Exempt Proxy Solicitations

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The Idea: Inexpensive, Discreet Director Campaigns

Inevitably, at most underperforming companies, activist investors find that they want to elect new directors that represent investor interests better than incumbent directors. And, in these situations, investors run right into a range of obstacles. Foremost among these is the complicated process for obtaining votes from other shareholders for an investor’s director nominees.

This process, generally called proxy solicitation, works according to specific SEC (not Delaware or other state) regulations. It can impose significant costs in legal fees, proxy solicitation fees, and even advertising and other public relations expense. It also follows an inconvenient timetable that the SEC imposes, and discloses an investor’s strategy and analysis to the company.

The SEC, though, provides an important exemption to these regulations, which entails soliciting the votes or proxies from at most ten other investors. This guide explains the legal and practical thinking needed to use this exemption, and to elect directors more effectively at a lower cost.

Legal Foundations of the Exemption

The exemption begins with the rules for soliciting proxies. Section 14(a) of the Exchange Act

sets forth these numerous rules: who can solicit, what constitutes a solicitation, the contents of written and oral solicitation, and the timetable for solicitations, including for filing proxy materials with the SEC and SEC review of proxy materials.

The SEC does provide a few exemptions from these rules. Most are technical or routine, such as for solicitations regulated by other laws (such as the Bankruptcy Code). One, though, is neither technical or routine - the “ten or fewer” exemption (Section 14(a)2-b(2)):

  1. [Proxy solicitation regulations do not apply to] any solicitation made otherwise than on behalf of the registrant where the total number of persons solicited is not more than ten.

In its simplicity it essentially admits that among sophisticated investors, the SEC need not regulate communications concerning director elections. So, very clearly, if an investor solicits the proxies from ten or fewer shareholders, the proxy regulations don’t apply.

Interpreting the Exemption

A couple of the terms of the exemption merit comment and interpretation.

“Soliciting” a proxy can mean many things: from discussing company performance, to asking another shareholder’s voting plans, to really soliciting the proxy, and thus asking to serve as that shareholder’s representative at a shareholder meeting. Very conservative activist investors will avoid any mention of proxies in discussions with other shareholders. Most others can safely discuss a range of issues, including how a shareholder plans to vote, without actually asking for that shareholder’s proxy.

More important, what constitutes ten shareholders? or one shareholder? We’ve seen surprisingly little guidance here. Generally, though, individual shareholders within a larger asset manager each count toward the ten shareholder threshold. So, if five funds within a mutual fund company each hold shares, soliciting that company means an investor has solicited five shareholders, not one. Shares held by a single hedge fund would constitute a single shareholder.

Advantages of the Exemption

  1. Avoid the expense of a formal proxy solicitation, including legal fees, proxy solicitor costs, and public relations costs.

  2. Coordinate support from a small number of larger blockholders, and assert confidently to the portfolio company that the activist represents the views of major shareholders.

  3. Conceal discussions with other shareholders from they company, since the investor does not file any materials publicly with the SEC.

  4. Tailor proxy materials to the individual needs of a given shareholder.

  5. Communicate with shareholders according to the investor’s schedule, rather than according to SEC deadlines.

  6. Act quickly and nimbly, since the investor need not file documents with the SEC every time they communicate with other shareholders.

  7. Exert quiet, discreet pressure on the company, which can help encourage the company to negotiate a prompt response and resolution to the investor’s agenda.

Deciding Whether to Use the Exemption

If an investor decides to seek election to a portfolio company BoD, he can pursue either a conventional proxy solicitation, or use the ten-or-fewer exemption. The exemption makes sense mostly if the company has a concentrated base of institutional investors, and relatively small insider shareholdings.

The top ten shareholders should have shares that exceed comfortably the shareholdings of insiders. Of course, should the ten account for at least 50% of shares outstanding, and the investor can count on the support of all ten, then the investor will win the director election.

Director elections usually work pursuant to a plurality vote standard, though. The investor nominees need only have more shares than incumbents to prevail. If investors have support from the top ten investors and incumbents have support from insiders with significantly fewer shares, then investors have a good chance of winning.

What constitutes “significantly fewer”? It varies, naturally, based on the relative size of:

  1. insider holdings

  2. the holdings of the top ten investors

  3. the institutional shareholders outside of the top ten

  4. individual shareholders.

While the investor can solicit proxies from the top ten investors, the company can solicit the shareholders outside of the top ten and the individual shareholders, in addition to counting on insider holdings. So, an investor needs to have enough shares from the top ten investors to overcome those of insiders, plus what management might win from other institutions and individuals.

How to Use the Exemption

An exempt solicitation proceeds somewhat differently than a conventional one: much lower-key, with less publicity and cost.

It begins the same way, though. The investor notifies the company that it intends to nominate directors at the next shareholder meeting, mostly likely the next annual meeting. This can occur in a letter or even an email message. Most companies have lengthy notice periods, so an investor will do this several months before the annual meeting.

Smart investors, though, begin the process before the notice, and research the investor base. Companies with a proper concentration of institutions of course make the most sense. Ideally, the largest shareholders are hedge funds, with shares in a single investment fund.

After notifying the company, the investor can then approach the top ten investors to seek their support. Investors can safely discuss a range of matters, including how a shareholder plans to vote at the annual meeting. We usually being these discussions with a question: “does the shareholder plan to attend the annual meeting in person?” If so, there’s no need to solicit any proxy from that shareholder - after gaining that shareholder’s support, you can move on to the next investor on the roster.

If the shareholder will support the investor, the investor does need a written agreement with the shareholder to serve as proxy. The investor can use a simple form of proxy, on the shareholder’s letterhead, that they together agree expresses the voting authorization that the shareholder grants to the investor. The investor can thus tailor that agreement to that shareholder’s specific desires.

All this can take place privately - no SEC filings or news releases required. The investor would need limited legal input, perhaps in drafting the form of proxy, if that.

With proxies in hand from the major shareholders, the investor can attend the annual meeting with the authority to vote enough shares to win the BoD election. Of course, a smart investor will communicate this to the company before the annual meeting, and seek to settle the election without the hassle and expense of attending the shareholder meeting.

Three Caveats

There are three other possible trouble spots worth discussing.

  1. 1.Can the shareholder execute a form of proxy? Most institutions understand proxy cards, proxy statements, and the other trappings of conventional BoD elections. An investor can educate many of them about an exempt solicitation, especially for a portfolio company that performs very poorly. But, not all shareholders can understand and execute a form of proxy on their corporate letterhead. This may limit what certain shareholders can do to support the investor BoD nominees.

  2. 2.Educating proxy advisors. Some shareholders will consult with, or rely on, a proxy advisor such as ISS or Glass Lewis. Proxy advisors have little experience with exempt solicitations, though, and would prefer to render an opinion about director candidates based on SEC filings. An investor can work with proxy advisors, though, to make them more comfortable with the director nominees and the form of proxy process.

  3. 3.Multi-fund investors. As noted above, certain institutional shareholders will hold shares in multiple funds. Each fund counts toward the ten investor threshold, thus limiting the other solicitations that the investor can make.