Corporate Governance

Business Roundtable v. SEC: The Battle for Access (The Administrative Law Basis for the Challenge)(Part 4)

By J Robert Brown Jr.

Without a meaningful challenge to rulemaking authority, the suit against Rule 14a-11 is really a matter of administrative law.  Rules adopted under the APA must be done pursuant to notice and comment.  In adopting the final version, after notice and comment, the rule must not be arbitrary and capricious.  In determining whether a rule is arbitrary, courts examine the agency's decision in the context of the record created as part of the decision making process.  

To the extent that the decision appears unsupported by the record or does not include elements that are required to be considered, the rule can be struck down as arbitrary.  Much of this is set out in the seminal case Citizens to Preserve Overton Park, Inc. v. Volpe, 401 U.S. 402 (1971), probably the most cited administrative law opinion save Chevron. 

In addition to the prohibition on arbitrary rulemaking, Section 3(f) of the Exchange Act requires that the SEC consider the effect of certain proposed rules on efficiency, competition and capital formation.  See 15 USC 78c(f) ("Whenever pursuant to this title the Commission is engaged in rulemaking, or in the review of a rule of a self-regulatory organization, and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.").  

Similarly, Section 23(a) of the Exchange Act prohibits any rulemaking that would unnecessarily or inappropriately burden competition.  15 USC 78w(a) ("The Commission and the Secretary of the Treasury shall not adopt any such rule or regulation which would impose a burden on competition not necessary or appropriate in furtherance of the purposes of this title."). 

The SEC has had problems with the adequacy of the rulemaking record before.  In Chamber of Commerce v. SEC, 412 F.3d 133 (DC Cir. 2005), a case cited by Petitioners, the court struck down an SEC rule seeking to increase the percentage of independent directors on the boards of investment companies and requiring that the chair be independent.  The court conceded that the SEC had the substantive authority to adopt the rule but found the record inadequate.

The court did so on two grounds.  First, the SEC failed to adequately assess the costs of the rule.  It was not a quibble over the method used to determine the costs but the complete failure to do so.  See Id. (noting that agency lacked a "reliable basis for determining how funds would choose to satisfy the [condition] and therefore it [was] difficult to determine the costs associated with electing independent directors.").  While this precluded a precise measurement, it did not, as the court noted, prevent the determination of a range of expenses.  

The other basis for striking down the rule was more subtle.  It was not that the Commission had failed to adequately weight the consequences of the rule.  Instead, the Commission had failed to take into account alternatives, particularly alternatives to the requirement that the chair be an independent director.  Specifically, two dissenting commissioners had called for increased disclosure in place of substantive regulation.  While noting that the Commission need not consider every alternative, it did have an obligation to consider those that were not "frivolous" or otherwise "out of bounds."  The court was not specifying the need to select an alternative, only to consider it.  See Id.  ("The Commission may ultimately decide the disclosure alternative will not sufficiently serve the interests of shareholders, but the Commission -- not its counsel and not this court -- is charged by the Congress with bringing its expertise and its best judgment to bear upon that issue.").  

The case to some degree provides a roadmap for challenging an SEC rule.  Petitioners make two broad arguments (although they also make many sub-arguments).  First, the Commission made a "flawed assessment" of the "costs, benefits, and effects on efficiency, competition, and capital formation."  In other words, the Commission violated the requirements in the Exchange Act requiring assessment of costs and competition.

Second, it was arbitrary to adopt a categorical rule that denied shareholders the right to resolve issues given the Commission's "stated purposes of empowering shareholders" and the "admission that the rules could harm corporate performance." 

Petitioners object to the rule because they believe it is bad policy.  Disagreement over policy is not, however, a basis for challenging the rule.  As a result, Petitioners were forced to couch their policy disagreements in terms of legal issues such as costs and competition. 

Assorted briefs and motions in this case, including the brief filed by the Business Roundtable, can be found at the DU Corporate Governance web site.?

Full post as published by The Race to the Bottom on January 19, 2011 (boomark / email).