Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC

J. Robert Brown, Jr.[1]

Business Roundtable v. SEC[2] arose out of a legal challenge to what is probably the most controversial rule ever adopted by the Securities and Exchange Commission (SEC or Commission). Rule 14a-11, commonly known as the “shareholder access” rule, mandated that public companies allow long term shareholders to include nominees for the board of directors in the company’s proxy statement.[3] The rule held out the promise that shareholders would be able to more easily nominate and elect their own candidates to the board. Access was popular among shareholders and strenuously opposed by public companies.[4]

The Business Roundtable, an organization consisting of the CEOs of many of the largest public companies in the United States, challenged the rule.[5] With the SEC’s authority to adopt the rule resolved in Dodd-Frank,[6] the suit mostly raised concerns over the Commission’s economic analysis.[7] The challenge was viewed by some as a “long shot.”[8]

The “long shot,” however, occurred. The DC Circuit struck down the rule, imposing a “nigh impossible” standard with respect to the applicable economic analysis.[9] The decision far exceeded the standards set out by Congress and the courts with respect to cost/benefit analysis.[10] Moreover, in making its decision, the panel relied on mistaken interpretations of the fiduciary obligations of both boards and pension plans. The short term impact of the decision is to make more difficult the implementation of a shareholder access rule. The long term implications are more severe. The decision effectively discourages the SEC from using rulemaking as a means of establishing legal requirements and instead encourages the use of more informal and less uniform methods such as no-action letters and enforcement proceedings.

I. Shareholder Access: A Brief Background

A corporation’s directors are, as a practical matter, selected by its board. While shareholders have the legal right to submit nominations, their candidates have no realistic possibility of winning absent a competing proxy solicitation. Proxy contests are, however, expensive and, as a result, rarely occur.[11] To mitigate some of the costs associated with this process, shareholders have long sought the right to include their nominees in the company’s proxy statement. In those circumstances, the company, rather than shareholders, incurs the costs of distributing the proxy statement and card on behalf of these candidates.

Proposals for shareholder access first surfaced in the 1940s.[12] The issue, however, remained largely dormant until the new millennium. Rule proposals appeared in 2003 and 2007 but were never adopted.[13] Only in 2010 did the SEC finally put in place a rule that allowed shareholders (or groups of shareholders) owning 3% of the company’s shares for at least three years to include a short slate of nominees (no more than 25% of the board) in the company’s proxy statement.[14]

The final rule entailed an immense bureaucratic effort. The rule received approximately 600 comment letters, a number that was combined with approximately 13,000 letters from earlier efforts.[15] The staff put in 21,000 hours on the rule, an amount of time equal to $2.2 million.[16] With respect to the economic analysis of the rule, the final version consisted of 73 pages in the release (26 pages in the Federal Register) and almost 40,000 words.

II. Business Roundtable v. SEC

The DC Circuit ultimately opted to strike down Rule 14a-11, concluding that the SEC conducted faulty economic analysis and therefore acted in an arbitrary and capricious fashion.[17] In examining the Commission’s economic analysis, the court emphasized that, under Section 3(f) of the Exchange Act, the SEC had a “unique obligation” to analyze rules for their impact upon “efficiency, competition, and capital formation.”[18] The court effectively decided that the Commission overstated the benefits of shareholder access and understated the costs. 

The court faulted the SEC for predicting that “directors might choose not to oppose shareholder nominees,” concluding that the statement “had no basis beyond mere speculation.”[19] For support, the court relied on a letter submitted by the American Bar Association Committee on Federal Regulation of Securities (ABA Letter) suggesting that the board had a fiduciary obligation to oppose shareholder nominated directors. According to the letter:   

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.[20]

Because the board was “compelled” to resist, the court imposed an obligation on the Commission to explain why resistance would not occur.[21]

The approach used by the court, however, incorrectly interpreted the board’s fiduciary obligations. To require resistance is to assume that the board’s fiduciary duties are substantive. In fact, however, the duty of care is a process-oriented standard.[22] Under such an approach, the board is not “compelled” to take action one way or another. Instead, any action taken by the board will be upheld if it results from a reasoned decision-making process.[23]

