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(The article featured below is a selection from Federal Securities Law Reporter, which is available to subscribers of that publication.)

DC Circuit Vacates SEC’s Proxy Access Rule

The U.S. Court of Appeals for the District of Columbia vacated the SEC’s proxy access rule, Exchange Act Rule 14a-11, holding that the SEC was arbitrary and capricious in promulgating the rule. The court said the SEC failed once again to adequately assess the economic effects of a new rule.

Rule 14a-11 would permit a shareholder or group of shareholders to submit a nomination to the board of directors if they have continuously held at least three percent of the voting power of a company’s securities for at least three years. The company would have to include the nominee in its proxy statement and on the proxy voting card. The SEC adopted Rule 14a-11 in a three to two vote. The majority believed the rule would lead to improved performance by boards, which would justify its costs. The commissioners who voted against the rule argued that the SEC had failed to act on the basis of empirical data and sound analysis.

The court said the SEC has a unique obligation to consider the effect of a new rule upon efficiency, competition and capital formation. The failure to do so makes the promulgation of the rule arbitrary and capricious, and not in accordance with the law, according to the court.

The petitioners argued that the SEC had 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. Petitioners also challenged the SEC’s decision to apply the rule to investment companies

The court said the SEC inconsistently and opportunistically framed the costs and benefits of the rule. It failed to adequately quantify the costs or to explain why the costs could not be quantified. The SEC also failed to support its predictive judgments and contradicted itself, according to the court.

The SEC predicted that companies may include shareholders’ director nominees rather than use corporate funds to resist them without a good faith corporate purpose, and that the ownership threshold and ownership period would limit the number of nominations that a board would receive. The court agreed with petitioners that the SEC’s prediction had no basis beyond mere speculation. The SEC did nothing to estimate and quantify the costs that companies might incur to oppose a nomination, the court said, even though empirical evidence from traditional proxy contests was readily available.

The court said the SEC also relied upon insufficient empirical data when it concluded that Rule 14a-11 would improve board performance and increase shareholder value by facilitating the election of dissident shareholder nominees. Numerous studies were submitted by commenters that reached the opposite result, but he SEC relied on two studies which the court found to be unpersuasive.

The court said the SEC discounted the costs, but not the benefits of the rule. The SEC also failed to seriously evaluate the costs that could be imposed by special interest groups’ use of the rule, such as unions and government pension funds. The court noted that the SEC revised its cost estimate in the adopting release from that used in the proposing release. The adopting release did not address whether and to what extent Rule 14a-11 would take the place of traditional proxy contests.

The SEC’s discussion of the estimated frequency of nominations under Rule 14a-11 was internally inconsistent, in the court’s view. The court said the SEC anticipated the frequent use of the rule when estimating benefits, but assumed an infrequent use when estimating costs.

The court concluded that, because the rule is arbitrary and capricious on its face, it is also invalid as applied to investment companies. The court outlined its concerns about the application of the rule to investment companies, which it said had not been addressed by the SEC.

The court said the SEC failed to adequately address whether the regulatory requirements of the Investment Company Act reduce the need for, and the benefit to be derived from proxy access, and whether the rule would impose greater costs upon investment companies by disrupting the structure of their governance. The SEC did not adequately address the probability that the rule would be of no net benefit as applied to investment companies, according to the court.

In holding that the SEC was arbitrary and capricious in promulgating Rule 14a-11, the court found no need to address the petitioners’ First Amendment challenge to the rule.

Meredith Cross, the director of the Division of Corporation Finance, said the SEC was disappointed by the court’s decision to strike down a rule that would make it easier for shareholders to nominate a candidate to a company’s board of directors. She added that a rule to allow shareholders to submit proposals for proxy access, which was adopted at the same time, is unaffected by the ruling. The SEC is considering its options in light of the court’s decision, according to Ms. Cross.

Business Roundtable v. SEC (DC Cir) is reported at ¶96,358.