Revisiting the SEC’s Proxy Advisor Rule

After a methodical, decade-long review of the role of proxy advisors, the Securities & Exchange Commission (SEC) promulgated a final rule in June 2020 intended to increase the transparency, accuracy, and completeness of the information proxy advisors provide their institutional investor clients. This proxy advisor rule was the subject of a vigorous debate during the notice and comment period, and the SEC modified its proposed rule significantly as a result of discussion and feedback from proxy advisors, institutional investors, academics, and others.

As we detailed in a report prepared for the U.S. Chamber Center for Capital Markets Competitiveness, the final rule took a flexible and measured approach that requires proxy advisors to provide conflicts of interest disclosures, to ensure that companies that are the subject of their voting advice have such advice made available to them in a timely manner, and to provide that proxy advisors’ clients have the means to become aware of any registrant’s response to the proxy voting advice. The rule also codified (at 38) the SEC’s longstanding interpretation, dating back to 1956, that “persons who do not seek proxy authority themselves,” including those providing proxy advice, “nevertheless engage in solicitation when they communicate with shareholders in a manner reasonably calculated to ‘result’ in a proxy vote,” and are subject to the proxy rules’ antifraud provision.

Yet less than two months after he was sworn in as SEC chair—and before the rule had taken effect—Chair Gary Gensler announced that he was directing SEC staff to reconsider its rule and accompanying guidance on proxy voting advice, including the codification of the definition of solicitation as encompassing proxy voting advice, the 2019 Interpretation and Guidance regarding that definition, and the conditions on exemptions from the information and filing requirements in the 2020 Rule Amendments. As a result of this direction, SEC staff determined that it would suspend enforcement of the final rule against proxy advisors that do not comply with it during the time the SEC deliberates whether to rescind or modify the rule.

After such a long and thorough rulemaking process, the SEC’s sudden about-face raises important concerns about the law and policy at stake in such a regulatory decision, especially by an independent agency that is designed to be insulated to some degree from presidential control. Since the SEC staff’s blanket nonenforcement decision, the SEC held a public meeting on November 17, 2021, and declared that it was proposing a new rule, which would go through notice and comment, to “address concerns expressed by investors and others that the current rules may impede and impair the timeliness and independence of proxy voting advice and subject proxy voting advice businesses to undue litigation risks and compliance costs.”

In this post, we do not explore the potential revisions to the proxy advisor rule that this proposed rule would create. Instead, we focus on the SEC chair’s and SEC staff’s decision to try to unwind the final rule through enforcement discretion. We address the policy concerns first, and then explore the potential legal avenues for unwinding a final rule.

Regulatory Lawmaking and Stability of the Administration

As a matter of policy, the SEC’s decision to essentially suspend the proxy advisor rule raises concerns about the stability of the SEC’s rules and rulemaking process, the potential for politicization of the SEC, and the role of the SEC’s cadre of professional staff in developing and implementing its rules.

SEC Commissioners Hester Pierce and Elad Roisman asked the initial and most obvious question: What changed in the ten months since the final rule issued “that would call into question such recently adopted requirements”? Because it is not yet in force, no data suggest the rule had created unexpected burdens or had unanticipated consequences. In fact, the most dramatic change coming from the SEC’s decision is the shift away from its 65-year-old interpretation of the term “solicitation,” an understanding that public companies and their investors have relied on in evaluating the quality of proxy voting advice.

Further, it would be unfair to characterize the SEC’s reversal as a necessary corrective to an overtly partisan rule from the prior administration. The rule was developed after a lengthy analysis that spanned both the Obama and Trump administrations. During the Obama administration, proxy advisors were the subject of a concept release in 2010, a roundtable in 2013, and a Staff Legal Bulletin in 2014 that provided guidance about the “availability and requirements of two exemptions to the federal proxy rules that are often relied upon by proxy advisory firms.” The SEC held another roundtable in 2018 seeking “input on questions that arise regarding the use of proxy advisory firms and their activities.” And in 2019 the SEC continued to build toward the final rule through its Guidance Regarding Proxy Voting Responsibilities of Investment Advisers.

