In improving the current shareholder proposal process, legislators should trade the butcher knife for the scalpel.
What influence, if any, should shareholders have over corporate policy? The answer to this question has long been guided by the Securities Exchange Act of 1934, which offers shareholders the opportunity to propose changes that all shareholders can vote on annually. Among both institutional and individual investors, such proposals are popular. Over the past decade, shareholders filed nearly 1,000 proposals a year seeking changes in a variety of corporate matters including firm leadership, compensation policy, and corporate transparency.
While legislators have empowered investors to propose changes, they have also recognized that unlimited proposals can stymie a firm’s ability to operate effectively. Thus, legislators have sought to limit the breadth of changes investors can pursue. For example, proposals related to ordinary business or those that violate local regulations are not permitted. When managers receive a proposal they believe falls under one of these excludable categories, the firm can seek a “no-action” letter from the Securities and Exchange Commission (SEC) that grants the firm the right to exclude a proposal from consideration by all shareholders without penalty.
With little fanfare, in June the House passed sweeping changes to the rules guiding the shareholder proposal process in the CHOICE Act. Preferring hatchet over chisel, the House bill dramatically alters the proposal exclusion process by effectively lowering the bar to exclude proposals. In a recent paper, my co-authors (Suraj Srinivasan and Rajesh Vijayaraghavan) and I compiled and analyzed the comprehensive historical record of contested proposals. Notably, we found a mismatch between the typical historical function of shareholder proposals and the assumptions underlying the House bill. In particular, the legislation’s assumptions seem to reflect outliers in the historical data rather than the more typical proposal functions.
Before describing our data, let’s consider the assumptions underlying the House’s bill more fully. The CHOICE Act strongly presumes that most shareholder proposals are created by gadflies who have little stake in the firm or interest in its long-term success. As framed by the House proposal: “Over time, the board’s ability to focus on shareholder value has been inhibited by the proliferation of shareholder proposals for public companies annual meetings…the shareholder proposal process has become one of the favorite vehicles for special interest activists to advance their social, environmental, or political agendas.” To support this, the summary of the act cited three examples, including a 2007 proposal for Yum! Brands to provide more data on fish sustainability practices at its Long John Silver’s franchise, and a 2013 proposal for Choice Hotels to track how much water flows through each of its showers at every hotel it owns.
To combat the assumed proliferation of costly and ineffective proposals, the CHOICE Act seeks to significantly limit shareholders’ eligibility to make proposals. In particular, the act seeks to increase the qualifying size and duration of an investor’s holding in order to make a proposal, and seeks to eliminate proposals by proxy. Effectively, by restricting proposal-making to only those with the longest-held and largest stakes in a firm, the House hoped to improve the efficiency of the proposal process in the interest of long-term shareholder value maximization.
The examples cited in the legislation—perhaps most notably the proposal to measure shower water—try to paint a picture of “special interest” frivolity, the product of social or political agendas, which shareholders ultimately won’t support. But how representative are these cited examples of proposals in general? The historical data is indicative. Over our sample period from 2003-2015, nearly a quarter (21 percent) of all proposals contested by management, but denied exclusion by the SEC, go on to win shareholder or firm support—a kind of vindication of these proposals’ validity in spite of their opposition by management. Defined differently, fully 17 percent of proposals contested by management that are actually brought to a vote win majority shareholder support. Non-contested proposals, by comparison, fair only slightly better: 25 percent of such proposals win majority shareholder support when brought to a vote. These simple statistics undermine the assumption that the proposals managers seek to exclude represent fringe interests, since many such proposals actually earn broad shareholder support.
The House bill takes aim at the minimum shareholding thresholds for proposal-making. Currently, regulation requires that shareholders hold at least $2,000 of stock, or at least 1 percent of shares, for at least one year to be eligible to create a proposal. Since shareholders are required to report their holdings, my co-authors and I examined this data to determine whether proposals created by smaller investors with fewer holdings more rarely gain support. It turns out that the size of an investor’s shareholdings is not associated with the ultimate success of the investor’s proposal. Put differently, large holders are no more likely to create “successful” proposals than small holders.
However, the revised regulation plans to drop the $2,000 requirement clause, thus requiring an investor to simply hold at least 1 percent of a firm’s outstanding shares to submit a proposal. For many of the largest U.S. firms, this could practically eliminate proposal-making. For example, a shareholder submitting a proposal to Apple and Exxon would need over $7 billion and $3 billion of stock respectively under this new requirement. For Apple and Exxon, only five institutional investors—all of which have large indexing activities—would meet this extraordinary threshold.
Over our sample period, we identify 155 successful, but contested by management, proposals that would have been ineligible under this revised minimum requirement. The majority of these proposals would hardly be considered social or political special interest either. Substantively, these proposals most frequently targeted executive compensation and takeover efforts. And the mean submitter of proposals contested by management held $10.7 million in shares, substantially exceeding the current minimum holding requirement of $2,000.
I hardly wish to suggest that the current shareholder proposal process is perfect and cannot be improved. Admittedly, some proposals represent the special interests of minority shareholders, and managers often correctly contest such proposals for offering little benefit to the firm or its shareholding base more broadly. Still, the historical data suggest that such qualifying proposals are more exceptional than typical.
As the legislation begins to make its way through the Senate this fall, there are several worthwhile revisions for legislators to consider.
First, they should note that managers and shareholders are increasingly challenging the dominant logic of shareholder “value” maximization. As Oliver Hart and Luigi Zingales describe in a recent paper, shareholder “welfare” maximization better reflects the spirit of many proposals that shareholders support today.
Second, the data suggest that extending the minimum duration of stock ownership does little to ensure the proposal-makers’ long-term interests in a firm. Alternatively, creating future holding requirements could better ensure the alignment of proposal-makers with firms’ long-term interests.
Third, it is sensible to raise the minimum threshold of ownership, in part to raise the “stakes” for those investors inspired to challenge a firm, regardless of their motivation. But surely, an effective threshold could be established somewhere between the current $2,000 threshold and the variable threshold proposed by the CHOICE Act: a threshold that would exceed billions for investors in many large firms.
Finally, simplification of the SEC’s exclusion proposal evaluation process, to reduce the burden on firms, is an idea whose time has come. From 2003-2015, 73 percent of all proposals that managers contested received no-action letters. Even when a no-action letter is sought and received, it generally entails extensive correspondence between attorneys at the SEC and at the firm, a costly process for both sides. In particular, managers complain that, even when a proposal clearly violates the requirements for appropriate proposals (e.g., wrong length or format), firms must expend considerable resources to secure a no-action letter and ensure the proposal’s exclusion. The SEC could develop an automated or centralized response process for proposals in this category—those that clearly fail to meet the basic eligibility requirements—thereby reducing the burden on firms.
Ultimately, legislators should trade the butcher knife for the scalpel. Improving the shareholder proposal process ought to involve suppressing tangential, frivolous, and “special interest” proposals, but not at the expense of crippling the overall system and mutually suppressing useful and potentially successful proposals.
(Note: Eugene Soltes is the Jakurski Family Associate Professor of Business Administration at Harvard Business School where his research focuses on corporate misconduct and fraud, and how organizations design cultures and compliance systems to confront these challenges. He is the author of the book Why They Do It: Inside the Mind of the White-Collar Criminal [Public Affairs, 2016].)
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