March 24, 2016

Revitalizing SEC Rule 14a-8’s Ordinary Business ExemptionStephen M. Bainbridge, UCLA School of Law

Current Issues

CSR:• Global human rights policies• Contract supplier standards• Sexual orientation non-discrimination

– Gender identity non-discrimination• Global warming reporting• Emissions reduction & energy

efficiency reporting• Renewable energy sources• Indigenous rights policy• Recycling • Pesticides and other toxic chemicals• Israeli-Palestinian conflict

Governance• Political contribution disclosure• Proxy access• Takeover defenses• Board diversity and independence• CEO compensation• Pay disparity• Separate CEO and Chair

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~ 400 excluded or withdrawn

Allows qualifying shareholders to put a proposal before their fellow shareholders• And have proxies solicited in favor of them in the company’s

proxy statement• Expense thus borne by the company• Company may seek to exclude proposals for various reasons– Procedural: E.g., not timely submitted, duplicative of company

proposal, proponent does not mean ownership thresholds, etc…– Substantive: Not a proper subject of shareholder action, relates to

dividends or elections, personal grievance, etc…

Legal Basis for Shareholder proposals: SEC Exchange Act Rule 14a-8

Grounds for Exclusion

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Trinity Wall St. v. Wal-Mart Stores, Inc.992 F.3d 323 (3d Cir.), cert. dismissed, 136 S. Ct. 499 (2015).

2014 Audited Financial Statement:Total assets: $878,234,000Investments (other than real estate):

$210,246,000

April 1, 2014 letter from Rev. Dr. James Cooper to Trinity parishioners:“Trinity Wall Street has long recognized that our considerable resources give us both a responsibility and an opportunity to engage constructively with businesses in which we invest where opportunities exist to enhance returns for both shareholders and society. “As part of this effort, we recently initiated dialogue with certain companies toward assuring they balance the benefits of selling certain products against the risks these sales pose to the public and to the companies’ reputation and brand value.”

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“Stockholders request that the Board amend the Compensation, Nominating and Governance Committee charter (or add an equivalent provision to another Board committee charter) as follows:

‘”’27. Providing oversight concerning the formulation and implementation of, and the public reporting of the formulation and implementation of, policies and standards that determine whether or not the Company should sell a product that:

1) especially endangers public safety and well-being; 2) has the substantial potential to impair the reputation of the Company; and/or 3) would reasonably be considered by many offensive to the family and community values integral to the Company's promotion of its brand.’

“This oversight and reporting is intended to cover policies and standards that would be applicable to determining whether or not the company should sell guns equipped with magazines holding more than ten rounds o f ammunition ("high capacity magazines") and to balancing the benefits of selling such guns against the risks that these sales pose to the public and to the Company's reputation and brand value.”

Trinity’s proposal for inclusion on Wal-Mart’s 2014 proxy statement for the annual meeting of shareholders

Part II

Why not let the shareholders decide?

“The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors” DGCL 141(a)• The board’s powers are “original and undelegated” - Manson v. Curtis, 119

N.E. 559, 562 (N.Y. 1918)– Shareholder control rights limited– Voting rights limited to review of a few fundamental decisions– Proxy system and 13(d) restrictions on shareholder voting and

communication– Derivative litigation burdened by procedural barriers and BJR– Market for corporate control hampered by combination of poison pill and

classified boards

The director primacy model

The ABA Committee on Corporate Laws (2010)Hollinger Inc. v. Hollinger Intern., Inc. (Del.Ch.2004)

Klaassen v. Allegro Development Corporation (Del. Ch. 2013) Kevin L. Turner, 57 ALA. L. REV. 907

Larry Ribstein, 1 BERKELEY BUS. L.J. 183 In re CNX Gas Corp. S'holders Litig. (Del.Ch.2010)

Cases and Commentators

“[D]irector primacy remains the centerpiece of Delaware law, even when a controlling stockholder is present.”

Noting “the bedrock statutory principle of director primacy established by Section 141(a) of the DGCL.”

“It is through … centralized management that stockholder wealth is largely created.”

“Corporate governance is best characterized as based on ‘director primacy.’”

“Delaware jurisprudence favors director primacy in terms of the definitive decision-making power …”

Reaffirmed MBCA policy of vesting “the power to direct and oversee the management of the corporation in the board of directors, rather than in the shareholders.”

