Is it ok for an agency to change its mind? Well that depends. If the agency was “arbitrary and capricious” in failing to provide an adequate explanation to justify its change, a court may well vacate that about-face. At least, that’s what just happened to the SEC and Chair Gary Gensler in the Fifth Circuit in National Association of Manufacturers v. SEC, the case challenging the SEC’s rescission in 2022 of some of the key controversial provisions governing proxy voting advice that were adopted by the SEC in July 2020 and favored by NAM—the notice-and-awareness provisions that were designed to facilitate engagement between proxy advisors and the subject companies. You may recall that, in July 2022, NAM filed a complaint asking that the 2022 rescission be set aside under the Administrative Procedure Act and declared unlawful and void, and, in September, NAM filed a motion for summary judgment, characterizing the case as “a study in capricious agency action.” The Federal District Court for the Western District of Texas begged to differ, however, issuing an Order granting summary judgment to the SEC and Gensler and denying summary judgment to NAM and the Natural Gas Services Group in this litigation (see this PubCo post). NAM appealed. In August last year, a three-judge panel of the Fifth Circuit heard oral argument on NAM’s appeal, and it was apparent that the Court was none too sympathetic to the SEC’s case, with Judge Edith Jones mocking the SEC’s concern with the purported burdens on proxy advisors as “pearl-clutching.” (See this PubCo post.) Now, almost a year later, in an opinion by Judge Jones, the panel has concluded “that the explanation provided by the SEC was arbitrary and capricious and therefore unlawful,” reversing the district court’s judgment and vacating and remanding to the SEC the 2022 rescission in part.
Background
2020 rules. For years, many companies and business lobbies, such as NAM, repeatedly raised concerns about proxy advisory firms’ concentrated power and significant influence over corporate elections and other matters put to shareholder votes, leading to questions about whether these firms should be subject to more regulation and accountability. (See, e.g., this PubCo post, this PubCo post and this PubCo post.) Whether and how to regulate proxy advisory firms has long been a contentious issue, with some arguing that their vote recommendations were plagued by conflicts of interest and often erroneous, while others saw no reason for regulation, given that the clients of these firms were satisfied with their services. Some have even thrown proxy advisory firms into the current culture wars over ESG, arguing that proxy advisors have a predisposition to view these ESG programs positively. In September 2019, the SEC published in the Federal Register a new interpretation and guidance directed at proxy advisors confirming that their vote recommendations were considered to be “solicitations” under the proxy rules and subject to the anti-fraud provisions, and providing some “suggestions” about disclosures that would help avoid liability. (See this PubCo post.) Not surprisingly, the proxy advisory firms were not happy with the new interpretation and guidance, leading one, ISS, to sue the SEC. (See this PubCo post.) Then, in 2020, the SEC adopted amendments to the proxy rules that codified the SEC’s interpretation regarding proxy advisors and “solicitations.” In addition, the 2020 rules added to the exemptions from those solicitation rules two significant new conditions, both viewed favorably by many companies and business organizations—one requiring disclosure of conflicts of interest and the second designed to facilitate effective engagement between proxy advisory firms and the companies that were the subjects of their advice by making the advice available for review to the subject companies. Although the proposal had required that the proxy advice be provided to companies in advance of dissemination to clients, in response to public comment that the proposed rules would affect the timeliness and independence of proxy advice, the SEC adopted modifications in the final rules to provide that the advice be sent to companies at or prior to the time it was sent to clients and to require a mechanism for clients to become aware of company responses. Compliance with the new conditions was not required prior to December 1, 2021. (See this PubCo post).
