Shareholders should be allowed to consider proposals that seek to establish a procedure by which shareholder-nominated candidates for a companys board may be included on the corporate ballot, according to a ruling by the United States Court of Appeals for the Second District.

The ruling reversed a U.S. District Court for the Southern District of New York decision, and ran contrary to an SEC Division of Corporation Finance policy on the matter.

The case dealt primarily with the interpretation of Securities Exchange Act Rule 14a-8(i)(8), also called the election exclusion. The court explained, If a shareholder seeking to submit a proposal meets certain eligibility and procedural requirements, the corporation is required to include the proposal in its proxy statement and identify the proposal in its form of proxy, unless the corporation can prove to the SEC that a given proposal may be excluded based on one of 13 grounds enumerated in the regulations. One of these grounds, Rule 14a-8(i)(8), provides that a corporation may exclude a shareholder proposal [i]f the proposal relates to an election for membership on the companys board of directors or analogous governing body.

AIG Rejects AFSCME Proposal

According to the court, in American Federation of State, County & Municipal Employees (AFSCME), Employees Pension Plan v. American International Group, Inc. (AIG), AFSCME " which, through its pension plan, holds 26,965 shares of voting common stock of American International Group " submitted to AIG for inclusion in the companys 2005 proxy statement a shareholder proposal that, if adopted by a majority of AIG shareholders at the companys 2005 annual meeting, would amend the AIG bylaws to require the company, under certain circumstances, to publish the names of shareholder-nominated candidates for director positions together with any candidates nominated by AIGs board of directors.

AIG sought guidance from the SEC Division of Corporation Finance policy, the court continued, regarding whether AIG could exclude the proposal from its proxy statement under the election exclusion, on the basis that the AFSCME proposal relates to an election.

The court noted, The division issued a no-action letter in which it indicated that it would not recommend an enforcement action against AIG should the company exclude the proposal from its proxy statement.

AIG thus excluded the proposal from its proxy statement, and AFSCME brought suit in the district court. The district court denied AFSCMEs motion for a preliminary injunction, deciding that AFSCMEs proposal on its face relates to an election. Indeed, it relates to nothing else.

The case was then appealed. The appeals court explained, This case raises the question of whether a shareholder proposal requiring a company to include certain shareholder-nominated candidates for the board of directors on the corporate ballot can be excluded from the corporate proxy materials on the basis that the proposal relates to an election under [the election exclusion]. Complicating this question is not only the ambiguity of Rule 14a-8(i)(8) itself, but also the fact that the Securities Exchange Commission has ascribed two different interpretations to the Rules language. The SECs first interpretation was published in 1976, the same year that it last revised the election exclusion. The Division of Corporation Finance, the group within the SEC that handles investor disclosure matters and issues no-action letters, continued to apply this interpretation consistently for 15 years until 1990, when it began applying a different interpretation, although at first in an ad hoc and inconsistent manner.

It Depends on What the Definition of an Is

Regarding interpretations of the rule, the court said, AFSCME reads the election exclusion as creating an obvious distinction between proposals addressing a particular seat in a particular election (which AFSCME concedes are excludable) and those, like AFSCMEs proposal, that simply set the background rules governing elections generally (which AFSCME claims are not excludable). AFSCMEs distinction rests on Rule 14a-8(i)(8)s use of the article an, which AFSCME claims necessarily implies that the phrase relates to an election is intended to relate to proposals that address particular elections, instead of simply elections generally.

Noting that this interpretation is plausible the court continues, It is, however, also plausible that the phrase was intended to create a comparatively broader exclusion, one covering a particular election or elections generally since any proposal that relates to elections in general will necessarily relate to an election in particular.

The language of Rule 14a-8(i)(8) provides no reason to adopt one interpretation over the other.

SEC Contradictions

The court then looked for an SEC interpretation of the rule. We are aware of two statements published by the SEC that offer informal interpretations of Rule 14a-8(i)(8). The first is a statement appearing in the amicus brief that the SEC filed in this case at our request. The second interpretation is contained in a statement the SEC published in 1976, the last time the SEC revised the election exclusion.

