The New World of Director Nominations
By Diane Holt Frankle, Henry Lesser, and Mark F. Hoffman

Introduction

Following the recent cascade of corporate governance lapses and concerns over the accountability of public company directors, the SEC’s Division of Corporation Finance in July 2003 issued a report containing recommendations to overhaul the proxy rules relating to the nomination of directors.¹ The SEC followed up by issuing proposed rules concerning two director nomination initiatives. The first initiative, covering disclosure about director nominations, stockholder communications with the board of directors, and directors’ attendance at stockholder meetings, is the focus of final SEC rules (the “Disclosure Rules”).² The second initiative, concerning stockholder nominations for director and stockholder access to the proxy statement, is the subject of hotly contested proposed rules (the “Proposed Access Rules”).³

At the same time as the SEC was launching its director nomination initiatives, the SROs were separately overhauling their rules relating to the director nomination process as part of their general corporate governance initiatives. Both the New York Stock Exchange and The Nasdaq Stock Market have adopted new listing standards requiring or facilitating formation of nominating committees and adoption and disclosure of policies concerning director qualification standards and the director nomination process. Together, the Disclosure Rules and the SRO rules are forcing companies to reexamine, or to consider for the first time, their policies, practices, and procedures concerning the nomination of directors and other corporate governance matters.

Overview of the New Rules

In light of these new rules, companies now must grapple with several decisions, including:

• Whether to have a nominating committee;
• The composition of a nominating committee;
• The specific duties of a nominating committee;
• Whether to adopt a policy addressing consideration of stockholder-recommended director candidates, and if so, what that policy should be;
• Minimum required and desired qualifications of directors; and
• How to identify and evaluate director candidates.

A number of the new requirements embodied in the Disclosure Rules, while in form descriptive, are potentially prescriptive because companies may be reluctant to make disclosures about procedures and processes that would not be regarded as best (or at least acceptable) practices by institutional investors. On the other hand, some companies will determine that the appropriate approach to these requirements, at least for the 2004 proxy season, is to disclose if they do not have procedures and processes in place, and indicate that they are studying the subject with a view to reporting back to the stockholders at the 2005 annual meeting.

Summary of the SRO Rules

The NYSE has adopted a new Section 303A, which requires in part that each listed company:

• Have a nominating/corporate governance committee composed entirely of independent directors;
• Have a publicly available nominating/ corporate governance committee charter that addresses topics specified in the rule; and
• Adopt and publicly disclose corporate governance guidelines that address director qualification standards and director responsibilities.

The Nasdaq Stock Market has similarly adopted amendments to Rule 4350(c), which require:

• Director nominees to be selected, or recommended for the board’s selection, either by a majority of the independent directors or by a nominating committee composed entirely of independent directors; and
• Each company to certify that it has adopted a formal written charter or board resolution addressing the nominating process and such related matters as may be required under federal securities laws.

Companies listed with the NYSE or on Nasdaq must comply with these new rules by the earlier of the first annual meeting after January 15, 2004, or October 31, 2004.

Summary of the SEC’s Disclosure Rules

The Disclosure Rules, which primarily mandate certain disclosure regarding the functions of the nominating committee and procedures for stockholders to present director candidates, will shed light on the once-secretive director nomination process. These rules expand current proxy statement disclosure by requiring companies to include the following in their proxy statements:

• If the company does not have a standing nominating committee, explain the board’s view that it is appropriate not to have one and name the directors who participate in the consideration of director candidates;
• If the nominating committee has a charter, disclose where it is available; if the committee does not have a charter, state that fact;
• If the company’s securities are listed, disclose whether each member of the nominating committee is independent, as defined in the applicable listing standards;
• If the company’s securities are not listed, disclose whether each member of the nominating committee is independent, applying an identified definition of independence from a national securities exchange or a national securities association;
• If the nominating committee has a policy with regard to the consideration of director candidates recommended by stockholders, describe the material elements of the policy; if the committee does not have such a policy, state that fact and explain the board’s view that it is appropriate not to have such a policy;
• If the nominating committee will consider candidates recommended by stockholders, describe how stockholders can submit recommendations;
• Describe any specific, minimum qualifications that the nominating committee believes its nominees must have, and any specific qualities or skills that the committee believes are necessary for one or more of the company’s directors to possess;
• Describe the nominating committee’s process for identifying and evaluating director candidates, including candidates recommended by stockholders, and any differences in the manner in which the nominating committee evaluates director candidates recommended by a stockholder;
• For each director nominee on the company’s proxy card (other than nominees who are executive officers or are standing for reelection), state whether the nominee was recommended by a stockholder, a nonmanagement director, the CEO, another executive officer, a third-party search firm, or another source;
• If the company pays a fee to any third party to identify or evaluate, or assist in identifying or evaluating, director candidates, disclose the function performed by each such third party; and
• If the nominating committee received, not later than 120 days before the anniversary of the prior year’s release of the proxy statement, a director candidate recommended by a stockholder or group of stockholders who individually, or in the aggregate, beneficially owned greater than 5% of the company’s voting common stock for at least one year as of the date of the recommendation, (i) identify the candidate and the stockholder or group that recommended the candidate, and (ii) disclose whether the nominating committee chose to nominate the candidate.⁴

The balance of this article focuses on the Disclosure Rules related to the director nomination process. We note, however, that the SEC in the Disclosure Rules also requires companies to publish their policies for stockholders to communicate with directors, and that the NYSE has similar rules that extend to “interested parties.” The Disclosure Rules also require companies to disclose their policies regarding director attendance at annual meetings, which is a factor that nominating committees can consider in the evaluation process.

Practical Issues for Boards and Nominating Committees

Nominating committee formation

For NYSE-listed companies, the question whether to form a nominating committee is academic: such a committee is required under the NYSE rules.

The Nasdaq rules do not require companies to form a nominating committee, but at companies without a separate committee, the director nomination function must be performed by a majority of the independent directors. Further, under the Disclosure Rules, these companies must disclose that they have not formed a nominating committee and explain why they concluded that one is not needed. Given these disclosure requirements, it seems likely that most companies will take the path of least resistance and form a separate nominating committee.

Composition of the nominating committee

The SRO rules, and the implicit prescriptive nature of the Disclosure Rules, require that the “old” (pre-Sarbanes-Oxley) composition of the nominating committee (which typically included a company’s CEO and Chairman) give way to the new independence standards.

As with the decision whether to form a nominating committee, the composition “decision” for NYSE-listed companies is clear: all committee members must be “independent,” as defined by the NYSE.

Nasdaq-listed companies again have slightly more flexibility. Nasdaq companies may, under “exceptional and limited circumstances,” appoint a non-independent, non-officer/employee director to the nominating committee, although that appointment would have to be publicly disclosed. Many companies have founders or other directors who may not meet the qualitative independence requirements. It is often politically difficult to remove these individuals (who are perhaps key stockholders) from the nomination process, and in any case the board may feel that their input on nominations is valuable and critical to avoiding controversy that will distract from corporate operations. The Nasdaq rules enable companies to retain such directors on the committee and still comply with the independence standards.

Who is “independent”?

Under the SRO rules, the board must make an affirmative determination that all members of the nominating committee are “independent.” The Disclosure Rules require companies to disclose in the proxy statement whether each member of the nominating committee is independent. This issue requires some diligence.

Most companies require candidates to make representations concerning their independence and to complete a “director and officer” questionnaire. These questionnaires have generally been modified to request information on a host of possibly material transactions that could impact independence, and typically also include an open-ended question eliciting disclosure of “any other transaction that might affect independence as a director.” Whether in the interest of efficiency, or to clearly focus directors’ attention on the issue, some companies have circulated “independence questionnaires,” separate from the annual “director and officer” questionnaire, that specifically address independence matters.

Finally, while the NYSE and Nasdaq definitions of “independent” differ slightly, both sets of rules require that the board go beyond the specifically enumerated independence criteria and make a general finding that there is no other relationship that, in the opinion the board, would interfere with the director’s exercise of independent judgment. Forms of questionnaire should anticipate the need for this broader independence finding by giving directors the opportunity to explain any other relationships, transactions, arrangements, or agreements involving themselves, their family members, or affiliates, on the one hand, and management, the company, or another third party on the other hand, that might otherwise impact their independence.

