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Crafting a shareholder voting rights policy.

Crafting a Shareholder Voting Rights Policy

One of the most important decisions a public company must make concerns the voting rights of its shareholders. From the vantage point of the National Association of Securities Dealers Inc. (NASD), an organization that operates and regulates one of the largest securities markets in the world, an acceptable shareholder voting rights policy should meet two tests: It should be fair to the shareholders and it should be compatible with corporate efficiency and capital raising.

This is easier said than done. Voting rights issues have come to involve other parties besides shareholders and management. Securities markets are involved with voting rights from both a listings standard and an investor rights perspective. Congress, the Securities and Exchange Commission (SEC), state securities commissions, and state legislatures have interests in voting rights from varying standpoints of public policy. Attorneys, accountants, academicians, and the media also have views on the issue.

Over a five-year period, from 1985 to late 1990, the NASD gradually developed a shareholder voting rights policy for the 2,500 companies in the National Market System (NMS), the upper tier of the Nasdaq Stock Market, which at this point appears nominally to satisfy all parties concerned. The process makes for an interesting case study. Here are selected highlights.

The NASD is the largest self-regulatory organization of the U.S. securities industry, with 6,000 member firms - from the largest to the smallest - and 425,000 securities professionals registered with it. Like the stock exchanges, the NASD operates by statutory authority and under the oversight of the SEC. In 1971, out of the sprawling, obscure over-the-counter market, it launched the Nasdaq market which rapidly became the fast-growing and the second-largest equity market in the U.S.

The Quest for Parity

As the Nasdaq market grew, the movement toward parity of treatment for its leading securities with exchange-listed stocks was begun. A priority objective was to secure for Nasdaq/NMS securities - the larger Nasdaq securities traded with real-time price and volume reporting - the same exemption from state Blue Sky registration which listed securities enjoyed. As state securities administrators were approached on this issue, a number of them pointed out that Nasdaq/NMS companies were not subject to corporate governance requirements similar to those that the exchanges imposed.

In mid-1985, the NASD filed with the SEC a series of corporate governance requirements for NMS companies which included: at least two independent directors on the board; an audit committee composed in the majority of independent directors; ongoing review of all related-party transactions; and, subsequently, shareholder approval of transactions that impact the control of the company. These requirements were approved by the Commission, and, as a result, many states were granted exemption from registration to Nasdaq/NMS securities.

Fischel Study

The question of shareholder voting rights remained. Surveys of Nasdaq issuers produced no clear consensus on how to approach the subject. In November 1985, the NASD retained Daniel R. Fischel, Professor of Law and Director of the Law and Economics Program at the University of Chicago, to examine the issue in depth. Professor Fischel presented a study, entitled "Organized Exchanges and the Regulation of Dual-Class Common Stock," to the NASD Board of Governors in March 1986. Among the principal conclusions of the Fischel study were: * The rule of one share, one vote appears to be optimal for the vast majority of companies. The available empirical evidence shows that dual-class common stock is desirable for certain types of firms and does not systematically harm investors. * There may well be significant costs associated with prohibiting dual-class common stock. Entrepreneurs of certain firms will be less willing to go public, which, in turn, will decrease public ownership of shares and cause some promising investment projects to be abandoned.

The NASD distributed more than 14,000 copies of the Fischel study and invited comments on it. Few were received. For some months, the study appeared to be the last word on the subject of shareholder voting rights.

The NASD's 1987 Proposal

It was not. In the fall of 1986, the New York Stock Exchange petitioned the SEC for permission to eliminate the one-share, one-vote rule that had been on its books for decades. The NYSE was acting primarily in response to the decision by General Motors Corp. to issue a new class of stock, with reduced voting rights, in connection with its acquisition of Electronic Data Systems Corp. More than 50 other NYSE-listed companies had gone, or were about to go, to dual classes of stock, mainly to thwart takeovers. The NYSE petition reopened the issue of one share, one vote and cast it into the arena of public policy.

The SEC was under pressure from Congress and other quarters to adjudicate the NYSE matter and to establish a common standard for all markets. In May 1987, the NASD circulated a new proposal, according to which: * Nasdaq companies would be prohibited from issuing any class of securities or taking any other corporate action that would restrict, nullify, or disparately reduce the voting rights of holders of an outstanding class or classes of publicly traded securities of the issuer. * Transactions presumed not to restrict, nullify, or disparately reduce voting rights would include: (1) issuance of securities in an initial public offering; (2) issuance of securities in a public offering with voting rights not greater than those of any outstanding class of the issuer's common stock; and (3) issuance of securities approved by shareholder vote pursuant to a proxy statement in a merger, acquisition, or a stock dividend transaction in which the voting rights of the securities would not be greater than those of any outstanding class of the issuer's common stock. * Transactions that were presumed to restrict, nullify, or disparately reduce voting rights included: (1) restrictions on voting power based upon the number of shares held; (2) restrictions on voting power based upon the length of time shares have been held; and (3) issuance of securities pursuant to an exchange offer where the securities being issued result in a restriction, nullification, or disparate reduction of voting rights of outstanding common stock.