2022 amendments. In June, soon after assuming his position as SEC Chair, Gensler directed the staff to take another look at the 2020 rules, and the staff announced that it would decline to recommend enforcement in the interim. Then, following a notice-and-comment process, the SEC adopted new amendments to the proxy advisor rules reversing some of those key provisions governing proxy voting advice that were adopted in July 2020. Under the 2022 amendments, proxy voting advice would still be considered a “solicitation” under the proxy rules and proxy advisors would still be subject to the requirement to disclose conflicts of interest; however, the new amendments rescinded the second central condition that was designed to facilitate engagement between proxy advisors and the subject companies—the notice-and-awareness provisions—which some might characterize as a core element of the 2020 amendments. The amendments also rescinded an explanatory note to Rule 14a-9, also adopted as part of the 2020 rules, which provided examples of situations in which the failure to disclose certain information in proxy voting advice may be considered misleading. As summarized in the order by the District Court, the SEC explained that the rescinded condition designed to facilitate engagement “did not ‘sufficiently justify the risks they pose[d]to the cost, timeliness, and independence of proxy voting advice on which many investors rely.’ And when rescinding Note (e), the SEC highlighted that Note (e) presented a ‘risk of confusion regarding the application of Rule 14a-9 to proxy voting advice.’” (See this PubCo post.)
In the District Court. NAM then filed the complaint at issue here, contending that the 2022 rules were “both procedurally defective and arbitrary and capricious, and therefore must be set aside” under the APA. “The agency,” NAM argued, “has come to a completely opposite outcome to that reached only two years ago, and it has done so on the basis of the exact same factual record that drove the SEC to adopt the 2020 Rule in the first place. The SEC does not—no doubt because it cannot—offer any compelling justification for why the exact same factual record requires a different result this time around.” NAM’s motion for summary judgment was then filed in September and the SEC’s cross-motion in October. In its motion, NAM contended that the 2020 rules represented a rulemaking compromise that was the result of a “decade of bipartisan policymaking”; new Chair Gensler, NAM argued, made “an abrupt about-face.” What’s more, when it issued the new proposal in November, NAM highlighted, the SEC provided only a 31-day public comment period, which took place over the holidays. NAM contended that the 2022 rules should be set aside under the APA because the SEC “erred in several independent respects: In abruptly reversing course, the SEC improperly disregarded its earlier factual findings that contradict its new action; the SEC’s reasoning is demonstrably irrational; the SEC failed to address significant criticisms leveled by commenters and dissenting Commissioners; and the SEC denied the public a meaningful opportunity to comment.”
The District Court granted the SEC’s motion for summary judgment and denied NAM’s motion. NAM had contended that, under the “arbitrary and capricious” standard, the SEC must provide a “‘more detailed justification’ than normal because the 2022 Rescission reversed a prior policy decision.” As explained by the District Court, the standard for “arbitrary and capricious” enunciated by SCOTUS is whether the “agency examined ‘the relevant data’ and articulated a ‘satisfactory explanation.’ A ‘satisfactory explanation’ includes a ‘rational connection between the facts found and the choice made.’” Normally, that standard would apply unless the change in policy rested on new factual findings. But the SEC contended that it “merely weighed the same risks that the 2020 Rule did but reached a different conclusion”; in 2020, it had concluded that the rules posed little risk to the timeliness and independence of proxy advisors, but in 2022, it concluded that there were potential adverse effects sufficient to tank those aspects of the 2020 rule. The District Court concluded that the SEC “did not contradict prior factual findings and was not required to provide a more detailed justification.”
The District Court also concluded that the stated justifications were rational. As described by the District Court, the SEC gave two reasons for its policy change: first, to alleviate the costs to proxy advisors and companies of the 2020 rules and, second, to address the concerns of clients and investors about proxy advisors’ timeliness and independence. In light of public comments indicating that the company engagement provisions increased costs “without corresponding investor protection benefits,” the District Court found that the SEC’s “reasoning rationally connected the facts (the increased compliance costs) to its conclusion (rescinding the 2020 rule would alleviate those costs).” In addition, the Court concluded, in light of the “continued, strong opposition” in the public comments, rescinding those provisions of the 2020 Rules “was ‘rationally connected’ to the public commentators’—and the Commission’s—concerns that such conditions posed a risk to the timeliness and independence of [proxy advisors].”
