Business Roundtable v. Securities & Exchange Commission

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued April 7, 2011 Decided July 22, 2011

No. 10-1305

BUSINESS ROUNDTABLE AND CHAMBER OF COMMERCE OF THE

UNITED STATES OF AMERICA,

PETITIONERS

v.

SECURITIES AND EXCHANGE COMMISSION,

RESPONDENT

On Petition for Review of an Order

of the Securities & Exchange Commission

Eugene Scalia argued the cause for petitioners. With him

on the briefs were Amy Goodman, Daniel J. Davis, and Robin

S. Conrad. Amar D. Sarwal entered an appearance.

Steven A. Engel, Ruth S. Epstein, and G. Eric Brunstad,

Jr. were on the brief for amici curiae Investment Company

Institute and Independent Directors Council in support of

petitioners.

2

Shannon E. German was on the brief for amicus curiae

State of Delaware in support of petitioners.

Randall W. Quinn, Assistant General Counsel, Securities

and Exchange Commission, argued the cause for respondent.

With him on the brief were David M. Becker, General

Counsel, Jacob H. Stillman, Solicitor, Michael A. Conley,

Deputy Solicitor, Michael L. Post, Senior Litigation Counsel,

and Tracey A. Hardin, Senior Counsel.

Reuben A. Guttman was on the brief for amici curiae

Law Professors in support of respondent.

Jeffrey A. Lamken, Christopher J. Wright, Timothy J.

Simeone, Peter Mixon, and Robert M. McKenna, Attorney

General, Office of the Attorney for the State of Washington,

were on the brief for amici curiae Council of Institutional

Investors, et al.

Before: SENTELLE, Chief Judge, GINSBURG and BROWN,

Circuit Judges.

Opinion for the Court filed by Circuit Judge GINSBURG.

GINSBURG, Circuit Judge: The Business Roundtable and

the Chamber of Commerce of the United States, each of

which has corporate members that issue publicly traded

securities, petition for review of Exchange Act Rule 14a-11.

The rule requires public companies to provide shareholders

with information about, and their ability to vote for,

shareholder-nominated candidates for the board of directors.

The petitioners argue the Securities and Exchange

Commission promulgated the rule in violation of the

Administrative Procedure Act, 5 U.S.C. § 551 et seq.,

because, among other reasons, the Commission failed

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adequately to consider the rule’s effect upon 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, codified at 15 U.S.C. §§ 78c(f) and

80a-2(c), respectively. For these reasons and more, we grant

the petition for review and vacate the rule.

I. Background

The proxy process is the principal means by which

shareholders of a publicly traded corporation elect the

company’s board of directors. Typically, incumbent directors

nominate a candidate for each vacancy prior to the election,

which is held at the company’s annual meeting. Before the

meeting the company puts information about each nominee in

the set of “proxy materials” — usually comprising a proxy

voting card and a proxy statement — it distributes to all

shareholders. The proxy statement concerns voting

procedures and background information about the board’s

nominee(s); the proxy card enables shareholders to vote for or

against the nominee(s) without attending the meeting. A

shareholder who wishes to nominate a different candidate

may separately file his own proxy statement and solicit votes

from shareholders, thereby initiating a “proxy contest.”

Rule 14a-11 provides shareholders an alternative path for

nominating and electing directors. Concerned the current

process impedes the expression of shareholders’ right under

state corporation laws to nominate and elect directors, the

Commission proposed the rule, see Facilitating Shareholder

Director Nominations, 74 Fed. Reg. 29,024, 29,025–26

(2009) (hereinafter Proposing Release), and adopted it with

the goal of ensuring “the proxy process functions, as nearly as

possible, as a replacement for an actual in-person meeting of

shareholders,” 75 Fed. Reg. 56,668, 56,670 (2010)

4

(hereinafter Adopting Release). After responding to public

comments, the Commission amended the proposed rule and,

by a vote of three to two, adopted Rule 14a-11. Id. at 56,677.

The rule requires a company subject to the Exchange Act

proxy rules, including an investment company (such as a

mutual fund) registered under the Investment Company Act of

1940 (ICA), to include in its proxy materials “the name of a

person or persons nominated by a [qualifying] shareholder or

group of shareholders for election to the board of directors.”

Id. at 56,682–83, 56,782/3.

