On Nov. 5, 2019, Securities & Exchange Commission Chairman Jay Clayton announced a proposal to “modernize” the proxy voting system by adding more limitations on shareholders’ ability to place proposals on a company’s proxy statement, based on the dollar amount of shares held (among other things), as well as additional limits on proxy advisory firms. This was the second in a proposed series of modifications to the proxy architecture.
For the reasons below, the second round of proposed rule changes was proposed in violation of governing law, and should be stricken in their entirety.
Clayton did not justify these changes as something large public companies had been lobbying for over many years. Instead, he professed to have been moved by letters he received from “long-term Main Street investors”—including veterans, a teacher and public servant, a single mom, and retirees, “all of whom expressed concerns about the current proxy process.”
This made the later discovery by Bloomberg News that these, and many other letters cited in support of the SEC proposal, were utterly bogus, somewhat embarrassing. The letters instead sprang from the imaginations of a corporate lobbying group. Several alleged signatories told reporters that they had nothing to do with the missives submitted in their names.
Rulemaking Process Deeply Infected
This is more than simply an embarrassment to the rule-making process, and an affront to the credibility of the SEC. Even though the rules are, at this stage, simply proposals (there is a 60-day public comment period, after which the SEC must again vote whether to approve the rules), the procedural and institutional impropriety occasioned by the reliance on fraudulently procured investor “evidence” so deeply infects the rule-making process as to preclude the adoption of the proposed rules in their current form.
The Administrative Procedure Act allows courts to invalidate rules promulgated by federal agencies that are found to be, among other things, “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”
Under the APA’s “arbitrary and capricious” standard, a court should evaluate whether the agency’s factual determinations were rationally related to the ultimate rule(s). The U.S. Supreme Court has emphasized the importance of a disciplined fact-finding process wherein an agency demonstrates that it “examine[d] the relevant data and articulate[d] a satisfactory explanation for its action including a rational connection between the facts found and the choice made.”
Courts have invalidated SEC rules based on an insufficient factual foundation. A previous attempt at modifying proxy rules was struck based on “insufficient empirical data” because the SEC cherry-picked the data it considered by relying upon unpersuasive evidence. See Business Roundtable v. SEC (D.C. Cir. 2011); see also American Equity Inv. Life Ins. Co. v. SEC (D.C. Cir. 2010) (invalidating rule due to “flawed” reasoning based on inadequate fact-finding). American Equity also held that when the SEC purports to rely on something, like the investor letters here, the rule shall be judged based on that reliance—even if it was not required.
Consequently, since the investor letters have proven to be fictitious, approval of the proposed rules in their current state would violate the requirement that SEC rules be based on a rational review of existing evidence. It is also clear if one reads the letters that they are not from actual individual investors—among other things, the address headings contain the phrase “A Coalition of Growth Companies.”
The fact that the SEC relied on these letters but did not pay enough attention to determine they were suspicious also undermines the integrity of the rule-making process.
While these are not yet approved rules, simply proposals, the claimed reliance on the letters has infected the rule-making process. The letters represent not merely statements of fact, but reflect statements about what ordinary investors want and believe—statements that have proven to be false.
Just like a party would not be permitted to present evidence in a civil proceeding purporting to be from a neutral witness but actually supplied by an interested party, we should be repelled when a government agency purports to be presenting rules supposedly motivated by “Main Street” investors that are actually from Wall Street lobbyists. The investing public, investment advisers, and the companies the SEC regulates, deserve better.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Howard Fischer is a partner in the litigation and white collar departments of Moses & Singer LLP. As a former senior trial counsel at the SEC, he was lead counsel in the litigation against Wing Chau and Harding Advisory LLC (relating to CDO asset selection in the run-up to the financial crisis) resulting in a major victory against one of the characters lampooned in the film “The Big Short.” He also led the SEC litigation involving the infamous London Whale, arising from JPMorgan Chase trader Bruno Iksil’s multi-billion dollar loss in its credit derivatives book.
Matthew Handler is an associate with the securities litigation and white collar practices of Moses & Singer.