Rather than a result of a heavy-handed, midnight rulemaking push by Trump-appointed SEC Chair Jay Clayton, the final proxy advisor rule was years in the making. Indeed, Chair Clayton, an independent, was criticized by some Republicans because he moved too cautiously on rule changes and often sided with the Democratic commissioners on SEC decisions. Moreover, as we detail in our prior report, the final rule responded to critics’ concerns, abandoned the proposed rule’s more bright-line framework, and instead adopted a narrower, more flexible, principles-based regulatory approach. In this light, it is not the rule but its reversal that appears politically motivated.

It also bears noting that the SEC’s professional staff, who act as independent protectors of investors, were the primary drafters of the rule. It was the staff, not the political appointee Commissioners, who wrote the concept release, evaluated information gleaned from roundtable discussions, and crafted guidance for proxy advisory firms in the years leading up to the final rules. While the SEC chair undoubtedly sets a policy agenda for the Commission, the staff must shape rules that will not only withstand legal challenge (and with this rule in particular, the likelihood of a legal challenge was not in doubt), but also protect investors across administrations in the years to come. The abrupt reversal effectively erases a decade of careful work that resulted in a relatively modest regulation that protects against proxy advisor conflicts of interest, gives companies a chance to respond to proxy advice, and codifies a longstanding interpretation.

The Legal Means to Unwind a Final Rule

To be sure, stability in the administration does not mean an agency should never revisit its prior regulatory approaches in light of new data and developments, or even in light of a change on political personnel at the agency. But some processes for regulatory change are better than others—in terms of both law and policy. Here we turn to the law.

Shortly before President Biden took office, Dick Pierce (co-author of the Administrative Law Treatise) outlined the main mechanisms to address “midnight rulemaking”—regulatory actions taken in the final months of an outgoing presidential administration. Although the SEC’s proxy advisor rule is not a midnight rule, Pierce’s framing is equally helpful when it comes to an agency’s decision to unwind any prior rule.

As Pierce documents, there are three main mechanisms to unwind a rule legally: (1) engage in a new notice-and-comment rulemaking; (2) use the Congressional Review Act to invalidate the rule; and (3) decide not to defend the regulation in court. Each has pros and cons.

First, the conventional approach under the Administrative Procedure Act to rescind a final rule is to engage in another rulemaking. This is a time-intensive process, as the agency would need to propose the new rule (to rescind or modify the prior rule), allow the public to comment on that new rule, and then issue a final rule that engages with the substantial comments submitted and other countervailing evidence. For a rule such as SEC’s proxy advisor rule that is based on a decade of agency consideration, an extensive administrative record, and a final rule that took a narrower regulatory approach than the proposed rule, rescission would be particularly resource-intensive and daunting.

To survive judicial review, the agency would need to build an administrative record that could justify the rescission, to demonstrate that it has considered reliance interests and regulatory alternatives, and to otherwise show it engaged in reasoned decision-making. A reviewing court may be particularly skeptical of such a rule recission that occurs before the rule has even gone into effect and the only intervening development seems to be a change in political leadership at the agency.

Second, the new administration could turn to Congress and its expedited agency rule invalidation process under the Congressional Review Act (CRA). This approach would require no reasoned decision-making and would be insulated from judicial review. But it would require Congress to use precious floor time and other resources to pass the resolution by a simple majority in both chambers.

In a prior post on the Forum, we explored how Congress could have used the CRA to invalidate the SEC’s proxy advisor rule. The statutory time window to do so has now closed, so this is no longer an option. And, in all events, we expressed concerns about how a CRA invalidation—which would also ban the agency from promulgating “a new rule that is substantially the same”—could affect future SEC regulatory action in this area. As a policy matter, we ultimately concluded that “the CRA is perhaps best suited to repeal hastily drafted and poorly developed midnight rules, rather than a rule demonstrating compromise and thoughtful agency engagement over the course of a decade.”

Third, the new administration could just, in Pierce’s words, “let[] the [agency] rules die a natural death in court.” He concluded that this is likely the most attractive option for unwinding midnight rules promulgated at the end of the Trump administration:

In the context of any prior administration that would not be a promising option. Agencies in every prior administration of both parties had success rates of about 70 percent in their efforts to defend their rules in court. In the context of the Trump administration, however, this is a promising option. As Bethany Davis Noll documents in an article that will appear in the next issue of Administrative Law Review [now published here], agencies in the Trump administration have been able to defend their regulatory actions in only 10 percent of cases. Their extraordinary 90% failure rate is attributable to their failure to comply with the most basic principles of administrative law.