Nominating committee charter

NYSE-listed companies must have a written, publicly available nominating/corporate governance committee charter that addresses, at a minimum:

• The committee’s purpose and responsibilities, which must at least be to:
  • identify individuals qualified to become directors, consistent with criteria approved by the board;
  • select, or recommend that the board select, director nominees;
  • develop and recommend to the board a set of corporate governance principles applicable to the company; and
  • oversee the evaluation of the board and management.
• Committee member qualifications;
• Committee member appointment and removal;
• Committee structure and operations;
• Committee reporting to the board;
• Sole authority to retain and terminate a search firm; and
• Annual performance evaluation of the committee.

The corporate governance principles referenced above must address, at a minimum:

• Director qualification standards;
• Director responsibilities;
• Director access to management and, as necessary and appropriate, independent advisers;
• Director compensation;
• Director orientation and continuing education;
• Management succession; and
• Annual performance evaluation of the board.

Companies are free to allocate the corporate governance responsibilities to a separate committee, provided such other committee is composed entirely of independent directors.

Nasdaq-listed companies must adopt either a formal written charter or a board resolution addressing the nomination process. Nasdaq-listed companies are not required to have separate corporate governance guidelines or evaluation processes, but many Nasdaq-listed companies are developing both. One reason for this trend is that the Disclosure Rules require companies to state any minimum or specific qualifications for directors; this topic is often covered in corporate governance guidelines. The major corporate governance ratings services also give credit for having guidelines, having an evaluation process for the directors, and addressing other policies often covered in guidelines, including the topics required to be addressed in an NYSE-listed company’s guidelines.

As noted above, the Disclosure Rules require companies to disclose whether they have a nominating committee charter and, if so, how it is made publicly available. Companies often will post the charter on their Web sites rather than including it in their proxy statements. Companies required to adopt corporate governance guidelines, or considering adoption of such guidelines as a matter of good corporate governance practice, should consider whether the nominating committee should also serve as the corporate governance committee or whether the company should have a separate corporate governance committee. Nasdaq-listed companies could reserve these issues to the full board, but many are either assigning corporate governance functions to the nominating committee or establishing a new corporate governance committee. Boards recognize the importance of the corporate governance function, and, given their already heavy workloads, have concluded that governance is more likely to be addressed if it is delegated to a standing committee.

In addition to the required content, boards should consider whether some or all of the following issues should be addressed in a nominating/ corporate governance committee charter:

• A quorum threshold;
• An approval threshold where a quorum is established;
• Whether the committee is responsible for determining the qualifications for other committees, and for appointing and removing members of other committees;
• An annual/periodic review of compliance with applicable listing standards; and
• Whether the committee has a drafting, approval, or ongoing oversight role with respect to a code of conduct and ethics.

As to the issue of whether the nominating committee is responsible for committee qualifications generally, many boards have concluded that this is a natural companion to the nominating committee’s function. For the same reason, many companies assign to the nominating committee the key role in developing performance evaluations for the directors, the committees, and the board. A corporate governance committee would typically participate in developing a code of business conduct and ethics, and in some companies, monitoring compliance with applicable listing standards is considered a corporate governance function.

Adoption of qualifications for director candidates

As noted above, the Disclosure Rules require a description of any minimum qualifications for director candidates, as well as any specific qualities or skills the nominating committee believes are necessary for one or more of the directors to possess. Many companies have not previously established minimum criteria, or indeed any specific criteria, for director candidates. Instead they rely on a flexible, but unspecified, view of what makes a “good” director for the particular company.

Of course, every board of directors is different, just as every company is different, and for this reason it is difficult to generalize about requisite qualifications or skills. However, one obvious point is that, if minimum qualifications are established, the company’s incumbent directors should satisfy those qualifications when they are subject to renomination. Companies should not be overly restrictive in establishing minimum qualifications since they need to apply the standards equally to all candidates going forward.

Companies first need to consider how a nominating committee might go about establishing director qualifications. Many boards, often with the help of a nominating or corporate governance committee, have established qualifications for directors as part of their corporate governance guidelines. This is a requirement of the NYSE rules and, as noted above, many Nasdaq-listed companies are voluntarily adopting guidelines that include some discussion of director qualifications. Even if a nominating committee doesn’t establish corporate governance guidelines, the committee can set qualifications by adopting a policy on director nominations or resolutions relating to qualification criteria.

