Internal Contradictions in the SEC’s Proposed Proxy Access Rules

Professor Grundfest’s post is based on extracts (with footnotes removed) from his Working Paper of the same name published by the Rock Center For Corporate Governance on July 24, 2009; the complete Working Paper, including footnotes, can be downloaded from Social Sciences Research Network Electronic Paper Collection here.)

Administrative agencies are wise not to contradict themselves when rulemaking: contradictions invite courts to overturn agency action as arbitrary and capricious. Also like Charles Barkley’s claim that he was misquoted in his autobiography, contradictions spawn skepticism as to the credibility of an entire enterprise.

This simple observation strikes a death knell for the Securities and Exchange Commission’s 2009 proposed Proxy Access Rules. If adopted, these rules would dramatically transform the process by which directors of publicly traded corporations are nominated and elected. They would establish a “Mandatory Minimum Access Regime” under which corporations would be compelled, even against the will of the shareholder majority, to provide proxy access in accordance with SEC-established standards. Shareholders could, by majority vote, set less stringent access standards, but could not adopt more stringent proxy access rules.

The Commission proposes to add one new rule and amend an existing rule:

• Proposed Rule 14a-11 would provide for proxy access in the event a nominating shareholder, or group of shareholders, of a large accelerated filer have, for at least one year, held one percent or more of the company’s voting securities. Access would not be available to stockholders seeking a change in control, or to stockholders seeking more than a limited number of seats on a board. Nominating stockholders would be required to make certain disclosures, subject to the antifraud provisions of Rule 14a-9. These disclosures include representations that the nominees satisfy the objective criteria for director independence set forth in listing standards, that there is no agreement with the company regarding the nomination of the nominees, and that the nominating stockholders intend to continue holding the requisite number of shares through the date of the stockholder meeting. Disclosure would also be required of relationships between the nominating stockholders, the nominee, and the company, if any.

• Modifications to Rule 14a-8(i)(8) would recast the election exclusion so as to require that companies include in their proxy materials stockholder proposals that would amend, or propose to amend, the company’s governing documents regarding shareholder nominations. The proposals could not, however, weaken or eliminate the proxy access criteria prescribed by proposed Rule 14a-11.

Taken together, the Proposed Rules create a mandatory form of proxy access to be imposed on all publicly traded corporations subject to the rule, even if the majority of each corporation’s shareholders object strenuously to the operation of the Proposed Rules. The Proposed Rules would permit modifications making access easier for stockholder-nominated directors, but forbid modification making access more difficult. Again, the will of the shareholder majority is irrelevant to the Commission. The Proposed Rules are thus accurately described as creating a “Mandatory Minimum Access Regime.”

The text of the Proposing Release is, however, at war with the text of the Proposed Rules in a clash that generates two profound contradictions. Each contradiction is sufficiently material that there is little prospect that the Proposed Rules can withstand challenge under the Administrative Procedure Act (“APA”).

The first contradiction relates to core principles of shareholder self determination. A fundamental premise of every proxy access proposal is that the majority of shareholders are sufficiently intelligent and responsible that they can be relied upon to nominate and elect directors other than the nominees proposed by an incumbent board. If this premise is correct, then these same shareholders are also sufficiently intelligent and responsible to define the protocols governing when, how, and to whom access is granted. But the Proposed Rules prohibit the identical shareholder majority from establishing a proxy access regime, or from amending the Proposed Rules to establish more stringent access standards. The Commission fails to explain how or why shareholders are so selectively intelligent or responsible. It cites no support for the proposition that shareholders can be relied upon to nominate and vote on directors, but not to set the rules by which directors are nominated and elected. Absent a rational basis upon which to conclude that shareholders are selectively intelligent or responsible in a manner that supports discriminatory reliance on the majority’s mandate, the Mandatory Minimum Access Regime cannot withstand scrutiny under the APA.

A second contradiction relates to the Commission’s repeated assertion that the Proposed Rules merely modify the proxy process better to replicate the physical shareholder meeting as governed by state law. Nothing in state law sets a minimum standard for proxy access, defines the contours of any proxy access proposal that must be considered by shareholders, or prohibits a majority of shareholders from amending a proxy access standard to make it more stringent while forbidding the same majority to make it more relaxed. The Proposed Rules thus fail utterly to replicate the shareholder meeting process. Instead, they impose restrictions that exist nowhere in corporate law. Again, absent a rational explanation that resolves this contradiction, the Proposed Rules cannot withstand APA scrutiny.

How can these contradictions be eliminated? In theory, the Commission could disavow its commitment to shareholder self-determination and to the replication of the state law meeting process. But if the Commission does not believe in shareholder self-determination, then what does it believe in? And, if the Commission does not believe in shareholder self-determination, then how can it be a strong advocate of proxy access? Also, if the Commission is not replicating the shareholder meeting process as governed by state law, then is it in the business of writing a federal corporation code? If not, from where do the principles guiding proxy access emanate?

Alternatively, and more realistically, the Commission can cure its self-created contradictions by restructuring the Proposed Rules so that they are fully enabling. Fully enabling rules would create shareholder referenda pursuant to which shareholders could propose, and a majority could adopt, proxy access standards for each individual corporation. No other strategy resolves the contradictions inherent in the Commission’s Proposing Release, or generates a rulemaking record able to withstand APA review.

These same observations are relevant to the rules that the Commission might adopt in the event Congress enacts legislation mandating proxy access. Pending legislation would resolve questions regarding the Commission’s statutory authority to adopt proxy access rules, but would not affect the Commission’s obligation to comply with the APA.

While “foolish consistency” may be the “hobgoblin of little minds,” the inconsistencies between the Proposing Release and the Proposed Rules are far from foolish. They are fundamental to the Commission’s enterprise. They are also fatal to the Proposed Rules under the Administrative Procedure Act. The inconsistencies can, however, be cured by revising the Proposed Rules so that they constitute fully enabling provisions that allow a majority of shareholders to adopt a wide range of proxy access rules through an opt-in mechanism.

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One Comment

  1. Joe
    Posted Wednesday, August 5, 2009 at 8:21 pm | Permalink

    I’d say the SEC is quickly losing any credibility or authority it ever had.