SEC Faces More Scrutiny After Court Spiked Rule

When a federal appeals court last month overturned a rule to allow shareholder proxy access, it didn't just deliver a rebuke to the Securities and Exchange Commission; it gave a roadmap to SEC critics eager to thwart the agency's many other forthcoming rules.

Now those critics seem to be proceeding just so, raising objections to SEC proposed rules that echo the logic the appellate court used to declare the proxy access rule invalid. The practical result could be still more delays in implementing many rules of the Dodd-Frank Act, when the SEC is already well behind schedule—with corporate compliance departments left in the lurch.

The SEC's proxy access rule was overturned on July 22, in a decision by a three-judge appellate court in Washington, D.C. Siding with the plaintiffs, the U.S. Chamber of Commerce, and the Business Roundtable, the judges held that the SEC failed to do an adequate study of the costs its proxy access rule would impose on businesses before the agency adopted the rule earlier this year. In the words of Judge Douglas Ginsburg: “The [SEC] inconsistently and opportunistically framed the costs and benefits of the rule [and] failed adequately to quantify the certain costs or to explain why those costs could not be quantified.”

Already other corporations and business lobbyists are citing that point in comment letters about other rule proposals. Royal Dutch Shell and the American Petroleum Institute, for example, have both cited compliance costs and economic harm in letters they recently submitted to the SEC about proposed new disclosure rules affecting oil and mining companies. The rule would require such businesses to disclose all payments made to foreign governments.

The American Petroleum Institute's letter, submitted by Kyle Isakower, vice president for regulatory and economic policy, read in part: “The pending rulemaking … has the potential to impose substantial costs and to have significant adverse effects on efficiency, competition, and capital formation. We refer not only to the potential for hundreds of millions of dollars in direct reporting and compliance costs, but to the very real potential for tens of billions of dollars of existing, profitable capital investments to be placed at risk” because the disclosures the SEC wants are often illegal to make in other countries, where companies might then be barred from doing business.

Stephen Comstock, tax policy manager at API, says his group wanted to highlight the importance of economic analysis in the proposed rule. “We felt that since the SEC is still in the process of writing the rule, it will be good for them to recognize they should look at the cost and benefits of the rule,” he said.

In the letter sent by Martin ten Brink, corporate controller at Royal Dutch Shell, he explicitly cites the proxy access ruling in his first sentence. Ten Brink then goes on to warn, “If [the SEC] were to adopt rules requiring disclosure for immaterial projects, disclosure that by definition is not important to reasonable investors, our marginal costs for this additional disclosure, with the required changes to our financial systems, needed to gather, assure, and disclose the proposed information, would be in the tens of millions of dollars.”

“Based on the court's decision, it is absolutely clear that they are setting an extremely high standard for the SEC in rulemaking, particularly from the economic analysis standpoint.”

—David Martin,

Partner,

Covington & Burling

So how often will commenters cite cost-benefit analyses—which the SEC is required to do when issuing new rules—when criticizing future proposals? Nobody knows yet, but few doubt that it will happen much more often. Conventional wisdom is already forming that SEC opponents will use the tactic as a matter of course.

“Based on the court's decision, it is absolutely clear that they are setting an extremely high standard for the SEC in rulemaking, particularly from the economic analysis standpoint,” says David Martin, partner at law firm Covington & Burling. “There is no question that opposition will use the proxy access case to defy future rulemaking.”

David Scileppi, partner at law firm Gunster, Yoakley & Stewart, says numerous Dodd-Frank requirements unpopular with Corporate America—disclosure of pay-for-performance plans, ratios of CEO pay to median employee pay, and hedging by executives, to name a few—could all see more delays in adoption as the SEC and opponents spar over cost-benefit studies.

“Although market players cannot challenge every rule, I will expect the increase in dispute over finalized rules to be costly to regulators,” Scileppi says. He also notes that the appellate court decision applies to all regulatory agencies, not just the SEC.

Doing Its Best

COST WORRIES

Below is an excerpt from American Petroleum Institute's letter to the Securities and Exchange Commission:

As explained in detail in prior comment letters submitted by API and by many of our member companies, the pending rulemaking under Section 13(q) of the Exchange Act has the potential to impose substantial costs and to have significant adverse effects on efficiency, competition and capital formation. We refer not only to the potential for hundreds of millions of dollars in direct reporting and compliance costs, but to the very real potential for tens of billions of dollars of existing, profitable capital investments to be placed at risk should the final rules require public disclosure of information that is prohibited from disclosure by the laws of other countries. In addition to the risk to existing investments, substantial value could be lost to SEC filers and their shareholders because of competitive harm from disclosure of overly detailed information, and from the fact that such filers may be excluded from many future projects altogether. Of course, since energy underlies every aspect of the economy, these negative impacts have repercussions well beyond resource extraction issuers.

