We write as legal scholars and economists who conduct research and teach in areas of corporate law, securities law, and administrative law. In addition, one of us has previously worked at the Securities and Exchange Commission (“Commission”) as a financial economist and an attorney advisor between 2007 and 2012, in what is now called the Division of Economic & Risk Analysis. None of us is being compensated or otherwise assisted in developing the opinions articulated below. Every word is our own, drafted solely by the three of us.

We submit this letter pursuant to the notice-and-comment request issued by the Commission related to its proposal to amend proxy solicitation rules, and in particular their applicability to proxy advisory firms (File # S7-22-19). As you know, a workable shareholder governance system depends critically on the integrity of the shareholder proxy voting system, and we therefore share the Commission’s concern that this system must operate as smoothly, efficiently, and transparently as possible. For the reasons described below, we support the Commission’s proposal, subject to modest (but important) modifications delineated at the end of this letter.

The prudent design of rules to govern securities markets is not only vital to the public interest, but it is also enormously challenging for regulators to carry out: complexity, sophistication, automation, and the sheer speed and volume of trading pose enormous challenges to regulators, who must stand ready to justify their regulatory decisions against potential judicial review under the arbitrary-and-capricious standard.[1] In our own scholarship, we have advanced the analytic argument that these difficulties need not place a prohibitive roadblock in the way of new financial regulations. To the contrary, they often represent an opportunity for regulatory experimentation—i.e., the embrace of new regimes on a provisional basis, and the concomitant value of information and learning that comes from such experimentation. Moreover, we are of the view that the added wisdom that comes through regulatory learning—along with the value of the “real option” to decide whether to retain the provisional rules—constitute unappreciated benefits in the calculus of cost-benefit analysis (“CBA”). Our more comprehensive views on this subject can be found in the following publications (digital copies of which are attached to this letter[2]):

• Lee, Yoon-Ho Alex, “An Options Approach to Agency Rulemaking,” 65 ADMIN. L. REV. 881 (2013);
• Spitzer, Matthew & Talley, Eric, “On Experimentation and Real Options in Financial Regulation,” 43 J. LEGAL STUD. S151 (2014).

This brings us to the instant proposal that the Commission has put forth: to extend federal proxy solicitation rules and antifraud provisions to proxy advisers. There is little question that this reform would be significant, as advisory firms have long benefitted from an exemption from federal solicitation rules. As you may be aware, several prominent academics in both law and finance have voiced criticism of the proposed rule change, asserting that it will raise costs and increase concentration in the proxy advisory industry.[3] If pressed to conjecture about the matter in the form of a permanent policy change, we might well share their concern and even join their position.

At the same time—and in recognition of the myriad complexities involved—we confess to some epistemic uncertainty on the matter.[4] There simply is no scientifically reliable way to measure the effects of a reform that has never been attempted. In our opinion, however, this very uncertainty can serve as the linchpin of a prima facie case in favor of the Commission’s proposal, as a form of regulatory experimentation. The case in favor would be the most compelling had the proposed rule been advanced on a provisional basis, subject to a mandatory sunset after some number of years, so that it could be re-assessed with the benefit of experience and observation. And indeed, it is in this same spirit that the Commission has conducted its recent tick-size and (pending) transaction-fee pilots.

In our view, then, the Commission’s current proposal still lacks the language and approach that would characterize it as a bona fide piece of experimental regulation. This is unfortunate in two respects. First, as noted above, this area of corporate governance is sufficiently complex and recondite that experimental approaches are bound to be particularly probative for regulatory decision making. Second, it forecloses the Commission from being able to rely on the value of experimental learning and optionality as key pillars of its CBA to defend the rule change. This would leave the Commission navigating a much more perilous path in justifying its proposal under a likely onslaught of criticisms about the reliability of its CBA (many of which have already been enumerated by others[5]).