Frequently, qualifications established in guidelines or policies are expressed in the form of factors the nominating committee should consider rather than as true “minimum” requirements. The nominating committee is generally charged with evaluating candidates against the perceived needs of the board. Factors the committee might consider include the skills, background, reputation, and business experience of a candidate compared to the skills, background, reputation, and business experience of the other members of the board; the candidate’s independence from management; regulatory and listing requirements, such as independence requirements and antitrust considerations; how the candidate would contribute to the working relationship among directors; the desire to balance the benefit of continuity with the value of a fresh perspective provided by new members; and the perceived needs of the board for a director with particular attributes. A nominating committee may conclude that a significant goal is to assemble a board that brings a variety of perspectives and skills derived from high quality business and professional experience. If so, the committee will likely want to disclose this goal in the proxy statement.

Any factors established by a committee to use in the nominating process should balance the desire to define a set of specific attributes against the need for flexibility. As an example, a company may be moving into a new line of business or a new geographic area, selling to a new type of customer, using a new sales channel, or encountering a new set of technology, manufacturing, or business issues. Changes in the company’s business would ordinarily suggest the need for new and different skills, experience, and background for one or more directors. The policies of the nominating committee should be designed to facilitate the committee’s work in determining and then satisfying those needs.

Some examples of minimum qualifications for directors are:

• The highest personal and professional ethics, integrity, and values, and a commitment to acting in the best interests of the stockholders;
• An inquisitive and objective perspective and mature judgment;
• Sufficient time available to fulfill all board and committee responsibilities;
• At least 21 years old;
• Diverse experience at policy-making levels in business, government, education, and technology, and in areas that are relevant to the company’s global activities; and
• Experience in positions with a high degree of responsibility and leadership roles in the companies or institutions with which they are affiliated.

None of these minimum standards is essential and the establishment of such standards is an endeavor unique to each company’s perceived needs.

Companies are required to disclose not only established minimum qualifications, but also any specific qualities and skills the nominating committee believes are necessary for one or more directors to possess. Most nominating committees have concluded that, if possible, the company should have at least one director who meets the criteria to be deemed an “audit committee financial expert” under SEC rules. Moreover, the SROs require that at least a majority of the directors meet the applicable definition of “independent director.” Many nominating committees also consider it important to have one or more management directors. Given these standards, it is likely that most companies will need to disclose some factors regarding qualifications of directors considered in the nomination process. Note, however, that nothing in the Disclosure Rules or the SRO rules precludes the nominating committee from considering other director qualification factors it considers relevant.

Identification and evaluation of director candidates

The Disclosure Rules require companies to disclose their policies for identifying and selecting director nominees. As noted earlier, the determination of whom to nominate, and, in particular, whether to renominate incumbents and/or add new directors, was previously often left to an unspecified and informal process lacking any precise criteria. Often a decision to nominate an incumbent was a result of a private consultation between the CEO and one or more influential directors. Further, the determination that new directors were needed for the board, or that a candidate brought forward by directors or management was worthy of consideration and appointment, was generally made on an ad hoc basis. Typically, the board had not chartered any committee to consider nominations, and although nomination of director candidates was indisputably a board function, decisions were arrived at with no significant discussion in the boardroom. Resolutions setting forth the nominations were adopted by the full board as a routine matter and without any deliberation; the decisions had in fact been made earlier.

The need to disclose the identification and selection process in the proxy statement, together with the SROs’ new requirements for nominating committees or at least nomination procedures, has forced companies to consider, often for the first time, the nomination process in detail. This disclosure requirement, coupled with the requirement that companies state minimum qualifications and other factors important in the consideration of directors, is intended in part to make the director nomination process less subjective, and remove it from the discretion of a few influential board members.

In many companies, these developments have led to a more robust discussion of the merits of both incumbent and newly proposed director candidates by the nominating committee. This trend is complicated by the perception that the commitment, effort, and expertise required of directors, as well as the potential liability they must assume, have increased dramatically, with the unfortunate result of limiting the pool of qualified candidates just as the need for strong directors is increasing. Moreover, nominating committees are requiring directors to limit the number of boards on which they serve, causing some otherwise qualified directors to resign. There are several considerations relating to the identification and selection of nominees. The incumbent directors may not all want to be renominated. Because of the trends noted above, some directors are not willing to continue when their term expires. Others are not able to meet the standards of the nominating committee under the more rigorous scrutiny.

