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Federal Court Strikes Down the SEC's Proxy Access Rule

Choate Alert

 | July 28, 2011

 | Public Company Group

 

What you need to know

A federal appellate court has ruled that the SEC’s proxy access rule was adopted in violation of federal administrative procedure law and is therefore invalid, meaning that it is extremely unlikely that the rule will apply to the 2012 proxy season.  

What you need to do

Even though the future of the SEC’s proxy access rule is very much in jeopardy, it is still possible that public company shareholders may be permitted under existing rules to propose on a company-by-company basis that procedures be established for including shareholder nominees in company proxy materials, so companies should continue to anticipate such proposals and strengthen their relationships with shareholders to understand and respond to key investor concerns.

 

On July 22, the US Court of Appeals for the District of Columbia Circuit concluded that the SEC’s proxy access rule, which was adopted as new Rule 14a-11 by the SEC in 2010, is arbitrary and capricious and therefore invalid under federal law.  In a strongly-worded opinion issued by the Court in a lawsuit brought against the SEC by the Business Roundtable and the US Chamber of Commerce challenging the proxy access rule, which would have required that public company director candidates nominated by certain shareholders be included in a company’s proxy materials, the Court sided with the plaintiffs and determined that the SEC had overstepped its authority in adopting this rule.  As a result, Rule 14a-11 has been vacated and the SEC will face an uphill climb if it decides to try to press forward with this rulemaking initiative.

Background

As further detailed in our previous alerts available here, the SEC adopted its proxy access rule in the wake of last year’s Dodd-Frank Wall Street Reform and Consumer Protection Act in an effort to enable qualifying public company shareholders to nominate directors for election at shareholder meetings directly utilizing the company’s proxy statement.  Where no such access right exists, as is the case in a traditional proxy contest, a shareholder wishing to nominate a candidate for the board of directors has to separately, and at the shareholder’s own cost, solicit votes in favor of the nominee.  Rule 14a-11 would have allowed holders of at least 3% of a company’s voting securities during the last continuous three years to nominate candidates in the company’s proxy statement, subject to notice and disclosure requirements. 

At the same time it adopted this rule, the SEC also amended the existing shareholder proposal rule, Rule 14a-8, so that companies would no longer be able to exclude a shareholder proposal seeking to establish a procedure in a company’s governing documents for the inclusion of shareholder nominees for director in the company’s proxy materials.  The effectiveness of Rule 14a-11 and the amendments to Rule 14a-8 had been subject to a stay by the SEC pending a decision in this case.

The Ruling

In its opinion, the DC Circuit Court held that the SEC had failed “once again”—referring to two other recent cases in which the SEC was found to have acted in an arbitrary and capricious manner while adopting its rules—adequately to consider the economic consequences of the proxy access rule and their effect on efficiency, competition and capital formation, as required by federal law.  The Court therefore vacated the application of this rule both to publicly traded companies and to mutual funds and other investment companies.  Specifically, the Court noted that during the SEC’s rulemaking process, the agency:

  • made no attempt to estimate the costs that companies would incur to oppose shareholder nominees under Rule 14a-11;
  • failed to support its conclusion that proxy access would improve board performance and increase shareholder value (the Court stated that the SEC relied only on two “relatively unpersuasive” studies in this regard, while improperly discounting studies that showed that the rule would actually achieve the opposite results);
  • did not address the consequences of shareholders that represent special interests, particularly unions and government pension funds, using the proxy access rule to pursue their own self-interested objectives rather than to maximize shareholder value;
    failed properly to evaluate the frequency with which shareholders would initiate election contests using this rule; and
  • applied Rule 14a-11 to investment companies despite the fact that such companies are already subject to enhanced regulation under the Investment Company Act of 1940 that would reduce the benefits of proxy access.

Implications

It is unclear at this point how the SEC will respond to the Court’s decision in this case.  Its options are to:

  • seek an en banc review in the DC Circuit Court or appeal the decision to the US Supreme Court in hopes of keeping Rule 14a-11 intact,
  • re-formulate another proxy access rule in a manner that satisfies the concerns expressed by the DC Circuit Court or
  • abandon this rulemaking effort altogether. 

In any event, it is extremely unlikely that Rule 14a-11 or any similar proxy access rule will apply to the 2012 proxy season.  It should be noted, however, that the amendments to Rule 14a-8 described above were not subject to the lawsuit brought by the Business Roundtable and the Chamber of Commerce.  Therefore, the SEC could maintain the existing stay on that rule while it considers its response to this decision or, alternatively, it could lift that stay and permit shareholder proposals under Rule 14a-8 for providing proxy access on a company-by-company basis.  In fact, in its initial statement expressing its disappointment with the DC Circuit Court’s ruling, the SEC made clear that its “rule allowing shareholders to submit proposals for proxy access at their companies … is unaffected by the court’s decision.”

 

 

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