by T. GormanPosted on Posted in SECActions

The Commission’s new “proxy access” Rule was vacated by the Circuit Court of the District of Columbia for failing to comply with the Administrative Procedure Act or APA. The Court sustained the challenges to the Rule by the Business Roundtable and the Chamber of Commerce. Business Roundtable v. SEC, No. 10-1305 (D.C. Cir. Decided July 22, 2011). This is the second time in two years that the Circuit Court has sustained a challenge to a Commission rule for failing to comply with the APA. See also American Equity Investment Life Ins. Co. v. SEC, 613 (F. 3d 166 (D.C. Cir. 2010).

Rule 14a-11 was enacted under Section 971 of Dodd-Frank. Essentially the Rule requires that an issuer include in its proxy materials the names of persons nominated by shareholders who have continuously held at least 3% of the voting securities for three years. The Rule is intended to ensure that the “’proxy process functions, as nearly as possible, as a replacement for an actual in-person meeting of shareholders,’” according to the issuing release. Slip. Op. at 3. The Rule applies to all issuers subject to the Exchange Act proxy requirements including investment companies. The SEC, by a 3-2 vote, concluded that the Rule could create potential benefits of “improved board and company performance and shareholder value” sufficient to justify its potential costs.

In reviewing a rule under the APA the Court has the obligation to determine if the agency examined the relevant data and articulated a satisfactory explanation for its action according to the Court. This includes a rational connection between the facts found and the choices made. In this regard the SEC has a unique obligations to consider the effect of the new rule on the “efficiency, competition, and capital formation” the Court stated. Otherwise the rule must be vacated as arbitrary and capricious.

Here the SEC failed to comply with the requirements of the APA. 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. For these and other reasons, its decision to apply the rule to investment companies was also arbitrary” the Court held. Id. At 7.

To support its conclusion the Court detailed the failures of the SEC to conduct the proper analysis. For example, in the adopting release the SEC acknowledged that company boards my be motivated when faced with the rule to expend significant amounts of corporate resources opposing shareholder offered slates of directors. The SEC opined, however, that this would not occur because the directors have a fiduciary obligation to act in the best interest of the shareholders. This conclusion is supported by noting but “mere speculation” the Court found.

The SEC also failed to marshal sufficient empirical data to conclude that Rule 14a-11 would improve board performance and increase shareholder value. Yet there are a significant number of studies which support the opposite result. While the Commission acknowledged this fact, it “completely discounted those studies . . .” while electing to rely on two other studies. The Court found this inadequate.

A third point the SEC failed to properly consider is the potential impact of investors with special interests such as unions, pension funds and others. While this issue was presented by various commentators “the Commission failed to respond to . . .[the fact that] investors with a special interest, such as unions and state and local governments whose interests in jobs may be greater than their interest in share value, can be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value . . “

Finally, in adopting the Rule the SEC “arbitrarily ignored” its impact on the total number of election contests. Absent this data the Court concluded that “the Commission has no way of knowing whether the rule will facilitate enough election contests to be of net benefit.” Accordingly, the Court vacated the Rule. Whether the SEC will attempt to reissue the rule is at this point an open question.

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by T. GormanPosted on Posted in SECActions

The SEC failed to overturn a directed verdict entered in favor of Engineered Support Systems, Inc. outside director Michael F. Shanahan Jr. in an options backdating case. SEC v. Shanahan Jr., No. 10-1820 (8th Cir. Filed July 19, 2011). The Circuit Court agreed with the district court’s conclusions that the Commission failed to establish a violation of the company’s plan or that Mr. Shanahan Jr. engaged in securities fraud.

The SEC’s complaint alleged that from 1997 through 2002 Michael F. Shanahan, the former CEO of the company, and his son, Michael Shanahan Jr., a member of the board and its compensation committee, participated in a scheme to backdate about $20 million in options for senior executives and employees. Approximately $16 million of those grants were issued to senior executives. In at least two instances, the father approved the issuance of backdated grants which had been previously backdated to obtain a more favorable pricing. In other instances, the father approved additional grants for non-employees. Mr. Shanahan Jr., as a member of ESSI’s compensation committee, was also involved in the approval process. Overall, the father obtained about $8.9 million from backdated grants while the son made approximately $379,000. Both defendants were alleged to have caused the annual reports as well as other filings of the company to be falsified as a result of the scheme. SEC v. Shanahan, Case No. 4:07-cv-1262 (E.D. Mo. Filed July 12, 2007).

Following eight days of trial on the SEC’s claims Michael F. Shanahan, Jr. moved for dismissal of all claims prior to their submission to the jury. The SEC argued in large part that the son was responsible for a series of false statements and omissions in the filings. In a February 12, 2010 ruling, the court granted the defendant’s request. In each instance the court concluded that the SEC had failed to meet its burden of proof.

The Circuit Court affirmed the dismissal of the SEC’s claims. Those centered on claims that the company engaged in the unlawful and undisclosed backdating of its options in violation of its disclosed plan which provided in part: “Options granted are at an option price equal to the market value of the date the option is granted . . . The Company applies Accounting principles Board opinion No. 25 . . . Accordingly, no compensation expense has been recognized for stock option awards.” The Commission did not claim that ESSI failed to follow APB 25 which governs the accounting for options.

Here the SEC clearly established that ESSI backdated its options the Court concluded. The Commission failed however to establish its claim that backdating the options clearly violated the disclosed ESSI plan. The evidence demonstrated that the price at which the options were issued corresponded to the stock price on the certificate date. That is all the plan actually requires if literally read. There is nothing in the plan which specifically prohibited backdating the options.

Furthermore, even if Mr. Shanahan Jr. perceived an apparent contradiction between the option dating and pricing practices of the company and its disclosed plan from his work on the compensation committee, the SEC did not establish that he recklessly failed to see an obvious danger that investors would be misled. It is undisputed that no one at the company, including its outside auditors who monitored compliance with APB No. 25 “perceived that the undisclosed grant of ‘in-the money’ stock options – which had no impact on ESSI’s financial performance – would be a material misstatement or omission . . .” Indeed, the Commission presented virtually no evidence on the question of materiality.

Likewise, the Commission failed to present any evidence to support its negligence based claims under Securities Act Sections 17(a)(2) & (2). In this regard the district court concluded that the SEC failed to present any evidence “with respect to the degree of care than an ordinary careful person would use under the same or similar circumstances, whether Mr. Shanahan, Jr. exercised reasonable care in obtaining and communicating information, or whether he undertook an appropriate investigation before allegedly making statements to investors or prospective investors.” The SEC’s contention on appeal that its claim was “clearly” supported by the plain language of the plan is simply incorrect.

Finally, the SEC’s claimed violations of Section 14(a) for proxy fraud and Section 20(e) for aiding and abetting must also fail. Under the facts here the SEC has simply failed to establish the intent required to establish a violation of either Section the Court concluded.

Michael F. Shanahan, Sr. settled with the Commission before trial, consenting to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions. He also agreed to pay a civil penalty of $750,000 and to the entry of an officer and director bar. Previously in July 2008, Mr. Shanahan Sr. pleaded guilty to falsifying company records in violation of Exchange Act Sections 13(b)(2) & (5). He was sentenced to three years probation and ordered to pay restitution of about $7.8 million and a $40,000 criminal fine. See Litig. Rel. 21362 [1] (Jan. 6, 2010).

Webcast: Securities Cases in the Supreme Court: A Review of the 2010-2011 Term and a Look at the Next, by Thomas Gorman, presented by Celesq-West Legal Education, available at http://bit.ly/jpoijv

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