The NASD was prepared to, but did not, file its rule proposal for SEC approval, because events were taking a different turn.

SEC Rule 19c-4

The NYSE essentially agreed with the NASD's concept, but the American Stock Exchange advocated a strict one-share, one-vote standard. In the absence of agreement among the three markets, the SEC decided to propose a rule of its own which would be binding on them. In June 1987, the SEC said:

"The proposed Rule 19c-4 reflects concepts agreed to in principle by both the NASD and NYSE boards.

"The rules of exchanges and associations would be amended to prohibit them from listing or continuing to list any of the common stocks and equity securities of an issuer that ... issues any securities, or takes other corporate action, that has the effect of nullifying, restricting, or disparately reducing the voting rights of shareholders of an outstanding class or classes of common stock. Proposed Rule 19c-4 will also provide a certain degree of flexibility by permitting an exchange or association to issue rules that would specify the types of securities issuances or corporate actions covered by, or excluded from, the prohibitions contained in rule 19c-4."

Approximately 1,000 commentators supported adoption of the rule, and it became effective on July 7, 1988.

NASD Interpretations

The NASD put its own proposed voting rights rule back in the files and began to enforce SEC Rule 19c-4 by interpreting the rule to those Nasdaq companies that were contemplating changes in their capital structures. No company challenged the NASD's interpretations; where necessary, companies adjusted their plans to conform to 19c-4.

From July 1988 to July 1990, a number of companies adopted acceptable forms of dual-class stock. This brought the total number of Nasdaq/NMS companies with such capital structures to some 175, or 6.5 percent, of all Nasdaq/NMS companies. For the overwhelming majority - over 93 percent - one share, one vote remained the standard.

Roundtable Wins, NASD Acts

The Business Roundtable, an association of 200 CEOs from the Fortune 500, filed suit in the United States Court of Appeals for the District of Columbia Circuit to overturn the rule. The Roundtable contended that the Commission did not have the authority to regulate matters of corporate governance, which were traditionally left to the states. On June 12, 1990, the appeals court found for the Business Roundtable and declared its intention to vacate Rule 19c-4.

This created a problem for the NASD. It had a commitment to a shareholder voting rights policy essentially like Rule 19c-4. With the rule gone, there was a possibility that some companies could change their shareholder voting practices with impunity.

On July 24, 1990, the Association filed its own rule proposal, protecting shareholder voting rights within Nasdaq/NMS, and requested temporary SEC approval, to be good for 90 days. The SEC granted the NASD's request before the court's mandate vacating Rule 19c-4 was formally issued on Aug. 3, 1990. This closed the "window" for companies to adopt unacceptable policies without being subject to delisting from Nasdaq/NMS.

The NASD Rule

The NASD rule, approved on a permanent basis on Oct. 25, 1990, by the SEC and now in force, is virtually identical to the proposal that the Association submitted to its members and others in May 1987, but has two additions: * A further transaction presumed not to restrict, nullify, or disparately reduce voting rights is "corporate action taken pursuant to state law requiring a state's domestic corporation to condition the voting rights of a beneficial or record holder of a specified threshold percentage of the corporation's voting stock on the approval of the corporation's independent shareholders." * An added transaction which is presumed to harm shareholder voting rights is "any issuance of securities pursuant to a stock dividend, or any other type of distribution of stock, in which the securities issued have voting rights greater than the per-share voting rights of any outstanding class of the common stock of the issuer."

Review and Outlook

After five years of discussion, a consensus appears to have been reached on the matter of shareholder voting rights in Nasdaq/NMS. The fairness issue in this area seems to have been settled, at least for now. The new rule has been enforced: Companies that have chosen not to abide by it have been dropped from Nasdaq/NMS and their securities have been moved to the lower tier of the Nasdaq Stock Market, in which only 4% of its securities by market value are traded.

This does not mean that the question of shareholder voting rights has been permanently laid to rest. Nasdaq/NMS, in 10 years of existence, has gone through great growth and extensive change. It will, no doubt, continue to do so. New mergers and acquisitions, changing business conditions, and the shifting mix of shareholders may demand new adjustments in the future.

There is comfort, however, in this review of the process of the last five years. The established procedures whereby shareholders, management, the markets, government regulators, and interested parties from the broader public eventually hammer out an agreement appear to be rational, flexible, and ultimately productive. These established procedures should continue to serve shareholder voting rights and the broader rights of all investors to be treated fairly.

Joseph R. Hardiman became President of the National Association of Securities Dealers Inc. (NASD) on Sept. 1, 1987. A member of the NASD Board of Governors since 1985, Hardiman was the 1987 Chairman of the Board at the time of his appointment. Prior to assuming the presidency of the NASD, Hardiman was a Managing Director and Chief Operating Officer of the investment banking firm of Alex. Brown & Sons in Baltimore. There, Hardiman had senior management responsibility for administration, operations, legal affairs, accounting, human resources, and information services.
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Title Annotation:Chairman's Agenda: Balancing Shareholder Interests
Author:Hardiman, Joseph R.
Publication:Directors & Boards
Date:Mar 22, 1991
Previous Article:A vision of value-based governance.
Next Article:What investors want executive pay to do.

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