The board or nominating committee also must consider the optimum size of the board. For example, if an incumbent director chooses to stand down and not be renominated, the board could be reduced by that seat if the charter permits. In some cases, however, the loss of even one director may be unacceptable—particularly if it means the board will cease to have a financial expert, a majority of independent directors, or sufficient directors to populate three active committees. There is an increasing need for strong directors to spread the expanding workload of the various committees equitably. Accordingly, the nominating committee must consider whether the board is at an optimum size even if all incumbents are continuing.

The nominating committee also must consider whether the board has all necessary skills and experience. This past year, for example, many public company boards have been seeking directors with financial expertise to serve on audit committees as designated “audit committee financial experts.” Alternatively, as we mentioned earlier, a company experiencing a business transition may wish to recruit directors with a background or business experience in the new area.

In evaluating director candidates, including incumbents, the nominating committee must consider the minimum and specific qualifications it has established. These criteria should be evenly applied to all candidates. Naturally, the committee will have more information about the incumbents due to their previous service. The committee also may consider the results of an evaluation undertaken by the board or a committee. NYSE-listed companies are required to develop evaluation methods for the board and committees, and many Nasdaq-listed companies are also developing evaluation procedures. Indeed, such a process may be required by the nominating committee charter.

There are many different types of evaluations. Most typical are board and committee self evaluations, either by the individual directors of their own performance or by the entity (the board or a particular committee), usually prompted by a list of factors or evaluative questions. Less frequently, directors are called upon to review each other. Any evaluation results, whether from a self evaluation or a peer evaluation, may be helpful to the nominating committee in determining whether it is advisable to seek a new director with particular skills, experience, or other characteristics judged to be lacking in the current board, and also may highlight merits of (or concerns regarding) incumbent directors.

Significantly, many companies conduct director evaluations orally, or discard written evaluation materials once the process is completed, to ensure candor and confidentiality. As companies develop new processes for evaluation, they must think about how the nominating committee will access evaluation results. In some companies the nominating committee chair receives an oral briefing on any information bearing on the committee’s responsibilities.

The search for new directors

If the nominating committee is seeking new directors, or is presented with potential candidates for nomination, there are a few additional disclosure hurdles to address. If the committee concludes that a search is warranted and decides use a third party, like an outside search firm, the company must disclose the fees paid to that firm and the function performed by the firm. Also, the company must disclose for each new director candidate whether the director was recommended by a stockholder, a non-management director, the chief executive officer, another executive officer, a third-party search firm, or another specified source. The disclosure about the company’s process for identifying and selecting nominees should make clear that the committee considers candidates throughout the year as they are brought to the committee’s attention, and will consider these candidates under the qualification standards applied for all directors.

Consideration of director candidates recommended by stockholders

Many companies have bylaws permitting stockholder nominations so long as certain time periods for notice are met and specified information is provided to the company. Significantly, this bylaw provision is not designed to result in a nomination considered by a committee of the board, but rather to take the nomination directly to the stockholders in a proxy contest. Nevertheless, the committee has an important role in connection with such a nomination because ultimately the board must decide, having considered the committee’s views, whether to reject a nominated candidate and solicit against his or her election. Alternatively, the company may wish to avoid a full-blown proxy contest by brokering a settlement with the nominating shareholder under which the director candidate is made a company nominee. Of course, any such settlement will be difficult to arrange if the shareholder is nominating candidates for a majority of the board.

Advance notice bylaws often require nominations to be made a certain time period prior to the annual meeting. The same type of requirement might be applied in connection with stockholder nominations made to the committee, although a time limit is not absolutely necessary. As noted above, the committee should be in a position to consider director candidates yearround and add qualified directors by board appointment if the board concludes an additional director is needed earlier than the next annual meeting.

Another typical requirement of an advance notice bylaw is that the company must receive information about the director candidate’s and the nominating stockholder’s holdings of company stock. The standard advance notice bylaw also requires candidates to provide their name, age, and at least five year’s business experience, as well as the other information required to be disclosed in the proxy statement for any director nominee.