The District Court also made short shrift of NAM’s argument that the SEC’s 30-day comment period was too short and did not provide a “meaningful opportunity for comment.” The District Court observed that the APA does not specify a time period, but notes that SCOTUS has considered the comment period under the APA to be a minimum of 30 days, a standard that has also been followed in the Fifth Circuit. The District Court stated that it would not introduce its own policy preferences about what is a ‘meaningful opportunity,’” and found that the 2022 rules were not procedurally deficient.
“Like it or not,” the District Court concluded, “changing political winds may factor into an agency’s policy preference. But ‘a court may not set aside an agency’s policymaking decision solely because it might have been influenced by political considerations or prompted by an Administration’s priorities.’ The Commission’s 2022 Rescission need only to have been within ‘the bounds of reasoned decision making.’ As explained above, it was.” Accordingly, the District Court granted the SEC’s motion for summary judgment. (See this PubCo post.)
Oral argument before Fifth Circuit panel. During oral argument, NAM contended that the SEC’s rescission of the 2020 rules was unlawful for three reasons: it was based on a direct contradiction of prior findings without doing what is necessary for an agency to change its position; the justifications given were arbitrary and capricious on their face; and it was procedurally unlawful. In NAM’s view, to reverse the rule based on a change of prior factual findings required a much more detailed justification than the SEC provided of why the prior view was mistaken. In its presentation, the SEC observed that reasonable people can and do disagree about the notice-and-awareness provisions in the 2020 rule, stemming from different reasonable judgments about how to weigh the conditions’ uncertain and unquantifiable benefits and risks. In 2022, the SEC argued, it had provided good reasons for weighing the interests differently than the SEC had done in 2020, particularly in light of the strong objections from the vast majority of clients of proxy advisors about the burdens on timeliness and independence.
During oral argument, Judge Jones was implicitly critical of the absence of detailed explanation by the SEC in the 2022 amendments—only 20 pages compared to the 80 pages in 2020. And, in her view, the 2022 amendments just parroted the earlier contentions about timeliness and independence. But in 2020, she said, the SEC believed that it had addressed those issues by requiring that the notice to issuers be delivered only “at or before” the advice is sent to clients, instead of the original requirement to allow issuers an advance preview. It didn’t make sense to her to undo the whole process developed in the 2020 rule because of this one thread that the SEC pulled. In addition, the SEC had acknowledged that there weren’t a lot of proxy advisor errors anyway. So just what is the problem with timeliness, she asked? It seemed irrational to her. Jones also observed that this process of trying to put more democracy and transparency into the proxy process had been going on for ten years. That was ten years of discussion and debate but not consensus, the SEC responded. The point, she contended, was to level the playing field between proxy advice, which may be in favor of goals and purposes that were “inimical to shareholder value maximization,” and the issuers’ ability to be informed of that advice and to counter it. “But you’re saying,” she added mockingly, “Oh my, I clutch my pearls! They may have to spend a little more time monitoring responses to their proxy advice, so the whole idea of notice to inspire rational debate falls by the wayside.” Jones then made an interesting big-picture observation: “The whole point of administrative agencies,” she said, “is that they are supposed to be disinterested and experts, but the trend in today’s administrative world—and we’ve now had three administrations affected by this trend—is that there is one change in the balance on the commission, and suddenly the experts have a different view and the former disinterested advice is not today’s disinterested advice. So we’re now in a Kafkaesque world. It undercuts the whole idea of the administrative state.” The SEC countered that this has happened for many years. As the cases have shown, agencies can change their minds on difficult or controversial issues—there’s nothing nefarious or surprising about it.
The SEC concluded that, while NAM argued that the SEC made a definitive finding in 2020 that the rule did not raise any risks at all, in fact, those risks were only mitigated; distinct risks remained that were cited in 2022. The SEC just made a policy change based on a different balancing of those uncertain risks and benefits and gave reasons why it came out differently.