“Cheaper and more efficient to transmit all the

pieces of information to a

central place” that makes “the

collective choice and transmit it

rather than retransmit all the

information on which the decision

is based”

Asymmetric information

Divergent interests

Collective action problems

Kenneth ArrowThe Limits of Organization

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Kenneth ArrowThe Limits of Organization

The power to review is the power to decide:• “If every decision of A is

to be reviewed by B, then all we have really is a shift in the locus of authority from A to B”

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Endorsed the “board centric” model Why?

Reaffirmed MBCA policy of vesting “the power to direct and oversee the management of the corporation in the board of directors, rather than in the shareholders.”

Board centric model gives shareholders “the regular opportunity to elect the members of the board, but during the directors’ terms, the board has the power, informed by each director’s decisions in the exercise of his or her fiduciary duties, to direct and oversee the pursuit of the board’s vision of what is best for the corporation.”

If the actions of management were the subject of frequent shareholder review:• The ability to rely on

management teams would be diluted

• The time and attention of managers could be diverted from activities designed to pursue sustainable economic benefit for the corporation.

• Particular shareholders may have interests that diverge from those of other shareholders or interests other than sustainable economic benefit.

The ABA Committee on Corporate Laws (2010)

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Individual shareholders lack sufficient stake to justify monitoring• Free-riding issue

Interests of large investors likely to differ from those of shareholders as a whole

Transfer of authority from board to shareholders• Undesirable in itself

– Less efficient decision making– Swapping consensus for authority under conditions favoring the latter

Shareholders do not “own” the corporation

Individual Shareholders Institutional Shareholders

But what about the “ownership” rights of shareholders?

Part III

The Law of 14a-8(i)(7)

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The Trinity Standard

Discern subject matter of proposal

Does subject relate to ordinary

business?

If not, no grounds

for exclusion

If yes, go to social Significance

1. Does proposal raise significant policy issue?2. Does it “transcend”

ordinary business

If no, exclude

If yes, include

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Proposal nominally requested a board

review process

But substance prevails over form

“Clever drafting” cannot rescue

improper proposal

Asking for a review or adoption of a

policy no guarantor of inclusion

Look to “ultimate consequence” of

proposal[How?]

The process of discernment

Proposal was really about selling guns

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“so long as the subject matter of the proposal

relates—that is, bears on—a company’s ordinary business operations, the proposal is excludable

unless some other exception to the

exclusion applies”

A proposal bearing on decisions about product

offerings is thus excludable even if the

“proposal doesn’t direct management to stop selling a particular

product or prescribe a matrix to follow”

Does proposal “relate” to ordinary business?

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“The first [issue] is whether the proposal focuses on a significant policy (be it social or, as noted below, corporate).”

It “is hard to counter that Trinity’s proposal doesn’t touch the bases of what are significant concerns in our society and corporations in that society.”

1.Court provides no general metric for significance.2.In this case, resolved by pure fiat: No explanation of why issue rose

to requisite level in this case.

But

Prong A Result

Social Significance

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Prong B But

Social Significance

A “shareholder must do more than focus its proposal on a significant policy issue; the subject matter of its proposal must ‘transcend’ the company’s ordinary business.”

The “transcendence requirement plays a pivotal role in the social-policy exception calculus.”

“Without it shareholders would be free to submit ‘proposals dealing with ordinary business matters yet cabined in social policy concern.’”

This is analysis by epithet and reasoning by pejorative :• Transcend is undefined in

the opinion. “A court's focus on labels

rather than on reasoning not only impedes law students' understanding of what the law is and how to answer questions on an exam, but also lawyers' understanding of how to advise clients and how to present arguments to arbitrators and judges.”

Part IV

Our Proposal

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“Although a core business of courts is to interpret statutes and rules, our job is made difficult where agencies, after notice and

comment, have hard-to-define exclusions to their rules and exceptions to those exclusions. For those who labor with the ordinary business exclusion and a social-policy exception

that requires not only significance but “transcendence,” we empathize. Despite the substantial uptick in proposals attempting to raise social policy issues that bat down the business operations bar, the SEC’s last word on the subject came in the 1990s, and

we have no hint that any change from it or Congress is forthcoming . . . We thus suggest that [the SEC] consider revising its regulation of proxy contests and issue fresh

interpretive guidance.”

