Business Roundtable v. SEC

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
 3
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
 5
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.
 6
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
 7
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
 8
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
 9
[to] 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
 10
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
 11
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 contest.” 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
 12
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
 19
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.
 21
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 views 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 56,684–85. 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.