In a rebuke to the Securities and Exchange Commission and its rule making process, a federal court of appeals vacated a rule enacted as part of the agency’s attempt to implement the controversial Dodd-Frank legislation. The case, Business Roundtable v. SEC, No. 10-1305 (D.C. Cir.), was brought by The Business Roundtable and the Chamber of Commerce of the United States to challenge Exchange Act Rule 14a-11—a rule designed to make it easier for shareholders to oust incumbent board members. The Court of Appeals found that the SEC promulgated the rule in violation of the Administrative Procedure Act (“APA”), 5 U.S.C. § 551 et seq., because, among other reasons, the SEC failed to “consider the rule’s effect upon efficiency, competition, and capital formation.”

Assessing Potential Costs

The SEC adopted Rule 14a-11, in large measure, as a response to complaints made by corporate governance advocates that companies effectively denied shareholders access to public company proxies to challenge directors nominated by the company. These advocates claimed that investors were effectively barred from nominating their own slate of directors because of the extraordinary expense of initiating a “proxy contest.” Under the Rule, investors or groups of shareholders that have held at least 3% of a company’s voting securities for at least three years can have their nominees included as part of the company’s proxy materials. This would, in the SEC’s view, promote greater shareholder oversight, prevent excessive executive compensation, and dislodge entrenched and unresponsive boards.

The Court, however, found the SEC acted arbitrarily and capriciously because it failed in its duty to “apprise itself—and hence the public and the Congress—of the economic consequences” of the regulation. For instance, while the SEC noted that the Rule would impose substantial costs on companies and shareholders—by imposing costs of preparing, printing, and mailing proxy materials, distracting corporate management, and causing the Board to drain corporate resources opposing candidates it deemed less qualified than its own nominees—it drew the conclusion that these costs would be offset by “improved board performance” and “the efficiency of the economy on the whole.” The Court concluded that there was no empirical evidence supporting the SEC’s conclusion: “it (the SEC) did nothing to estimate and quantify the costs it expected companies to incur; nor did it claim estimating those costs was not possible, for empirical evidence about expenditures in traditional proxy contests was readily available.”

In addition, the Court expressed concern over the SEC’s failure to respond to arguments that interest groups, such as employee unions and state and local governments, would make use of the Rule to pursue self-interested objectives. These comments noted that unions and government groups, whose primary interests might lie in their jobs and their level of pay and benefits rather than their share value, could pursue self-interested objectives rather than the primary corporate goal of maximizing shareholder value.

The SEC’s Economic Analysis

The Court also identified what it believed to be a fundamental flaw in the SEC’s analysis: a failure to view the costs imposed by the Rule at the margins. This failure, according to the Court, resulted in “unacceptable” economic analysis.

According to the Court, instead of considering the potential costs of the Rule, such as greater management distraction and reduction in the time a board spends on “strategic and long-term thinking,” the SEC thought it “important to note that these costs are associated with the traditional State law right to nominate and elect directors, and are not the costs incurred for including shareholder nominees for director in the company’s proxy materials.” In other words, the SEC did not take into account that the Rule would have the unintended consequence of causing companies to incur greater costs than those produced under state law. By creating a more competitive nomination and election process designed to make incumbent directors more responsive to shareholders, the rule could cause incumbent directors to spend more time and effort improving shareholder relationships (especially with those likely to pose challenges) and less time on strategic and long-term planning and oversight, which, in turn, might negatively affect overall shareholder value.

Are Other Dodd-Frank Rules Legally Vulnerable?

In rejecting the SEC’s rulemaking analysis, the ruling calls into question the validity of many of the Dodd-Frank rules because in many cases the SEC justified their adoption on increased efficiency rationales. This is especially so given that the Courts of Appeal have rejected rules promulgated by the SEC at least five times since 2005 on grounds that the agency failed to adequately assess the economic effects of a new rule. In light of the Business Roundtable ruling and its criticism of the SEC rulemaking process, there will surely be more litigation testing the validity of the Dodd-Frank rules in the near future.