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The Financial CHOICE Act: An Unprecedented Challenge to Shareholder Rights
By Holly Testa, Director, Shareowner Engagement

While on one hand, long-term ESG issues raised via shareholder proposals are increasingly receiving serious consideration, opponents of the proposal process wish to eliminate them altogether. All fiduciaries have a duty to monitor investment risk and many, including First Affirmative, consider filing proposals to be inherent to this duty. The Financial CHOICE Act recently passed the House of Representatives. This legislation includes Section 844, which seeks to curtail our clients' rights as investors and our ability to meet our fiduciary responsibilities to our clients. While the outcomes of proposal votes are non-binding, this process is a cost-effective way for corporate executives and boards to better understand shareholder priorities and concerns. Certain practices now considered standard, such as the requirement for boards to hold annual director elections, were first introduced via proposals.

Section 844 would amend the current shareholder proposal process, established in 1942 by the Securities and Exchange Commission (SEC) under rule 14a-8. Currently, investors who own at least $2,000 or 1% in common stock for one year, and meet other eligibility and procedural requirements, have the right to file shareholder proposals for presentation at the annual general meeting (AGM) to all other shareholders for a vote. Under Section 844, an investor would need to own at least 1% in common stock over three years to file. The resubmission thresholds – the ability to refile the same proposal in subsequent years – would increase to 6% in year 1 (up from 3%); 15% in year 2 (up from 6%); and 30% in year 3 (up from 10%). In addition, 844 prohibits proposals by proxy thus preventing investors from delegating the exercise of this right of ownership to professional advisors.

Doing the Math on the 1%

Supporters, as well as some opponents of Section 844, believe that the current submission threshold is too low. Even so, Section 844 would employ a nuclear device when a flyswatter might do.

Most shareholder proposals are filed at large cap companies (companies with a minimum market capitalization of $10 billion). Under 14a-8, a broad spectrum of investors can file a proposal. Under Section 844, only investors that have owned at least $100 million of a $10 billion firm for three years could file.

Take Apple, which has a market capitalization of around $800 billion: An investor would need to hold $8 billion worth of shares for three years. Consequently, only ten of the very largest money managers would be eligible to file, and they meet this threshold only because they manage a large enough pool of assets on behalf of many smaller investors. Given their size, these firms already have access to corporate boardrooms. While larger firms generally don't file proposals, many do vote proxies and some vote for proposals submitted by smaller shareholders.

The proposed resubmission thresholds would be a barrier to educating companies and shareholders on emerging or little understood issues. Change takes time, especially within large and complex corporations. The avereage support level for shareholder proposals that asked for annual board of director elections was less than 10% in 1987, but increased to 81% by 2012. As previously noted, annual board elections are now widely accepted as good corporate governance.

Prohibiting proposals by proxy denies investors professional assistance when exercising this right of ownership. Our clients, for example, would continue to authorize us to make buy and sell decisions, and vote their proxies, but would need to act on their own when filing shareholder proposals.

Understanding the Opposition to the Current Process

Two common objections relate to concerns about materiality and cost.

Materiality

The Business Roundtable states that "Most social, environmental, and political proposals, such as those related to corporate political spending, climate change and human rights, have only an attenuated connection to shareholder value and are generally not issues material to a company's business."

This quote puts them behind the curve. Many shareholder proposals are aimed at transparency on ESG issues to ensure corporations have accurately assessed risks. Per Michael Bloomberg: "Increasing transparency makes markets more efficient and economies more stable and resilient."

The Sustainable Accounting Standards Board (SASB) and the Task Force on Climate Related Disclosures (TFCD) are both examples that reflect mainstream acceptance of the relevance and value of the information sought via the shareholder proposal process. In April 2017, EY surveyed 320 global institutional investors on their attitudes to non-financial reporting. It found that over 80% of respondents believe that ESG risks have been ignored for far too long and that nonfinancial risks are not adequately disclosed by companies. 68% indicated that non-financial performance plays a pivotal role in investment decisions.

The materiality of ESG information to investment decisions is increasingly reflected in proxy voting results on several key issues. Gibson Dunn, reporting on the 2017 proxy season, indicates that "…there was an unprecedented level of shareholder support for environmental proposals this proxy season, with three climate change proposals receiving majority support and climate change proposals averaging support of 32.6% of votes cast." Governance proposals fared even better. The 32 resolutions addressing super majority voting requirements, proxy access, and majority voting in uncontested elections averaged in excess of 60% support.

Cost

A report by the U.S. Chamber of Commerce postulated $87,000 as the average cost to a company of responding to a proposal. However, the figure is based on an ambiguously worded 1998 company survey conducted by the SEC that produced a perplexing range of estimated costs from just $10 up to $1.2 million.

Moreover, the $87,000 estimate is disclosed as the "implied cost…per proposal based on the assumption that corporations seek to exclude all proposals." In reality companies seek to exclude relatively few proposals each year, utilizing the SEC "no action process" that allows for exclusions based on specific criteria. Only 27% of resolutions submitted were challenged in 2016. Given that legal expenses increase the cost of any given proposal, the $87,000 estimate is highly questionable.

Companies can control some costs and our engagement with BlackRock is an example. When companies battle with their shareholders, the cost can be substantial. Conversely, when companies choose dialogue the outcome can be a withdrawal of the proposal and productive engagement that is arguably an investment, not a cost.

Bottom line: Companies that focus on the benefits can develop effective communications strategies and investor relationships that leverage the shareholder proposal process for the benefit of multiple stakeholders.

Posted: August 9, 2017