Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

SEC Commissioner Daniel M. Gallagher and Joseph A. Grundfest, Stanford Law School, Rock Center for Corporate Governance, have just published a paper titled “Did Harvard Violate Federal Securities Law? The Campaign Against Classified Boards of Directors.

According to the paper, the Harvard Shareholder Rights Project, or the Harvard SRP, has played a central role in the debate over classified boards, and claims to have contributed to the declassification of boards at about 100 S&P 500 and Fortune 500 companies.  The Harvard SRP uses the shareholder proposal mechanism under Rule 14a-8 to pressure boards to declassify.

According to the paper, the proposal submitted by the Harvard SRP on at least 129 occasions, or the Harvard Proposal, relies substantially on empirical academic research to support the proposition that classified boards are associated with inferior corporate financial performance and shareholder valuations.  The authors state the Harvard Proposal is categorical in its description of the literature as suggesting no exception to the proposition that declassification benefits shareholders.

Gallagher and Grundfest posit these questions:  Is the Harvard Proposal’s characterization of the empirical evidence accurate? Or, to frame the question in a more pointed manner, is the Harvard Proposal materially false or misleading in violation of Rule 14a-9? Materiality, the authors believe, “does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote.”  Instead, the test for the materiality of an omission in a voting context is whether there is “a substantial likelihood that a reasonable shareholder would consider [the information] important in deciding how to vote.” The authors believe in the context of a vote to de-classify a board, the significance of the empirical research is clear: if declassification categorically improves a corporation’s financial performance then a reasonable shareholder would likely consider that information as important to a voting decision.

The paper states the Harvard Proposal, and its description of the literature, could, however, be viewed as materially false and misleading, at least as of January 2014,29 for at least two distinct reasons:

  • The Harvard Proposal’s description of the relevant empirical literature is severely incomplete. At least five recent studies conclude that classified boards are associated with inferior financial performance [Blogger’s note: There appears to be a mistake in the summary, as other parts of the paper refer to “improved financial performance.”], and that declassification is harmful to shareholder interests. These studies are emphatic that the research relied upon by the Harvard Proposal is in error.  None of these studies, however, are cited in the Harvard Proposal. The Harvard Proposal can therefore be criticized as cherry picking the literature in order to generate the false and misleading impression that the data supporting its position are far stronger than is in fact the case.
  • Recent research concludes that classified boards have heterogeneous effects and identifies specific sub-categories of firms at which the effects of classified boards are more likely to be beneficial.  The Harvard Proposal’s categorical assertion opposing classified boards fails to admit the possibility of such heterogeneity. It therefore also fails to consider the possibility that some companies that declassify in response to pressure from the Harvard SRP are within the category of firms at which classified boards are more likely to have beneficial effects and that shareholders may therefore be harmed by the success of the Harvard Proposal.

Gallagher and Grundfest then seek to establish the culpability of Harvard:  “Here, the potentially false and misleading nature of the Harvard Proposal exposes Harvard, as a university, to liability in SEC enforcement proceedings, as well as in private actions alleging violations of Rule 14a-9. The Courts of Appeal have held that negligence establishes the requisite culpability for purpose of Rule 14a-9, and a straightforward analysis supports the conclusion that it is negligent for the Harvard SRP not to be aware of — or, if it is aware, to not address — contradictory studies that are broadly disseminated among academics.”

Next the authors blame the SEC: “Rather than act as an arbiter of accuracy or materiality, the staff prefers that the company address potential misrepresentations or omissions in its response in the proxy statement. This approach is, we fear, an abdication of responsibility by the Commission, not its Staff, that damages the integrity of the proxy process and places an unnecessary burden on registrants forced to respond to potentially misleading proxy statements.  It also reflects a fundamental misapprehension of the operation of Rule 14a-8. “[U]se of the statement in opposition is sometimes an incomplete remedy” and “[t]aking valuable space to correct misstatements distracts from a substantive discussion about the proposal itself….” Litigating to exclude a proposal is also more time consuming and expensive than seeking a no-action request.   Moreover, if proponents anticipate that the Commission Staff will refuse to grant no action relief to exclude false or misleading proposals then proponents have diminished incentives to ensure the accuracy of their statements. . . The articulated defense of this position is that a “hands-off” policy helps conserve “the extensive Staff resources that were being consumed in their line-by-line review of shareholder proposals.”  However, after years of passivity, the danger arises that “the pendulum has swung too far in the direction of non-intervention.”

No commentary is this area can be complete without a reference to “broken windows:”  “The “hands-off” policy with regard to the integrity of Rule 14a-8 proposals is also at odds with the SEC Chair’s recently announced “broken windows” enforcement policy, which is based on the theory that “minor violations that are overlooked or ignored can feed bigger ones, and, perhaps more importantly, can foster a culture where laws are increasingly treated as toothless guidelines.”

I’m normally a fan of Commissioner Gallagher, believe staggered boards have their place, particularly with small and mid-cap companies, and think that the Rule 14a-8 process is often abused by shareholder proponents and is counterproductive.  But I wonder what good can really come from a sitting Commissioner undertaking this detailed attack.


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