SEC Rule 14a-11

On Sept. 6, 2011, the Securities and Exchange Commission (SEC) gave up the ghost on Rule 14a-11, the Commission rule that required companies to include shareholders' director nominees in company proxy materials in certain circumstances. The Commission eschewed rehearing or a petition for certiorari after the Federal Circuit negated the Rule in Business Roundtable and Chamber of Commerce v. Securities and Exchange Commission, ___ F.3d ___, No. 10-1305 (D.C. Cir. 7/22/11).

The core of the Business Roundtable court holding was that the Commission had failed to articulate a satisfactory explanation for its action including a rational connection between the facts found and the choices made regarding 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. The Commission's decision not to seek review was somewhat surprising in that the Business Roundtable court had directly and pointedly stated that the Rule was arbitrary, capricious, and an abuse of discretion under the Administrative Procedure Act.

Background

Rule 14a-11 provided that a company subject to the Exchange Act proxy rules, including an investment company, had to include in its proxy materials the name of a person nominated for election to the board of directors by a shareholder or group of shareholders. These shareholders had to 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 or group submitted notice of its intent to use the Rule.

The Business Roundtable court did not mince words in condemning Rule 14a-11. It held that 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.” Citing its two recent holdings invalidating Commission regulations, American Equity Investment Life Insurance Company v. SEC, 613 F.3d 166, 167'68 (D.C. Cir. 2010) and Chamber of Commerce v. SEC, 412 F.3d 133, 143 (D.C. Cir. 2005), the Business Roundtable court strongly hinted at a pattern of simply sloppy Commission rule-making over the past six years.

Itemizing the Defaults

The excoriation continued as the Business Roundtable court itemized the defaults in the Commission's findings. The court found that the Commission had neglected to quantify the costs companies would incur opposing shareholder nominees; to substantiate the rule's predicted benefits; to consider the consequences of union and state pension funds using the rule; and to properly to evaluate the frequency with which shareholders would initiate election contests.

Moreover, the court held the Commission failed adequately to address whether the regulatory requirements of the Investment Company Act had been met. These included an analysis of the need for, and hence the benefit to be had from, proxy access for shareholders of investment companies was manifest, and whether the rule would impose greater costs upon investment companies by disrupting the structure of their governance.

The View of the Court

The Business Roundtable court disputes the rational bases of Rule 14a-11 on every conceivable evidentiary basis. As to factors affecting consideration of costs and benefits, the court found that the Commission's prediction that directors might choose not to oppose shareholder nominees and therefore reduce the cost of Rule 14a-11 had no basis beyond mere speculation. The supposition that such forbearance would exist was contrary to experience, and the court noted the corporate fiduciary duty to oppose malign candidacies no matter what the economic cost. In addition, the Commission did nothing to estimate and quantify the costs it expected companies to incur in the event of corporate opposition to certain candidates and it did not claim that estimating those costs was not possible.

The court also held that the Commission had discounted the costs of Rule 14a-11 by discounting them as a mere artifact of the state law right of shareholders to elect directors. Thus, another cost of the Rule had not been fully considered.

The Commission had failed to respond to the argument that investors with special interests, such as unions and state and local governments whose interests in jobs may 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 would likely cause companies to incur costs even when the nominees are unlikely to be elected.

In weighing the Rule's costs and benefits, the Commission arbitrarily ignored the effect of the Rule upon the total number of traditional proxy contests. Therefore, the Commission had no way of knowing whether the Rule would facilitate enough election contests to be of net benefit.

Finally, 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.

Errors of Commission

Coupled to these sins of omission in consideration of Rule 14a-11 were errors of commission. The court found that the Commission had ignored a substantial body of empirical data relating to improvement of board
performance and increase in shareholder value through easing the election of dissident shareholder nominees. The court said that the Commission had exclusively relied upon two relatively unpersuasive studies that reinforced the value of easing dissidents' pathway to board membership.

Next, the Commission, by both minimizing the cost of the Rule's proxy contests and acknowledging the high cost of such elections, had contradicted itself and therefore had acted arbitrarily.

Analysis

The Business Roundtable holding was as rare in its frankness as the Commission's subsequent decision not to further challenge so direct an attack on its competence. However, any reasonably objective appellate adviser would tell the Commission that the court had so written the opinion as to maximize very real laucunae in the data underpinning the Rule. The net effect was to force the Commission to defend the Rule on too many factual propositions and assumptions to ensure success before the Supreme Court. Therefore, the Rule could not be saved after the opinion without extensive new hearings rectifying the sins of omission and buttressing of the seemingly unreliable data to which it had formerly committed itself.