To use Rule 14a-11, a shareholder or group of

shareholders must 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 submits notice of its intent to use the

rule, and must continue to own those securities through the

date of the annual meeting. Id. at 56,674–75. The

nominating shareholder or group must submit the notice,

which may include a statement of up to 500 words in support

of each of its nominees, to the Commission and to the

company. Id. at 56,675–76. A company that receives notice

from an eligible shareholder or group must include the

proffered information about the shareholder(s) and his

nominee(s) in its proxy statement and include the nominee(s)

on the proxy voting card. Id. at 56,676/1.

The Commission did place certain limitations upon the

application of Rule 14a-11. The rule does not apply if

applicable state law or a company’s governing documents

“prohibit shareholders from nominating a candidate for

election as a director.” Id. at 56,674/3. Nor may a

shareholder use Rule 14a-11 if he is holding the company’s

securities with the intent of effecting a change of control of

the company. Id. at 56,675/1. The company is not required to

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include in its proxy materials more than one shareholder

nominee or the number of nominees, if more than one, equal

to 25 percent of the number of directors on the board. Id. at

56,675/2. *

The Commission concluded that Rule 14a-11 could

create “potential benefits of improved board and company

performance and shareholder value” sufficient to “justify [its]

potential costs.” Id. at 56,761/1. The agency rejected

proposals to let each company’s board or a majority of its

shareholders decide whether to incorporate Rule 14a-11 in its

bylaws, saying that “exclusive reliance on private ordering

under State law would not be as effective and efficient” in

facilitating shareholders’ right to nominate and elect directors.

Id. at 56,759–60. The Commission also rejected the

suggestion it exclude investment companies from Rule 14a-

11. Id. at 56,684/1. The two Commissioners voting against

the rule faulted the Commission on both theoretical and

empirical grounds. See Commissioner Troy A. Paredes,

Statement at Open Meeting to Adopt the Final Rule

Regarding “Proxy Access” (Aug. 25, 2010), available at

http://www.sec.gov/news/speech/2010/spch082510tap.htm;

Commissioner Kathleen L. Casey, Statement at Open Meeting

to Adopt Amendments Regarding “Proxy Access” (Aug. 25,

2010), available at

http://www.sec.gov/news/speech/2010/spch082510klc.htm

(faulting Commission for failing to act “on the basis of

empirical data and sound analysis”).

*

When several nominating shareholders are eligible to use Rule

14a-11, “the nominating shareholder or group with the highest

percentage of the company’s voting power would have its nominees

included in the company’s proxy materials.” 75 Fed. Reg. at

56,675/2.

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The petitioners sought review in this court in September

2010. The Commission then stayed the final rule, which was

to have been effective on November 15, pending the outcome

of this case.

II. Analysis

Under the APA, we will set aside agency action that is

“arbitrary, capricious, an abuse of discretion, or otherwise not

in accordance with law.” 5 U.S.C. § 706(2)(A). We must

assure ourselves the agency has “examine[d] the relevant data

and articulate[d] a satisfactory explanation for its action

including a rational connection between the facts found and

the choices made.” Motor Vehicle Mfrs. Ass’n of U.S., Inc. v.

State Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983)

(internal quotation marks omitted). The Commission also has

a “statutory obligation to determine as best it can the

economic implications of the rule.” Chamber of Commerce v.

SEC, 412 F.3d 133, 143 (D.C. Cir. 2005).

Indeed, the Commission has a unique obligation to

consider the effect of a new rule upon “efficiency,

competition, and capital formation,” 15 U.S.C. §§ 78c(f),

78w(a)(2), 80a-2(c), and its failure to “apprise itself—and

hence the public and the Congress—of the economic

consequences of a proposed regulation” makes promulgation

of the rule arbitrary and capricious and not in accordance with

law. Chamber of Commerce, 412 F.3d at 144; Pub. Citizen v.

Fed. Motor Carrier Safety Admin., 374 F.3d 1209, 1216 (D.C.

Cir. 2004) (rule was arbitrary and capricious because agency

failed to consider a factor required by statute).

The petitioners argue the Commission acted arbitrarily

and capriciously here because it neglected its statutory

responsibility to determine the likely economic consequences

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of Rule 14a-11 and to connect those consequences to

efficiency, competition, and capital formation. They also

maintain the Commission’s decision to apply Rule 14a-11 to

investment companies is arbitrary and capricious.

