The U.S. Court of Appeals for the District of Columbia Circuit (the “Court”) issued an opinion vacating Rule 14a-11 under the Securities Exchange Act of 1934 (the “Exchange Act”), which allows a shareholder or a group of shareholders of an issuer subject to the proxy rules, including a registered investment company (a “fund”), to nominate directors if they meet certain conditions in the rule. Rule 14a-11 and related rule amendments (the “Proxy Access Rules”) were adopted by the SEC in August 2010. In response to the petition for review filed by the Business Roundtable and the U.S. Chamber of Commerce with the Court, the SEC stayed the November 15, 2010 effective date of the Proxy Access Rules. (For more detail on the Proxy Access Rules see the September 1, 2010 Goodwin Procter Alert and the September 7, 2010 Financial Services Alert.) The petitioners challenged the Proxy Access Rules, asserting that the SEC’s rulemaking had failed to meet the requirements of the Administrative Procedure Act because the SEC failed to adequately consider their effect upon efficiency, competition and capital formation as required by Section 3(f) of the Exchange Act and Section 2(c) of the Investment Company Act of 1940 (the “1940 Act”). This article describes the Court’s principal findings.
SEC’s Obligation to Consider Economic Impact. The Court observed that the SEC has a unique obligation to consider the economic consequences of proposed rules, and failure to do so as part of a rulemaking renders the rulemaking arbitrary and capricious and therefore, violates the standards of the Administrative Procedure Act. The Court found that the SEC had “inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.”
Costs of Opposing Shareholder Nominees. The Court found that the SEC had not properly assessed the costs that would be incurred by issuers in opposing shareholder nominees. First, the Court held that the SEC’s prediction that directors might choose not to oppose shareholder nominees, which the SEC asserted as a basis for limiting the costs of opposing shareholder nominees, had no basis beyond mere speculation, noting that the SEC had presented no evidence of such forbearance in practice. The Court also found fault with the SEC’s failure to either (i) estimate and quantify the costs it expected companies opposing shareholder nominees to incur or (ii) claim that estimating those costs was not possible.
Impact on Board Performance. The Court found that the SEC relied upon insufficient empirical data when claiming that Rule 14a-11 would improve board performance and increase shareholder value. The Court found that by relying on “two relatively unpersuasive studies” and in view of the “admittedly (and at best) ‘mixed’ empirical evidence,” the SEC had not sufficiently supported its conclusion that increasing the potential for election of directors nominated by shareholders would provide the claimed benefits.
The Court found “illogical and, in an economic analysis, unacceptable,” the fact the SEC discounted the Rule 14a-11s’ potential costs, such as management distraction and reduction in board time spent on other matters such as strategic and long term thinking due to the burdens of addressing shareholder nominee matters, because those costs were associated with the traditional state law right to nominate and elect directors, and were not costs incurred for including shareholder nominees in company proxy materials.
Shareholders Representing Special Interests. The Court held that although it had not completely ignored the potential costs of shareholders who used the rule as a means to promote their narrow interests at the expense of other shareholders, the SEC had, nevertheless, failed to respond to comments arguing that investors with a special interests, such as union and government pension plans whose interests in jobs could well be greater than their interest in share value, could be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value and would likely cause companies to incur costs even when a special interest shareholder’s nominee was unlikely to be elected.
Frequency of Election Contests. The Court found that the SEC arbitrarily ignored the effect of Rule 14a-11 on the total number of election contests when the SEC failed to address whether and to what extent the rule would take the place of traditional proxy contests. The Court observed that without this information the SEC had no way of knowing whether the rule would facilitate enough election contests to result in the anticipated benefit of making “‘election contests a more plausible avenue for shareholder to participate in the governance of their company.’” The Court also found that the SEC’s discussion of the estimated frequency of nominations under the rule was internally inconsistent and therefore arbitrary, because the SEC anticipated frequent use of the rule when estimating benefits, but assumed infrequent use when estimating costs.
Issues Specific to Registered Investment Companies. The Court cited a number of specific concerns regarding the propriety of the SEC’s rulemaking as it applied to funds. The Court noted that while the SEC acknowledged the significant degree of “regulatory protection” for fund shareholders provided by the 1940 Act, it did almost nothing to explain why the rule would nonetheless yield the same benefits for fund shareholders as it would for shareholders of operating companies. The Court also found that the SEC had failed to adequately address the concern that Rule 14a-11 would impose greater costs on funds by introducing into the unitary and cluster board structures commonly used by fund complexes, shareholder-nominated directors who would sit on only a single fund’s board. The SEC determined that disruptions to unitary and cluster boards could be mitigated through the use of confidentiality agreements with shareholder-nominated directors. The Court, however, found that this determination was without evidentiary support and did not respond to claims that shareholder-nominated directors would have no fiduciary duty to other funds in a fund complex and could not be legally obliged to enter into confidentiality agreements. Separately, the Court observed that while the SEC estimated costs of the rule would be lower for funds because of their mostly retail shareholder base, the SEC had failed to consider that less frequent use of the rule by fund shareholders would also reduce the expected benefits of the rule for funds.
Rule 14a-8. In a statement issued after the announcement of the Court’s decision, Meredith Cross, Director of the SEC’s Division of Corporation Finance, noted that changes to Rule 14a-8, the Exchange Act rule that requires a company under certain conditions to include a shareholder proposal in the company’s proxy materials, were unaffected by the Court’s action. Those changes to Rule 14a-8, which focused in part on shareholder proposals that seek to establish a procedure in a company’s governing documents for including one or more shareholder nominees for director in the company’s proxy materials, are discussed in the September 1, 2010 Goodwin Procter Alert and the September 7, 2010 Financial Services Alert.