Recently, the U.S. Court of Appeals for the District of Columbia Circuit vacated Rule 14a-11 under the Securities Exchange Act of 1934, known as the Proxy Access Rule, promulgated by the Securities and Exchange Commission (SEC) (Business Roundtable and Chamber of Commerce v. SEC, No. 10-1305, July 22, 2011).

The rule would have allowed certain shareholders to nominate directors in a company’s proxy materials, thus lending them power to oust existing board members. In vacating the rule, the court concluded, among other things, that:

  • the SEC had not adequately considered the economic consequences of the rule;
  • the rule as applied to investment companies was invalid because the SEC failed to address existing regulatory requirements and whether the costs would outweigh benefits as a result of the effects of the rule;
  • the SEC relied on insufficient data in concluding that the rule would “improve board performance and increase shareholder value”; and
  • the SEC failed to consider how union and state pension funds might use the rule to gain concessions.

The Case

In its ruling, the court agreed with petitioners that the SEC had violated the Administrative Procedure Act in promulgating the rule by failing to consider the rule’s effect on “efficiency, competition and capital formation.” It held that the SEC was “arbitrary and capricious” in promulgating the rule because it did not adequately consider the economic implications of the new rule. The court stated in its opinion:  

[T]he [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 example, the court noted that the SEC had not estimated or quantified the costs companies would incur upon application of the Proxy Access Rule, even when shareholder nominees were not ultimately elected. Specifically, petitioners had focused on the millions of dollars that companies would spend in proxy battles that might ensue as a result of the new rule. The SEC had justified these costs in noting that not every board would oppose shareholder candidates. The court held that the SEC argument “had no basis beyond mere speculation.” The court pointed out that “the [SEC] anticipated frequent use of [the Proxy Access Rule] when estimating benefits, but assumed infrequent use when estimating costs.”

The court addressed application of the Proxy Access Rule to investment companies and determined that it would be especially invalid as applied to those companies. It noted that the SEC had not shown that the rule would create the same benefits for investment company shareholders as it would for shareholders of other companies. The court pointed out that the SEC had given no legitimate justification for the disruption such a rule might cause to the unitary boards of directors that are often used by fund complexes containing multiple funds. In an Investment Company Institute release following the decision, President and CEO Paul Schott Stevens was quoted saying, “The court correctly recognized that the SEC failed to address how funds’ current regulatory structure reduces the need for proxy access and to assess the rule’s disruptive effect on the efficient functioning of funds’ boards. Given the unique protections that the Investment Company Act of 1940 provides for fund shareholders, the court was not convinced that the SEC had considered whether the benefits of proxy access would exceed the costs.”

The Rule

SEC efforts to adopt a proxy access rule have been ongoing for years and were most recently encouraged through section 971 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which authorized the SEC to establish rules allowing shareholders to include director nominees in a company’s proxy materials. The SEC issued the Proxy Access Rule on Aug. 25, 2010, and stated that it would become effective Nov. 15 that same year. Prior to the Proxy Access Rule’s effectiveness, the Business Roundtable and the U.S. Chamber of Commerce filed the petition for judicial review of the Proxy Access Rule and related amendments. Concurrently, the SEC granted the petitioners’ request to stay the effective date of the rules pending the judicial resolution.

Had the Proxy Access Rule become effective, qualifying shareholders or groups holding at least three percent of the voting power of a company’s securities would have had the ability to request that their director nominees be included in the proxy materials if they met certain requirements, such as having held shares of a company for at least three years. Shareholder director nominees would be limited to the greater of one director or 25 percent of the board at any time. An amendment to Rule 14a-8 would have required that companies not be able to exclude shareholder proposals in the proxy materials for less restrictive proxy access procedures.

Going Forward

The SEC may now choose whether to appeal the court’s decision vacating the rule or to revisit its economic analysis of the Proxy Access Rule. The SEC issued a statement from the Director of the Division of Corporation Finance, stating that it was considering its options moving forward. The statement noted that the amendments to Rule 14a-8 adopted at the same time as the Proxy Access Rule were unaffected by the decision. Therefore, if the SEC decides to lift its stay on the effectiveness of those amendments, companies would be able to adopt proxy access rules through shareholder proposals.

In the wave of SEC rulemaking following Dodd-Frank, the court’s decision indicates that there will be strict standards the SEC must meet in order that its rules will not be vacated.

A previous Investment Management article explaining vacated Rule 14a-11 is available at: http://www.drinkerbiddle.com/imgdevelopment112010/.

A copy of the court’s decision is available at: http://www.cadc.uscourts.gov/internet/opinions.nsf/89BE4D084BA5EBDA852578D5004 FBBBE/$file/10-1305-1320103.pdf