More specifically, we are concerned with the possibility that, should the Commission’s proposed rule be challenged, courts will feel compelled under existing precedent to vacate it, even though the rule might well prove beneficial to investors. Over the past decade, the D.C. Circuit has shown its willingness to second-guess the Commission’s expert judgment calls in several contexts that are analogously complex. For example, with its 2011 decision in Business Roundtable (invalidating the Commission’s “proxy access” rule), the D.C. Circuit set a high bar for cost-benefit analysis needed to survive arbitrary-and-capricious review.  Notably, the opinion went so far as to fault the Commission for “rel[ying] upon insufficient empirical data” even though the proposed rule was one of first impression.[6] Given this precedential legacy, we believe that the formulation of the proposed rule at present risks being subjected to similar (and similarly successful) legal challenges.

That said, if the proposed rule were characterized as provisional (and subject to an express sunset provision), the Commission would benefit in three concrete ways:

• First, including a sunset will allow the Commission to tally as an additional benefit the “option value” associated with a provisional rule. In other words, given the high degree of uncertainty concerning the effects of the proposed rule, the Commission can legitimately recognize expected benefits of information generated from the provisional rule change simply by including a sunset provision.[7]
• Second, the provisional period will allow the Commission to gather data from the industry so that, upon sunset, the Commission will be much better equipped to move forward with a more permanent version (and possibly a better version) of its rule with reliable empirical data.
• Finally, in the case that the rule’s critics prove correct in their fears about the rule’s prohibitive costs, the sunset provision would allow the Commission a more seamless path to repealing the rule.

On the basis of the foregoing analysis, we are of the opinion that the Commission’s proposal is a promising one as measured through a regulatory experimentation lens. At present, however, our support for the proposal is substantially compromised by the non-experimental framing of the proposal.

Fortunately, this infirmity admits a relatively straightforward fix. We urge the Commission to approve the proposal only after inserting language substantially similar to the following:

This proposed rule will automatically cease to have any effect and will be repealed with no additional action by the Commission eight years after the date it becomes effective. Six years after this rule becomes effective, the Commission shall review the effects of this rule. At that time, the Commission will issue a Notice of Inquiry, collecting data and analysis from industry participants, academics, and others. Further Commission action with respect to this rule will be based upon the Commission’s expert analysis of the data and analyses collected pursuant to such Notice of Inquiry.

This language would appropriately compel the Commission to revisit the issue after a reasonable period of time has passed, and it would require the re-authorization of the rule at that time. In our estimation, an eight-year period is sufficient to permit significant regulatory learning prior to the reauthorization time. We stand ready to work with the Commission to create any needed modifications to the above language, as well as to develop necessary metrics for assessing the benefits associated with the modification proposed above.

ENDNOTES

[1] See, e.g., Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011).

[2] In addition, we also recommend Zachary J. Gubler, “Experimental Rules,” 55 B.C. L. REV. 129 (2014); and Zachary J. Gubler, “Making Experimental Rules Work,” 67 ADMIN. L. REV. 551 (2015).

[3] See Letter of January 15, 2020 to the Commission by Viral Acharya et al. (available at https://www.sec.gov/comments/s7-22-19/s72219-6668185-203962.pdf)

[4] For the record, we think the authors of the aforementioned letter should have done so as well.

[5] See Letter of January 30, 2020 by John Coates and Barbara Roper (available at https://www.sec.gov/comments/s7-22-19/s72219-6729671-207390.pdf); see also Letter of January 29, 2020 by William J. Stromberg, President & CEO, T. Rowe Price (available at https://www.sec.gov/comments/s7-22-19/s72219-6721059-206207.pdf).

[6] 647 F.3d at 1150.

[7] In theory, of course, the proposal’s current wording does not forbid the Commission from repealing the rule sometime in the future. Nevertheless, explicitly specifying a sunset provision with the rule has the significant benefit of committing the Commission to take into account the rule’s real-option value.

This letter was submitted to the U.S. Securities and Exchange Commission on February 3, 2020, by Professor Yoon-Ho Alex Lee at the Northwestern Pritzker School of Law; Matthew Spitzer, the Howard and Elizabeth Chapman Professor of Law and director of the Northwestern University Center on Law, Business, and Economics at the Northwestern Pritzker School of Law; and Eric Talley, the Isidor & Seville Sulzbacher Professor of Law and co-director of the Millstein Center for Global Markets and Corporate Ownership at Columbia Law School. The full version of the letter, as filed, is available here.