A unanimous panel of the DC Circuit Court of Appeals ruled that the SEC was arbitrary and capricious in promulgating the process access rule, Exchange Act Rule 14a-11, and vacated the rule. Among other things, the appeals panel found that the SEC’s discussion of the estimated frequency of nominations under Rule 14a-11 was internally inconsistent and therefore arbitrary. The Commission anticipated frequent use of Rule 14a-11 when estimating benefits, but assumed infrequent use when estimating costs. The appeals court also found that the Commission relied upon insufficient empirical data when it concluded that Rule 14a-11 will improve board performance and increase shareholder value by facilitating the election of dissident shareholder nominees. Business Roundtable and Chamber of Commerce v. SEC, DC Circuit, No. 10-1305, July 22, 2011.
Writing separately on the application of the proxy access rule to investment companies, the appeals panel found that the SEC failed to adequately address whether the regulatory requirements of the Investment Company Act would reduce the need for, and hence the benefit to be had from, proxy access for shareholders of investment companies, and whether the rule would impose greater costs upon investment companies by disrupting the unique structure of their governance.
The proxy process is the principal means by which shareholders of a public company elect the board of directors. Typically, incumbent directors nominate a candidate for each vacancy prior to the election, which is held at the company’s annual meeting. Before the meeting the company puts information about each nominee in the set of proxy materials, usually comprising a proxy voting card and a proxy statement, it distributes to all shareholders. The proxy statement concerns voting procedures and background information about the board’s nominees and the proxy card enables shareholders to vote for or against the nominees without attending the meeting.
A shareholder who wishes to nominate a different candidate may separately file his or her own proxy statement and solicit votes from shareholders, thereby initiating a proxy contest. Rule 14a-11 provides shareholders an alternative path for nominating and electing directors. Concerned that the current process impedes the expression of shareholders’ right under state corporation laws to nominate and elect directors, the Commission adopted the rule with the goal of ensuring the proxy process functions, as nearly as possible, as a replacement for an actual in-person meeting of shareholders. Rule 14a-11 requires a company subject to the Exchange Act proxy rules, including an investment company registered under the Investment Company Act,, to include in its proxy materials the name of a person or persons nominated by a qualifying shareholder or group of shareholders for election to the board of directors.
To use Rule 14a-11, a shareholder must have continuously held at least 3% of the voting power of the company’s securities entitled to be voted for at least three years prior to the date the nominating shareholder submits notice of its intent to use the rule, and must continue to own those securities through the date of the annual meeting. The nominating shareholders must submit the notice, which may include a statement of up to 500 words in support of each of its nominees, to the Commission and to the company. A company that receives notice from an eligible shareholder or group must include the proffered information about the shareholders and their nominees in its proxy statement and include the nominee on the proxy voting card.
The Commission did place certain limitations upon the application of Rule 14a-11. The rule does not apply if applicable state law or a company’s governing documents prohibit shareholders from nominating a candidate for election as a director. Nor may a shareholder use Rule 14a-11 if he or she is holding the company’s securities with the intent of effecting a change of control of the company
The panel noted that the Commission has a unique obligation to consider the effect of a new rule upon efficiency, competition, and capital formation, and its failure to apprise itself, and hence the public and Congress, of the economic consequences of a proposed regulation makes promulgation of the rule arbitrary and capricious and not in accordance with law.
The appeals court held that the Commission acted arbitrarily and capriciously for having failed to adequately assess the economic effects of the new rule. The Commission 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.
The panel reasoned that the Commission’s prediction that company directors might choose not to oppose shareholder nominees because their fiduciary duties would prevent them from using corporate funds to resist shareholder director nominations for no good-faith corporate purpose had no basis beyond mere speculation. While conceding the possibility that a board may, consistent with its fiduciary duties, forgo expending resources to oppose a shareholder nominee, the panel said that the SEC presented no evidence that such forbearance is ever seen in practice.
To the contrary, noted the panel, the American Bar Association Committee on Federal Regulation of Securities commented that if the shareholder nominee is determined by the board not to be as appropriate a candidate as those to be nominated by the board’s independent nominating committee, then the board will be compelled by its fiduciary duty to make an appropriate effort to oppose the nominee, as boards now do in traditional proxy contests.