When it comes to the SEC’s proxy advisor rule, however, this natural judicial death is unlikely to be an option. As we detailed in our prior report and concluded in our prior post on the Forum, “Especially in light of the SEC’s decision to narrow the regulatory reach on proxy advisors in the Final Rule, it is difficult to see how proxy advisors (or proponents of the Proposed Rule, for that matter) could mount a successful legal challenge to the Final Rule under the APA’s arbitrary-and-capricious standard.”

It is thus not surprising, then, that SEC Chair Gensler did not pursue this third option but, instead, seemed to opt for the more conventional approach: directing the SEC staff to begin the process of considering whether to rescind or modify the final rule. This agency-head instruction is typical for a new administration, and Chair Gensler’s instructions are worth repeating in full:

I am now directing the staff to consider whether to recommend further regulatory action regarding proxy voting advice. In particular, the staff should consider whether to recommend that the Commission revisit its 2020 codification of the definition of solicitation as encompassing proxy voting advice, the 2019 Interpretation and Guidance regarding that definition, and the conditions on exemptions from the information and filing requirements in the 2020 Rule Amendments, among other matters.

Indeed, the Commission subsequently announced a proposed rule to substantially narrow the reach of the proxy advisor rule.

But the agency’s initial response to these instructions is less conventional. The SEC Division of Corporation Finance responded:

At the direction of the Chair, we are now considering whether to recommend that the Commission revisit the 2019 Interpretation and Guidance and the 2020 Rule Amendments. In light of this direction, the Division of Corporation Finance has determined that it will not recommend enforcement action to the Commission based on the 2019 Interpretation and Guidance or the 2020 Rule Amendments during the period in which the Commission is considering further regulatory action in this area. In addition, in the event that new regulatory action leaves the 2020 exemption conditions in place with the current December 1, 2021 compliance date, the staff will not recommend any enforcement action based on those conditions for a reasonable period of time after any resumption by Institutional Shareholder Services Inc. of its litigation challenging the 2020 amendments and the 2019 Interpretation and Guidance. (ISS v. SEC, 1:19-cv-3275 (D.D.C.).

In other words, the SEC seems to be exploring a fourth, alternative avenue for unwinding a final rule: a blanket nonenforcement policy. Not surprisingly, a lawsuit has already been filed to challenge the SEC’s attempt to suspend the proxy advisor rule.

Nonenforcement is less-charted terrain when it comes to rule recission. Blackletter administrative law would suggest that an agency cannot delay a rule’s effective date without going through a new notice-and-comment rulemaking first. Such rule suspension would be an amendment to a final rule. At the same time, it is well settled that agencies have broad enforcement discretion. In a world of limited resources and abundant statutory mandates, agencies have to make tough decisions about how to use those resources to fulfil the agency’s statutory mission. It is for this reason that the Supreme Court has held that agencies enjoy a form of prosecutorial discretion—a “presumption that agency decisions not to institute [enforcement] proceedings are unreviewable . . . .”

On the other hand, there is a difference between a context-specific, case-by-case nonenforcement decision and a blanket policy announcement of not enforcing a legal mandate in any case. Debates about how to draw those lines have been front and center in litigation concerning the DACA and DAPA immigration nonenforcement programs. Zachary Price, among others, has argued that, absent congressional authorization, “nonenforcement authority extends neither to prospective licensing of prohibited conduct nor to policy-based nonenforcement of federal laws for entire categories of offenders.”

If not mooted by the new rulemaking, the latest litigation concerning the SEC’s attempt to suspend its proxy advisor rule would give courts another chance to explore whether a blanket nonenforcement policy that has not gone through notice-and-comment rulemaking is an acceptable means to unwind a prior rule. We are skeptical a court would allow it. After all, such a precedent would recognize a powerful tool for a new administration to unwind a prior administration’s regulatory actions in a way that evades the Administrative Procedure Act’s notice-and-comment rulemaking requirements. Indeed, when EPA Administrator Scott Pruitt attempted something similar during the Trump administration, the D.C. Circuit held that the EPA had no statutory or inherent authority to issue a temporary stay of a final rule’s enforcement while the agency deliberated whether to reconsider the rule.

In all events, we look forward to following the litigation as it progresses, as well as the notice-and-comment process regarding the SEC’s attempt to significantly narrow its proxy advisor rule.