SEC Must Avoid Errors of Omission

Sanford Lewis, Director, Shareholder Rights Group

In deciding whether to allow exclusion of shareholder proposals, the Securities and Exchange Commission must consider its clearly stated investor protection mission.  History has shown it can be far more detrimental to that mission to make errors of omission (wrongly omitting proposals) than to make errors of inclusion.  Recent history contains numerous examples of proposals that were excluded only to later prove to have been early warnings of highly material risks.

As early as 2000, shareholders recognized the risk posed by subprime lending, a practice which contributed to the mortgage crisis of the mid-2000s.  The risks taken by individual financial institutions generated concern amongst shareholders, who filed some on-target resolutions that were excluded by the SEC as pertaining to ordinary business.

In 2000, Household International was one of the largest subprime lenders in the United States.  Predatory lending in the subprime market was of growing concern to some investors as it became clear that borrowers were unable to repay these loans and were losing their homes.  Subprime lending was already beginning to indicate the financial risks that would ultimately produce the housing bubble, the mortgage meltdown, and the financial crisis.  There had already been bankruptcies of several large subprime lenders over the course of 1998-99.

Shareholders of Household International brought a resolution in 2000 citing interest in predatory lending amongst policy makers on the national and state level, and large settlements with lenders already being required by the FTC.  The shareholder resolution filed in 2000 requested the establishment of a committee of outside directors to develop and enforce policies to ensure “that accounting methods and financial statements adequately reflect the risks of subprime lending and … employees do not engage in predatory lending practices” and issue a report to shareholders.  In Household International, (March 13, 2000) the Staff determined that this proposal could be excluded as ordinary business.  These shareholders who had the foresight to sound the alarm were rebuffed, and by 2002 Household International subsequently settled a groundbreaking case with 20 state attorneys general over predatory lending (Iowa DOJ News Release, October 11, 2002).  A significant opportunity to alert shareholders and boards of directors to the problems and risks posed was barred by the SEC decision. 

By 2007 it became clear that subprime lending posed systemic risk, and as subprime lending burst the housing bubble, several proposals at Washington Mutual (February 5, 2008), Merrill Lynch (February 19, 2008; February 20, 2008), KB Home (January 11, 2008), and Lehman Brothers (February 5, 2008) were excluded.  Even as the market was in early signs of collapse, these proposals were considered by the SEC to be excludable, regardless of the fact that these risky practices were at the time clearly causing systemic risk.  In fact, the collapse of Lehman Brothers, one of the hedge funds whose shareholders submitted a proposal, was a uniquely catastrophic event in the crisis.  Lehman’s shareholders were denied their opportunity to engage with the company in 2007 Lehman Brothers (February 5, 2008).  Lehman collapsed in September 2008.  

In contrast, when the SEC allows shareholders to do their work through the shareholder proposal process, many smaller and institutional investors attentive to early warning signs can spur management and board attention where due.  To cite one example, some religious pension fund shareholders that were in some instances able to flag subprime lending issues in 2000 through the shareholder proposal process, assisted some companies that cooperated to avoid the disastrous fate met by numerous big banks.  As Attorney Paul Neuhauser has noted although a number of other proposals on subprime lending:

survived company challenges at the SEC, [but] they never appeared on any proxy statement because the recipients in each case agreed to a change of policy with regard to predatory lending to subprime borrowers (in one case the securitizer called the proponent the day after it lost its no-action request at the SEC to request a meeting and dialogue on the matter and at the meeting agreed to alter its due diligence process with respect to loans purchased for securitization).  Notably, the securitizers that received the precatory proposals and changed their practices have not been among those who have suffered during the recent unpleasantness.

To cite one of many other errors of omission in Staff decisions, ordinary business exclusions were allowed for a proposal at Wells Fargo inquiring about whether the employee compensation system was exposing the bank or economy to excess risk.  Wells Fargo (February 14, 2014) These proposals were early warnings of what later proved a scandalous and costly crisis due to fraudulent cross selling spurred by employee incentives.  To date, Wells Fargo has paid at least over a $1 billion in fines and penalties for its reckless risk management and employee incentives, including penalties for opening 3.5 million accounts for customers without their consent, abusive auto loan practices, and in related suits by customers and investors.  

Are the Staff decisions today allowing exclusion of proposals that seek improved performance and risk management destined to be viewed in hindsight as further “errors of omission”?

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