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In the wake of the 2003 mutual fund trading scandal, the Securities and Exchange Commission embarked on an ambitious agenda to enhance its regulation of the fund industry. Now, the SEC’s agenda is facing a court challenge � one that just might succeed. Over the last 11 months, the SEC has adopted close to a dozen major rules, representing the most sweeping change in the regulation of mutual funds at least since 1970 and perhaps since the adoption of the Investment Company Act of 1940. The centerpiece of the recent regulatory initiatives is the SEC’s fund governance rule, adopted in early August. The rule is, in essence, a series of amendments to existing provisions of the Investment Company Act, upon which most, if not all, mutual funds rely in carrying out their operations. Under the amendments, reliance on these provisions will be conditioned, as of Jan. 16, 2006, on a fund having (1) a chairman of its board of directors who is independent of the fund’s adviser and its affiliates and (2) a board of which 75 percent of the members are similarly independent. From the moment it was proposed, the SEC’s fund governance rule has been controversial. Major mutual fund industry participants criticized the rule as costly and unnecessary to protect the interests of shareholders. The SEC itself adopted the rule by the barest of margins, 3-2. The two commissioners voting against the rule took the unusual step of dissenting in writing, contending that the commission was acting by “regulatory fiat” and “simply to appear proactive.” The dissenters also questioned the factual basis upon which the rule was adopted. The saga of the fund governance rule continued on Sept. 2, when the U.S. Chamber of Commerce filed a petition for review in the U.S. Court of Appeals for the D.C. Circuit. Because of jurisdictional uncertainty, the Chamber also filed a complaint in the U.S. District Court for the District of Columbia, which has since stayed its proceedings pending resolution of the jurisdictional issues by the D.C. Circuit. Seemingly taking a page from the dissenting commissioners, the Chamber argued that the SEC lacked legal authority to impose new governance standards on mutual funds. It also claimed that the SEC failed to follow the appropriate administrative process in considering and adopting the rule. Within a month of filing its petition for review, the Chamber sought an emergency stay of the rule’s implementation. Although the D.C. Circuit denied a stay, it has indicated that it will hear the case on an expedited basis. THE SEC’S REACH Fundamentally at issue is the scope of the SEC’s authority to adopt rules under the Investment Company Act, the principal federal statute applicable to the mutual fund business. No court has addressed this matter for at least the past three decades. Courts have considered the rulemaking and interpretative powers of the SEC and other federal regulators under other federal statutes, typically supporting the actions of the regulators by deferring to their expertise with respect to the statutes they administer (that is, the well-known doctrine of Chevron deference). Courts have made clear, though, that agencies are bound by some limits on their rulemaking actions. As the Supreme Court stated in Ernst & Ernst v. Hochfelder (1976) regarding the SEC’s power, the “rulemaking power granted to an administrative agency charged with the administration of a federal statute is not the power to make law.” The limits on the SEC’s authority were highlighted in Business Roundtable v. SEC (1990). In that case, the D.C. Circuit held that the SEC lacked statutory authority to issue a rule under the Securities Exchange Act of 1934 that barred national securities exchanges from listing stock of corporations that took actions to diminish per-share voting rights of their common shareholders. The court concluded that “[a]bsent a clear indication of congressional intent, we are reluctant to federalize the substantial portion of the law of corporations that deals with transactions in securities, particularly where established stated policies of corporate regulation would be overridden.” Echoing the themes articulated by the court in Roundtable, the Chamber has asserted that the SEC adopted the fund governance rule “as a mere artifice and pretext for exerting far-reaching, non-statutory authority over the governance of virtually all mutual funds.” The Chamber points out that the Investment Company Act already set out specialized governance standards carefully crafted by Congress, which do not require the chairman of a fund’s board to be independent of the fund’s adviser and which generally establish a percentage test of independence well below 75 percent of a fund’s board. The Chamber also asserts that Congress did not intend for the Investment Company Act to impose a regime of federal corporate law, and that, as noted by the Supreme Court in Burks v. Lasker (1979), state law should be viewed as the primary source of fund governance standards unless those standards conflict with the policy goals of the Investment Company Act. In adopting its new rule, the SEC has impermissibly expanded the reach of that act, says the Chamber. When opposing the Chamber’s motion to stay implementation of the rule, the SEC emphasized that the new standards are simply an effort to strengthen the conditions that funds must meet in engaging in activities otherwise prohibited by the Investment Company Act. The SEC contends that its authority to permit funds to undertake those activities, which derives principally from the SEC’s power to exempt transactions from provisions of the act, necessarily entails the authority to impose conditions designed to protect the interests of fund shareholders. A QUESTION