If the director candidate wants instead to be considered by the committee, or the committee is evaluating a possible settlement of a threatened proxy contest by co-opting an insurgent director candidate as a company nominee, the committee would likely want more information, including a more complete description of the candidate’s qualifications and skills. Any policy to elicit this additional information must be described in the proxy statement or, if adopted later by the committee, must be disclosed in the company’s next quarterly or annual report.

The committee may have some other information requirements that could be applied across the board to all candidates. It is typical, for example, to require that every candidate for director complete a directors’ and officers’ questionnaire. It is also typical for the committee to conduct interviews, check references, and conduct background checks on non-incumbent candidates. If this practice were only employed for stockholder-recommended candidates, that fact may need to be disclosed, but it seems unlikely a company would make such a distinction.

Some companies are establishing additional criteria for stockholder nominations. For example, many impose a minimum stock ownership threshold—often setting the bar at 1%. Other nominating committees have chosen to omit any ownership threshold for stockholder nominations since ownership thresholds are not applied to nominations by other constituencies.

The Disclosure Rules rely on a higher ownership threshold to trigger one particular disclosure. Specifically, if a nominating committee (or board, in the committee’s absence) receives (within a time period prescribed in the Disclosure Rules) a recommendation for a director candidate from a stockholder who has beneficially owned for at least one year more than 5% of the company’s voting stock, the committee must make certain disclosures if the stockholder and the candidate consent. These disclosures include the identity of the candidate and the recommending stockholder or group, and whether the committee decided to nominate the candidate.

Even if there are no nominations from significant shareholders, the Disclosure Rules do not permit companies to ignore the issue of stockholder nominations. Companies must disclose if the committee will consider stockholder recommendations for director and if so, to describe the procedures to be followed in submitting such a recommendation. If a company has an advance notice bylaw relating to stockholder nominations of directors, the company can fairly be said to have a policy.

If the company will accept stockholder recommendations, the next issue is whether the board or nominating committee will consider stockholders’ candidates affirmatively. As an alternative, a board or committee may conclude that it is more appropriate to require a stockholder-recommended candidate to proceed directly to the stockholders, with no review of the merits of the recommendation by the committee. In reality, most nominating committees will likely consider a qualified candidate recommended by a significant stockholder, if only to avoid the expense and distraction of a proxy contest. Moreover, institutional investors would not favor a policy that would force every stockholder nomination, no matter the merits, to a proxy contest. In any event, companies recognize that stockholders can be the source of qualified candidates not otherwise known to the committee. If a company does not have a policy regarding stockholder nominations, the company must explain why. Many companies may find it easier to permit shareholders to submit director candidates under a carefully regulated procedure than to explain why they do not accept such recommendations.

Work required by the nominating committee

Clearly, the modern nominating committee has a lot of work that may require more meetings —and meetings farther in advance of the annual meeting of stockholders. If there is a possibility that the company needs additional directors, the process must start early enough to permit a search. This schedule also must take into account the other tasks of the committee: many nominating committees with additional mandates for corporate governance have recently developed, or are now developing, codes of conduct, corporate governance principles, evaluation procedures, orientation procedures, and policies regarding continuing education. Clearly, the time commitment for committee members is substantial.

Current Impact of the Proposed Access Rules

In the Proposed Access Rules, the SEC is proposing that, under limited circumstances where a “triggering event” has occurred, stockholders and stockholder groups would be entitled to place director nominees on the company’s proxy statement. The two triggering events described in proposed Rule 14a-11 are:

• At least one of a company’s director nominees receives “withhold” votes from more than 35% of the votes cast at an annual stockholder meeting held subsequent to January 1, 2004;⁵ and
• Where a stockholder proposal to become subject to the stockholder nomination procedure in proposed Rule 14a-11 is submitted by a greater-than-1% stockholder or group that has held such stock for at least one year and such proposal receives more than 50% of the votes cast.

In addition, in connection with its evaluation of responses to the Proposed Access Rules, the SEC has indicated that it is considering a third possible triggering event: where a stockholder proposal other than one related to proposed Rule 14a-11 has been submitted by a greater-than-1% stockholder or group that has held stock for at least one year and receives more than 50% of the votes cast, but is not implemented by the company within a prescribed period of time. Notably, the SEC is encouraging companies that include proposals submitted by such eligible stockholders to disclose the potential impact of the passage of such proposals, and the company’s failure to implement the proposals should they pass, on the future ability of stockholders to include director nominees in the company’s proxy statement. Although the Proposed Access Rules have not been adopted, the SEC is suggesting that lack of disclosure about the import of pending rules might constitute a material omission under Exchange Act Rule 14a-9.

