Rogue Missives Friday, July 25, 1997

One of the more curious paradoxes of the corporate world over the last fifteen years is that even as most forms of regulation on capital have been lifted or modified, the regulation of shareholder rights has, in certain respects, become only stronger. Although the Securities and Exchange Commission has improved the position of shareholders in some ways, in general the SEC has continued to protect corporate management from accountability to shareholders. Indeed, in important ways corporate managers are as insulated from shareholders today as at any time in the last twenty-five years.

To be sure, this is a contrarian take, one that runs against prevailing understandings of the rise in shareholder activism and the growing importance of owners in shaping corporate policies. Certainly the phrase "shareholder value" has never been uttered by CEOs and CFOs as often as it has over the last two or three years. In addition, this decade has seen an unprecedented number of corporate chieftains dismissed by activist boards for underperformance. And the recent attention paid to the composition of boards of directors by pension funds like CalPERS has, in some cases, yielded fruitful results.

Nevertheless, there remain crucial constraints on the ability of shareholders to influence the direction of the companies they own. On the most basic level, those constraints are the product of management's desire for independence. But in a more general sense, those constraints reflect two powerful strains in American thought: the faith in managerial control and the assumption that business somehow operates independent of society. Both ideas help animate the regulations that the SEC has formulated to restrict the impact of shareholders' wishes on corporate policies.

The faith in managerial control, as we've remarked on here before, reached its high point during the 1950s and 1960s (although it became the dominant force in American business much earlier than that, around the time of the breakup of what's been termed "family capitalism"). In 1954, for instance, A.A. Berle wrote:

"In effect, when an individual invests capital in the large corporation, he grants to the corporate management all power to use that capital to create, produce, and develop, and he abandons all control over the product... He is an almost completely inactive recipient. He can spend his dividends or sell his shares for cash, taking care of his needs for consumption and enjoyment. But he must look elsewhere for opportunity to produce or create."

According to this model, the corporation not only does resemble, but should resemble, something out of a utopian novel like Edward Bellamy's Looking Backward, where the idea of democratic control has been not so much rejected as rendered meaningless and where the only role shareholders play is as recipients of the corporation's generosity. The managers keep the machines running smoothly, and everyone benefits. In the event that a shareholder becomes disillusioned or uncomfortable with the corporation's performance, he or she simply sells the shares and moves on.

Now, it's almost certainly true that this is a fairly accurate description of the way things are for most shareholders even today. Most shareholders are interested in buying low and selling high, and spend little or no time thinking about changing the behavior of the companies they own. It's safe to say, in fact, that most shareholders don't really think of themselves as owners at all. The paradigm shift that will have been effected when they do think of themselves that way could have tremendous consequences for the system as a whole.

In any case, what's important to see about Berle and other apostles of managerialism is that Berle was not merely describing the way things were, but was also making a statement about the way things should be. Or, to put it differently, he was making a statement about the way things had to be. There was no real alternative to managerialism, he suggested. Business was simply too complicated to allow any room for real democracy.

This concept was reflected in the SEC's regulations regarding shareholder resolutions included in the proxy statements mailed out before annual resolutions. In 1942, the SEC came up with rule 14a-8, which sought to define what kinds of shareholder resolutions management had to include in proxy materials. The commission's definition was remarkably vague, saying only that proposals had to deal with "a proper subject for security holders."

What that meant, of course, was that the commission arrogated to itself the right to determine what "a proper subject" was. From the beginning, then, the commission followed a line of reasoning designed to restrict shareholder rights. Instead of limiting shareholder resolutions according to the length of time a shareholder had owned the stock, or requiring a certain number of shareholders to sign on to a resolution before it could be included on a proxy ballot, the commission tried to define the acceptability of resolutions according to their topics. Almost inevitably, that meant that some of the more important aspects of corporate performance would be ruled off-limits.

In 1952, for instance, after a case in which the SEC had barred a resolution asking Greyhound to abolish segregation on its buses, the commission banned all resolutions that "appear[ed]" to be offered "primarily for the purpose of promoting general economic, political, racial, religious, social or similar causes." In other words, the commission gave itself the authority to rule on why someone had offered a resolution, and then to use its interpretation of shareholder motives as a justification for keeping other shareholders from voting on it. Two years later, the most important limitation on shareholder rights was introduced, when the SEC amended its regulations to permit the exclusion of proposals "relating to the conduct of the ordinary business operations of the issuer."