In its amicus brief, the SEC interprets Rule 14a-8(i)(8) as permitting the exclusion of shareholder proposals that would result in contested elections. The SEC explains that [f]or purposes of Rule 14a-8, a proposal would result in a contested election if it is a means either to campaign for or against a director nominee or to require a company to include shareholder-nominated candidates in the companys proxy materials. Under this interpretation, a proxy access bylaw proposal like AFSCMEs would be excludable under Rule 14a-8(i)(8) because it is a means to require AIG to include shareholder-nominated candidates in the companys proxy materials.

However, that interpretation is plainly at odds with the interpretation the SEC made in 1976.

In that year, the court said, the SEC issued a statement that clearly reflects the view that the election exclusion is limited to shareholder proposals used to oppose solicitations dealing with an identified board seat in an upcoming election and rejects the somewhat broader interpretation that the election exclusion applies to shareholder proposals that would institute procedures making such election contests more likely. The SEC suggested as much when, four months after its 1976 statement, it explained that the scope of the election exclusion does not cover shareholder proposals dealing with matters such as cumulative voting and general director requirements, both of which have the potential to increase the likelihood of election contests.

That the 1976 statement adopted this narrower view of the election exclusion finds further support in the fact that it was also the view that the [Division of Corporation Finance] adopted for roughly 16 years following publication of the SECs 1976 statement.

It was not until 1990 that the division first signaled a change of course by deeming excludable proposals that might result in contested elections, even if the proposal only purports to alter general procedures for nominating and electing directors.

The court continued, In its amicus submission, the SEC fails to so much as acknowledge a changed position, let alone offer a reasoned analysis of the change. The amicus brief is curiously silent on any division action prior to 1990, and characterizes the intermittent post-1990 no-action letters which continued to apply the pre-1990 position as mere mistake[s].

While we by no means wish to imply that the commission or the division cannot correct analytical errors following a refinement of their thinking, we have a difficult time accepting the SECs characterization of a policy that the division consistently applied for 16 years as nothing more than a mistake.

Although we are willing to afford the commission considerable latitude in explaining departures from prior interpretations, its reasoned analysis must consist of something more than mea culpas.

Accordingly, we deem it appropriate to defer to the 1976 statement, which represents the SECs interpretation of the election exclusion the last time the Rule was substantively revised. We therefore interpret the election exclusion as applying to shareholder proposals that relate to a particular election and not to proposals that, like AFSCMEs, would establish the procedural rules governing elections generally.

However, the court noted, In deeming proxy access bylaw proposals non-excludable under Rule 14a-8(i)(8), we take no side in the policy debate regarding shareholder access to the corporate ballot. There might be perfectly good reasons for permitting companies to exclude proposals like AFSCMEs, just as there may well be valid policy reasons for rendering them non-excludable. However, Congress has determined that such issues are appropriately the province of the SEC, not the judiciary.

For the foregoing reasons, we reverse the judgment of the district court and remand the case for entry of judgment in favor AFSCME.

Reactions

AFSCME president Gerald McEntee hailed the decision, stating, The Second Circuit decision is hugely significant for shareholders. We have always argued that you cant have a true election when only one party is empowered to put a name on the ballot. This ruling can give shareholders a meaningful voice in board elections by opening up the director nominating process.

Michael Barry, partner at Grant and Eisenhofer, which represented AFSCME, said, The proxy access debate isnt over, however. He added, The Second Circuits decision represents a huge victory, and we trust that the SEC will embrace the Second Circuits decision and ensure that the proxy rules will be interpreted uniformly to enable shareholders to introduce proxy access proposals regardless of where their particular companies are located.

SEC Action

For its part, the SEC announced that it will recommend an amendment to Rule 14a-8 that will address issues raised by the court decision. The recommendation will be considered on October 18.

The SEC explained that the recent court decision is important because of the large number of public companies that are subject to the jurisdiction of that court.

Christopher Cox, chairman of the SEC, said, Rule 14a-8, the shareholder proposal rule, provides shareholders important rights in the proxy process. These rights are best secured under consistent national application of Rule 14a-8 to shareholder proposals. Therefore, to provide certainty with regard to shareholder proposals in every judicial circuit, I have directed the staff to prepare recommendations for revisions to Rule 14a-8 that will assure its consistent nationwide application. Following the publication of a proposed amendment and the opportunity for public comment, a final proposal will be considered at an open meeting of the Commission that will be scheduled to allow a final rule to go into effect in time for the 2007 proxy season.