Fortunately, as also detailed in our prior letters, the Commission has clear discretion to implement Section 13(q) in a manner that substantially achieves the objectives of the legislation while minimizing the potential for damaging impacts.

First, the statutory language gives the Commission discretion to hold individual company data in confidence, and to use that data to prepare a public report consisting of aggregated payment information by country. Such a high-level public report would address many of industry's concerns regarding disclosure of commercially sensitive or legally prohibited information, while still providing transparency as to the amounts received by governments from the extraction of their resources. Such an approach would also be consistent with the Extractive Industries Transparency Initiative, as provided in the statute.

In addition to holding such information in confidence and reporting only aggregated payment information by country, the Commission also has discretion in a number of additional areas to implement Section 13(q) in a manner that achieves its purposes while protecting against disproportionate harm. Specifically, the Commission has authority to (i) define the term “project” so as to minimize the disclosure of commercially-sensitive individual contract terms; (ii) limit disclosure to “material” projects, consistent with long-standing disclosure principles; (iii) provide an exemption from the disclosure of information if prohibited by the laws of another country, consistent with existing Instruction 4 to Paragraph (a)(2) of Item 1202 of Regulation S-K; and (iv) provide an exemption from the disclosure of information that would result in competitive harm, consistent with existing General Instruction E of Form 10-K. To satisfy the requirements to consider the rule's effect upon efficiency, competition, and capital formation, we strongly encourage the Commission to use its discretion as described above, in addition to holding company data in confidence and preparing a public report consisting only of aggregated payment information by country.

In short, we believe there is a path forward that would appropriately balance costs and benefits under Section 13(q), achieve the positive objectives of the statute without causing disproportionate harm to SEC filers and their shareholders, and be supportable under recent court precedent. We urge the Commission to take that path.

Source: American Petroleum Institute Letter to the SEC, Aug. 11, 2011.

Martin expects the SEC to be more attentive to its economic analyses in future rulemaking, to avoid another defeat like the proxy access lawsuit. Still, he says, given the agency's tight budget and looming deadlines to implement the rest of the Dodd-Frank Act, the SEC might push ahead with rulemakings using the same procedures anyway. “At some point, the Commission is going to say we have done the best we can,” he says.

Enacted in July 2010, the Dodd-Frank Act saddled the SEC and various other agencies with writing more than 400 new regulations. As of July 2011, only 51 rules have been fully adopted. Just last month the SEC published a new timeline for future rules, pushing many that were scheduled for adoption later this year into the first half of 2012.

In theory, the SEC and other regulators could win some relief through a directive from Congress (unlikely), or avoid fights if the rule in question is less controversial, says Stanley Keller, partner at law firm Edwards Angell Palmer & Dodge. He also warns that the SEC and other regulators will now be better equipped to fight future court battles about other rules and says companies should not use the proxy access decision as their go-to reference when challenging regulatory agencies' rulemaking procedures.

“Depending on the nature of the subject, the court does not necessarily maintain the same standard toward every rule,” he says. 

Keller also says the proxy access rule was a special case, since the SEC had the discretion to write a different type of proxy access rule if it wanted; that differs from many other Dodd-Frank rules that Congress has specifically ordered the SEC to adopt—and litigation over those rules might produce a different outcome. In that latter scenario, Keller says, the only burden regulators will have is to prove the actual legislative intent over such rule.

Martin agrees: Challengers of a proposed rule will cite the proxy access decision as reason for the SEC to drop or revamp a rule, but the SEC will also have a stronger grip in the case of congressional mandates. “I do not foresee delays in future rulemaking unless the rule in question is not directly ordered by Congress,” he said.

Keller adds that while Corporate America may want regulators to consider their comments about compliance costs when adopting a new rule, sometimes those regulators will have no freedom to do so. “When referring to rules that are mandated by Congress, there is little flexibility the SEC will have in accommodating comments from market players,” he says. The upcoming rule on disclosure of payments by resource extraction issuers will be one of those instances when it will be tough for the SEC to accommodate comments it receives from the public, he says.