September 13, 2006
More on the AIG Case
A few weeks ago a federal circuit court in New York City, known for its expertise on corporate law matters, decided a case that is a watershed moment in corporate governance.
The Second Circuit held that American International Group Inc. (AIG) has to submit a new bylaw to its shareholders for a vote at the next annual meeting. The bylaw enables any AIG shareholder holding over three percent of the voting stock of the company to nominate candidates for election to the AIG board of directors. The company must include the nominations on the company’s proxy card.
The bylaw, if passed, will facilitate election contests. In the past the board of directors nominates its own candidates for the board and includes only these nominations on the firm’s proxy card. Shareholders wishing to nominate other candidates must create and mail their own proxy card, which can cost a half million dollars or more. As a consequence, contested elections are very, very rare.
With the AIG bylaw, contested elections would be common. This is a huge change.
This case began when a major shareholder, a public pension fund (The American Federal of State, County and Municipal Employees) requested that AIG include the bylaw in its proxy materials. The shareholder claim authority under a Rule of Securities and Exchange Commission (SEC), Rule 14a-8, on shareholder proposals.
The company asked the SEC for permission to refuse. In February of 2005, the Securities and Exchange Commission sided with AIG. The agency relied on an exception to the Rule for any proposal that “relates to an election.” The District Court agreed, holding that the bylaw deals with nothing but a board election.
The Second Circuit focused on the article “an” in the language of the exception and reversed the District Court. The Second Circuit held that general election procedures were not exempted. Election procedures, the court held, affect many elections not just a single election.
Management control of a firm’s proxy card and, through that control, control over who is nominated to be a director has been a defining feature of American corporate governance for over one hundred years. The AIG bylaw creates an easy opportunity for a single shareholder to create a contested election. Management that has not performed well for its shareholders may find its candidates rejected.
The Second Circuit ruling stunned the management community and their lawyers. They have put immediate and heavy pressure on the SEC to revise its rules to put the older system back in place. It appears that the SEC will respond to the pressure and act to overturn the Second Circuit decision with a rule change. Pity.
We will soon know as a public hearing on the rule revisions is scheduled for October 18th.
An SEC rule change back to the old system will not be the end of the matter, however. The rule change must stand up to a court challenge on rule adoption procedures and the SEC has not done well recently in such challenges. Moreover, Congress may put opposite pressure on the SEC to be more sympathetic to shareholders. If unsatisfied, Congress can overrule any SEC rule change with legislation.
A decade ago this change would have been unthinkable. Suggestions for contested board elections have been around for a long time and have never been taken seriously. But a decade of managerial misbehavior, accounting and stock backdating scandals and compensation excesses, have given calls for more shareholder power over board elections a new strength and vitality.
There is real depth to the public’s discontent with management compensation levels, for example, and the AIG taps directly into that discontent. Managers will come to realize that their over-reaching on salary has generated a sea change in public confidence in their prerogatives.
And it may play out in the AIG bylaw controversy. The Second Circuit decision may be the event that dislodges the massive boulder of management control and begins its roll down the hill.
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