It's back on the table: a controversial 2003 Securities and Exchange Commission rule--the shareholder access proposal--intended to make it easier for shareholders to nominate and elect members of corporate boards.

Resident Fellow Peter J. Wallison

The 2003 proposal was intended to promote "shareholder democracy," but what it really did was open the nomination process to groups with policy agendas. As in Europe, opponents argued, directors of U.S. corporations elected under the SEC's proposal would be representatives of corporate "stakeholders" or proponents of various public interest objectives, rather than advocates for increased shareholder value. A fundamental shift in the nature of U.S. corporate governance was at stake, and protests spread like wildfire in the corporate community. Soon, the SEC wisely backed off.

Now, however, a decision by the Second U.S. Circuit Court of Appeals in American Federation of State, County and Municipal Employees (AFSCME) v. American International Group has revived the issue. This time, there are signs that the ruling may push the SEC--its new leadership notwithstanding--to allow 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 decision revolved around the obscure question of when a shareholder proposal "relates to an election." The SEC's current proxy rules let shareholders offer proposals of various kinds. Companies must include these proposals in their proxy materials even if they disagree.

This is not true when it comes to contests for board seats. The SEC has taken the position that the competing parties--the company's management and the challengers--must solicit proxies separately in support of their candidates. Pursuing this approach since 1976, the SEC has allowed companies to exclude from their proxy material any shareholder proposal that "relates to an election." That's a potentially broad exception.

Enter the AFSCME case. It began with a request by the giant public employee union to include in AIG's proxy materials a proposal to amend the company's by-laws so "qualified shareholders"--including AFSCME--could nominate directors for the company's board and have the names of their candidates 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 likely effect is not obvious. In one sense, it clearly sets up conditions that would result in a contested election, and the district court that initially reviewed the facts so concluded. On the other hand, a vote on a by-law is clearly not, on its face, about an election.

So the question is, what did the SEC mean by the term "relates to an election"?

Asked for guidance on the meaning of the regulation, the SEC submitted a well-crafted memorandum pointing out that since 1976, the agency had followed a policy of excluding proposals that would produce election campaigns for board seats that were not conducted under the SEC's proxy rules. The court, however, citing past inconsistencies in the SEC's rulings, rejected the SEC's position and declared that AIG must put the AFSCME by-law proposal in its proxy statement.

But the court missed the forest for the trees. Whether or not the SEC has had a consistent position since 1976, the underlying policy is what's important. The obvious purpose of the SEC exclusion is to assure that shareholders get the information that competing proxy statements would produce when they are asked to vote on something as fundamental as a contest for board seats. The competition inherent in a proxy contest, as in a contested political election, will provide this information. The AFSCME proposal would clearly undermine this policy. A by-law that requires a company to include unwanted directors in its own proxy statement will reduce the opportunity for the expression of competing views, and hence the information provided to shareholders.

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 adopt reasonable rules, and to change its interpretation of its existing rules, as long as it gives reasons for doing so. This clearly gives the SEC the authority to reaffirm its exclusion policy.

If an agency can change its interpretation of its own rules as long as it gives reasons for doing so, it can certainly reaffirm its existing policy in the same way. What the SEC must do in this case is what it did not do in its original memorandum to the court: explain why its policy of excluding election-related shareholder proposals is essential for the protection of shareholders, and why the AFSCME proposal falls into this category.

The language on which the court focused--whether a particular shareholder proposal is "related to an election"--is thus largely irrelevant. The policy behind the language--what the SEC was trying to achieve--is what's important. That has not yet been made clear by the agency, either in its past rulings or in its memorandum for the court.

The SEC's clear purpose in adopting and maintaining the exclusion policy is to assure that shareholders get the information they need to make an informed choice on the important issue of board membership. It would be absurd to allow inconsistent prior rulings--if, in fact, they occurred--to invalidate a perfectly valid underlying policy.

The AFSCME by-law, by requiring a board election to occur outside the context of the proxy rules, clearly runs counter to the policy. The SEC should quickly end the current uncertainty by reaffirming its original policy that contests for board seats should be carried on only through proxy solicitations, and that by-laws or other devices that evade this requirement can be excluded from corporate proxy statements.

Peter J. Wallison is resident fellow at AEI.