We agree with the petitioners and hold the Commission

acted arbitrarily and capriciously for having failed once again

— as it did most recently in American Equity Investment Life

Insurance Company v. SEC, 613 F.3d 166, 167–68 (D.C. Cir.

2010), and before that in Chamber of Commerce, 412 F.3d at

136 — adequately to assess the economic effects of a new

rule. Here 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. For

these and other reasons, its decision to apply the rule to

investment companies was also arbitrary. 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.

A. Consideration of Economic Consequences

In the Adopting Release, the Commission predicted Rule

14a-11 would lead to “[d]irect cost savings” for shareholders

in part due to “reduced printing and postage costs” and

reduced expenditures for advertising compared to those of a

“traditional” proxy contest. 75 Fed. Reg. at 56,756/2. The

Commission also identified some intangible, or at least less

readily quantifiable, benefits, principally that the rule “will

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mitigate collective action and free-rider concerns,” which can

discourage a shareholder from exercising his right to

nominate a director in a traditional proxy contest, id., and

“has the potential of creating the benefit of improved board

performance and enhanced shareholder value,” id. at

56,761/1. The Commission anticipated the rule would also

impose costs upon companies and shareholders related to “the

preparation of required disclosure, printing and mailing ...,

and [to] additional solicitations,” id. at 56,768/3, and could

have “adverse effects on company and board performance,”

id. at 56,764/3, for example, by distracting management, id. at

56,765/1. The Commission nonetheless concluded the rule

would promote the “efficiency of the economy on the whole,”

and the benefits of the rule would “justify the costs” of the

rule. Id. at 56,771/3.

The petitioners contend the Commission neglected both

to quantify the costs companies would incur opposing

shareholder nominees and to substantiate the rule’s predicted

benefits. They also argue the Commission failed to consider

the consequences of union and state pension funds using the

rule and failed properly to evaluate the frequency with which

shareholders would initiate election contests.

1. Consideration of Costs and Benefits

In the Adopting Release, the Commission recognized

“company boards may be motivated by the issues at stake to

expend significant resources to challenge shareholder director

nominees.” 75 Fed. Reg. at 56,770/2. Nonetheless, the

Commission believed a company’s solicitation and campaign

costs “may be limited by two factors”: first, “to the extent that

the directors’ fiduciary duties prevent them from using

corporate funds to resist shareholder director nominations for

no good-faith corporate purpose,” they may decide “simply to

9

include the shareholder director nominees ... in the company’s

proxy materials”; and second, the “requisite ownership

threshold and holding period” would “limit the number of

shareholder director nominations that a board may receive,

consider, and possibly contest.” Id. at 56,770/2–3.

The petitioners object that the Commission failed to

appreciate the intensity with which issuers would oppose

nominees and arbitrarily dismissed the probability that

directors would conclude their fiduciary duties required them

to support their own nominees. The petitioners also argue it

was arbitrary for the Commission not to estimate the costs of

solicitation and campaigning that companies would incur to

oppose candidates nominated by shareholders, which costs

commenters expected to be quite large. The Chamber of

Commerce submitted a comment predicting boards would

incur substantial expenditures opposing shareholder nominees

through “significant media and public relations efforts,

advertising ..., mass mailings, and other communication

efforts, as well as the hiring of outside advisors and the

expenditure of significant time and effort by the company’s

employees.” Id. at 56,770/1. It pointed out that in recent

proxy contests at larger companies costs “ranged from $14

million to $4 million” and at smaller companies “from $3

million to $800,000.” Id. In its brief the Commission

maintains it did consider the commenters’ estimates of the

costs, but reasonably explained why those costs “may prove

less than these estimates.”

We agree with the petitioners that the Commission’s

prediction directors might choose not to oppose shareholder

nominees had no basis beyond mere speculation. 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

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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. To the

contrary, the American Bar Association Committee on

Federal Regulation of Securities commented:

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. Letter from

Jeffrey W. Rubin, Chair, Comm. on Fed. Regulation of Secs.,

Am. Bar Ass’n, to SEC 35 (August 31, 2009), available at

http://www.sec.gov/comments/s7-10-09/s71009-456.pdf.

