Harvard Law School
Cambridge, MA 02138

Lucian Arye Bebchuk
William J. Friedman and
Alicia Townsend Professor of
Law, Economics, and Finance
Tel (617)- 495-3138
Fax (617)-496-3119
Email: bebchuk@law.harvard.edu
URL: www.harvard.law/faculty/bebchuk

June 13, 2003

Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609

Re: File No. S7-10-03

Dear Mr. Katz:

I am writing in response to the Securities and Exchange Commission Press Release No. 2003-46 concerning possible changes in the proxy rules and regulations for the election of corporate directors.

I very much welcome the Commission's decision to review the proxy rules. I am a member of the Harvard Business School/Harvard Law School corporate governance group that sent you earlier a comment letter. That letter expressed general support for the idea of permitting shareholders that have a certain minimum percentage of the company's shares (e.g., 5%) to nominate a short slate of directors whose names would appear in the company's proxy materials and proxy card. I am sending this letter to make several additional points that are not necessarily shared by all members of this group:

    (1) The case for reforming the corporate electoral process is compelling;

    (2) The Commission should consider additional measures to facilitate shareholder nomination of "short slates;" and

    (3) The Commission should consider measures to invigorate elections where control is at stake.

The Need for Reforming Corporate Elections

In my view, corporate governance could be substantially improved by appropriate measures to enhance the power of shareholders. I develop this view in detail in recent and current work, which is the basis for much of the remarks below.1 The current rules excessively insulate boards, and reducing this insulation would benefit shareholders and the economy.

The shareholder franchise has a special place in our corporate governance system. As Chancellor Allen observed, "[t]he shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests."2 In theory, the power to replace directors should make directors accountable and, when they fail, should enable shareholders to replace them with directors that would perform better. While the ability of shareholders to replace directors is supposed to be an important element of our corporate governance system, it is largely a myth.

Attempts to elect directors not nominated by the company are extremely rare outside the takeover context. Although determining the optimal incidence of such attempts is not an easy question, there can be little doubt that the current incidence is far too low to have the beneficial impact on corporate governance it could, in principle, deliver. The case for at least some invigoration of the electoral challenges is thus strong.

The main proposal under consideration - to require companies to include in their proxy statement and proxy card a short slate nominated by shareholders with sufficient ownership of shares - is a moderate measure, both in terms of its being limited to attempts to replace a minority of the directors and in terms of its providing shareholders with no more than the ability to have their nominees included in the material distributed to shareholders. Indeed, as I explain below, stronger measures would be worthwhile adopting. Still, because adoption of the proposal would signal an important departure from the long-standing control by incumbent directors of the company's proxy machinery, defenders of the status quo have mounted many objections to it. Below I list some of the main objections that have been raised in letter comments and elsewhere and briefly note why they are not warranted:

  • Disruption: It has been argued that nominations by shareholders might have a disruptive, distracting effect on the board. Some such distractions, however, might be the worthwhile cost of increased accountability. Members of Congress who face regular challenges are certainly regularly distracted from other work by such contests, but that has not led us to prefer a system that makes challenges to incumbents exceedingly rare. While the threat of ouster can be distracting, it can also very useful. The better directors perform, the less they will have to be concerned about challenges and the easier it will be for them to defeat a challenge should it occur. Indeed, I expect that, even if shareholders get the considered access to proxy statements and cards, challenges to well-performing directors are not going to be common, and certainly much less frequent than the regular challenges that incumbents face in other contexts.

  • "Special interest directors:" It has been argued that shareholder access would produce directors who will serve and further the goals and views of a limited fraction of shareholders. This objection is warranted because shareholder-nominated directors would not be elected without majority support. Directors would thus join the board only if they have an appeal to a broad body of shareholders, not to a "special interest."

  • "Balkanization:" It has been argued that directors need to work as a largely harmonious team, and that the election of a shareholder-nominated director would lead to division and discord in a balkanized, politicized board. However, this is undoubtedly a consideration that shareholders can and would likely take into account in deciding whether to vote for a shareholder-nominated director. There is little reason to believe that they would give this consideration too little weight. When a majority of the shareholders conclude that the value of adding a given nominee to the board would exceed whatever costs might arise from "balkanization," the addition of the director is more likely to have a beneficial rather than an adverse effect on corporate governance.

  • Confusion and insufficient information: It has been argued that the proposal would lead shareholders to confusion and to making decisions on the basis of insufficient information. At most, consideration suggests that the Commission ensures that shareholder-nominated directors are clearly marked as such and that sufficient information about them is given. The AFL-CIO has suggested in its letter comment that such nomination be accompanied by a short (e.g., 500 word) blurb. In my view, however, while a short blurb might be sufficient in connection with non-binding shareholder proposals, it would be insufficient for decisions to add directors to the board. It might well be desirable to require that more information about a shareholder-nominated director be given and included in the materials sent to shareholders. But while the scope of required information should be carefully considered, these concerns hardly warrant precluding any shareholder access to the proxy card.

  • Shareholders can propose directors to the nomination committee: This objection is inconsistent with the claim that, if shareholder-nominated directors are elected, incumbent directors would not be able to work with them in harmony. If that is the case, why should one expect the nominating committee made of such directors to be sufficiently open to such nominees? In fact, facilitating shareholder access to the proxy materials would operate to induce nominating committees to include in the company's slate directors proposed by shareholders when such directors would be likely to have broad support among the company's shareholders.

  • Proxy contests are already taking place under the existing rules: Indeed, each year there are several dozen contests taking place. An examination of these contests, however, indicates that most of them accompany acquisition attempts. Bidders, for example, run slates to facilitate an acquisition. But the classic contest - one in which directors seek a seat to improve the way in which the company operates as a stand-alone entity - are exceedingly rare.