Indeed, the severity of the court's criticism should lead to a cautious and pragmatic view of the prospects for seeking certiorari. The appellate record strongly indicates that further litigation would have been fruitless for the Commission as a direct finding of abuse of discretion in rarely overturned on further review. Part of the Commission's reluctance to pursue its appellate remedies may have been that the Supreme Court could well have granted certiorari and then affirmed the Federal Circuit's stringent view of the APA.

The real issue is why the Commission has not instituted new hearings for the revitalization of Rule 14a-11. It has the prescription for success, as the Business Roundtable court has provided the recipe for correction of the rule-making process. As to every gap in consideration of the issues, the Commission has only to resolve contradictions and address each missed topic.

One possible reason for the Commission's not immediately reinstituting the administrative process may lie in the issuance of two Executive Orders. The first, Executive Order 13563 (1/18/11), states that agencies must use the best available techniques to quantify anticipated present and costs as accurately as possible, with the goal of promoting careful and accurate quantification.

The second, Executive Order 13579 (7/11/11), states the general principle that regulatory decisions should be made only after consideration of their costs and benefits, both quantitative and qualitative. In addition, the Order, in discussing periodic review of existing regulations, stated that such retrospective analyses should include supporting data and evaluations. The Commission, on Sept. 6, announced the beginning of its retrospective analyses of its regulations.

The net effect of the two Executive Orders is to institute an explicit requirement that there be objective, empirical, and neutral exploration of data supporting pending and existing regulations. Rule 14a-11, given the Business Roundtable court's findings, failed equally on lack of consideration of issues and objectively considered data. On the other hand, should Rule 14a-11 have been reenacted in accordance with the opinion, it would have had to survive both internal administrative review under the Executive Orders as well as a court challenge.

Conclusion

In light of these new Executive Orders that further delineate the processes for establishing the basis for regulatory issuance, it may be that the Commission's administrative processes leading to Rule 14a-11 were overtaken by new and stricter administration factual standards for the formation of rules and regulations. Under this interpretation, the seeming demise of the Rule is grounded less in the oversight of the Executive Branch than on the President's overseeing of the Executive Branch.

James Ching is a former Supervising Deputy Attorney General, California Department of Justice, and a graduate of Stanford University and Stanford Law School.

On Sept. 6, 2011, the Securities and Exchange Commission (SEC) gave up the ghost on Rule 14a-11, the Commission rule that required companies to include shareholders' director nominees in company proxy materials in certain circumstances. The Commission eschewed rehearing or a petition for certiorari after the Federal Circuit negated the Rule in Business Roundtable and Chamber of Commerce v. Securities and Exchange Commission , ___ F.3d ___, No. 10-1305 (D.C. Cir. 7/22/11).

The core of the Business Roundtable court holding was that the Commission had failed to articulate a satisfactory explanation for its action including a rational connection between the facts found and the choices made regarding 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. The Commission's decision not to seek review was somewhat surprising in that the Business Roundtable court had directly and pointedly stated that the Rule was arbitrary, capricious, and an abuse of discretion under the Administrative Procedure Act.

Background

Rule 14a-11 provided that a company subject to the Exchange Act proxy rules, including an investment company, had to include in its proxy materials the name of a person nominated for election to the board of directors by a shareholder or group of shareholders. These shareholders had to 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 or group submitted notice of its intent to use the Rule.

The Business Roundtable court did not mince words in condemning Rule 14a-11. It held that 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.” Citing its two recent holdings invalidating Commission regulations, American Equity Investment Life Insurance Company v. SEC , 613 F.3d 166, 167'68 (D.C. Cir. 2010) and Chamber of Commerce v. SEC , 412 F.3d 133, 143 (D.C. Cir. 2005), the Business Roundtable court strongly hinted at a pattern of simply sloppy Commission rule-making over the past six years.

Itemizing the Defaults

The excoriation continued as the Business Roundtable court itemized the defaults in the Commission's findings. The court found that the Commission had neglected to quantify the costs companies would incur opposing shareholder nominees; to substantiate the rule's predicted benefits; to consider the consequences of union and state pension funds using the rule; and to properly to evaluate the frequency with which shareholders would initiate election contests.

Moreover, the court held the Commission failed adequately to address whether the regulatory requirements of the Investment Company Act had been met. These included an analysis of the need for, and hence the benefit to be had from, proxy access for shareholders of investment companies was manifest, and whether the rule would impose greater costs upon investment companies by disrupting the structure of their governance.

