On July 22, 2011, the United States Court of Appeals for the District of Columbia Circuit vacated an SEC rule that would have enabled shareholders of public companies to propose their own director nominees for inclusion in their company's proxy materials. A divided SEC adopted the rule (commonly known as the "proxy access" rule) in August 2010, but stayed the effectiveness of the rule and a related amendment to the SEC's shareholder proposal rule pending the outcome of the D.C. Circuit's review. The court's decision, which is available at 2011 WL 2936808 (D.C. Cir. July 22, 2011), represents a significant setback for the SEC and casts substantial uncertainty over the future of proxy access.
As discussed in our SEC Update of August 31 2010, the SEC adopted the proxy access rule (officially known as proxy Rule 14a-11) and a related amendment to Rule 14a-8 involving shareholder proposals on August 25, 2010, following express authorization provided the previous month by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The adoption of Rule 14a-11 was the culmination of a series of SEC proposals designed to provide shareholders of public companies with enhanced access to director nominations. But soon after the rule's adoption, the Business Roundtable and the U.S. Chamber of Commerce filed a petition for review of the rule by the D.C. Circuit, alleging, among other things, that the SEC violated the Administrative Procedure Act (APA) in adopting it. The D.C. Circuit responded to the petition by issuing its decision invalidating the rule.
In its opinion, the D.C. Circuit harshly criticized the SEC, stating that the agency acted "arbitrarily and capriciously for having failed once again" to properly consider the economic consequences of a new rule. In doing so, the court held that the SEC fell short of meeting its rulemaking responsibilities under the APA. The court took care to point out that its decision is one of a number in recent years in which it determined that the SEC had failed to meet its obligations under the APA.
The court's decision focused on three of the petitioners' various claims that the SEC failed to consider adequately the economic consequences of the new rule. These were:
- The SEC did not quantify the costs that would be incurred by companies in opposing shareholder nominees, nor did it substantiate the benefits it predicted the new rule would provide;
- The SEC did not properly evaluate, when it examined the potential costs of the new rule, the use of the new rule by special interest shareholders, most notably union and state pension funds; and
- The SEC's evaluation of the predicted frequency with which shareholders would use the new rule to nominate shareholders was internally inconsistent.
The court agreed with each of the foregoing claims. It also agreed with the petitioners that the SEC's proposed application of Rule 14a-11 to investment companies registered under the Investment Company Act of 1940 (ICA) was "assuredly invalid." The court noted as some of the "more serious" concerns not addressed by the SEC the fact that existing regulatory requirements of the ICA may obviate the need for, and the benefits to be derived from, proxy access at investment companies. The court also found the SEC did not adequately consider the concern that proxy access could impose greater costs on investment companies by disrupting their unique governance structures.
Because it determined that the SEC had violated the APA in adopting Rule 14a-11, the court found it unnecessary to address the petitioners' challenge to the rule based on the First Amendment or various other claims of deficiencies in the SEC's rulemaking process.
No effect on Rule 14a-8 amendment
The petitioners did not challenge the SEC's amendment to Rule 14a-8(i)(8), which has yet to become effective. In its current pre-amendment form, Rule 14a-8(i)(8) permits the exclusion of a shareholder proposal that would result in an immediate election contest or that would set up a process for shareholders to conduct an election contest in the future by requiring the company to include shareholders' director nominees in the company's proxy materials for subsequent meetings. The amendment would enable shareholders, under certain circumstances, to require companies to include in their proxy materials proposals that would amend, or request an amendment to, a company's governing documents regarding nomination procedures or disclosures related to shareholder nominations, provided the proposal does not conflict with Rule 14a-11. In a statement released after the court's decision, Meredith Cross, the Director of the SEC's Division of Corporation Finance, noted that the decision did not affect the Rule 14a-8 amendment. Thus, the SEC must now determine whether to permit the amendment to Rule 14a-8 to become effective (presumably after deleting the obsolete reference to Rule 14a-11) or, in light of the court's decision, to continue the stay of effectiveness, revise the amendment and re-propose it for public comment.
If the SEC decides to make the Rule 14a-8 amendment effective, it seems likely that activist shareholders will submit a significant number of shareholder proposals seeking to amend the governing documents of companies to provide enhanced access by shareholders to director nominations. Notably, the Rule 14a-8 amendment would have permitted the exclusion of shareholder proposals that conflicted with Rule 14a-11. Among other things, Rule 14a-11 imposed a condition that a shareholder proposing a nominee must have held at least 3 per cent of the total voting power of a company's securities eligible to be voted on the election of directors for at least three years. As a result of the invalidation of Rule 14a-11, this basis for excluding shareholder proposals no longer would exist. Accordingly without substantive change by the SEC to the amendment, many shareholder proposals seeking proxy access that might otherwise have been excluded may be required to be included in company proxy statements.
The SEC has a number of options that it can consider when deciding how to react to the decision. From a litigation standpoint, the SEC can request that the entire D.C. Circuit review the plaintiffs' petition en banc, or it can appeal the decision to the Supreme Court. Alternatively, from a rulemaking standpoint, the SEC could attempt to cure the APA deficiencies cited by the court by conducting additional analysis and then re-proposing a revised proxy access rule reflecting that analysis. In view, however, of the strong language in the court's decision, it is unclear whether the SEC will be in a position to meet this challenge satisfactorily, especially considering that the rule might still be subject to challenge under the First Amendment arguments and other claims by the petitioners that the court did not address. The SEC could also consider proposing a revised Rule 14a-11 that contains the private ordering and opt-out provisions that many of the opponents of the rule had suggested. And, as previously mentioned, the SEC could also permit the Rule 14a-8 amendment to take effect, and review the degree to which proxy access proponents are able to achieve their goals through the shareholder proposal framework. This latter course could result in some companies seeking to adopt bylaw changes that would make shareholder proxy access resolutions more difficult to propose and implement.
Regardless of the path the SEC takes with respect to proxy access, it is likely that future rulemaking by the agency will be heavily influenced by the court's decision, which is likely to serve as a prod to a more complete examination by the SEC of the economic consequences of its rulemaking.