In May this year, the SEC adopted final rules intended to modernize and improve disclosure regarding company stock repurchases. The rule requires quarterly reporting of detailed quantitative information on daily repurchase activity and revises and expands the narrative requirements, including disclosure regarding the rationale for the buyback. (See this PubCo post.) It didn’t take long for the Chamber to object.  Just over a week following adoption, the U.S. Chamber of Commerce, along with two Texas co-plaintiffs, submitted a petition to the Fifth Circuit for review of the final rule. Petitioners made three arguments: that “(1) the rationale-disclosure requirement violates the First Amendment by impermissibly compelling their speech; (2) the SEC acted arbitrarily and capriciously in adopting the final rule by not considering their comments or conducting a proper cost benefit analysis; and (3) the SEC did not provide the public with a meaningful opportunity to comment.”   On Halloween, the three-judge panel issued its opinion. The Court granted the petition, holding that the SEC violated the Administrative Procedure Act. But the Court did not vacate the rule—not yet anyway. Instead, the Court remanded the rule back to the SEC for 30 days to attempt to repair the analytical defects. Will the SEC adequately repair the defects? Will the Court ultimately vacate the rule? That all remains to be seen.

An SEC spokeswoman told the WSJ that “‘we’re reviewing the decision’ and declined to elaborate.”  The Chamber was a bit more forthcoming.  Tom Quaadman, executive vice president of the Chamber’s Center for Capital Markets  told the WSJ that “[t]he Chamber will not shy away from litigation where necessary to protect companies’ abilities to act in the best interests of their investors.” He also “described the ruling as ‘a victory for the ability of companies to make business decisions free from government micromanagement.’”

Background

As discussed in the adopting release, the SEC maintained that “share repurchases can have a positive or negative impact on the market for an issuer’s securities.” In some cases, “share repurchases may represent an efficient use of the issuer’s capital, such as when returning money to shareholders exceeds other possible internal investments of capital.” Some studies have found that issuers use repurchases to maximize shareholder value (e.g., to offset share dilution after new stock is issued), to facilitate stock-based employee comp programs, to signal that the company views its stock to be undervalued or simply because the board believes a repurchase to be a prudent use of cash. For some investors, repurchases may offer potential tax advantages over dividends.

However, the SEC observed, some repurchases may not be efficient or may be motivated in part by factors other than long-term value maximization, such as “repurchases conducted to increase management compensation or to affect various accounting metrics, in either case when those actions do not increase the value of the firm.”  Some studies have shown that repurchases can be used for earnings management (by decreasing the EPS denominator) to help executives meet or beat consensus forecasts. Studies have also found that announcements of repurchases and actual repurchase trades can help to increase share prices, which, some contend, could incentivize executives with share price- or EPS-tied comp to undertake buybacks to maximize their compensation.  Other studies have found trading by insiders close in time to predictable price increases caused by repurchases or repurchase-plan announcements, such as in the period immediately following the issuer’s repurchase.

According to the Court, as a result of “increasing public skepticism of share repurchases,  the SEC conducted a study on buybacks and why issuers repurchase their own shares.  The study concluded that repurchasing shares can be an efficient use of capital and may indicate that an issuer’s shares are undervalued.”

As described by the Fifth Circuit in the opinion, even after the staff study, the SEC “still believed investors could benefit from enhanced repurchase disclosures designed to address supposed information asymmetries between investors and issuers as to why an issuer was repurchasing its shares.  The SEC’s rationale was that, because a share repurchase could signal either that the issuer’s shares were undervalued (and hence an attractive investment) or that the company was attempting to boost its metrics (and hence a poor investment), shareholders, in order to make fully informed investment decisions, needed to know why a company was repurchasing its shares.”

At the end of 2021, the SEC proposed a new rule requiring detailed disclosure about stock repurchases. According to the Court, the proposing release “stated that the SEC was unable to quantify most of the economic effects of the proposed amendments.  Thus, the SEC relied primarily on a qualitative assessment of the rule’s potential effects, while encouraging commenters to provide information that could help quantify the costs and benefits of the proposed rule.” The proposal was open for comment for 45 days and then, after discovery of a technical error, for an additional 30 days.