The "ordinary business" clause, which can be found in Section (c)7 of Rule 14a-8, has become the most important instrument used by corporations seeking to keep shareholder scrutiny of their labor or employment practices to a minimum. The 1952 clause that banned resolutions dealing with economic and social causes was essentially overturned by a 1970 court decision that held that Dow Corporation stockholders could offer a resolution calling for an end to Dow's production of napalm. In 1972, the SEC modified the clause substantially, such that only proposals that dealt with "causes not significantly related" to a company's business could be excluded.

As with the definition of "fiduciary responsibility" for pension fund managers looking to divest themselves of tobacco stocks," "not significantly related" really meant whatever regulators believed it meant. Still, the narrowing of the exclusion made it harder for corporations to avoid shareholder votes on things like doing business with dictatorial regimes or plant closings at home. As a result, management came to rely more and more on the "ordinary business" clause to omit shareholder resolutions.

On the face of it, the "ordinary business" exclusion would seem to be straightforward enough. Even the most fervent advocates of shareholder rights don't believe that shareholders should be voting on whether or not a particular vice-president should be hired or whether a new product should cost $159 or $129. Nor do they believe that shareholders should make decisions about the introduction of new product lines. Wasting shareholders' time and money with resolutions about these matters would seem to be in the interests of no one, and the "ordinary business" clause serves that purpose.

Other matters, though, would seem to be squarely within the purview of shareholder control: whether a company should do business in South Africa or Burma; whether a company should have a policy of non-discrimination on the basis of sexual orientation; or whether a company should subscribe to environmental codes of conduct like the Ceres Principles. These are questions that are central both to the company's financial future and to the company's public reputation. They are also, presumably, central to people's desire that the companies they own act in a manner of which they would approve. These are not routine or mundane matters, but rather fundamental ones.

Yet, throughout the 1990s the "ordinary business" clause has been used to exclude shareholder resolutions on precisely these kinds of questions. In 1990, CITICORP and BANKAMERICA were allowed to omit proposals that would have required them to write down part of their Third World debt. In 1991, DUPONT was allowed to omit a resolution requiring it to speed up plans to phase out production of chlorofluorocarbons and halon, a baffling decision given both the international pressure to phase out CFCs and the potential health impact of an acceleration of the plan. And in 1992, perhaps most strikingly, WAL-MART was allowed to omit a resolution asking for a report on its equal employment opportunities practices.

That same year saw the codification by the SEC of its willingness to limit shareholder democracy in important ways, notably in a case involving CRACKER BARREL's discrimination against gay employees. The SEC ruled that a resolution filed by the New York City Employees' Retirement System asking Cracker Barrel to implement an explicit policy of nondiscrimination was out of bounds because it dealt with the "ordinary business" of the company. More than that, though, the SEC went further and proclaimed that the fact that shareholder proposals tying "a company's employment practices for the general work force" to broader social issues would now fall under the "ordinary business" clause and would not be included in proxy statements.

The N.Y.C. pension fund appealed that decision, and initially won an injunction against the SEC. Two-and-a-half years later, though, that decision was overturned, and the injunction lifted. This means, in the words of the "Social Issues Reporter," that "employment-related shareholder proposals raise ordinary business issues, and may be excluded from proxy statements for that reason." Or, to put it more bluntly, the owners of a company are being denied the right to decide whether that company should, as a matter of policy, discriminate.

In the end, of course, the Cracker Barrel case itself is not what matters. What matters is the basic principle at stake, which is that it is the business of shareholders to determine the fundamental course that corporations will follow. The SEC is currently in the process of reviewing Rule 14a-8, and some shareholder activists have raised the possibility that a modification of the "ordinary business" clause could be in the works. Certainly e-mailing the SEC to recommend that it embrace the idea of shareholder democracy could only help.

-- Jim Surowiecki (Surowiecki)

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