NAM concluded that the APA was designed to have a stabilizing effect on agencies. To make a change requires a reasonable explanation of why prior factual determinations were mistaken, which the SEC did not provide. Contrary to the SEC’s contention, any risk that remained after 2020 was not significant. In addition, NAM did not see the risk to timeliness and independence remaining in the final 2020 rules—the SEC provided no rational articulation of how those risks were posed. Accordingly, in the absence of any substantive rationale for the change, the rulemaking was arbitrary and capricious. (For a more detailed discussion of the oral argument, see this PubCo post.)
Opinion
The opinion began by observing the influential role that proxy advisors play in the shareholder voting process, with “institutional investors and investment advisers relying so extensively on them.” But as their influence has grown, the Court continued, concerns have been raised about their practices, given that ISS and Glass Lewis control about 97% of the market: “Investors, registrants, and others have questioned the accuracy of the information and the soundness of the advice that proxy firms provide in this duopolistic market, and they complain about the proxy firms’ unwillingness to engage with issuers to correct errors. Attention has also been drawn to potential conflicts of interest arising from proxy firms’ provision of consulting services to the same registrants about which they provide voting advice.”
As described by the Court, the SEC first considered addressing these issues in 2010 and, in 2019, after “nearly ten years of study and collaboration with all interested parties spanning two presidential administrations,” introduced its first formal regulatory proposal. That proposal treated proxy advice as a form of proxy solicitation, the Court explained, making it subject to those rules, but also made proxy advisors eligible for exemptions if they complied with certain conditions, a key one of which was to allow registrants an opportunity for review and feedback on the advice before it was disseminated. After a 60-day comment period and receipt of criticism that the advance-review requirement would interfere with proxy advisors’ ability to timely communicate with their clients, the Court continued, the SEC made revisions in the final rule to address those comments: under the revision, the rule would require proxy advisors to make their proxy advice available to registrants only “at or prior to” the time of dissemination of the advice.
But the 2020 rule was rescinded in 2021 when Gensler became Chair and never went into effect. According to the Court, the SEC’s “proposal to rescind the 2020 Rule was published in November 2021, following a closed-door meeting between Chairman Gensler and opponents of the 2020 Rule.” The comment period for the proposal was thirty-one days over the holiday season. “Unsurprisingly,” the Court observed, there were few comments over this period, and the SEC went ahead with the rescission, with two dissents, citing as justification timeliness and independence concerns expressed by “many institutional investors and other [proxy firm] clients.”
NAM and NGS sued, arguing that the “2022 Rescission was arbitrary and capricious for two reasons: (1) the agency failed to provide an adequate justification for contradicting its prior factual finding that the 2020 Rule did not threaten the timeliness and independence of proxy voting advice, and (2) the agency failed to justify the 2022 Rescission on its own terms. They also contended that the thirty-one-day comment period did not provide interested parties a meaningful opportunity to comment on the proposal.” The District Court granted summary judgment in favor of the SEC. NAM and NGS appealed.
The Court reviewed the case de novo, applying the same standard as the District Court. Under the APA, courts are directed to “‘hold unlawful and set aside agency action’ that is ‘arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.’…’The APA’s arbitrary-and-capricious standard requires that agency action be reasonable and reasonably explained.’… Applying this standard entails considering whether ‘the agency has acted within a zone of reasonableness and, in particular, has reasonably considered the relevant issues and reasonably explained the decision.’” When a new administration comes into office, the Court explained, the SEC does have authority to rescind or change policies, but if the new policy is based on facts different from those underlying the prior policy, a more detailed explanation is required. Failure to explain its decision to rely on different facts can be arbitrary and capricious.
The Court held that, in its rescission of the 2020 rule, the SEC was arbitrary and capricious “in two ways. First, the agency failed adequately to explain its decision to disregard its prior factual finding that the notice-and-awareness conditions posed little or no risk to the timeliness and independence of proxy voting advice. Second, the agency failed to provide a reasonable explanation why these risks were so significant under the 2020 Rule as to justify its rescission. These shortcomings require vacatur of the 2022 Rescission, but only to the extent it rescinded the notice-and-awareness conditions.”