The Commission’s second point, that the required

minimum amount and duration of share ownership will limit

the number of directors nominated under the new rule, is a

reason to expect election contests to be infrequent; it says

nothing about the amount a company will spend on

solicitation and campaign costs when there is a contested

election. Although the Commission acknowledged that

companies may expend resources to oppose shareholder

nominees, see 75 Fed. Reg. at 56,770/2, it did nothing to

estimate and quantify the costs it expected companies to

incur; nor did it claim estimating those costs was not possible,

for empirical evidence about expenditures in traditional proxy

contests was readily available. Because the agency failed to

“make tough choices about which of the competing estimates

is most plausible, [or] to hazard a guess as to which is

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correct,” Pub. Citizen, 374 F.3d at 1221, we believe it

neglected its statutory obligation to assess the economic

consequences of its rule, see Chamber of Commerce, 412 F.3d

at 143.

The petitioners also maintain, and we agree, the

Commission relied upon insufficient empirical data when it

concluded that Rule 14a-11 will improve board performance

and increase shareholder value by facilitating the election of

dissident shareholder nominees. See 75 Fed. Reg. at 56,761–

62. The Commission acknowledged the numerous studies

submitted by commenters that reached the opposite result. Id.

at 56,762/2 & n.924. One commenter, for example, submitted

an empirical study showing that “when dissident directors win

board seats, those firms underperform peers by 19 to 40%

over the two years following the proxy contests.” Elaine

Buckberg, NERA Econ. Consulting, & Jonathan Macey, Yale

Law School, Report on Effects of Proposed SEC Rule 14a-11

on Efficiency, Competitiveness and Capital Formation 9

(2009), available at

www.nera.com/upload/Buckberg_Macey_Report_FINAL.pdf.

The Commission completely discounted those studies

“because of questions raised by subsequent studies,

limitations acknowledged by the studies’ authors, or [its] own

concerns about the studies’ methodology or scope.” 75 Fed.

Reg. at 56,762–63 & n.926–28.

The Commission instead relied exclusively and heavily

upon two relatively unpersuasive studies, one concerning the

effect of “hybrid boards” (which include some dissident

directors) and the other concerning the effect of proxy

contests in general, upon shareholder value. Id. at 56,762 &

n.921 (citing Chris Cernich et al., IRRC Inst. for Corporate

Responsibility, Effectiveness of Hybrid Boards (May 2009),

available at

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www.irrcinstitute.org/pdf/IRRC_05_09_EffectiveHybridBoar

ds.pdf, and J. Harold Mulherin & Annette B. Poulsen, Proxy

Contests & Corporate Change: Implications for Shareholder

Wealth, 47 J. Fin. Econ. 279 (1998)). Indeed, the

Commission “recognize[d] the limitations of the Cernich

(2009) study,” and noted “its long-term findings on

shareholder value creation are difficult to interpret.” Id. at

56,760/3 n.911. In view of the admittedly (and at best)

“mixed” empirical evidence, id. at 56,761/1, we think the

Commission has not sufficiently supported its conclusion that

increasing the potential for election of directors nominated by

shareholders will result in improved board and company

performance and shareholder value, id. at 56,761/1; see id. at

56,761/3.

Moreover, as petitioners point out, the Commission

discounted the costs of Rule 14a-11 — but not the benefits —

as a mere artifact of the state law right of shareholders to elect

directors. For example, with reference to the potential costs

of Rule 14a-11, such as management distraction and reduction

in the time a board spends “on strategic and long-term

thinking,” the Commission thought it “important to note that

these costs are associated with the traditional State law right

to nominate and elect directors, and are not costs incurred for

including shareholder nominees for director in the company’s

proxy materials.” Id. at 56,765/1–2. As we have said before,

this type of reasoning, which fails to view a cost at the

margin, is illogical and, in an economic analysis,

unacceptable. See Chamber of Commerce, 412 F.3d at 143

(rejecting Commission’s argument that rule would not create

“costs associated with the hiring of staff because boards

typically have this authority under state law,” and assuming

that “whether a board is authorized by law to hire additional

staff in no way bears upon” the question whether the rule

13

would “in fact cause the fund to incur additional staffing

costs”).

2. Shareholders with Special Interests

The petitioners next argue the Commission acted

arbitrarily and capriciously by “entirely fail[ing] to consider

an important aspect of the problem,” Motor Vehicle Mfrs.

