SEC Enforcement: Will They or Won’t They?

A Houston firm bringing a case before a Houston judge with representation from a prominent Houston law firm, Apache must have figured they had the advantage.

The SEC has a reputation of enforcing regulations against two-bit players in the financial arena while tiptoeing around the big boys. Back in December, Apache Corp. (APA) announced plans to flaunt US securities laws. The Commission’s response has been three months of unbroken silence.

Apache’s CEO, G. Steven Farris, is waging a war against shareowner rights. We don’t have many left, and he is targeting the biggest. I am not talking about electing directors. We lost that right decades ago. Under the SEC’s draconian “proxy solicitation” rules, corporate elections in America resemble Politburo elections in the former Soviet Union, with entrenched autocrats running unopposed year in and year out. No, what I am talking about is shareowners’ right to submit proposals to be included in management’s proxy materials and voted on at the annual meeting. That right is alive and well. It is what Farris is targeting.

Annual meetings are supposed to be deliberative bodies, where shareowners move proposals, debate them and then vote. That doesn’t happen. You might suppose the problem is shareowner apathy, but it was actually corporate boards who, long ago, took steps to suppress deliberation. Many corporations’ bylaws include an “advance notice” provision. If you want to make a motion at an annual meeting, you have to give the corporation several weeks notice. Even then, your motion won’t appear on the proxy materials the firm distributes. Those are management’s proxy materials. If you want to create awareness of—and get votes for—your proposal, be prepared to spend a few million dollars distributing your own proxy materials.

Back in the 1940s, the SEC addressed this problem with a new Rule 14a-8. In its current form, this allows any shareowner who has held $2,000 of a company’s stock for a year to submit a proposal and have it included in management’s proxy materials. This is one of the most enlightened things the SEC ever did. It didn’t restore deliberation to annual meetings, but it did ensure shareowners have some ability to raise issues. There are plenty of restrictions. Read the rule itself as well as Staff Legal Bulletin 14 for more information. As a practical matter, most Rule 14a-8 proposals are precatory. That means they are advisory only—even if they receive a majority vote, the board can ignore them.In its early days, the rule was used to prompt corporations to hire independent auditors. Then it languished. Activists used it to raise awareness about social or environmental issues, but their proposals received few votes. Only in the last two decades has the rule come into its own, as the emerging corporate governance movement embraced it. Today, shareowners submit proposals on a host of issues, including the elimination of staggered boards, director independence and elimination of poison pills. Proposals often receive majority votes.

For the most part, boards are responsive when a proposal receives a majority vote, even if it is merely precatory. There are exceptions. For six years, between 2005 and 2009, shareowners of First Energy (FE) submitted a proposal asking that all shareowner votes require just a simple majority to pass. Any bylaw provisions requiring super-majority votes would be amended. This precatory proposal received between 71% and 80% support every year, and every year the board ignores it.

Corporate CEOs despise Rule 14a-8. Most of them try to nurture a cult of personality around themselves, with image consultants, public relations firms and media department all working to present them as brilliant, charismatic visionaries, always in tune with shareowners as they propel corporations to success after success. Shareowner proposals prick that little bubble, suggesting there may be matters of concern to shareownes that well-coiffed CEOs somehow miss. Whenever Rule 14a-8 proposals appear in a corporation’s proxy materials, there is an accompanying note from the board advising a “no” vote.Rule 14a-8 proposals are a painstaking way to implement reform. If Congress wants to implement reform, they pass a law. If the Supreme Court wants to affect change, they make a ruling. If a shareowner is successful with a proposal at a firm, that only impacts one firm. What about the other 10,000 or so publicly traded firms in the United States? Suppose shareowners wanted to do away with the “advance notice” bylaws provision I mentioned earlier. To implement that reform at all publicly traded corporations would require submitting a proposal to every single one.

This is where John Chevedden comes in. He is a shareowner who strives to facilitate reform via Rule 14a-8. He and a small team off supporters will identify a proposal that wins a majority vote at one firm and then submit that same proposal to other firms. In this way, they give shareowners the opportunity to vote on proposals that shareowners at other firms have already embraced. Through plenty of hard work, company by company, reforms gradually spread.

Remember I mentioned how shareowners have submitted the same proposal to First Energy for six years? That is John Chevedden in action.

Well-coiffed CEOs hate John Chevedden. They spend millions of shareowner dollars a year in legal fees trying to shut him down. That is not particularly effective because Mr. Chevedden’s work is entirely legal. The lawyers look at all the SEC’s exceptions to Rule 14a-8 and try to make them apply to Mr. Chevedden’s proposals, or they try to devise novel legal arguments against him.

Such disputes are generally decided through a no-action process established by the SEC to conveniently and inexpensively resolve issues. Through that process, a corporation that wants to exclude a shareowner proposal from its proxy materials may request a no-action letter from the SEC confirming the SEC would be unlikely to take regulatory action. The process is informal. Parties always have recourse to the courts, but disputes between corporations and shareowners rarely go beyond the no-action process.

