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Joris M. Hogan and Alicia M. Gimenez
Special to Law.com
November 29, 2006

A recent shareholder proposal promises to substantially affect the director-nomination process in boardrooms across the United States. The 2nd U.S. Circuit Court of Appeals recently upheld the right of shareholders to include in a company's proxy statement proposals that relate to procedures for elections of directors generally. Following this court decision, the SEC's Division of Corporation Finance is reeling as it scrambles to amend the proxy rules affected by the decision in time for the 2007 proxy season.

Section 14a-8 of the Securities Exchange Act specifies when a company must include a shareholder's proposal in its proxy statement and identify the proposal in its form of proxy when the company holds an annual or special meeting of shareholders. A proposal is made on behalf of one or more shareholders, addressed to the company, recommending or requiring that the company and/or its board of directors take certain action.

Shareholders must be eligible and follow certain procedures to have their proposals included in a company's proxy statement. For example, a shareholder must have continuously held at least $2,000 in market value or 1 percent of the company's securities entitled to be voted on the proposal at the meeting for at least one year before the date on which the shareholder submits the proposal. If a shareholder fails to follow one of the eligibility or procedural requirements, the company may exclude the proposal, but only after it notifies the shareholder of the problem and the shareholder fails to adequately correct it.

Under a few specific circumstances, a company is permitted to exclude proposals, even though the shareholder met the proposal eligibility and procedural requirements. A company must first submit to the SEC its reasons for excluding a given proposal, based upon one or more of 13 grounds listed in the regulation.

Relevant to this discussion, one of the grounds provides that a corporation may exclude a shareholder proposal if it relates to an election for membership on the company's board of directors or analogous governing body.

On Dec. 1, 2004, The American Federation of State, County & Municipal Employees (AFSCME), one of the country's largest public service employee unions, submitted a shareholder proposal to American International Group, Inc. (AIG) for inclusion in its proxy materials for its 2005 annual meeting of shareholders. If the shareholder proposal had been adopted by a majority of AIG shareholders at the company's 2005 annual meeting, it would have amended the company's bylaws to require AIG, under certain circumstances, to publish the names of shareholder-nominated candidates for director positions, together with any candidates nominated by the company's board of directors.

In response to AFSCME's request, AIG filed a request for no-action with the SEC on Jan. 13, 2005 that it properly could exclude the shareholder proposal. In its letter to the SEC, AIG argued that the shareholder proposal could be excluded on the basis of one of the 13 grounds listed in Rule 14a-8(i), specifically that the shareholder proposal related to an election to the company's board of directors or analogous body. To support its argument, AIG cited past SEC no-action letters in which the SEC deemed shareholder proposals that might result in contested elections to be excludable, even if the proposal purported only to alter general procedures for nominating and electing directors (e.g., Thermo Electron, SEC No-Action Letter, 1990 WL 286329, at 19 [March 22, 1990]; Unocal Corp., SEC No-Action Letter, 1990 WL 285946 at 7 [Feb. 6, 1990]; Bank of Boston, SEC No-Action Letter, 1990 WL 285947 at 14 [Jan. 26, 1990]).

AFSCME then responded to AIG's letter by submitting a letter to the SEC on Feb. 8, 2005, challenging AIG's view that the shareholder proposal could be excluded and claiming that although Rule 14a-8 permits exclusion of proposals that relate to a specific election, it does not permit exclusion of proposals that relate to procedures for elections of directors generally. To support its argument, AFSCME pointed to the history of the SEC's no-action positions on similar Rule 14a-8 applications from 1976 to 1990. During that period, the SEC issued several no-action letters in which it held that the election exclusion did not allow companies to exclude an eligible shareholder's proposal to have the names of one or more director candidates published in the company's proxy materials. For example, in Union Oil Co. of California, the SEC considered a bylaw amendment to permit any shareholder owning 125,000 shares to place nominees on the company's proxy statement "in the same manner as any and all other nominees presented for election." The SEC determined that the proposal could not be omitted because it did "not relate to the election of directors at a particular meeting, but rather to the procedure to be followed to select nominees in general" (SEC No-Action Letter, 1983 WL 30873 at 4-5).

