The U.S. Court of Appeals in Washington found that the SEC fumbled one of its biggest initiatives in recent years by failing to adequately assess the potential economic effects of the rule.
The decision preserves a long-standing corporate voting system that gives powerful advantages to candidates nominated by incumbent directors.
The stakes are high: Corporate boards have the power to direct business strategy and set executive pay. They are also supposed to serve as watchdogs over management.
Passage of the rule was a top priority for shareholder activists and a watershed in the long-running battle over executive pay. Some investors have argued that compensation packages approved by boards contributed to the financial crisis by encouraging executives to take reckless risks. Investors have also protested that boards have rewarded executives excessively.
In throwing out the rule, the court sided with two major business groups that filed suit: the Business Roundtable, whose members are top executives of large companies, and the U.S. Chamber of Commerce.
The SEC “acted arbitrarily and capriciously” and “neglected its statutory responsibility” in adopting the rule, Judge Douglas H. Ginsburg said, writing for a three-judge panel.
The agency “inconsistently and opportunistically framed the costs and benefits of the rule . . . and failed to respond to substantial problems” that were raised during the rule-making process, the court said.
The rule was intended to give shareholders greater power to replace directors when they disagree with the way executives and boards are running a company. The SEC predicted it could lead to “improved board performance and enhanced shareholder value.”
“As a matter of fairness and accountability, long-term significant shareholders should have a means of nominating candidates to the boards of the companies that they own,” SEC Chairman Mary Schapiro said last year when the agency issued the rule.
The business groups said the SEC failed to factor in the costs companies would incur campaigning against candidates advanced by shareholders.
The court agreed, and said the SEC did not adequately assess another risk: that institutional shareholders such as unions and state pension funds would use the rule as leverage to extract concessions such as additional benefits for workers.
Those investors could could give higher priority to jobs than to shareholder value, the court said.
Backers of the rule included pension plans for teachers, firefighters and other public employees and the Council of Institutional Investors.
The appeals court opinion was a major slap-down for the SEC. Courts have rejected other SEC rules on similar grounds, Ginsburg wrote.
“We are reviewing the decision and considering our options,” SEC spokesman Kevin Callahan said.
The SEC has also been faulted recently for bungling other responsibilities, including a technology contract and a $557 million office lease
It approved the shareholder voting rule last year 3 to 2, with two Republican commissioners voting against it. The measure is known as the “proxy access” rule because it involves the proxy documents that companies mail to shareholders for voting in board elections.
The mailings are sent at the company’s expense and include the names of the candidates the board has nominated. If investors want to nominate rival candidates, they would have to mail separate materials at their own expense.
The rule would have given shareholders or groups of shareholders the ability to put names on the official ballot if they held at least 3 percent of the company’s stock continuously for at least three years leading up to the election.
In passing the rule, the agency was using authority that Congress gave it under the Dodd-Frank Act, which was adopted last year in response to the crisis.
The appeals court’s posture could signal trouble for the SEC as it tries to implement other rules that business groups oppose.
The agency “really could be tied up in knots trying to dot all the ‘i’s and cross all the ‘t’s,” said Roger Dennis, dean of the Earle Mack School of Law at Drexel University.