The conclusion in the ABA letter that boards were compelled to resist access candidates was based upon a faulty premise. The ABA Letter characterized the board’s duties with respect to access candidates as the same as those in a “traditional proxy contest.”[24] Proxy contests and access elections, however, raise different concerns and impose different duties. Proxy contests often involve short term shareholders seeking control of the company. The contests are often not about the quality of the candidates for the board but about competing visions of the company’s future. Proxy contests are also typically initiated by those willing to incur substantial costs in order to ensure that their vision prevails.[25] 

Access challenges involve very different considerations. They cannot be brought by short term shareholders. They cannot be used to obtain control of the board. Shareholders submitting access nominees are unlikely to expend the resources typical of a proxy contest.[26] Management is not, therefore, compelled to resist. The board could determine that both sets of candidates are equally qualified.[27] The board could decide that the access candidates have no realistic chance of winning. In those circumstances, the board could reasonably conclude that it is unnecessary to oppose the access candidates.[28]

The court also incorrectly required the SEC to consider costs associated with the use of access by union pension plans as leverage in wage negotiations. Specifically, the Commission was faulted for failing 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.[29]

This “cost,” however, was entirely speculative.[30] While commentators did raise the concern, the court provided no empirical support. The only source was a single sentence in a law review article written by a jurist who was commenting on differences among shareholders, not on the use of access.[31] Moreover, given the widespread involvement of union pension plans in the corporate governance process, the existence of empirical or anecdotal evidence on the use of governance to influence wage concessions would presumably exist.[32] Yet the opinion is devoid of any empirical support.  

More importantly, however, the use of access to obtain wage concessions presupposes that union pension plans are willing to disadvantage the interests of beneficiaries in order to benefit workers. This is in effect a violation of the pension plan’s fiduciary obligations to its beneficiaries. Thus, the court faulted the Commission for failing to first assume a breach of fiduciary duties then failing to assess the costs of the violations.  

III. The Consequences

The DC Circuit’s decision imposed an extraordinarily difficult burden on the Commission. The court required the SEC to assess costs that have not been empirically shown to exist, to assume pension plans will violate their fiduciary obligations, and to use a fiduciary standard for directors that is not consistent with state law. The decision will make rulemaking more difficult and encourage legal challenges.[33]

In the short term, the Commission will have to overcome substantial hurdles in adopting an access rule that will withstand judicial scrutiny of the type imposed by the panel in this case. Indeed, some have suggested that the decision effectively requires the SEC to seek “independent economic analysis,”[34] a consequence that the DC Circuit[35] and Congress[36] had previously disclaimed. Moreover, with other avenues of challenge left open, the Commission cannot be assured the rule will be upheld even if it conducts the economic analysis mandated by the court.[37]

More broadly, the decision discourages the SEC from relying on rulemaking as a means of setting down administrative policies. This encourages the SEC to use informal means such as no action letters and enforcement proceedings to impose administrative policies.[38] Thus, for example, the antifraud provisions have been used in the past to require companies to disclose information about insurgent candidates to the board.[39]

Finally, each time shareholder access has failed in the new millennium, proposals have resurfaced that would make the right even broader.[40] To the extent the Commission seeks to readopt an access rule, it could easily delete restrictions that existed in the version adopted in 2010, thus increasing the likelihood that shareholders will take advantage of the authority and in fact submit access nominees.[41]

 


[1] Professor of Law, Director, Corporate-Commercial Law Program, University of Denver Sturm College of Law.

[2] 647 F.3d 1144 (D.C. Cir. 2011).

[3] The 2010 Proxy Access Adopting Release, Exchange Act Release No. 62,764, 2010 WL 3343532 (Aug. 25, 2010) (adopting Rule 14a-11). See discussion infra note 14.

[4] See Keir D. Gumbs & David B.H. Martin, Shareholder Access Litigation and Beyond, Covington & Burling (Aug. 3, 2011), http://www.cov.com/files/Publication/187574f4-1e57-4878-9f1a-2e0dc5b2d95c/Presentation/PublicationAttachment/530f1bfa-3555-4074-ae50-36dba78747d1/Shareholder%20Access%20Litigation%20and%20Beyond.pdf (“This rule was preceded by a lengthy, and at times, contentious comment period. During the process, the SEC received over 600 comment letters that were sharply divided.”).