The SEC disagreed with AFSCME's interpretation of Rule 14a-8 in its inquiry letter and issued a no-action letter in which it indicated that it would not recommend an enforcement action against AIG if it excluded the shareholder proposal from its proxy statement (American International Group, Inc., SEC No-Action Letter, 2005 WL 372266 [Feb. 14, 2005]). The SEC, relying on its post-1990 interpretation of Rule 14a-8, explained that the shareholder proposal could be excluded on the basis that the rule permits exclusion of stockholder proposals that "relate to an election" of the directors and/or would result in contested elections.

The shareholder proposal sought to amend the company's bylaws to require its proxy materials to include information about a candidate for election to the company's board. Because the company's board of directors nominated a sufficient number of candidates for all available board seats, the shareholder proposal would establish a procedure that would result in a contested election.

When AIG excluded the shareholder proposal from the company's proxy statement, on the basis of the SEC's no-action letter, AFSCME brought suit against AIG in the District Court for the Southern District of New York, seeking an order to compel AIG to include the shareholder proposal as part of AIG's next proxy statement. The court agreed with the SEC's decision (Am. Fed. of State, County & Mun. Employees, Employees Pension Plain v. Am. Int'l Group, Inc., 361 F.Supp.2d 344 (S.D.N.Y. 2005)).

AFSCME appealed the District Court's decision, and the 2nd Circuit reversed, holding that Rule 14a-8 permits exclusion of stockholder proposals that relate to a specific election but not proposals, such as this one, that relate to procedures for elections of directors generally (Am. Fed. of State, County & Mun. Employees, Employees Pension Plain v. Am. Int'l Group, Inc., No. 05-2825-cv, 2006 WL 255941 [2d Cir. Sept. 5, 2006]). Noting the conflict between the pre- and post-1990 interpretations, the court stated that the SEC's current interpretation of its rule advanced in its amicus brief in support of AIG's position "does not merit the usual deference we would reserve for an agency's interpretation of its own regulations."

The SEC's amicus brief never offered an explanation or acknowledgment of its changed position regarding the excludability of proxy access bylaw proposals. Rather, the SEC characterized the intermittent post-1990 no-action letters that continued to apply the pre-1990 position as "mistakes." The court, in response to the SEC's explanation, stated that "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 SEC's characterization of a policy that the Division consistently applied for sixteen years as nothing more than a 'mistake.'" As a result, the court deferred to the 1976 statement of the election exclusion and interpreted the election exclusion as applying to proposals that relate to a particular election and not to proposals that, like AFSCME's, would establish the procedural rules governing elections generally.

In light of the 2nd Circuit's ruling, the SEC's Division of Corporation Finance scheduled a public meeting for Dec. 13, 2006, to deal with issues raised by the court's decision and to consider proposed changes to the rule. Thus far, the SEC has given no clear indication of what its agenda will be for the Dec. 13 meeting, but the chairman said it was the SEC's intention to finalize the rule amendments in time for the 2007 proxy season.

Score the 2nd Circuit ruling as potentially huge for shareholders, especially institutional shareholders, who have been pushing for greater access to corporate proxy statements. In a statement made to BNA on Sept. 13, 2006, Richard Ferlauto, AFSCME's director of pension and benefit policy, stated that the court ruling "levels the playing field between directors and institutional shareholders when it comes to board nominations and company boards that have been ineffective." Ferlauto further commented that the decision, "probably one of the most important court decisions regarding shareholders' rights in 30 years, reopens the door to proxy access on a company-by-company basis, which is particularly important with the recent scandals relating to options backdating and the dysfunctional board at Hewlett-Packard" (BNA Corporate Accountability Report, ISSN 1542-9563, Sept. 15, 2006).

We agree.

Joris M. Hogan is a partner specializing in mergers and acquisitions as well as securities law, and Alicia M. Gimenez is an associate in the corporate group of Torys LLP.

FN1 Furthermore, the proposal and any accompanying statement may not exceed 500 words and must be received by the company's "principal executive officers" not less than 120 calendar days before the date of the company's proxy statement released to shareholders in connection with the previous year's annual meeting or, in other circumstances, within a reasonable time before the company begins to print and mail its proxy materials.

FN2 See Sears, Roebuck & Co., 2003 SEC No-Action Letter, Lexis 285 (Feb. 28, 2003); AOL Time Warner Inc., 2003 SEC No-Action Letter, Lexis 284 (Feb. 28, 2003) (both permitting exclusion of a proposal to amend the bylaws to require that the company publish the name, along with certain disclosures and statements, of any person nominated for election to the board by a stockholder who beneficially owns 3 percent or more of the company's outstanding common stock).