In the case of Business Roundtable and U.S. Chamber of Commerce vs. SEC, the U.S. Court of Appeals in Washington struck down the Securities and Exchange Commission's proxy access rule, adopted in 2010. The rule would have required companies to include in their annual meeting proxy materials information supplied by long-term, significant shareholders about their own nominees for director, as long as the shareholders were seeking only a minority of board seats and not a change of control.
In a harshly worded opinion, the court, in its July 22 decision, found that the SEC had “opportunistically framed” its analysis of the rule's economic effects, and set a standard requiring “substantial economic analysis that may be beyond the resources that the agency can reasonably expend on any one rulemaking,” wrote Noam Noked in “Implications of the Proxy Access Case,” Harvard Law School Forum on Corporate Governance and Financial Regulation, Aug. 23. The ruling has slowed the pace of rulemaking under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, even as the shadow of a new financial crisis is looming, casting doubt on the ability of the financial regulations responding to the 2008 crisis to survive legal challenge by the regulated firms and their Washington lobbies. The other federal financial regulators, aware that the scope and sophistication of the SEC's economic analyses generally exceeds their own, view the ruling with concern for their own ability to adopt valid rules, and are looking to the SEC for a way forward.
The various potential responses to the Business Roundtable decision fall into familiar categories of psychiatrist Elisabeth Kubler-Ross' model of five phases of grief.
Let's start with “anger.”
What made SEC economists and other officials particularly angry was the holding that the commission botched its evaluation of the existing empirical literature.
The standard of review is supposed to be whether a reasonable person considering the matters on the agency's table could find a rational basis to arrive at the same judgment. Instead, this skeptical court ignored the deference due an agency that employs two dozen respected Ph.D. financial economists. Instead, it placed uncritical reliance upon a long-discredited study gingerly advanced by the roundtable's paid experts, and weakly defended in its brief.
But there's no point in sour grapes, and, besides, anger is supposed to be the second of the Kubler-Ross phases of grief. There's a reason for that: the proxy access case has finally taken the ever-attractive “denial” option off the table once and for all.
The Business Roundtable case is the fourth opinion in a line of recent cases from the Court of Appeals in Washington involving three different SEC rules. If one were of a mind to deny the proposition that economics — not law or policy disagreements alone — is what this line of cases is about, the back-stories of the first three opinions could help you out.
In two of the three earlier case — U.S. Chamber of Commerce vs. the SEC, one decided in 2005 and the other in 2006 — and the third case — American Equity Investment Life Insurance Co. vs. the SEC, decided in 2010 — the primary claim was a legal challenge to the commission's statutory authority to adopt the rules in question. The SEC won that argument in those cases. The petitioners prevailed only on their secondary arguments, which got the rules remanded only to correct perceived defects in the economic analysis. Those decisions could have been viewed, therefore, as partial victories for the SEC, even though, for various reasons, those rules, once remanded, were never re-proposed. The operations were a success, some could say, even though the patients died.
The proxy access issue had been debated for decades, and the SEC proposed it almost a year before the enactment of the Dodd-Frank act. In the response to the proposal, the roundtable filed a 154-page comment letter and a 29-page report by law-and-economics experts, mainly challenging the SEC's statutory authority, but also offering legal, policy and economic arguments against the rule. The Dodd-Frank act expressly confirmed the SEC's authority to adopt proxy access rules, and the SEC devoted substantial effort to a sophisticated economic analysis of its rule that included an evaluation of the economics papers cited by the roundtable's consultants.
When anger and denial both subside, the patient enters the Kubler-Ross stage of “negotiation.” The term doesn't refer to practical problem-solving, but rather to the poignant attempts to bargain with God that occur after the death of a loved one. Into that category of magical thinking, I'm afraid we must place all hopes for a legislative fix for the impossible standards for economic analysis seemingly set by the Business Roundtable and U.S. Chamber of Commerce vs. SEC case.