Ass'n, 463 U.S. at 43, to wit, how union and state pension

funds might use Rule 14a-11. Commenters expressed

concern that these employee benefit funds would impose costs

upon companies by using Rule 14a-11 as leverage to gain

concessions, such as additional benefits for unionized

employees, unrelated to shareholder value. The Commission

insists it did consider this problem, albeit not in haec verba,

along the way to its conclusion that “the totality of the

evidence and economic theory” both indicate the rule “has the

potential of creating the benefit of improved board

performance and enhanced shareholder value.” 75 Fed. Reg.

at 56,761/1. Specifically, the Commission recognized

“companies could be negatively affected if shareholders use

the new rules to promote their narrow interests at the expense

of other shareholders,” id. at 56,772/3, but reasoned these

potential costs “may be limited” because the ownership and

holding requirements would “allow the use of the rule by only

holders who demonstrated a significant, long-term

commitment to the company,” id. at 56,766/3, and who would

therefore be less likely to act in a way that would diminish

shareholder value. The Commission also noted costs may be

limited because other shareholders may be alerted, through

the disclosure requirements, “to the narrow interests of the

nominating shareholder.” Id.

The petitioners also contend the Commission failed to

respond to the costs companies would incur even when a

14

shareholder nominee is not ultimately elected. These costs

may be incurred either by a board succumbing to the

demands, unrelated to increasing value, of a special interest

shareholder threatening to nominate a director, or by opposing

and defeating such nominee(s). The Commission did not

completely ignore these potential costs, but neither did it

adequately address them.

Notwithstanding the ownership and holding

requirements, there is good reason to believe institutional

investors with special interests will be able to use the rule and,

as more than one commenter noted, “public and union

pension funds” are the institutional investors “most likely to

make use of proxy access.” Letter from Jonathan D. Urick,

Analyst, Council of Institutional Investors, to SEC 2 (January

14, 2010), available at

http://www.cii.org/UserFiles/file/resource%20center/correspo

ndence/2010/1-14-10%20Proxy%20Access%20Comment%

20Letter.pdf. Nonetheless, the Commission failed 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. See, e.g.,

Detailed Comments of Business Roundtable on the Proposed

Election Contest Rules and the Proposed Amendment to the

Shareholder Proposal Rules 102 (August 17, 2009), available

at http://businessroundtable.org/uploads/hearings-

letters/downloads/BRT_Comment_Letter_to_SEC_on_File_N

o_S7-10-09.pdf (“‘state governments and labor unions ...

often appear to be driven by concerns other than a desire to

increase the economic performance of the companies in which

they invest’” (quoting Leo E. Strine, Jr., Toward a True

15

Corporate Republic: A Traditionalist Response to Bebchuk’s

Solution for Improving Corporate America, 119 Harv. L. Rev.

1759, 1765 (2006))). By ducking serious evaluation of the

costs that could be imposed upon companies from use of the

rule by shareholders representing special interests,

particularly union and government pension funds, we think

the Commission acted arbitrarily.

3. Frequency of Election Contests

In the Proposing Release, the Commission estimated 269

companies per year, comprising 208 companies reporting

under the Exchange Act and 61 registered investment

companies, would receive nominations pursuant to Rule 14a-

11. 74 Fed. Reg. at 29,064/1. In the Adopting Release,

however, the Commission reduced that estimate to 51,

comprising only 45 reporting companies and 6 investment

companies, in view of “the additional eligibility

requirements” the Commission adopted in the final version of

Rule 14a-11. 75 Fed. Reg. at 56,743/3–56,744/1. (As

originally proposed, Rule 14a-11 would have required a

nominating shareholder to have held the securities for only

one year rather than the three years required in the final rule.

See id. at 56,755/1.) In revising its estimate, the Commission

also newly relied upon “[t]he number of contested elections

and board-related shareholder proposals” in a recent year,

which it believed was “a better indicator of how many

shareholders might submit a nomination” than were the data

upon which it had based its estimate in the Proposing Release.

Id. at 56,743/3.

The petitioners argue the Commission’s revised estimate

unreasonably departs from the estimate used in the Proposing

Release, conflicts with its assertion the rule facilitates

elections contests, and undermines its reliance upon frequent

16

use of Rule 14a-11 to estimate the amount by which

shareholders will benefit from “direct printing and mailing

cost savings,” id. at 56,756 & n.872. The petitioners also

contend the estimate is inconsistent with the Commission’s

prediction shareholders will initiate 147 proposals per year

under Rule 14a-8, a rule not challenged here. * See id. at

56,677/2.

