Quality Shareholder Initiative’s Professor Lawrence Cunningham on New SEC Restrictions on Shareholders

Prof. Lawrence Cunningham, Director of the Quality Shareholders Initiative writes about his concern that the SEC’s new disclosure requirements for activist shareholders will make constructive engagement and oversight more difficult. He does concede, though, that portions of the proposal actually make activist engagement easier.

The 2022 proxy season is primed for historic levels of shareholder activism, and the U.S. Securities and Exchange Commission, traditionally a neutral referee in these contests, has chosen to get into the game.

Under Chairman Gary Gensler, the SEC is backing the team that views corporations mainly as social institutions, while trying to defeat the team that views corporations as primarily economic ones.

In a Feb. 25 proposal to speed up and broaden disclosure requirements for activist shareholders under Sections 13D and 13G of the Securities Exchange Act, Gensler’s SEC dealt a significant blow to economic activist investors who have long imposed financial discipline and accountability on corporate management.  These investors accumulate large long-term stakes in a company to influence control and get better economic performance.

The SEC proposal would chill this activity. First, the SEC will cut the 10-day window activists have to disclose taking a position of 5% or more in a company down to five days. That will hamper their ability to stay on the sidelines until they are ready to approach directors and officers with a formal business plan.

The proposal would change the meaning of several terms of art, broadening concepts like “group” and “ownership” for activists trying to influence control in ways designed to impair their ability to coordinate with fellow shareholders.

In the same proposal, the SEC would make it easier for political activists to use corporate shareholder voting in campaigns promoting climate control, civil rights and board diversity — policies championed by the environmental, social and governance, or ESG, movement. For instance, the proposal narrows the concept of “group” for this cohort to make it easier for social activists to coordinate campaigns with each other and increase votes for ESG proposals.

While the probable long-term effects of this proposal have not been studied, its aim is clear: The SEC seeks to handicap traditional economic activists in favor of ESG activists. This runs counter to the SEC’s historical mandate to serve the economic interests of Main Street shareholders, not put its weight behind particular political philosophies.

The broad scope of the SEC’s shift is clear in two of the SEC’s other major actions regulating activist contests ahead of the 2022 proxy season. Starting this year, the SEC has liberalized its approach to the topics shareholders may require companies to put on the corporate ballot.[2] Historically, companies could omit proposals pushing broad social policy unrelated to a company’s business.

But now anything having to do with ESG must go on the ballot, with updated guidance noting staff will disregard “the nexus between a policy issue and the company” and instead focus on “the social policy significance of the issue” raised in the proposal.[3] Expect novel proposals spanning from internal civil rights audits to disclosures of every director’s sexual preference.

Similar biases lurk in the SEC’s otherwise-sensible new way of handling director nominations.[4] Until now, in contested board elections, shareholders faced split ballots — company incumbents sent one listing their nominees and activist opponents sent another listing theirs. The shareholder had to choose between the two slates.

Under the new rules, all ballots must list all nominees. Shareholders will be able to split their votes and choose among directors from both slates. On its face, this appears neutral and natural, but there is a hidden twist. At least in some contests, the change will hurt economic activists by reducing support for some slates.

On the other hand, the change will help every political gadfly because anyone with a single share and a pet cause can insist that their nominee appear on the corporate ballot alongside those of incumbents and economic activists alike.

Why has the SEC become a team member of social activists promoting politics du jour, but disadvantaged investors who aim to grow value for all shareholders? While Gensler has not given a direct answer, he and his fellow progressives at the SEC have made it clear that they like ESG activism.  They are working on new laws to require companies to detail information on a sweeping range of ESG topics, taking the SEC far from its century-old focus on financial performance into the hotbed of politics.

Along this path, the SEC has been coaxed by interest groups that make a big business of ESG. These are led by proxy adviser firms. They rank companies on a variety of subjective ESG criteria and then sell services to those companies on how to improve their ratings. These firms have no incentives to promote the economic interests of shareholders, moreover, because they do not own any stock in these companies.

Companies have been influenced by such ratings and services. But many successfully resist on the grounds that there is no consensus on the right way to measure things like emissions disclosure policy or workforce diversity efforts. This process, while messy and cumbersome, allows for ongoing refinement of disclosures and ultimately improves their usefulness over time — or leads to their abandonment when proven otherwise.

Yet if the SEC makes such disclosure mandatory, social activists will have another nail to hammer into companies without conducting much analysis, despite legitimate ongoing debate on the best way to disclose and measure companies’ progress on these complex issues.

Meanwhile, companies will be incentivized to reactively prioritize these issues above their primary business objectives in an attempt to stave off shaming, destroying value in the process.

Early results this season affirm this potential. The SEC has greenlighted a proposal from People for the Ethical Treatment of Animals seeking animal welfare audits at Levi Strauss & Co.  and from the National Legal and Policy Center for a report on charitable donations at The Boeing Company.

The SEC is also requiring Apple Inc. to include a proposal from James McRitchie to remake the firm as a social purpose corporation.[9] While most shareholders will vote against such proposals as nonstarters — the latter would destroy billions in shareholder value — the costs the SEC is imposing on shareholders are nontrivial.

The SEC was once among the most respected and least political federal agencies, and it managed to maintain that status despite significant polarization. Its mission of investor protection and market efficiency meant that it promoted a fair playing field and let the players work out the priorities.

This deference for mainstream investment theory and market practices has stretched across initiatives led by both parties, from the recent market reforms of Republicans and former SEC Chairs Jay Clayton and Chris Cox that conservatives applauded, to more proregulatory initiatives from Democratic Chairs Arthur Levitt and Mary Schapiro that liberals championed.

By abandoning that restraint and taking sides in areas way out of its remit, the SEC has set itself on a dangerous course that may prove impossible to reverse.

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