[5] See http://businessroundtable.org/about-us/ (“Business Roundtable (BRT) is an association of chief executive officers of leading U.S. companies . . . BRT member companies comprise nearly a third of the total value of the U.S. stock market.”).

[6] See Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), Pub. L. No. 111-203, § 971, 124 Stat. 1376 (2010).

[7] The briefs and pleadings in the case are posted on the DU Corporate Governance web site available at http://law.du.edu/index.php/corporate-governance/sec-and-governance/business-roundtable-v.-sec.

[8] See Stephen Bainbridge, Proxy Access Invalidated on APA Grounds, ProfessorBainbridge.com (July 22, 2011  7:20 PM), http://www.professorbainbridge.com/professorbainbridgecom/2011/07/proxy-access-invalidated-on-apa-grounds.html (“while I am pleased, I'm also surprised. I had thought--and said publicly--that this suit was a long shot.”).

[9] Stanley Keller, What Now For Proxy Access?, The Harvard Law School Forum on Corporate Governance and Financial Regulation (Aug. 18, 2011 9:29 AM), http://blogs.law.harvard.edu/corpgov/2011/08/18/what-now-for-proxy-access/ (“There are many (and I am one) who, although believing the SEC acted unwisely in adopting proxy access, at least in the form of Rule 14a-11, are concerned about the high, nigh impossible, bar the Court set that could put in jeopardy most SEC rulemaking of any complexity or controversy.”).

[10] For the applicable judicial standards, see Letter from Jeff Mahoney, General Counsel, Council for Institutional Investors, to Mary Schapiro, Chairman, SEC (Aug. 22, 2011), available at http://www.cii.org/UserFiles/file/resource%20center/correspondence/2011/08-19-11%20Letter%20to%20SEC%20on%20Proxy%20Access%20%28Final%29.pdf.

[11] In 2008, there were 50 proxy contests. See Elaine Buckberg, & Jonathan Macey, Report on Effects of Proposed SEC Rule 14a-11 on Efficiency, Competitiveness and Capital Formation  (Aug. 17, 2009), available at http://www.nera.com/upload/Buckberg_Macey_Report_FINAL.pdf . There are approximately 14,000 public companies. See Exchange Act Release No. 47,226, 79 SEC Docket 1057 (Jan. 22, 2003).

[12] For a discussion of these efforts, see J. Robert Brown, Jr., The SEC, Corporate Governance, and Shareholder Access to the Board Room, 2008 Utah L. Rev. 1339 (2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1095032.

[13] See Security Holder Director Nominations, Exchange Act Release No. 48,626, 81 SEC Docket 770 (Oct. 14, 2003); Shareholder Proposals, Exchange Act Release No. 56,160, 91 SEC Docket 544 (July 27, 2007). No action was taken on the 2003 proposal. The one circulated in 2007 was affirmatively rejected. See Exchange Act Release No. 56,914, 92 SEC Docket 256 (Dec. 6, 2007).

[14] See Exchange Act Release No. 62,764, 2010 WL 3343532 (Aug. 25, 2010) (adopting Rule 14a-11).

[15] See id. (“As described in this release and the Proposing Release, the final rules include features from the proposals on this topic in 2003 and 2007, and reflect much of what we learned through the public comment that the Commission has received concerning this topic over the past seven years.”).

[16] See Letter from Mary Schapiro, Chairman, SEC, to the Rep. Scott Garrett (Aug. 5, 2011), available at http://www.law.du.edu/documents/corporate-governance/sec-and-governance/SEC-letter%208-5-11.pdf.

[17] See Administrative Procedure Act § 706, 5 U.S.C. § 706 (2006).

