On September 7, 2011, the Securities and Exchange (SEC) announced that it will not appeal the D.C. Circuit’s July ruling in Business Roundtable and Chamber of Commerce of the United States v. SEC, No. 10-1305, (D.C. Cir. July 22, 2011), where a unanimous panel of the D.C. Circuit vacated Exchange Act Rule 14a-11 requiring companies to give shareholders access to company proxy materials for the nomination of candidates to serve on the company’s board of directors. In a harshly worded opinion, the court found that the SEC violated the Administrative Procedures Act and “acted arbitrarily and capriciously [by] having failed once again. . .adequately to assess the economic effects of a new rule."
The SEC announced that it will not appeal the panel’s decision with respect to Rule 14a-11 and mandatory proxy access. However, the SEC also announced that it will move forward with companion rule changes, amendments to Rule 14a-8, allowing shareholder proposals for procedures related to board nominations. In the SEC’s announcement, Chairman Mary L. Shapiro reaffirmed her commitment “to finding a way to make it easier for shareholders to nominate candidates to corporate boards.”
For years, the SEC considered rulemaking to give shareholders access to company proxy materials but such considerations were met with concern that the SEC lacked authority to impose such a requirement. In July 2010 with the passage of Dodd-Frank, Congress expressly gave the SEC the power to prescribe rules for shareholder proxy access and the SEC proposed rules promptly on August 25, 2010. Exchange Act Rule 14a-11 would have allowed a shareholder or group of shareholders who have owned more than 3 percent of the company’s shares continuously for at least three years to propose their own candidates for boards. The rule also would have required companies to include information about and provide an opportunity for shareholders to vote for the investor proposed candidate on the same proxy statement in which the current board proposed its own candidates.
The SEC also adopted amendments to Rule 14a-8 to allow the “private ordering” of proxy access, in essence, allowing shareholders to propose establishing a procedure in a company’s governing documents for the inclusion of shareholder nominees in a company proxy statement. Both Rule 14a-11 and the amendments to Rule 14a-8 were to have come into effect November 15, 2010, but were stayed pending the outcome of the litigation filed by the Business Roundtable and Chamber of Commerce challenging Rule 14a-11. Although the suit did not attack Rule 14a-8, the SEC stayed its effective date as well, noting that it was a complement to and intertwined with Rule 14a-11.
D.C. Circuit Court Decision
In evaluating and ultimately vacating Rule 14a-11, the court stated that the SEC “failed adequately to consider the rule’s effect upon efficiency, competition and capital formation.” The court found that the SEC did not rely on sufficient empirical data when it suggested the rule would improve board performance and increase shareholder value, noting that the SEC relied on vague and unpersuasive studies while it ignored clear studies to the contrary. Although the SEC recognized when adopting the rule that companies might end up expending significant resources to oppose shareholder nominees, the court did nothing to estimate those costs, ignoring readily available empirical evidence. Further, the court rejected the SEC’s contention that the possible increase in costs was attributable to existing shareholder rights under state law. The court said that “this type of reasoning, which fails to view a cost at the margin, is illogical and, in an economic analysis, unacceptable.” Finally, the court noted the SEC’s attempted slight of hand when it came to estimating how often the rule would be applied. When estimating the benefits of the rule, the SEC assumed wide use, but when estimating the costs, the SEC assumed that the rule would be rarely used. The court did not find this analysis persuasive, holding that the estimates were “internally inconsistent and therefore arbitrary.”
The court also held that the SEC acted arbitrarily by “ducking serious evaluation of the costs that could be imposed upon companies from the use of the rule by shareholders representing special interests, particularly union and government pension funds[.]” The Business Roundtable and Chamber of Commerce had argued that unions and pension funds were the most likely users of the new rule. These groups may be interested in using the rule to get the board to promote interests other than shareholder value. As the SEC ignored comments pointing out the possible problems involved with union and pension fund use of the rule, the court said that the action was arbitrary.
Finally, the court found that the SEC failed to adequately address whether the regulatory requirements of the Investment Company Act would reduce the need for, and thus the benefits from, proxy access for shareholders of investment companies and whether the rule would impose greater costs given the structure of investment company governance. The court summarized the SEC’s reasoning as “tantamount to saying the saving grace of the rule is that it will not entail costs if it is not used, or at least not used successfully to elect a director. That is an unutterably mindless reason for applying the rule to investment companies.”
In short, the SEC lost on all points related to Rule 14a-11 and the Rule was vacated.
Implications of the SEC Announcement
Wednesday’s announcement, while still leaving room for the possibility that the SEC might re-propose a rule following more study and data collection, makes clear that mandatory shareholder access for director nominations is not coming soon. But, the lifting of the stay on the Rule 14a-8 amendments will allow for proxy access proposals in the 2012 proxy season. While these proposals will not allow for the direct nomination of directors, they may be nevertheless difficult, costly and time consuming to address. Strong investor relations and open communication with shareholders could alert company management of concerns related to director nominations and of shareholder discussions of proposals related to proxy access and other corporate governance matters. In addition, public companies may want to review their bylaws and, if appropriate, consider amending them to require advance notice of proposals from shareholders or even the adoption of procedures for shareholder nominations.