By Christopher P. Davis
The recent proxy access rule decision delivered by the U.S. Court of Appeals for the District of Columbia was a comprehensive rebuke to the SEC. Judge Ginsburg’s decision in Business Roundtable v. SEC could be a death warrant for a rule that would have allowed eligible investors to cheaply and efficiently get their suggested candidates elected to public company boards of directors. The SEC rule that was shot down by the court would have allowed an investor to propose the election of at least one director, but never more than 25% of all directors, if that investor held at least three percent of a company’s outstanding shares for at least three years. Not every hedge fund would see the proxy access rule as a tool of choice, but for those hedge funds meeting the eligibility requirements, a potentially important and relatively inexpensive activist tool is now on life support unless the SEC can find a way to undo what the court has done.
Read narrowly, the Business Roundtable decision finds that the SEC failed (rather miserably, it would seem) to meet its burdens under the Administrative Procedure Act to consider the proxy access rule’s “effect on efficiency, competition and capital formation.” The court found repeated examples of the SEC having been arbitrary, capricious and illogical or inconsistent in its cost-benefit analysis—which the court goes out of its way to note is not the first time that the SEC has failed before the court in its rulemaking duties. The completeness of the Business Roundtable’s victory and the SEC’s defeat is telling, with the court striking down the rule as it applies to both public companies and investment companies.
What may be most interesting for activist hedge fund managers, however, are the factors the court never considered and the unspoken assumptions the court seemed willing to make.
For instance, the court found that the SEC “failed to appreciate the intensity with which issuers would oppose the nominees” suggested by qualifying shareholders, while accepting plaintiff’s figures that proxy contests would cost those companies (and, by extension, their shareholders) between $4 million and $14 million for larger public companies and between $800,000 and $3 million for smaller companies. Not once, however, did the court consider the cost savings to qualifying shareholders in avoiding proxy contests against companies that would otherwise squander their shareholders’ money in opposing quality nominees suggested by someone other than its nominating committee. What’s more, the court seems to uncritically accept that because boards are willing to spend such large sums, the SEC must build even the most excessive examples of this behavior into its cost-benefit calculations in trying to justify the rule. It’s unclear whether the SEC can realistically satisfy such an artificially high hurdle.
In another instance, Judge Ginsburg spends considerable time focusing on minority shareholders who may act out of special interests not shared by all investors, particularly labor unions that might use the rule as leverage to gain wage concessions. Yet the court assumes that boards act from pure motives, and never considers that they may have their own territorial reasons for opposing nominations under the rule while wrapping themselves in the banner of fiduciary duty and the business judgment rule. Likewise, the court never considers that minority investors have no fiduciary duties to other shareholders and are supposed to be acting in pursuit of their own best interests, which in the case of hedge funds mean the interests of their investors, whose interests may be frustrated by an incompetent or entrenched public company board.
In finding fault with the SEC’s cost-benefit analysis, the court also latches on to a study provided by the plaintiffs purporting to show that in the two years following the election of so-called dissident directors to board seats, those companies underperformed their competitors by 19% to 40%. But the court never considers that it is companies with weaker, underperforming boards that typically face proxy contests in the first place, and that where control is not obtained by the activist, as would have been the case under the rule, the shareholder friendly directors simply don’t have the numbers on the board to bring prompt, wholesale improvements. In other words, holdover directors from the old regime can still serve as a drag on company performance, as every activist knows.
It will take an impressive display of skill for the SEC to reverse the downward trajectory of the rule at an en banc rehearing or on an appeal. Starting from scratch on a new rule would be time consuming, and it remains unclear whether the SEC can bear the burden the court demands of it, especially in the face of inevitable opposition from emboldened, well capitalized and litigious industry opponents such as the Business Roundtable and the Chamber of Commerce.
Ultimately, it may take an act of Congress to bring greater board access to minority shareholders unwilling or unable to spend a king’s ransom to get representation on the board of a public company willing to adopt scorched earth tactics to protect its nominating privileges. Given the political capital Congress recently expended on the Dodd-Frank Act, it is difficult to believe that this will be a priority on Capitol Hill anytime soon.
Christopher P. Davis is a partner and head of the investor activism practice at New York law firm Kleinberg, Kaplan, Wolff & Cohen.