier set of e-proxy rules that take effect on July 1. Those rules stipulate that companies may deliver proxy materials online via an e-mailed notice that contains links to the materials on a Web site other than the SEC’s EDGAR database. Shareholders can ask for hard-copy proxy materials at any time, free of charge, and those who prefer physical mailings can “opt out” of the online notice.
 
Under the new “universal e-proxy” amendments, companies must provide online access to proxy materials even for those shareholders who receive a full set of physical mailings (known as the “full-set delivery option”), so that they may view them electronically at any time.

The commissioners approved the amendments at their June 20 open meeting. The e-proxy rules are intended to reduce the proxy solicitation costs for companies, as well as for dissidents, who may have been deterred from launching proxy contests because of the significant expense of mailing printed materials to shareholders.

Large firms (also known as “large accelerated filers”) must start complying with the amendments on Jan. 1. Smaller issuers, investment companies, and dissident solicitors will not need to comply with the new requirements until Jan. 1, 2009.

The American Business Conference, which represents CEOs at mid-size firms, submitted a comment letter that urged the SEC to delay implementation for a year and instead do a pilot program at a small number of large companies.  --L. Reed Walton

SEC Panel to Look at Simplifying Financial Reports
SEC Chairman Christopher Cox has formed a panel to look at ways to make financial reporting simpler for companies and easier for investors to understand.

The independent committee, headed by Robert C. Pozen, chairman of MFS Investment Management, is expected to undertake a year-long examination of current financial reporting standards, compliance regulations, and systems for delivering financial information to investors, Cox said in a June 27 press release.

“Our current system of financial reporting has become unnecessarily complex for investors, companies, and the markets,” Cox told Bloomberg News.

Cox said the committee will look at whether some current standards impose costs that outweigh their benefits, and what effect that the growing use of international accounting standards will have on U.S. companies. The SEC has issued guidelines aimed at cutting the costs of complying with the internal control rules of Section 404 of the Sarbanes-Oxley Act, and has moved to eliminate mandatory reconciliation between international and U.S. accounting standards.

The agency is also pushing for technological solutions, including the SEC’s new XBRL computer language, which Cox said will make it easer for investors to search for financial results within--and across--companies.

Some governance observers are concerned that valuable information may be lost if the SEC tries too much to simplify the intricate world of international financial reporting.

“I’m not so optimistic that in a very complex world with very complex transactions that accounting rules can be simplified without giving up a lot,” Charles Mulford, an accounting professor at the Georgia Institute of Technology told Bloomberg News. --L. Reed Walton

CalPERS to Increase Governance Investments
The California Public Employees’ Retirement System (CalPERS) plans to increase its corporate governance and hedge fund investments to as much as $10 billion.

“This is in response to the solid performance of these funds in recent years and the need to capitalize on excellent market opportunities,” Rob Feckner, president of CalPERS’ board, said in a June 18 press release.

CalPERS, the nation’s largest state pension fund, has invested $50 million of its $245 billion total assets in five hedge funds under its Risk Managed Absolute Return Strategies program, and has so far seen better-than-average returns.

The pension fund’s Corporate Governance Program is significantly larger; CalPERS has put $5.1 billion into the program since it began in 1996.  This investment program has posted annual returns of around 15 percent, the pension fund said. 

CalPERS also said it is considering future investments in additional European and developing markets. --L. Reed Walton

Meetings to Watch

This section alerts readers to forthcoming shareholder meetings that have particularly interesting or controversial issues on the agenda.