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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