The Commission was not unreasonable in predicting

investors will use Rule 14a-11 less frequently than traditional

proxy contests have been used in the past. As Commission

counsel pointed out at oral argument, there would still be

some traditional proxy contests; the total number of efforts by

shareholders to nominate and elect directors will surely be

greater when shareholders have two paths rather than one

open to them. In any event, the final estimated frequency (51)

with which shareholders will use Rule 14a-11 does not clearly

conflict with the higher estimate in the Proposing Release

(269), or the estimate of proposals under Rule 14a-8 (147),

both of which were based upon looser eligibility standards.

In weighing the rule’s costs and benefits, however, the

Commission arbitrarily ignored the effect of the final rule

upon the total number of election contests. That is, the

Adopting Release does not address whether and to what

extent Rule 14a-11 will take the place of traditional proxy

contests. Cf. 75 Fed. Reg. at 56,772/2. Without this crucial

datum, the Commission has no way of knowing whether the

rule will facilitate enough election contests to be of net

benefit. See id. at 56,761/1 (anticipating “beneficial effects”

*

The Commission simultaneously amended Rule 14a-8 to prevent

companies from excluding from their proxy materials shareholder

proposals to establish a procedure for shareholders to nominate

directors. See 75 Fed. Reg. at 56,670/2.

17

because rule will “mak[e] election contests a more plausible

avenue for shareholders to participate in the governance of

their company”).

We also agree with the petitioners that the Commission’s

discussion of the estimated frequency of nominations under

Rule 14a-11 is internally inconsistent and therefore arbitrary.

In discussing its benefits, the Commission predicted

nominating shareholders would realize “[d]irect cost savings”

from not having to print or mail their own proxy materials.

Id. at 56,756/2. These savings would “remove a disincentive

for shareholders to submit their own director nominations”

and otherwise facilitate election contests. Id. The

Commission then cited comment letters predicting the number

of elections contested under Rule 14a-11 would be quite high.

See id. at 56,756/3 n.872. One of the comments reported,

based upon the proposed rule and a survey of directors, that

approximately 15 percent of all companies with shares listed

on exchanges, that is, “hundreds” of public companies,

expected a shareholder or group of shareholders to nominate a

director using the new rule. Letter from Kenneth L. Altman,

President, The Altman Group, Inc., to SEC 3 (January 19,

2010), available at http://www.sec.gov/comments/s7-10-

09/s71009-605.pdf. Thus, the Commission anticipated

frequent use of Rule 14a-11 when estimating benefits, but

assumed infrequent use when estimating costs. See, e.g.,

supra at 10 (SEC asserted solicitation and campaign costs

would be minimized because of limited use of the rule).

B. Application of the Rule to Investment Companies

Because the rule is arbitrary and capricious on its face, it

is assuredly invalid as applied specifically to investment

companies. Lest the Commission on remand apply to

investment companies a newly justified version of the rule,

18

however, only to be met in court again by valid objections, we

think it prudent to take up the more serious of the concerns

posed by investment companies but left unaddressed by the

Commission.

Investment companies, such as mutual funds, pool

investors’ assets to purchase securities and other financial

instruments. They are subject to different requirements,

providing protections for shareholders not applicable to

publicly traded stock companies. See 75 Fed. Reg. at

56,684/2. For example, the ICA requires shareholders’

approval of certain key decisions. See 15 U.S.C. § 80a-13(a)

(majority vote needed to change fund’s “subclassification,”

i.e., among open-end, closed-end, or diversified).

One “investment adviser” typically manages a family of

mutual funds, known as a “complex.” The boards of the

funds in a complex are generally organized in one of two

ways: Either there is a “unitary board,” comprising one group

of directors who sit as the board of every fund in the complex,

or there are “cluster boards,” comprising two or more groups

of directors, with each group overseeing a different set of

funds within the complex. A recent survey showed 81

percent of responding complexes have a unitary board and 15

percent a cluster structure. In either case, boards typically

address the business of multiple funds in a single meeting.

