WASHINGTON, D.C. — In 2003, the Securities and Exchange Commission proposed a controversial rule — known as a shareholder access proposal — intended to make it easier for shareholders to nominate and elect members of corporate boards.
While well-intended, the proposed rule would have dramatically restricted a company’s ability to govern itself effectively and efficiently, and opposition spread like wildfire throughout corporate America. As a result, the SEC wisely never moved it beyond the proposal stage.
Unfortunately, a September decision by the Second U.S. Circuit Court of Appeals in American Federation of State County and Municipal Employees (AFSCME) v AIG has put the issue back on the table and there are signs that the ruling may push the SEC — its new leadership notwithstanding — to permit something like the original shareholder access rule to come into effect. If so, this would be an overly broad reading of the court’s decision and a grave policy mistake.
The AFSCME/AIG case revolved around the obscure question of when a shareholder proposal “relates to an election.” The SEC’s current proxy rules permit shareholders to offer proposals of various kinds, and companies must include these proposals in their proxy materials even if they disagree with them. But this is not true when it comes to contests for board seats.
In these cases, the SEC has taken the position that the contesting parties — the company and the challengers — must solicit proxies separately in support of their candidates. Pursuing this approach since 1976, the SEC has permitted companies to exclude from their proxy material any shareholder proposal that “relates to an election.”
The AFSCME case began with a request by the giant public employees union to include in AIG’s proxy materials a proposal to amend the company’s by-laws so qualified shareholders could nominate a director for the company’s board and have the nomination included in the company’s proxy statement.
This is clearly a proxy access proposal masquerading as a by-law amendment. If adopted, it would require a company to include on the same ballot as its own management nominees the nominees of shareholders that meet the by-law’s qualifications.
Thus, an immense issue of corporate governance policy has arisen in a case where the narrow question before the court was merely whether the AFSCME proposal “relates to an election.”
The proposal’s language is ambiguous, in one sense, clearly setting up conditions that would result in a contested election, and the district court so held. On the other hand, a vote on a by-law is clearly not an election in itself. So the question becomes what the SEC meant by the term “relates to an election.”
Since the parties were arguing about ambiguous language in the SEC’s proxy rules, the court asked the SEC for guidance on the meaning of its regulation — a matter on which regulatory agencies usually receive deference from the courts.
In response, the SEC submitted a well-crafted memorandum that in essence made the point that the agency consistently has excluded proposals that would result in board election campaigns conducted outside the proxy rules.
This apparently did not convince the court of appeals, which seized on the fact that in adopting its proxy exclusion policy in 1976 the SEC had noted that the policy was not intended to cover such matters as cumulative voting and the qualifications of directors, which could still be included in company proxy statements as shareholder proposals — thus narrowing the scope of the exclusion.
The court thus determined that there was no way to distinguish logically between the SEC’s 1976 position—which narrowed the exclusion—and the SEC’s decision in 2006 that permitted AIG to exclude the AFSCME proposal from its proxy statement — a ruling that appeared to broaden the exclusion.
Following this logic, the court concluded, the SEC had changed its position and for this reason was not entitled to the deference normally accorded to administrative agencies in interpreting their own regulations.
This is obviously wrong. There is a world of difference between a shareholder proposal for or against, say, cumulative voting, and a proposal that would give shareholders the opportunity to put non-management nominees in the same proxy statement with the management slate.
The former sets the ground rules under which an election contest would be held; the latter will result immediately in an election contest against the company’s nominees without the requirement for a proxy solicitation. The SEC had not in fact changed its position by distinguishing between these two fact patterns.
The appeals court’s error is difficult to repair. The SEC was not a party to the case and thus cannot appeal the decision. That does not mean, however, that the SEC necessarily must comply with the ruling.
The appeals court also noted in its decision that the SEC — like all administrative agencies — has the authority to change its interpretation of its own regulations, as long as it gives reasons for doing so.
That interpretation gives the SEC the opportunity to explain its policy of excluding by-laws such as that proposed by AFSCME.
The language on which the court focused — whether a particular shareholder proposal is “related to an election” — thus is largely irrelevant. The policy behind the language — what the SEC was trying to achieve — is what’s important, and that has not yet been made clear by the agency — either in the past or in its memorandum for the court.
The SEC’s purpose obviously is to assure that shareholders get the information they need to make an informed choice on the important issue of board membership. The competition inherent in a proxy context, as in a contested political election, will provide this information. A by-law that requires a company to include an unwanted director in its own proxy statement will reduce the element of competing views and hence the information provided to shareholders.
In addition, circumstances have changed in the corporate governance world since 1976\ with institutional investors such as pension funds or environmental groups pushing harder to influence corporate policies by obtaining board seats. These contests should be encouraged, but not at the sacrifice of the competition for board seats that yield valuable information for shareholders about the priorities and purposes of the contestants.
Whether or not it is viewed as a change in position or simply an updating of its regulatory approach, the SEC should make clear that all efforts to change the composition of a company’s board without the company’s agreement are, in effect, election contests that must follow the proxy rules.
Under these circumstances, the AFSCME by-law provision must be excluded if the integrity of the proxy rules is to be maintained. If groups wishing to contest the company’s slate of directors are able through a mere by-law amendment to place their nominees on the same ballot as the company’s nominees, and thus avoid the disclosures associated with a proxy contest, the shareholders will be the losers.
The SEC should quickly end the current uncertainty by reaffirming its original policy that contests for board seats — in the interests of the shareholders — should be carried on through proxy solicitations.