Apache’s CEO, Stephen Farris, is somewhat of a crusader against Rule 14a-8. In a 2007 comment letter to the SEC, he argued that precatory proposals should be banned. Last year he had Apache sue Mr. Chevedden to block one of his proposals. I won’t go into the convoluted argument Apache’s lawyers made. It was the same argument Hain Celestial had made in a no-action request to the SEC in 2008 concerning another of Mr. Chevedden’s proposals. SEC staff had denied that request. Last year, Apache skipped the no-action process and went straight to court. A Houston firm bringing a case before a Houston judge with representation from a prominent Houston law firm, Apache must have figured they had the advantage. Chevedden couldn’t afford a lawyer and defended himself remotely from California.

As it turned out, the judge rejected Apache’s convoluted argument, but she found a reason to allow them to block Chevedden’s proposal anyway. The reason was contrived, but it is important. I will briefly explain:

Under Rule 14a-8,  shareowners must prove their ownership of shares in order to submit a proposal. They can do so with a letter from their bank or broker. But many financial institutions are conglomerates with multiple affiliated or subsidiary companies. Under Rule 14a-8, does a verification letter have to come from the specific firm that holds the proponent’s shares, or can it come from a parent, affiliate or subsidiary? Stated another way, does the letter have to be under the “right” letterhead? In the seventy year history of Rule 14a-8, I don’t think this novel issue has ever been raised. I believe such a requirement would needlessly complicate the process of submitting proposals. For example, if a proponent holds shares through Fidelity Brokerage Services, shouldn’t a letter on Fidelity Investments stationary suffice? The court disagreed, but its decision hinged on more than that:

Mr. Cheveddden held his shares through a bank called Ram Trust Services (RTS). Apache’s lawyers had visited the RTS website and noticed that RTS has a wholly owned broker subsidiary, Atlantic Financial Services (AFS). They then hypothesized that, perhaps, Mr. Chevedden actually held his shares through the broker subsidiary and not RTS. They then proposed—and the judge accepted that—the letter evidencing Mr. Chevedden’s share ownership should, perhaps, have come from AFS and not RTS. Here is what the judge said:

The record suggests that Atlantic Financial Services of Maine, Inc., a subsidiary of RTS … may be the relevant broker rather than RTS. Atlantic Financial Services did not submit a letter confirming Chevedden’s stock ownership. RTS did not even mention Atlantic Financial Services in any of its letters to Apache.

On these peculiar grounds, the judge ruled that Apache could ignore Mr. Chevedden’s 2010 proposal. But she was explicit that the ruling was narrow, applying only to the facts in that particular case:

The ruling is narrow. This court does not rule on what Chevedden had to submit to comply with Rule 14a-8(b)(2). The only ruling is that what Chevedden did submit within the deadline set under that rule did not meet its requirements.

After the judge’s ruling, Mr. Chevedden followed-up with RTS. They confirmed that they did in fact directly hold Mr. Chevedden’s shares. Their 2010 letter made no mention of AFS because AFS played no role in the custody of Mr. Chevedden’s shares. For purposes of Rule 14a-8, RTS was the record holder of Mr. Chevedden’s securities. The judge ruled “narrowly” against him because she thought, perhaps, AFS might be the real record holder.

Apache’s “success” has prompted other companies to submit frivolous no-action requests targeting Mr. Chevedden’s proposals, claiming they may do so based on the Apache vs. Chevedden decision. In all cases where Commission staff have so far made decisions, they have rejected these requests. Now KBR has hired the same lawyer that represented Apache in Apache vs. Chevedden to file a similar lawsuit before the same judge. They are no doubt hoping for a similarly flawed ruling. This has become a farce.

Apache was able to ignore Mr. Chevedden’s 2010 proposal, but he has submitted another one for 2011. This time, he provided a verification letter from RTS that makes it absolutely clear that they are the owner of record for his shares. There should be no issue here. He has addressed the court’s contrived concern, so the proposal should be included in Apache’s 2011 proxy material. Instead, Apache is upping the ante.

This time around, they are skipping the courts and they are skipping the no-action process. On December 29, they merely notified the SEC that they would not be including Mr. Chevedden’s latest proposal in their 2011 proxy materials. They provided various reasons, which largely reproduced the convoluted arguments the Houston court had rejected in Apache vs. Chevedden. Essentially, Apache is treating the court’s narrow and flawed ruling as a perpetual license to ignore Mr. Chevedden’s proposals.

If Apache excludes Mr. Chevedden’s proposal from their 2011 proxy materials, they will be flaunting Rule 14a-8. But what is the SEC going to do? It has been three months now, and all we have heard from them is silence. On March 2, Apache filed preliminary proxy materials with the SEC that did not include Mr. Cheveden’s latest proposal. In a week or two, they should file their final proxy materials.

Apache is forcing this issue, and they clearly expect the SEC to back down. If that happens, expect copycat firms to next year also bypass the courts and the no-action process and similarly ignore Mr. Chevedden’s proposals. The shareowner community could lose their champion. What is more, with Rule 14a-8 being trampled, every shareowner’s ability to submit proposals is at risk.Yesterday, the USPX wrote a letter to the SEC. On behalf of the shareowner community, we asked them to enforce Rule 14a-8.

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