According to the opinion, petitioners submitted comments “explaining how the SEC could quantify the proposed rule’s effects,” advising the SEC of “empirical data from academic sources and information available in existing SEC disclosures that could be used to quantify the economic effects of the proposed rule.”  In the adopting release, however, the SEC continued to maintain, petitioners comments notwithstanding, “that many of the effects of the daily-disclosure requirement could not be quantified.  The SEC did, however, perform a cost-benefit analysis for both the rationale-disclosure requirement and the daily-disclosure requirement.”  According to the Court, the SEC “continued to believe that the final rule would help investors evaluate whether a share repurchase was intended to increase the value of the issuer’s shares or, instead, was undertaken for a purpose unrelated to the market value of the issuer’s shares.”

Opinion analysis

The Court reviewed the legal and constitutional issues de novo, while findings of fact in support of the rule were considered “conclusive” if “supported by substantial evidence.”  Under the APA, the Court may set aside SEC actions that are “arbitrary and capricious,” unconstitutional or not consistent with procedure.

Compelled speech under the First Amendment.  Petitioners’ first claim was that the requirement to disclose the rationale for stock repurchases was compelled speech that violated the First Amendment.  In the context of compelled commercial speech, where the issue involves not a restriction on speech, but rather an affirmative obligation to disclose, the Court determined that the more lenient standard set forth in Zauderer v. Office of Disciplinary Counsel (1985) was applicable.  Under Zauderer, regulations may impose a requirement to disclose purely “factual and non-controversial” information, so long as those disclosures are “reasonably related to a legitimate state interest” and not “unjustified or unduly burdensome.”

Petitioners claimed that, by its very nature, an “issuer’s subjective opinion about the business benefits of its actions cannot be a purely factual disclosure.” Citing NetChoice, L.L.C. v. Paxton (5th Cir. 2022), the Court concluded that a requirement to “explain the reason” for a company’s  actions—i.e., the rationale-disclosure requirement—is still a purely factual disclosure. Petitioners also argued that share repurchase decisions are “one of the most controversial corporate decisions an issuer can make.” But the Court decided otherwise: “Petitioners, in essence, invite us to hold that the reasons behind a share repurchase are…more controversial than the reasons behind social media censorship,….” the mandated disclosure at issue in NetChoice. The Court “decline[d] that invitation.”

The Court also found that the SEC had satisfied its burden of showing that “the rationale-disclosure requirement is neither unjustified nor unduly burdensome.” According to the Court, the SEC has a “legitimate interest in promoting the free flow of commercial information,” and, because the stated purpose of the rationale-disclosure requirement is “to allow investors to separate out and assess the different motivations behind, and impacts of, share repurchases,” the “rationale-disclosure requirement is reasonably related to that interest.”  In addition, the rationale-disclosure requirement did not burden issuers’ protected speech or drown out their messages.  Accordingly, the Court found that the requirement satisfied Zauderer and was constitutional.

Notice and comment. Petitioners also contended that the SEC did not provide adequate opportunity for notice and comment—only 45 days initially. The Court disagreed, pointing out that the APA “generally requires only a minimum thirty-day comment period.” The Court concluded that petitioners were not deprived of a meaningful opportunity to comment and that the comment period satisfied the APA.

Violation of the APA.  But here’s where the SEC ran into trouble. Petitioners claimed that the SEC violated the APA by acting arbitrarily and capriciously “when it failed to (1) quantitatively analyze the economic implications of its proposed rule whenever feasible, (2) respond to petitioners’ comments about the agency’s economic implications analysis adequately, and (3) substantiate the proposed rule’s benefits adequately.”

The Court agreed that the SEC, “as a general matter, is not required to undertake a quantitative analysis to determine a proposed rule’s economic implications.” Rather, the SEC is required only to “consider . . . whether the action will promote efficiency, competition, and capital formation.” The word “consider,” the Court said, might involve any number of methods of analysis; a quantitative cost-benefit analysis is just one of those methods.