There is a second way the Proposed Access Rules are affecting the current proxy season. Footnote 74 of the proposing release⁶ states that the staff of the SEC is taking the position that a stockholder proposal submitted pursuant to Exchange Act Rule 14a-8 providing that the company become subject to Proposed Rule 14a- 11 will not be excludable under Rule 14a-8(i)(8). This represents a reversal of the SEC’s earlier position that, under Rule 14a-8(i)(8), an otherwise eligible stockholder proposal is excludable if “the proposal relates to an election for membership on the company’s board of directors.” This means that a stockholder who meets the eligibility criteria under Rule 14a-8 will be permitted to propose that the company “opt-in” to the SEC’s proposed director nomination procedures even before those procedures have been finalized. As a result, some companies could be required to include in their proxy statements director nominees recommended by stockholders as early as next year. As indicated in a recent no-action letter,⁷ the SEC’s position in footnote 74 is now interpreted to refer only to proposals that would grant stockholders access rights based solely on the criteria set forth in proposed Rule 14a-11.

Although the SROs have taken the position that affirmative statements regarding director independence are not technically required yet because the rules don’t apply to this year’s proxy statements, most companies are making the disclosure. The SEC also has indicated orally that the failure to include such disclosure might constitute a “material omission.”

Conclusion

The new disclosure rules and requirements for nominating committees are increasing transparency and objectivity of the director evaluation and nomination process. Companies can no longer simply renominate the incumbent directors in a vacuum. Boards and nominating committees are now adopting and implementing objective written policies and processes for evaluating director candidates, and threshold qualifications for such candidates. Nominating committees are just now beginning to apply these new qualification standards and evaluation processes to both new company- and stockholder- generated nominees and incumbents. These actions are proceeding in an environment in which directors are weighing the costs and benefits of board membership, where directors are being encouraged to limit their board memberships, and when the need for qualified directors is at a peak.

Whatever the long term impact of these new SEC and SRO rules proves to be, one thing is certain: the process of nominating director candidates for the boards of public companies is no longer business as usual.

Notes

1. Review of the Proxy Process Regarding the Nomination and Election of Directors, available at <www.sec.gov/news/studies/ proxyreport.pdf>.

2. SEC Release No. 33-8340 (Nov. 24, 2003), available at <www.sec.gov/rules/final/33-8340.htm>.

3. SEC Release No. 34-48626 (Oct. 14, 2003), available at <www.sec.gov/rules/proposed/34-48626.htm>.

4. The proposed version of the Disclosure Rules would have required a company to disclose the specific reason it did not nominate a shareholder-recommended director candidate, but that requirement was eliminated.

5. Two recent high profile examples—Disney, with its significant withhold vote for Michael Eisner, and Hewlett-Packard, with its significant withhold vote for Sanford Litvack—show that withhold votes are becoming a meaningful tool for the institutional investor community to express its dissatisfaction with one or more directors.

6. See supra note 3.

7. Qwest Communications Int’l Inc., SEC No-Action Letter (Mar. 22, 2004). In this letter, the SEC took the position that a stockholder proposal was not an “access proposal” for purposes of Rule 14a-8 because it would have granted access under stock holder ownership requirements that were less stringent than those contained in proposed Rule 14a-11.

About the Author

Diane Holt Frankle (dfrankle@graycary.com) is a partner in Gray Cary Ware & Freidenrich LLP, Silicon Valley, co-chair of the firm’s M&A group, and co-chair of the firm’s corporate governance advisory group. Henry Lesser (hlesser@graycary.com) is a partner in the firm based in Silicon Valley, co-chair of the firm’s M&A group, and a member of the firm’s corporate governance advisory group. Mark F. Hoffman (mhoffman@graycary.com) is a partner in the firm based in Seattle, and a member of the firm’s M&A group and corporate governance advisory group. The views expressed in this article are solely the authors’ and are not attributable to the firm, any of its other lawyers, or any of its clients.