We agree with the petitioners and amici curiae, the

Investment Company Institute and Independent Directors

Council, that the Commission failed adequately to address

whether the regulatory requirements of the ICA 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. Although the

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Commission acknowledged the significant degree of

“regulatory protection” provided by the ICA, it did almost

nothing to explain why the rule would nonetheless yield the

same benefits for shareholders of investment companies as it

would for shareholders of operating companies. For example,

the Commission justified applying Rule 14a-11 to investment

companies in part on the ground that “investment company

boards ... have significant responsibilities in protecting

shareholder interests, such as the approval of advisory

contracts,” 75 Fed. Reg. at 56,684/1–2, but did not consider

that the ICA already requires shareholder approval of

advisory contracts. See 15 U.S.C. § 80a-15(a). Cf. Am.

Equity, 613 F.3d at 178–79 (SEC’s analysis was “incomplete

because it fail[ed] to determine whether, under the existing

regime, sufficient protections existed” to advance the stated

benefits of the rule and to promote efficiency).

The Commission also failed to deal with the concern that

Rule 14a-11 will impose greater costs upon investment

companies by disrupting the unitary and cluster board

structures with the introduction of shareholder-nominated

directors who sit on the board of a single fund, thereby

requiring multiple, separate board meetings and making

governance less efficient. See, e.g., Letter from Jeffrey W.

Rubin, Chair, Comm. on Fed. Regulation of Secs., Am. Bar

Ass’n, to SEC 61–62 (August 31, 2009), available at

http://www.sec.gov/comments/s7-10-09/s71009-456.pdf

(predicting application of rule to investment companies will

“eliminat[e] any benefit to the ‘cluster board’ structure,”

which structure “creates[s] many efficiencies, such as

concurrent meetings among several or many different

investment companies that have similar interests, issues and

economies of scale that result from being part of a family of

funds”). The Commission acknowledged “the election of a

shareholder director nominee may ... increase costs and

20

potentially decrease the efficiency of the boards.” 75 Fed.

Reg. at 56,684/3. Nonetheless, it did not consider these as

incremental costs of the rule because it erroneously attributed

them to “the State law right to nominate and elect directors,”

perhaps a necessary but not a sufficient cause, and dismissed

them with the conclusory assertion that the “policy goals and

the benefits of the rule justify these costs.” Id.

The Commission did acknowledge that it believed costs

would be lower for investment companies because their

shareholders are mostly retail investors; would be less likely

to meet the three-year holding requirement; and would have

fewer opportunities to use the rule because some investment

companies may under state law elect not to hold annual

meetings. Id. at 56,685/1. It also determined disruptions to

unitary and cluster boards could be mitigated through the use

of confidentiality agreements “in order to preserve the status

of confidential information regarding the fund complex.” Id.

These observations do not adequately address the

probability the rule will be of no net benefit as applied to

investment companies. First, the Commission failed to

consider that less frequent use of the rule by shareholders of

investment companies also reduces the expected benefits of

the rule. Second, the Commission’s assertion that

confidentiality agreements could meaningfully reduce costs is

an ipse dixit, without any evidentiary support and

unresponsive to the contrary claim of investment companies

that confidentiality agreements would be no solution because

the shareholder-nominated director would have no fiduciary

duty to other funds in the complex and, in any event, could

not be “legally obliged” to enter into a confidentiality

agreement.

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Finally, the Commission observed that “any increased

costs and decreased efficiency of an investment company’s

board as a result of the fund complex no longer having a

unitary or cluster board would occur, if at all, only in the

event that investment company shareholders elect the

shareholder nominee.” Id. at 56,684/3. The Commission’s

point was that shareholders might benefit from getting proxy

materials “making [them] aware of the company’s view on

the perceived benefits of a unitary or cluster board and the

potential for increased costs and decreased efficiency if the

shareholder nominees are elected.” Id. at 56,685. And so

they might, but this rationale is tantamount to saying the

saving grace of the rule is that it will not entail costs if it is

not used, or at least not used successfully to elect a director.

That is an unutterably mindless reason for applying the rule to

investment companies.

III. Conclusion

For the foregoing reasons, we hold the Commission was

arbitrary and capricious in promulgating Rule 14a-11.

Accordingly, we have no occasion to address the petitioners’

First Amendment challenge to the rule. The petition is

granted and the rule is hereby

Vacated.