In a much anticipated ruling, on July 22, 2011, the D.C. Court of Appeals held that the SEC was arbitrary and capricious in adopting Rule 14a-11, the proxy access rule, for failing to adequately assess the economic effects of the rule, and vacated it. Rule 14a-11 provides shareholders who held 3% of the company’s voting shares for three years with the right to include their nominees, up to 25% of the board, in the company’s proxy materials. The SEC had stayed the effectiveness of the rule, which was set to have been effective on November 15, 2010, pending review by the court after the Business Roundtable and the Chamber of Commerce petitioned the court to review the rule.

The court held that the SEC failed to adequately consider the economic consequences of Rule 14a-11 for the following reasons:

Consideration of Costs and Benefits. The court found that the SEC’s prediction that directors would choose not to oppose shareholder nominees “had no basis beyond mere speculation” and that the SEC did not estimate and quantify the costs it expected companies to incur in opposing such nominees. The court also found that the SEC relied on insufficient empirical data when it concluded that Rule 14a-11 would improve board performance and increase shareholder value by facilitating the election of dissident shareholders. In addition, the court found that the SEC inappropriately discounted the costs of Rule 14a-11, such as management distraction and reduction of time spent on strategic and long-term thinking, but not the benefits, as associated with traditional state law rights in nominating directors, and not costs resulting from including nominees in proxy materials under Rule 14a-11.

Shareholders with Special Interests. The court found that the SEC acted arbitrarily by not seriously evaluating the costs that could be imposed on companies from use of the rule by shareholders representing special interests, particularly union and government pension funds.

Frequency of Election Contests. The court held that in weighing the rule’s costs and benefits, the SEC arbitrarily ignored the effect of the final rule upon the total number of election contests and did not address whether and to what extent Rule 14a-11 will take the place of traditional proxy contests. Without this data, the court stated that the SEC would have no way of knowing whether the rule will facilitate enough election contests to be of net benefit. Finally, the court noted that the SEC was internally inconsistent. When estimating benefits, such as cost savings for shareholders from not having to print or mail proxy materials, the SEC anticipated frequent use of Rule 14a-11, but when estimating costs, the SEC anticipated infrequent use.

The court also noted that with respect to investment companies, in adopting the rule, the SEC failed to address whether regulatory requirements applicable to investment companies reduce the need for, and benefit of, proxy accesses for shareholders of investment companies, and whether the rule would impose greater costs on investment companies by disrupting the structure of their governance.