The View of the Court

The Business Roundtable court disputes the rational bases of Rule 14a-11 on every conceivable evidentiary basis. As to factors affecting consideration of costs and benefits, the court found that the Commission's prediction that directors might choose not to oppose shareholder nominees and therefore reduce the cost of Rule 14a-11 had no basis beyond mere speculation. The supposition that such forbearance would exist was contrary to experience, and the court noted the corporate fiduciary duty to oppose malign candidacies no matter what the economic cost. In addition, the Commission did nothing to estimate and quantify the costs it expected companies to incur in the event of corporate opposition to certain candidates and it did not claim that estimating those costs was not possible.

The court also held that the Commission had discounted the costs of Rule 14a-11 by discounting them as a mere artifact of the state law right of shareholders to elect directors. Thus, another cost of the Rule had not been fully considered.

The Commission had failed to respond to the argument that investors with special interests, such as unions and state and local governments whose interests in jobs may 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 would likely cause companies to incur costs even when the nominees are unlikely to be elected.

In weighing the Rule's costs and benefits, the Commission arbitrarily ignored the effect of the Rule upon the total number of traditional proxy contests. Therefore, the Commission had no way of knowing whether the Rule would facilitate enough election contests to be of net benefit.

Finally, 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.

Errors of Commission

Coupled to these sins of omission in consideration of Rule 14a-11 were errors of commission. The court found that the Commission had ignored a substantial body of empirical data relating to improvement of board
performance and increase in shareholder value through easing the election of dissident shareholder nominees. The court said that the Commission had exclusively relied upon two relatively unpersuasive studies that reinforced the value of easing dissidents' pathway to board membership.

Next, the Commission, by both minimizing the cost of the Rule's proxy contests and acknowledging the high cost of such elections, had contradicted itself and therefore had acted arbitrarily.

Analysis

The Business Roundtable holding was as rare in its frankness as the Commission's subsequent decision not to further challenge so direct an attack on its competence. However, any reasonably objective appellate adviser would tell the Commission that the court had so written the opinion as to maximize very real laucunae in the data underpinning the Rule. The net effect was to force the Commission to defend the Rule on too many factual propositions and assumptions to ensure success before the Supreme Court. Therefore, the Rule could not be saved after the opinion without extensive new hearings rectifying the sins of omission and buttressing of the seemingly unreliable data to which it had formerly committed itself.

Indeed, the severity of the court's criticism should lead to a cautious and pragmatic view of the prospects for seeking certiorari. The appellate record strongly indicates that further litigation would have been fruitless for the Commission as a direct finding of abuse of discretion in rarely overturned on further review. Part of the Commission's reluctance to pursue its appellate remedies may have been that the Supreme Court could well have granted certiorari and then affirmed the Federal Circuit's stringent view of the APA.

The real issue is why the Commission has not instituted new hearings for the revitalization of Rule 14a-11. It has the prescription for success, as the Business Roundtable court has provided the recipe for correction of the rule-making process. As to every gap in consideration of the issues, the Commission has only to resolve contradictions and address each missed topic.

One possible reason for the Commission's not immediately reinstituting the administrative process may lie in the issuance of two Executive Orders. The first, Executive Order 13563 (1/18/11), states that agencies must use the best available techniques to quantify anticipated present and costs as accurately as possible, with the goal of promoting careful and accurate quantification.

The second, Executive Order 13579 (7/11/11), states the general principle that regulatory decisions should be made only after consideration of their costs and benefits, both quantitative and qualitative. In addition, the Order, in discussing periodic review of existing regulations, stated that such retrospective analyses should include supporting data and evaluations. The Commission, on Sept. 6, announced the beginning of its retrospective analyses of its regulations.

The net effect of the two Executive Orders is to institute an explicit requirement that there be objective, empirical, and neutral exploration of data supporting pending and existing regulations. Rule 14a-11, given the Business Roundtable court's findings, failed equally on lack of consideration of issues and objectively considered data. On the other hand, should Rule 14a-11 have been reenacted in accordance with the opinion, it would have had to survive both internal administrative review under the Executive Orders as well as a court challenge.

Conclusion

In light of these new Executive Orders that further delineate the processes for establishing the basis for regulatory issuance, it may be that the Commission's administrative processes leading to Rule 14a-11 were overtaken by new and stricter administration factual standards for the formation of rules and regulations. Under this interpretation, the seeming demise of the Rule is grounded less in the oversight of the Executive Branch than on the President's overseeing of the Executive Branch.

James Ching is a former Supervising Deputy Attorney General, California Department of Justice, and a graduate of Stanford University and Stanford Law School.