In addition, the Commission’s point that the required minimum amount and duration of share ownership will limit the number of directors nominated under the new rule as a reason to expect election contests to be infrequent says nothing about the amount a company will spend on solicitation and campaign costs when there is a contested election. Although the Commission acknowledged that companies may expend resources to oppose shareholder nominees, observed the panel, it 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.
The panel also concluded that the Commission acted arbitrarily by ducking serious evaluation of the costs that could be imposed upon companies from use of the proxy access rule by shareholders representing special interests, particularly union and government pension funds. Despite Rule 14a-11’s ownership and holding requirements, the panel said that there is good reason to believe that institutional investors with special interests will be able to use the rule and that pension funds are the institutional investors most likely to make use of proxy access.
Nonetheless, the Commission failed to respond to comments arguing that investors with a special interest, such as unions and state and local governments whose interests in jobs may well be greater than their interest in share value, can be expected to pursue self-interested objectives rather than the goal of maximizing shareholder value, and will likely cause companies to incur costs even when their nominee is unlikely to be elected.
While the Commission was not unreasonable in predicting investors will use Rule 14a-11 less frequently than traditional proxy contests have been used in the past, noted the panel, in weighing the rule’s costs and benefits the Commission arbitrarily ignored the effect of the final rule upon the total number of election contests. That is, the Adopting Release did not address whether and to what extent Rule 14a-11 will take the place of traditional proxy contests. Without this crucial datum, reasoned the court, the Commission has no way of knowing whether the rule will facilitate enough election contests to be of net benefit.
The panel separately discussed the application of the proxy access rule to investment companies. Lest the Commission on remand apply to investment companies a newly justified version of the rule only to be met in court again by valid objections, the panel thought it prudent to take up the more serious of the concerns posed by investment companies but left unaddressed by the Commission.
Investment companies, such as mutual funds, pool investors’ assets to purchase securities and other financial instruments. They are subject to different requirements, providing protections for shareholders not applicable to publicly traded stock companies. One investment adviser typically manages a family of mutual funds, and fund boards in a complex are generally organized in one of two ways: either there is a unitary board, comprising one group of directors who sit as the board of every fund in the complex, or there are cluster boards, comprising two or more groups of directors, with each group overseeing a different set of funds within the complex.
The court found that the Commission failed adequately to address whether the regulatory requirements of the Investment Company Act reduce the need for, and hence the benefit to be had from, proxy access for shareholders of investment companies, and whether the rule would impose greater costs upon investment companies by disrupting the structure of their governance. While the SEC recognized the significant degree of regulatory protection provided by the ICA, said the panel, it did almost nothing to explain why the rule would nonetheless yield the same benefits for shareholders of investment companies as it would for shareholders of operating companies.
The Commission also failed to deal with the concern that Rule 14a-11 will impose greater costs upon investment companies by disrupting the unitary and cluster board structures with the introduction of shareholder-nominated directors who sit on the board of a single fund, thereby requiring multiple, separate board meetings and making governance less efficient.
The Commission did acknowledge that it believed costs would be lower for investment companies because their shareholders are mostly retail investors; would be less likely to meet the three-year holding requirement; and would have fewer opportunities to use the rule because some investment companies may under state law elect not to hold annual meetings. It also determined disruptions to unitary and cluster boards could be mitigated through the use of confidentiality agreements in order to preserve the status of confidential information regarding the fund complex.
But the court found that these observations did not adequately address the probability the rule will be of no net benefit as applied to investment companies. First, the Commission failed to consider that less frequent use of the rule by shareholders of investment companies also reduces the expected benefits of the rule. Second, the Commission’s assertion that confidentiality agreements could meaningfully reduce costs was without any evidentiary support and was unresponsive to the contrary claim of investment companies that confidentiality agreements would be no solution because the shareholder-nominated director would have no fiduciary duty to other funds in the complex and, in any event, could not be legally obliged to enter into a confidentiality agreement.