Editor's Note: The following extracts from the DC Circuit's decision evidence its concern that regulatory bodies base their rules on a careful and well-documented justification. With a large number of rules expected to be issued by federal regulatory agencies (including under Dodd-Frank), we will be featuring in our September issue a Special Section devoted to comments of leading law firms on whether the treatment by the DC Circuit of the SEC's proxy access rules foreshadows similar painstaking analysis by the DC Circuit of Dodd-Frank and other rules.
The Business Roundtable and the U.S. Chamber of Commerce, each of which has corporate members that issue publicly traded securities, petitioned the United States Court of Appeals for the DC Circuit for review of Exchange Act Rule 14a-11. The rule requires public companies to provide shareholders with information about, and their ability to vote for, shareholder-nominated candidates for the board of directors. The petitioners argued that the Securities and Exchange Commission promulgated the rule in violation of the Administrative Procedure Act because, among other reasons, the Commission failed adequately to consider the rule's effect upon efficiency, competition and capital formation, as required by Section 3(f) of the Exchange Act and Section 2(c) of the Investment Company Act of 1940, respectively. For these reasons and more, on July 22, 2011 the court granted the petition for review and vacated the rule.
The following are edited extracts from the court's decision with citations removed:
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 the Congress - of the economic consequences of a proposed regulation" makes promulgation of the rule arbitrary and capricious and not in accordance with law.
The petitioners argue the Commission acted arbitrarily and capriciously here because it neglected its statutory responsibility to determine the likely economic consequences of Rule 14a-11 and to connect those consequences to efficiency, competition and capital formation. They also maintain the Commission's decision to apply Rule 14a-11 to investment companies is arbitrary and capricious.
We agree with the petitioners and hold the Commission acted arbitrarily and capriciously for having failed once again adequately to assess the economic effects of a new rule. Here 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. For these and other reasons, its decision to apply the rule to investment companies was also arbitrary.
The petitioners contend the Commission neglected both to quantify the costs companies would incur opposing shareholder nominees and to substantiate the rule's predicted benefits. They also argue the Commission failed to consider the consequences of union and state pension funds using the rule and failed properly to evaluate the frequency with which shareholders would initiate election contests.
In the Adopting Release, the Commission recognized "company boards may be motivated by the issues at stake to expend significant resources to challenge shareholder director nominees." Nonetheless, the Commission believed a company's solicitation and campaign costs "may be limited by two factors": first, "to the extent that the directors' fiduciary duties prevent them from using corporate funds to resist shareholder director nominations for no good-faith corporate purpose," they may decide "simply to include the shareholder director nominees . . . in the company's proxy materials;" and second, the "requisite ownership threshold and holding period" would "limit the number of shareholder director nominations that a board may receive, consider, and possibly contest."
We agree with the petitioners that the Commission's prediction that directors might choose not to oppose shareholder nominees had no basis beyond mere speculation. Although it is possible that a board, consistent with its fiduciary duties, might forgo expending resources to oppose a shareholder nominee - for example, if it believes the cost of opposition would exceed the cost to the company of the board's preferred candidate losing the election, discounted by the probability of that happening - the Commission has presented no evidence that such forbearance is ever seen in practice.
The Commission's second point, that the required minimum amount and duration of share ownership will limit the number of directors nominated under the new rule, is a reason to expect election contests to be infrequent; it 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, 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. Because the agency failed to "make tough choices about which of the competing estimates is most plausible, [or] to hazard a guess as to which is correct," we believe it neglected its statutory obligation to assess the economic consequences of its rule.
The petitioners also maintain, and we agree, 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. The Commission acknowledged the numerous studies submitted by commenters that reached the opposite result. One commenter, for example, submitted an empirical study showing that "when dissident directors win board seats, those firms underperform peers by 19 to 40 percent over the two years following the proxy contests."
The Commission completely discounted those studies "because of questions raised by subsequent studies, limitations acknowledged by the studies' authors, or [its] own concerns about the studies' methodology or scope."
The Commission instead relied exclusively and heavily upon two relatively unpersuasive studies, one concerning the effect of "hybrid boards" (which include some dissident directors) and the other concerning the effect of proxy contests in general upon shareholder value.
Indeed, the Commission "recognize[d] the limitations of one of these studies and noted "its long-term findings on shareholder value creation are difficult to interpret." In view of the admittedly (and at best) "mixed" empirical evidence, we think the Commission has not sufficiently supported its conclusion that increasing the potential for election of directors nominated by shareholders will result in improved board and company performance and shareholder value.
Moreover, as petitioners point out, the Commission discounted the costs of Rule 14a-11 - but not the benefits - as a mere artifact of the state law right of shareholders to elect directors. For example, with reference to the potential costs of Rule 14a-11, such as management distraction and reduction in the time a board spends "on strategic and long-term thinking," the Commission thought it "important to note that these costs are associated with the traditional state law right to nominate and elect directors, and are not costs incurred for including shareholder nominees for director in the company's proxy materials."As we have said before, this type of reasoning, which fails to view a cost at the margin, is illogical and, in an economic analysis, unacceptable.
Shareholders with Special Interests
The petitioners next argued the Commission acted arbitrarily and capriciously by "entirely fail[ing] to consider an important aspect of the problem," to wit, how union and state pension funds might use Rule 14a-11. Commenters expressed concern that these employee benefit funds would impose costs upon companies by using Rule 14a-11 as leverage to gain concessions, such as additional benefits for unionized employees, unrelated to shareholder value.
The Commission insists it did consider this problem, albeit not in haec verba , along the way to its conclusion that "the totality of the evidence and economic theory" both indicate the rule "has the potential of creating the benefit of improved board performance and enhanced shareholder value."
Specifically, the Commission recognized "companies could be negatively affected if shareholders use the new rules to promote their narrow interests at the expense of other shareholders," but reasoned these potential costs "may be limited" because the ownership and holding requirements would "allow the use of the rule by only holders who demonstrated a significant, long-term commitment to the company," and who would therefore be less likely to act in a way that would diminish shareholder value. The Commission also noted costs may be limited because other shareholders may be alerted, through the disclosure requirements, "to the narrow interests of the nominating shareholder." Id.
The petitioners also contend the Commission failed to respond to the costs companies would incur even when a shareholder nominee is not ultimately elected. These costs may be incurred either by a board succumbing to the demands, unrelated to increasing value, of a special interest shareholder threatening to nominate a director, or by opposing and defeating such nominee(s). The Commission did not completely ignore these potential costs, but neither did it adequately address them.
Notwithstanding the ownership and holding requirements, there is good reason to believe institutional investors with special interests will be able to use the rule and, as more than one commenter noted, "public and union 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. By ducking serious evaluation of the costs that could be imposed upon companies from use of the rule by shareholders representing special interests, particularly union and government pension funds, we think the Commission acted arbitrarily. We believe it neglected its statutory obligation to assess the economic consequences of its rule.