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CA v. AFSCME: Should the SEC Have Raised the Question?

A few years ago, the Delaware Legislature amended the state constitution to permit the Securities and Exchange Commission to request advisory opinions on Delaware corporate law from the Delaware Supreme Court. The SEC recently took Delaware up on its invitation, certifying a question arising out of an AFSCME effort to use the shareholder proposal power under rule 14a-8 to amend Computer Associates’ bylaws to require that the company reimbursed reasonable expenses incurred by a dissident shareholder who nominates a rival slate of directors for election to the board, provided at least one member of the dissident’s slate is actually elected to the board.

As is well known, of course, the rules on reimbursement of proxy expenses significantly favor the incumbent board of directors over dissidents. In brief, the incumbent board is generally free to make use of corproate funds to defend itself, while the insurgent is only entitled to seek reimbursement after the contest ends and may be reimbursed only if the board and shareholders approve.

Obviously, the AFSCME bylaw is intended to make reimbursement much easier and, thereby, to encourage more frequent proxy contests.

J.W. Verret and Lisa Fairfax have provided excellent reviews of the recent oral arguments before the Delaware Supreme Court. In the next several posts, I want to address several of the legal issues that were raised in those arguments.

First, however, I want to address the basic question of whether the SEC ought to have sought Delaware guidance at all. Jay Brown argues that:

First, as a matter of policy, the Commission should not be in the position of having its interpretation decided by the pro-management Delaware courts.
Second, it is entirely unnecessary. There is an alternative mechanism for testing the legality of this type of proposal. Allow it to be included and if it passes, let the company challenge the proposal in the Delaware courts. There is absolutely no reason to submit it to the courts now.
Third, the staff’s choice for submission to the Delaware Supreme Court for the first time is curious. These proposals, if adopted and implemented, would increase the ability of shareholders to elect directors. Having already squelched shareholder rights in this area through the denial of access, it now looks like a back door effort by the staff to restrict other types of proposals designed to increase the ability of shareholders to elect directors.

In this post, let’s focus on Brown’s first complaint. In short, it was entirely appropriate for the SEC to buck this question over to the Delaware Supreme Court.

The SEC’s proxy regulation regime raises serious questions with respect to delegation and federalism. Inevitably, proxy regulation intrudes to a certain extent on state regulation of shareholder voting rights. Given that corporations are creatures of state law and that state law remains the font of corporate governance rules, however, is essential that the SEC only exercise that authority that has been clearly delegated to it by Congress.

In Business Roundtable v. SEC, the District of Columbia Circuit Court of Appeals undertook the most significant evaluation of the scope of the SEC’s authority in this area to date. In that decision, the Court made clear that federal regulation of proxies was largely limited to disclosure and, to a much lesser extent, process issues. The substance of shareholder voting rights, accordingly, was beyond the scope of the authority delegated to the SEC by Congress and remained, as a matter of federalism, within the state’s purview.

While rule 14a-8 probably would survive a challenge based on the Business Roundtable decision, the SEC still needs to be careful to ensure that the shareholder proposal regime does not become a back door vehicle for effectively federalizing corporate governance. This concern is reflected in in the first of the many exceptions the rule provides pursuant to which companies may exclude the shareholder proposals from the proxy statement. Specifically, rule 14a-(i0(1) states that a proposal may be excluded from the proxy statement if it is not “a proper subject for action by shareholders under the laws of the jurisdiction of the company’s organization.” Likewise, rule 14a-8(i)(2) provides that the proposal may be excluded if it would require the company to violate, inter alia, state law. Finally, and most pertinent to the discussion at hand, the proposal may be excluded under rule 14a-8(i)(8) if it relates to election for membership to the Board of Directors, thereby reflecting the basic principle that who gets elected to the board and how it is a matter of state rather than federal concern. Given that the SEC must defer to state law in these respects, Brown’s complaint seems clearly mistaken. It is perfectly appropriate for the SEC to avail itself of this mechanism for obtaining a determination of a question of state law that is likely to repeatedly arise in the course of the SEC’s administration of rule 14a-8.

The SEC thus has taken the logical and appropriate step of seeking a conclusive resolution of a persistent issue from the decision maker to whom Congress and the Supreme Court have assigned the issue in question.