OF INTENT The success of the Chamber of Commerce’s claim that the SEC lacked authority to adopt the fund governance rule ultimately will turn on the court’s conclusion about the SEC’s intent in adopting the rule. The decision in Roundtable reflects the view that the SEC cannot impose governance standards on entities subject to its oversight unless the SEC is specifically empowered to do so under a relevant statute. By its terms, the Investment Company Act does not provide the SEC with the authority to impose fund governance standards. Following the Roundtable decision, the court should hold in the Chamber’s favor if the court concludes that the SEC was seeking to impose new standards on funds. If the court concludes that the fund governance rule simply represents the SEC’s efforts to establish tighter standards to be met when a fund engages in transactions otherwise prohibited under the Investment Company Act, then the court should hold in favor of the SEC. The power to exempt conditionally and unconditionally, which the SEC clearly has under the act, would seem logically to contemplate the authority to impose conditions the SEC deems necessary or appropriate to protect the interests of fund shareholders. Unfortunately, the SEC’s purpose in adopting the governance rule is hardly clear from the agency’s public pronouncements. In both proposing and adopting the rule, the SEC emphasized the need generally for independent directors to adhere to high standards in protecting the interests of fund shareholders. The SEC did not address in detail, however, why the rules to which it was attaching the independent chairman and 75 percent independence conditions needed those requirements. It did not offer specific examples of how the current rules failed to protect fund shareholders. Nor did it explain with any degree of specificity why the individual rules would be more protective if they were subject to the new conditions. The SEC’s failure to answer these sorts of questions and its generalized statements about enhancing fund governance could cause the court to conclude that the SEC’s true purpose was to rewrite the Investment Company Act. THE SEC’S PROCESS No court to date appears to have considered the procedural standards to which the SEC must adhere in adopting rules under the Investment Company Act. In other contexts, courts have reviewed the procedural adequacy of a federal agency’s rulemaking by focusing on whether the agency considered information relevant to the rulemaking and explained publicly how the substance of a rule reflected the information that the agency assessed. Although most courts are deferential to the process followed by an agency in adopting rules, that deference is not unlimited. Courts have invalidated rules upon finding deficiencies in the process, such as the agency’s failing to assemble a sufficient record to demonstrate a reasoned analysis, failing to consider alternatives to the action taken, and failing to consider properly a statutorily mandated factor in designing the rule. The Chamber has attacked the process the SEC followed in connection with the fund governance rule on a number of different fronts. It alleges (1) a lack of a demonstrated record of abuse under each rule to which the independent chairman and 75 percent independence conditions were added; (2) a lack of a clear relationship between the two provisions and the object of each rule; (3) a failure to consider possible alternatives to the two conditions; and (4) a failure to consider fully the costs of compliance with the new conditions and to explain how the provisions would promote efficiency, competition, and capital formation. The latter requirement is an express standard of rulemaking under the Investment Company Act. The SEC’s response to these allegations is that the procedures the agency followed were appropriate in light of its broad rulemaking authority under the Investment Company Act. For example, the SEC has argued that it did not need to discuss at length the necessity for adding the two conditions to each existing rule because the conditions serve the same end for each rule � enhancing oversight by independent directors of conflicts of interest. The SEC has also maintained that it did consider proposed alternatives and all other relevant data. Despite this response, the Chamber’s criticism of the SEC’s process could very well resonate with the court. The process would appear to have at least one noteworthy shortcoming: At no time did the SEC present a case as to how the new conditions would have prevented the market timing and other abuses that motivated the rule changes. The SEC has justified amending its rules principally by asserting that the two conditions would generally strengthen fund boards and enhance their independence. It has offered no factual showing to support its apparent assumption that the conditions would have prevented the past abuses. The failure to make such a showing could be seen by the court as precisely the kind of “regulation in a vacuum” that the federal procedural standards for rulemaking are intended to prevent. The Chamber of Commerce’s suit represents a serious challenge to the SEC’s fund governance rule. The Chamber’s arguments appear credible and are supported by the written dissent of two SEC commissioners. While judicial deference to agency rulemaking may still prevail, the court could very well find that the SEC overstepped its bounds, as a matter of substance and procedure, in adopting the rule. Barry P. Barbash, a partner in the D.C. office of Shearman & Sterling, is head of the firm’s asset management group. Robert W. Hawkins is an associate with the firm. They can be reached at [email protected] and [email protected], respectively.

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