The SEC Tries to Pry Open Corporate Boards

Ever since President Barack Obama signed the new law revamping financial regulation on July 21, the focus has been on Wall Street institutions that, in Obama's words, took risks that "endangered the entire economy." One provision that received relatively little public attention will make it easier for shareholders to oust board members from companies of all sorts. It's a move that businesses far from Wall Street have been fighting for nearly a decade.

Buried on page 1,257 of the legislation is language authorizing the Securities & Exchange Commission to let investors nominate directors on corporate proxies—the ballots and other information that companies mail to shareholders. Right now only the companies' own nominees appear on the ballots. If the SEC approves the proposed rules, as shareholder groups expect it will, at the end of August, candidates selected by pension funds, labor unions, or hedge funds could appear on proxies as early as the spring of 2011.

Public pension funds, including the California Public Employees' Retirement System (CalPERS), argue that competition for board seats will make directors more accountable to investors rather than rubber stamps for management. Many company executives see the issue differently. They say special interests—hedge funds pushing to spin off underperforming units, for example, or labor unions trying to prevent layoffs—could win board seats and impose their minority view. Pension funds and labor unions could use the threat of a fight over board seats to negotiate for other concessions, Eaton Chief Executive Sandy Cutler wrote in January in a letter to the SEC. Patrick McGurn, special counsel at Institutional Shareholder Services, which advises large investors, says that "directors and CEOs almost view the inclusion of an outsider as an invasion. They think this person is going to be a disruptive force in the boardroom."

The SEC has considered permitting so-called proxy access since 2003, only to back away several times because of opposition from corporations and questions over whether the change would stir up litigation. Harvey Goldschmid, a professor at Columbia Law School and a former SEC commissioner who fought to open the board nominating system, argues that the agency now has a clear directive to act, "and that ends the matter as a serious issue in the courts."

Maybe not. The U.S. Chamber of Commerce, which represents more than 3 million companies, has retained Eugene Scalia, the son of U.S. Supreme Court Justice Antonin Scalia, to review the forthcoming SEC rules for a potential legal challenge. "We will wait for the SEC to move forward and see what our options are," says Tom Quaadman, vice-president of the Chamber's Center for Capital Markets Competitiveness. Scalia, a partner at Gibson, Dunn & Crutcher in Washington, is three for three in winning lawsuits against the SEC, including cases involving what courts ultimately ruled were federal procedural violations.

Until now, the process of nominating outsiders as board candidates was expensive and time-consuming; it required mailing a ballot separate from the company's and persuading investors to vote for your slate. Corporations hate proxy fights because they lead to embarrassing questions by investors, customers, and employees about whether the board and management are competent, says Damien Park, a managing partner at Hedge Fund Solutions, a Philadelphia firm that advises companies in proxy battles. "The dissidents will highlight every inefficiency and every aspect of the business' underperformance," says Park. Competitors can take advantage of that by poaching clients and top performers.

Pension funds will likely target companies that have already faced scrutiny from investors, such as Massey Energy (MEE), Occidental Petroleum (OXY), and Bank of America (BAC), Park predicts. Massey, based in Richmond, Va., is under fire after an explosion at one of its coal mines killed 29 people in April. The company declined to comment. Los Angeles-based Occidental received a letter last month from the California State Teachers' Retirement System (CalSTRS) and Relational Investors, a money management firm, complaining that CEO Ray Irani's compensation was a "corporate giveaway program." A Bloomberg survey in March concluded that his $31.4 million in 2009 total compensation was the most of any CEO. CalSTRS and Relational say they plan to nominate four new Occidental directors. Company spokesman Richard Kline says Occidental's board compensation committee has been meeting with shareholders to discuss pay policies and will recommend changes within the next few months.

Bank of America faced a campaign in April by CalPERS, which urged shareholders to withhold votes for six directors. A year earlier, investors stripped then-CEO Kenneth Lewis of his chairmanship after the bank failed to disclose Merrill Lynch's (MER) worsening financial condition before shareholders approved its acquisition. The company declined to comment.

Getting board candidates on a proxy still won't be easy. The SEC is likely to require that shareholders hold a 3 percent stake in a company for at least two years to qualify, according to people familiar with the matter. The commission is tentatively scheduled to vote on the matter Aug. 25, the people say. SEC spokesman Jon Nester declines to comment. The 3 percent rule means groups of investors will need to team up, and even then they may fall short. The 18 biggest state pension funds hold 2.22 percent of Massey if they combine their holdings, according to Bloomberg data. The 21 largest public pension funds hold 2.97 percent of Bank of America and 2.69 percent of Occidental. Pooling Relational's 0.8 percent stake in Occidental with public pension fund holdings, however, would surpass 3 percent. San Diego-based Relational marks its two-year anniversary of holding Occidental shares in the first quarter of 2011, just months before the company's annual meeting.

The bottom line: Corporations are bracing for new rules that will make it easier for dissident shareholders to nominate board members.

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