[18] See 15 U.S.C. §§ 78c(f), 78w(a)(2) (2006).  The court apparently assumed that Business Roundtable had standing to raise this issue.  See Business Roundtable, 647 F.3d 1144. That may not be the case.  Congress adopted Section 3(f) in 1996.   Pub. L. No. 104-290, § 106(a), 110 Stat. 3416, 3424) (codified at 15 U.S.C. § 77b(b)).  In requiring the economic analysis, Congress noted that it did not override the SEC’s “foremost obligation” to protect investors.   Congress indicated that the purpose of the economic analysis was designed to permit private parties to intervene and overturn an agency rule but was “necessary to Congress in connection with the Congress’ review of major rules.” H.R. Rep. No. 104-622, at 39 (1996) (the provision referenced review under the Small Business Regulatory Enforcement Act of 1996).   In other words, the analysis was designed to assist Congress.   As such, the Business Roundtable was not in the “zone of interest” for the provision and therefore lacked standing under Section 702 of the APA.  See Thompson v. N. Am. Stainless, LP, 131 S. Ct. 863 (2011) (“We have held that this language establishes a regime under which a plaintiff may not sue unless he ‘falls within the “zone of interests” sought to be protected by the statutory provision whose violation forms the legal basis for his complaint.’   We have described the ‘zone of interests’ test as denying a right of review ‘if the plaintiff’s interests are so marginally related to or inconsistent with the purposes implicit in the statute that it cannot reasonably be assumed that Congress intended to permit the suit.’” Id. at 870.).

[19] Business Roundtable, 647 F.3d at 1150.

[20] See Letter from Jeffrey W. Rubin, Chair, ABA Comm. on Fed. Regulation of Secs., to SEC (Aug. 31, 2009), available at http://www.sec.gov/comments/s7-10-09/s71009-456.pdf.

[21] Business Roundtable, 647 F.3d at 1150 (citing Facilitating Shareholder Director Nominations, 75 Fed. Reg. 56,668-01, 56,770 (Sept. 16, 2010)  (“to the extent that directors determine not to expend such resources to oppose the election of the shareholder director nominees and simply include the shareholder director nominees and the related disclosure in the company’s proxy materials.”)).  

[22] See Brehm v. Eisner, 746 A.2d 244, 264 (Del. 2000) (“As for the plaintiffs’ contention that the directors failed to exercise ‘substantive due care,’ we should note that such a concept is foreign to the business judgment rule. Courts do not measure, weigh or quantify directors’ judgments. We do not even decide if they are reasonable in this context. Due care in the decisionmaking context is process due care only.”). See also J. Robert Brown, Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure, 57 Cath. U. L. Rev. 45, 47 (2007) (“Over time, the duty of care evolved into little more than a wooden process, and the duty of loyalty into a standard largely unmoored from fairness.”), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=982444.

[23] Thus, the court assumed there was a duty to resist and determined that the only reason that could explain the failure to do so was that the costs of resistance outweighed the benefits. See id. (“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.”). In the absence of a substantive duty to resist, this type of analysis would presumably be unnecessary.   

[24] ABA Letter, supra note 20 (“[W]e believe that the process will be the same as that which is experienced with traditional proxy contests, because the board’s fiduciary duties in each case will be the same.”).

[25] See Exchange Act Release No. 62,764 n.868 (Aug. 25, 2010) (“According to a study of proxy contests conducted during 2003, 2004, and 2005, the average cost of a proxy contest to a soliciting shareholder was $ 368,000. . . The costs included those associated with proxy advisors and solicitors, processing fees, legal fees, public relations, advertising, and printing and mailing of proxy materials.”).

[26] See id. at 147 (“Nominating shareholders also may see less need for additional soliciting efforts, such as the hiring of proxy solicitors, public relations advisors, or advertising, if their director nominees are presented alongside those of management in a set of company proxy materials with which the company's shareholders are familiar.”).

[27] The analysis has other disquieting implications. It suggests that shareholders can bring a claim for breach of fiduciary obligations whenever the board rejects a more highly qualified candidate that it submits for inclusion in management’s slate. The board will, of course, claim that its candidates are the most appropriate and under a process standard, this is largely an issue that would be beyond challenge. Given the examples of actors and elementary school principals sometimes nominated by the board (see Disney), this will objectively not always be the case. One suspects that management in Delaware companies will find this a rude shock to learn.

