D.C. Circuit Faults SEC on Cost-Benefit Analysis of Proxy Access, Vacates Rule 14a-11
Erica Smith | Bloomberg Law
In an opinion by Judge Douglas H. Ginsburg, writing for a three-judge panel, the U.S. Court of Appeals for the District of Columbia Circuit vacated Exchange Act Rule 14a-11, which would have required companies subject to the Exchange Act proxy rules to include in their proxy materials the names of individuals nominated by a qualifying shareholder for election to the board of directors, upon the satisfaction of certain conditions.
Adequacy of SEC Evaluation Is Challenged
The Business Roundtable and U.S. Chamber of Commerce petitioned for review of Rule 14a-11, arguing that the U.S. Securities and Exchange Commission promulgated it in violation of the Administrative Procedure Act,1 without sufficiently considering the rule’s effect on efficiency, competition, and capital formation.2 For an overview of the SEC’s arguments in favor of the rule, see this Bloomberg Law Reports® article. The rule was scheduled to go into effect last November, but the SEC stayed implementation of the rule so that the issues raised in the petition could be resolved.
After noting that agency action may be set aside if it is arbitrary and capricious,3 the court of appeals agreed with the petitioners’ argument that the SEC acted arbitrarily and capriciously by failing to sufficiently evaluate the economic consequences of the rule, and by failing to connect those consequences to efficiency, competition, and capital formation. Specifically, the court found that the SEC “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.” Business Roundtable at 7.
Costs and Benefits
The petitioners asserted that the SEC failed to “quantify the costs companies would incur opposing shareholder nominees and to substantiate the rule’s predicted benefits.” Id. at 8. The SEC contended that costs to oppose nominees would be limited because (1) directors’ fiduciary obligations might lead them to include the nominees in the proxy materials, where no good-faith corporate purpose existed to support the expenditure of company money in opposition to the candidates; and (2) only shareholders who, generally speaking, had owned a significant amount of the company’s shares for a significant amount of time were permitted under the rule to nominate director candidates, so the company would have a limited number of nominations to deal with. The court described as “speculation” the SEC’s argument that directors might decide not to oppose shareholder nominees and noted that no evidence was provided to show that such forbearance commonly occurs. Id. at 9. Further, the court noted that the SEC’s suggestion that election contests would be infrequent did not address how much they would cost when they occurred or resolve “competing estimates” about how high such costs were likely to be. Id. at 10. Lastly, the SEC inappropriately discounted the rule’s potential costs (e.g., management distraction) as a byproduct of shareholders’ general, state-law right to elect directors, rather than considering the marginal cost to include shareholder nominees in the company’s proxy materials.
Regarding the rule’s benefits, the court found that the SEC “relied upon insufficient empirical data when it concluded that Rule 14a-11 will improve board performance and increase shareholder value by facilitating the election of dissident shareholder nominees.” Id. at 11. Specifically, the SEC’s findings were based on “two relatively unpersuasive studies” and discounted other, conflicting studies. Id.
The petitioners also argued that the SEC did not consider the consequences of union and state pension funds using the rule as leverage to obtain concessions for their members. The SEC suggested that (1) the rule’s share ownership and holding requirements would limit its use by groups that were not committed to the long-term interest of the company, and (2) the disclosure requirements would inform other shareholders of a nominating shareholder’s special interest. The court found that the SEC did not undertake “serious evaluation” of the use of the rule, and resulting costs to the company, by shareholders with special interests. Id. at 15.
Regarding the petitioners’ argument that the SEC did not properly evaluate how often shareholders would initiate election contests, the court found that the SEC’s adopting release did not address whether and how much the rule would supplant traditional proxy contests. Thus, the SEC lacked the information necessary to determine “whether the rule will facilitate enough election contests to be of net benefit.” Id. at 16. Further, the SEC’s discussion of the likely frequency of nominations under the rule was “internally inconsistent.” Id. at 17. For example, the SEC assumed frequent use of the rule when touting its benefits (e.g., that shareholders at hundreds of companies might save the cost of printing or mailing their own proxy materials) but assumed infrequent use when evaluating its costs (e.g., that solicitation and campaign costs would be low based on limited use).
After finding the rule “arbitrary and capricious on its face,” the court addressed certain concerns voiced by investment companies. Id. at 17-21. Among other things, the court noted that the SEC failed to sufficiently explore whether the regulatory requirements of the Investment Company Act lessened the need for (and benefits of) proxy access for shareholders of investment companies, and whether the rule would cost such companies more by disrupting their governance structures.
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