With regard to the first point, the Court said that the SEC failed to explain why the factual findings underlying the 2020 rule—findings that the proposal’s risks to timeliness and independence had been “substantially address[ed], if not eliminate[d] altogether” in the 2020 rule—were, just two years later, considered to be significant risks that warranted rescission. The SEC had contended that the rescission involved a change in policy arising out of a reassessment of the risks, not a change in facts. But the Court rejected that argument, citing caselaw holding that assessment by an agency of the quantum of risk is a factual finding: “risk is measured on a continuum, and the determination whether a risk is high or low, substantial or insubstantial, is a factual finding drawn from the record available to an agency or court.” In this case, “the SEC contradicted itself two years later by placing these risks so far along the continuum that they were not only present but ‘sufficiently significant’ to justify rescinding the 2020 Rule.” As a result, the SEC was required to provide a more detailed explanation. Instead, however, the SEC explained only that it “weigh[ed] these competing concerns differently today,” without engaging in “any analysis of its prior finding regarding the level of risk or explain[ing] why it had changed its mind.” In effect, the Court observed, that “was the agency equivalent of saying, ‘That was then—this is now.’” Accordingly, the Court held, the rescission was arbitrary and capricious.
Even apart from the SEC’s failure to explain the change of facts, the Court found that the SEC failed to explain its justification given for the rescission—concerns about the timeliness and independence of proxy voting advice. That was also arbitrary and capricious. In the proposal, timeliness was a concern, but given that 2020 final rule eliminated the “pre-dissemination requirement, instead requiring proxy firms to share their advice with registrants at the same time they shared it with clients,” it was “wholly implausible that the 2020 Rule’s contemporaneous-disclosure requirement would pose a threat to timely delivery of proxy voting advice.” As a result, the Court said, the SEC had now shifted its rationale for the timeliness concern to “aggregate compliance burdens” on proxy advisors. But it included only one sentence making that point in the rescission release, relying instead “unquestioningly, on commenters’ purported concern about timeliness,” without tying those concerns to the 2020 rule and without addressing comments by appellants and others that disputed the timeliness argument. “In sum,” the Court concluded, “not only is timeliness in delivering proxy recommendations a facially irrational concern of proxy firms under the 2020 Rule, but the SEC’s failure either to explain the reasons why it was motivated by that concern or to address commenters’ disagreements are clear indicators of arbitrary and capricious rulemaking.”
While the Court acknowledged that the “independence” concern may be more legitimate, in the Court’s view, the SEC failed to reasonably explain that concern in the rescission release; the only reference was to a comment in a footnote that the 2020 rule could pressure proxy advisors “to tilt voting recommendations in favor of management more often, to avoid critical comments from companies that could draw out the voting process and expose the firms to costly threats of litigation.” But the Court took issue with the contention that proxy advisors were affected by a drawn-out voting process, and found no explanation in the rescission for the claimed exposure of proxy advisors to threats of litigation (although there was some explanation as part of the appeal). Neither of the SEC’s other independence justifications were discussed in the rescission—only in the appeal—and, the Court reasoned, post hoc rationalizations are not to be considered in this context. For example, the SEC now “contends that ‘adding new compliance burdens triggered only when a registrant responds to a [proxy firm’s] advice creates an incentive for’ proxy firms to favor management in voting recommendations.” But that theory, the Court maintained, was not discussed in the rescission. “Because the SEC did not offer reasonable or reasonably explained justifications for the decision to rescind the 2020 Rule,” the Court held, “its action was arbitrary and capricious for this additional reason.”
In light of its conclusions above, the Court found no need to address appellants’ arguments regarding the brief comment period, and appellants had abandoned on appeal the challenge to the rescission of explanatory Note E or the supplemental guidance.
The Court concluded that it must vacate and remand back to the SEC; however, the Court recognized the severability clause contained in the rescission, and determined to vacate and remand only those portions of the rescission related to the notice-and-awareness conditions. (The Court did not vacate the rescission of the explanatory Note E and supplemental guidance.)