Beyond Access to the Company's Proxy Materials

To facilitate a shareholder-nominated short slate, it would be desirable to do more than require companies to include nominees with sufficient initial support in the proxy materials. To have a meaningful chance of success, nominees would have to incur expenses to make their case effectively to the shareholders. This is all the more so given that, whenever incumbents face a meaningful chance of losing, they can be expected to spend substantial amounts on campaigning. A group of shareholders holding 5% of the shares might be unwilling to bear significant costs even if they believe that election of their nominee would enhance shareholder value. As Dean Clark observed, the problem is one of a "public good:" the group would have to bear the costs, but it would capture only 5% of the benefits that all shareholders would share.3

In an article about the problem of costs in proxy contests, Marcel Kahan and I concluded that it would be desirable to reform the rules governing the financing of proxy contests.4 We argued that such changes are especially needed in cases - like the one under consideration - in which victory by shareholders would not provide them with control of the board. Under existing state corporate law, dissidents who gain control of the board in a proxy contest may reimburse themselves for the costs of their successful campaign. However, when control is not at stake, success by those opposing incumbents might improve the situation of the company but would not provide them with a reimbursement of costs. Accordingly, we argued, it would be desirable to facilitate such contests by ensuring that, at least in the event that outsiders are sufficiently successful, they would receive some reimbursement of costs or some other form of assistance in meeting the costs of their election activities.

In the case under consideration, I propose that the Commission consider the extent to which its power in connection with the proxy rules enables it to adopt the following measures:

    (1) The Commission could require that, when a nominee has sufficient initial support, companies (at their expense) distribute to shareholders proxy statements by nominees who wish to have such materials distributed.

    (2) Also, the Commission could require that, when a nominee has sufficient initial support, companies bear reasonable costs incurred in connection with the proxy process (e.g., to cover legal costs necessary for preparing a proxy statement). Such support could be made dependent on sufficient success in the ultimate vote or on the level of initial support in the candidate.

The above measures could be opposed, of course, on grounds that they would be costly to shareholders. Shareholders, it might be argued, should not bear the costs resulting from the decision of, say, a group holding 5% of the shares to nominate a director. As I explained above, however, an improved corporate elections process would be in the interests of companies and shareholders at large. The proposed measures would not expend corporate resources on proposed directors whose chances of winning are negligible. Companies would be required to expend some resources only on the condition that a candidate has sufficient initial support and perhaps also on the condition that the candidate obtained sufficient support in the ultimate vote. These limited amounts that companies would have to spend under these measures would be a small and worthwhile price to pay for an improved system of corporate governance.

Beyond Short Slates

As I emphasized, there is compelling need to take steps to enhance shareholder ability to exercise their theoretical power to replace directors. Thus, as between the status quo and the short slate proposal, the latter is clearly preferable. It would be desirable, however, to go beyond the short slate proposal and to enhance shareholders' ability to replace all or a majority of the directors.

Providing shareholders with a more effective power to replace a majority of the directors would have a much greater payoff in terms of improving corporate governance than facilitating short slates. While the election of one director might sometimes have a merely symbolic effect, the election of a new team can ensure change when one is needed. And facilitating contests for control might provide directors with much stronger incentives to be attentive to shareholder interests.

Interestingly, shareholders might sometimes be willing to vote for a full slate nominated by shareholders even though they would be reluctant to vote for a short slate (which would produce a more modest change). The reason for this is that, even when shareholders prefer a change in governance, they might sometimes feel that electing a short slate would lead to discord on the board without effecting sufficient change. In such a case, they might not vote for a short slate, but, if given the opportunity, they might well vote to replace the incumbent directors with an alternative slate.

There are various ways in which contests for control can be facilitated to make the threat of replacement meaningful in a way that it is not today. The Commission could permit groups of shareholders with sufficiently large ownership stake and sufficiently long holding period to add an alternative slate to the company's proxy card. The Commission could also require that companies distribute to shareholders proxy statements made by such proposed directors. I discuss these and other ways of facilitating corporate elections elsewhere. Here I wish only to urge the Commission to expand its review to consider changes in the proxy rules in connection with shareholder-nominated full slates.

I would be happy to discuss any of the above points and proposals with the staff of the Division of Corporation Finance. I can be reached at (617)-495-3138 or Bebchuk@law.harvard.edu.

Very truly yours,

__/s/Lucian A. Bebchuk_______________________
Lucian A. Bebchuk, William J. Friedman and Alicia Townsend
Friedman Professor, Harvard Law School

cc. William H. Donaldson, Chair
Paul S. Atkins, Commissioner
Roel C. Campos, Commissioner
Cynthia A. Glassman, Commissioner
Harvey J. Goldschmid, Commissioner
Alan L. Beller, Director of Corporation Finance

1 See Lucian Arye Bebchuk, "The Case for Empowering Shareholders," March 2003, available on SSRN at http://papers.ssrn.com/abstract=387940; Lucian Arye Bebchuk, "Shareholder Access to the Ballot," forthcoming as Olin Discussion Paper, Harvard Law School (2003).
2 Blasius Industries v. Atlas Corp, 564 A.2d 651, 659 (Del. 1988).
3 Robert Charles Clark, Corporate Law § 9.5, at 389-94 (1986).
4 See Lucian Arye Bebchuk & Marcel Kahan, A Framework for Analyzing Legal Policy Towards Proxy Contests, 78 Cal. L. Rev. 1073 (1990).