In a perfect world, the SEC's economic analysis of its rule, while valid and useful, should be exempt by law from judicial review, the way it is for executive agencies. There are two sides to every story in economics, and it's only common sense that regulated entities shouldn't be able to knock down with a feather agency rules adopted after due deliberation for the greater good.
When appeals to the Higher Power prove vain, the patient's next move in the classical paradigm is “depression.”
The voice of despair would say, Those judges think that they're the experts in economics, so there's just no point in arguing economics to them: their opinions will always trump ours, no matter what we say or do.
What is the way forward out of this depression? The only way is the hard way: take the economics even more seriously, and soldier on. Kubler-Ross calls this “acceptance.” Professional economists well know the value of their empirical work and theoretical models. But they are scientists, not advocates or politicians, and they insist as much on the limits of those models and quantitative results of that research as they do on their value. Economic analysis should inform, but cannot determine, regulatory policy.
No economic analysis can be perfect, but the quality of the analysis in the proxy access case is a standard that other federal agencies are still struggling to reach, even though it garnered only scorn from the court of appeals.
Still, the financial regulatory agencies need to do more:
First, agencies must put aside fears of fresh rebukes, and give the courts what they're asking for: economics that financial economics professionals respect. Economic analysis isn't just about tallying up estimates of paperwork costs. It's about gains to investors and the economy as a whole through increased efficiency in trillion dollar capital markets, gains that dwarf the miniscule numbers that are sometimes mistaken for economic costs in the case law.
As pointed out to the court in the Business Roundtable and U.S. Chamber of Commerce versus SEC case in the amicus brief, filed by the Council of Institutional Investors, TIAA-CREF and 35 other institutional investors, “the SEC's predictions have already been proven correct,” citing a recent event study that concluded that “financial markets placed a positive value on shareholder access, as implemented in the SEC's August 2010 rule.”
Where benefits are measured in billions, the stakes for investors and the nation's economy are high. If financial regulatory agencies begin to include quantified estimates of benefits in rule releases, the public and the courts may begin to see those burdens in a better perspective. Benefits estimates will necessarily be inexact and inevitably will draw fresh attacks from regulated entities in litigation. But courts ask no more than an agency makes economic assessments as best it can, and should respect benefits estimates for what they are.
Another way to earn the respect of the Court of Appeals would be to articulate the economic theory behind each rule in a form that can be tested empirically after the fact in a retrospective analysis. The actual analysis made prior to adoption would therefore be of necessity a high-level, largely qualitative one. It would give policymakers guidance, and direct attention to the main mechanisms and effects of the rule.
Finally, the SEC should consider formally construing the sections of the securities laws that have been causing all this trouble. The U.S. Supreme Court's Chevron USA versus National Resources Defense Council decision in 1984 directed the lower courts to defer to agency interpretations of their own statutes. The federal securities laws were amended in 1996 to require the SEC when acting in the public interest to consider the effects of its rules on competition, efficiency and capital formation, in addition to the protection of investors. This single sentence is the hook on which the recent line of cases depends. The SEC would merit the Chevron decision deference to its economic analyses by defining what these terms actually mean, what it means for the commission to consider them. The SEC also entitled to define the relationship between its consideration of economic factors and its primary mandate of investor protection. One thing we do know: an administrative agency is due no deference as to determinations it fails to make.
The SEC's expertise in financial economics is the agency's ace in the hole. If that card is played right, a jurisprudence could develop under which the courts will permit the agency to define both the ground rules and the boundaries of the economic analysis that are suitable for the rule at hand, even as they continue to take a hard look at the results.
Bruce R. Kraus was co-chief counsel, division of risk, strategy and financial innovation, of the Securities and Exchange Commission, Washington, from 2009 until he left recently to explore opportunities in private legal practice. The commentary is adapted from a speech given Oct. 5 at The Yale Law School Center for the Study of Corporate Law. His views do not necessarily reflect those of the SEC.