The Trinity court was aware that a better test is needed

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Chevron (US 1984): Where Congressional intent is unclear a reviewing court should defer to the agency’s interpretation of the statute so long as it constitutes a permissible construction of the statute

SEC and staff have consistently failed to apply the ordinary business exemption consistently over time.

Multiple flip-flops (e.g., Cracker Barrel) that went unexplained.

Nat'l Cable & Telecomms. v. Brand X Internet Servs. (US 2005): An “unexplained inconsistency is ... a reason for holding an interpretation to be an arbitrary and capricious change from agency practice”).

Is the SEC entitled to Chevron Deference?

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Substance prevails over

form (no “clever” drafting saves)

Look to state law

(federalism and SEC authority)

Prong 1Bylaw

analogy

Prong 2Extraordinary act analogy

An Alternative Test

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CA, Inc. v. AFSCME Employees Pension Plan (Del. 2008):• The “proper function of bylaws is not to mandate how the board

should decide specific substantive business decisions, but rather, to define the process and procedures by which those decisions are made.”– “This distinction between substance (disallowed) and process (allowed) captures an

appropriate balance between authority and accountability. If shareholder interventions directed at substantive decisions can be discouraged, the board’s decision-making authority is respected. Indeed, if it is the case—as seems likely—that private rent seeking most often will take the form of substantive interventions, discouraging that category of interventions provides a useful prophylactic solution to the rent-seeking problem. Conversely, process and procedural interventions do not deprive the board of its authority but rather can be used to ensure that that authority is used accountably.” (Bainbridge 2015)

Bylaw analogy

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The SEC claims:

“State law precedent … is rarely conclusive as to what is or is not ordinary business, and the staff generally has had to make its own determination as to whether a proposal involves an activity relating to the issuer's ordinary business.”

– But the SEC is wrong.

Prong 2: The Ordinary versus Extraordinary Matter Analogy

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Prong 2: The Ordinary versus Extraordinary Matter Analogy

Lee v. Jenkins Bros. (2d Cir. 1959): The president of a corporation “only has authority to bind his company by acts arising in the usual and regular course of business but not for contracts of an ‘extraordinary’ nature ….”

Restatement (Third) of Agency § 3.03 cmt. e(3)• “The apparent authority

of a president or chief executive officer encompasses transactions falling within the ordinary course of the corporation's business.”

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Per se extraordinary Principles of Corp Gov

Prong 2: The Ordinary versus Extraordinary Matter Analogy

Acts that boards as a whole may not delegate to board committees “would normally not be within the authority of the president or other senior executives.”

Acts that would require shareholder approval.

Factors: “the economic magnitude of the action in relation to corporate assets and earnings, the extent of risk involved, the time span of the action's effect, and the cost of reversing the action.”

“A useful generalization is that decisions that would make a significant change in the structure of the business enterprise, or the structure of control over the enterprise, are extraordinary corporate actions, and therefore are normally outside the apparent authority of senior executives.”

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Compelled speech• Giving soapbox to shareholders to advance proposals motivated more by

politics than economics– At company expense (and thus ultimately at expense of all shareholders)– Under current law, the shareholder proposal rule is a species of private

eminent domain by which the federal government allows a small minority to appropriate someone else’s property.

Federal entanglement in disputes over social issues:• Should federal bureaucrats or federal judges decide whether a politically

charged proposal has enough ethical or social significance to justify its inclusion in the proxy statement?

The Case Against the Social Significance Exemption to the Exclusion

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Discern

• Influence decisions about product offerings

Substance/Process

• Substance: excludible• Clever drafting as request for a policy unavailing

Extraordinary Act

• Ordinary

Applications: Trinity

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Discern

• Set process by which shareholders can nominate directors

Substance/Process

• Procedure

Extraordinary Act

• Extraordinary

Applications: Proxy Access

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Discern

• Relates to how the company conducts operations

Substance/Process

• Substance

Extraordinary Act

• Ordinary

Applications: Report on/Adopt policy re sustainability

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Discern

• Sets procedural limits on how long directors can serve

Substance/Process

• Process

Extraordinary Act

• Extraordinary

Applications: Director term limits