[28] The court also faulted the SEC for “entirely” discounting studies indicating that access was bad for performance while “exclusively and heavily” relying on studies suggesting otherwise despite the presence of methodological flaws. Business Roundtable, 647 F.3d at 1151. The Commission did not rely “exclusively” on the positive studies. In addition to those relating directly to access, the Commission relied on numerous studies showing that “facilitating shareholders’ rights and voice may result in better company performance.” Exchange Act Release No. 62,764 n.914 (Aug. 25, 2010).Prior decisions indicated that this approach was sufficient. See Chamber of Commerce v. SEC, 412 F.3d 133, 143 (D.C. Cir. 2005) (“Although a more detailed discussion of the study might have been useful, the Commission made clear enough the limitations of the study, and we have no cause to disturb its ultimate judgment that the study was ‘unpersuasive evidence.’”).

[29] Business Roundtable, 647 F.3d at 1155.

[30] Thus, this is a very different issue than the one raised in Chamber of Commerce, where the Commission conceded the existence of the costs but disclaimed the ability to quantify them.

[31] See Leo E. Strine, Jr., Toward a True Corporate Republic: A Traditionalist Response to Bebchuk's Solution for Improving Corporate America, 119 Harv. L. Rev. 1759, 1765 (2006).

[32] Unions submitted 18.7% of proposals in 2011 and 19.8% in 2010.  Inst. S’holder Servs., Aug. 25, 2011.

[33] Burt W. Rein & Thomas W. Queen, The D.C. Circuit Finds the SEC's Proxy Access Rule to Be Arbitrary and Capricious, Sec. Reg. & L. Rep. (BNA) 1749 (Aug. 22, 2011) (“In particular, where a regulatory agency is required by statute to make specific findings to support the rulemaking under review or bases a “public interest” determination on fact-based findings, disaffected interests may have gained access to a new and potent disciplinary weapon.”), available at http://www.wileyrein.cm/resources/documents/ProxyAccessArticle.pdf.

[34] See Elaine Buckberg, Jonathan Macey, & James Overdahl, Will court short-circuit Dodd-Frank?, Politico (Aug. 15, 2011), available at http://www.politico.com/news/stories/0811/61363.html (“Better regulation, able to survive review by the D.C. Circuit Court, will likely require incorporating substantive and independent economic analysis into the development of every rule as standard operating procedure.”).

[35] See Chamber of Commerce, 412 F.3d at 142 (in addressing the argument that the SEC “should have directed its staff to do a study of the effect” of the rule, “we are acutely aware that an agency need not -- indeed cannot -- base its every action upon empirical data; depending upon the nature of the problem, an agency may be ‘entitled to conduct . . . a general analysis based on informed conjecture.’”).

[36] In adopting Section 3(f), Congress anticipated that it would impose no significant additional burdens on the agency. See H.R. Rep. No. 104-622, at 24 (1996) (“The bill also would require the SEC to consider the burden of regulations or rules on capital formation, efficiency, and competition. Because the SEC currently conducts cost-benefit analyses in conjunction with its rulemakings, CBO would not expect this provision to result in any additional costs to the federal government.”).

[37] Business Roundtable, 647 F.3d at 1149 (“Because we conclude the Commission failed to justify Rule 14a-11, we need not address the petitioners' additional argument the Commission arbitrarily rejected proposed alternatives that would have allowed shareholders of each company to decide for that company whether to adopt a mechanism for shareholders' nominees to get access to proxy materials.”).

[38] For an example of this, see generally J. Robert Brown, Jr., Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors (Mar. 9, 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1781987.

[39] See Brown, supra note 12.

[40] Thus, in 2007, the SEC proposed amendments to Section 14a-8 that would allow shareholders to submit bylaws that, if adopted, would provide for access. Although a form of private ordering, the proposal was opposed by many and, as a result, not adopted. The access proposal made in 2009 dispensed with the need for a bylaw and sought to impose the requirement on all public companies, not just those where the authority was approved by shareholders. Had the access bylaw proposal been adopted in 2007, a direct access proposal likely would not have been made by the Commission two years later.

[41] See J. Robert Brown, Jr., Access and the Opposition: Be Careful What You Wish For, TheRaceToTheBottom.org (Sept. 1, 2009 6:00 AM), http://www.theracetothebottom.org/shareholder-rights/access-and-the-opposition-be-careful-what-you-wish-for.html.