Petitioners also claimed that the SEC failed to respond to their comments about the economic implications of the rule, and that the SEC is required “to consider all relevant factors raised by the public comments and provide a response to significant points within.” In both buyback releases, the SEC “claimed that it provided quantified economic effects ‘wherever possible,’” but petitioners contended that that was not the case—and the Court agreed. In their comments, petitioners submitted three suggestions for quantifying the effect of the rule. For example, petitioners’ first suggestion was that the SEC quantify “the percentage of issuers’ annual and long-term incentive plans that is tied to [earnings per share] and how it correlates with buybacks” based on readily available “academic databases” that “provide detailed data on executive compensation.” According to the Court, the SEC admitted that “it never considered any of petitioners’ suggestions,” and sought to justify its omission by claiming that petitioners did not identify specific data for the SEC or raise any points that would require a change in the rule.  But the Court found no merit in those contentions, pointing out that petitioners identified relevant academic databases, existing SEC disclosures and existing academic studies. Nor did the Court agree that petitioners’ comments were only “recommendation[s] to conduct new studies that [they] contend might produce useful data.” Rather, “[a]ll three suggestions address costs and benefits the SEC identified in the proposed rule,” and “[a]ll three suggestions provide quantification of the rule’s expected costs and benefits—the very same costs and benefits the SEC asserts ‘cannot be quantified.’” The Court concluded that the “SEC—by continuing to insist that the rule’s economic effects are unquantifiable in spite of petitioners’ suggestions to the contrary—has failed to demonstrate that its conclusion that the proposed rule ‘promote[s] efficiency, competition, and capital formation’ is ‘the product of reasoned decisionmaking.’”

Finally, the Court determined that the SEC failed to adequately substantiate the rule’s benefits and costs.  While the rule’s benefits were more than “hypothetical” (although sufficient for the First Amendment analysis above), they were not adequately substantiated under the APA’s arbitrary and capricious standard.  The SEC, the Court said, identified two primary benefits: first, “to help investors ‘better evaluate whether a share repurchase was intended to increase the value of the firm’ or for an improper purpose such as ‘providing additional compensation to management’”; second, the SEC asserted that the rule “promotes price discovery.”

Petitioners claimed that the SEC never substantiated the underlying contention that improperly motivated buybacks were actually a problem. The SEC responded that the rule was not premised on the idea that “‘improperly motivated buybacks regularly occur’ in ‘significant numbers,’” but that it addressed the issue of investor uncertainty about the motivations behind a buyback, substantiating the first benefit. But the Court agreed with petitioners that “[i]f opportunistic or improperly motivated buybacks are not genuine problems, then there is no rational basis for investors to experience any of the uncertainty the SEC now claims warrants the rule.” According to the Court, the “SEC must therefore show that opportunistic or improperly motivated buybacks are a genuine problem even under its theory of investor uncertainty.  Because the agency has not done so, the first benefit is inadequately substantiated.”

As to the second cited benefit of price discovery, the SEC argued that more granular information about repurchases and prices would allow investors to infer management’s beliefs about company value.  The Court found that the SEC failed to demonstrate that it considered relevant factors in concluding that the costs of the more granular disclosure would be modest. According to the Court: “Looking at the rule’s disclosure requirements explains why that is the case.  Plainly put:  The rule’s requirements are clear as mud.“ As illustrations, the Court asserted that the rules offered little guidance and omitted a safe harbor.  What’s more, “when pressed at oral argument, counsel for the SEC offered little in the way of clarifying what disclosures the rule actually mandated.  The price-discovery benefit is not the product of reasoned decision-making.”

The Court concluded that the primary benefit of easing investor uncertainty about motivations for buybacks was inadequately substantiated. In essence, the SEC had failed to show “that opportunistic or improperly motivated buybacks are a genuine problem.“ But the SEC’s concerns about opportunistic or improperly motivated buybacks permeated the SEC’s justification and explanation of the rule and infected the rule itself. Holding that the SEC acted arbitrarily and capriciously, the Court granted the petition for review. 

Conclusion

In granting the petition, the Court held that the “SEC acted arbitrarily and capriciously, in violation of the APA, when it failed to respond to petitioners’ comments and failed to conduct a proper cost-benefit analysis.” However, recognizing that “there is at least a serious possibility that the agency will be able to substantiate its decision given an opportunity to do so,” the Court decided that, instead of vacating the rule, it would allow the SEC 30 days “to remedy the deficiencies in the rule,”  and remanded the matter with directions to the SEC to correct the defects in the rule.  The three-judge panel, however, “retain[ed] jurisdiction to consider the decision that is made on remand.” Time will tell whether the SEC will be able to adequately repair the defects or whether the Court will ultimately vacate the rule. Currently, reporting under the new rule, along with the new narrative disclosure, is required beginning with the first Form 10-Q or 10-K covering the first full fiscal quarter (i.e., for the 10-K, the 4^th quarter) that begins on or after October 1, 2023. 

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