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Probably never in its history has the Securities and Exchange Commission (SEC) faced the same concentrated legal attack that it confronts today from business groups. Within recent months, Siebel Systems Inc. has sought to invalidate Regulation FD, claiming that the rule impermissibly chills its right to engage in First Amendment-protected speech; the U.S. Chamber of Commerce has challenged the SEC’s mutual fund governance rule that mandates an “independent” chairman and a 75% “independent” board in a suit now pending in the U.S. Circuit Court for the District of Columbia; and in the near future, the hedge fund trade associations are expected to seek to enjoin a recent SEC rule mandating the registration and inspection of hedge funds. Finally, should the commission yet adopt some compromise version of its proposed proxy access rule-proposed Rule 14a-11-either or both the Business Roundtable and the U.S. Chamber of Commerce can be expected to challenge that rule. Industry interprets 1990 case to limit SEC’s power While the merits differ in each of these actions, their common denominator is the claim that the SEC lacks authority to adopt rules that it has either proposed or promulgated. Particularly in the case of the SEC’s fund governance rule and its proposed Rule 14a-11, this assertion rests largely on the industry’s interpretation of a 1990 decision, The Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990). Those seeking to confine the SEC’s reach read that case to hold that the SEC cannot federalize matters normally relegated to state corporate governance in the absence of a clear indication of congressional intent to do so. Moreover, because Burks v. Lasker, 441 U.S. 471 (1979), long ago held that mutual funds are ordinarily to be governed by state corporate law standards, the SEC’s fund governance rule faces an obvious problem. But the application of Business Roundtable‘s logic to the mutual fund context requires that we first identify the statutory policies that drive the Investment Company Act of 1940. In the Business Roundtable case, the D.C. Circuit began its analysis by surveying the SEC’s authority under the Securities Exchange Act of 1934. The rule there at issue required stock exchanges to delist the securities of companies that took any action to “nullify, restrict or disparately reduce” the per-share voting rights of their existing common stockholders. The SEC defended this prohibition on shareholder “disenfranchisement” by relying on � 19(c) of the 1934 act, which authorizes the commission to amend the rules of the stock exchanges “in furtherance of the purposes of” that act. But what were the “purposes” of the 1934 act that were thereby furthered? Here, the D.C. Circuit concluded that only � 14(a) of the 1934 act, which grants the SEC power to regulate the proxy process, could possibly be used to support the commission’s disenfranchisement rule. Although the SEC argued that � 14(a)’s purpose was “to ensure fair corporate suffrage,” the D.C. Circuit found that this claim swept overbroadly. Rather, it held that the goal of federal proxy regulation was to “enable proxy voters to control the corporation as effectively as they might have by attending a shareholder meeting.” This goal was best furthered, it said, by full disclosure and, possibly, fair procedures. In essence, the court drew a distinction between substance and procedure. Because it found that the disenfranchisement rule “controls the substantive allocation of powers among classes of shareholders,” the D.C. Circuit concluded that the disenfranchisement rule exceeded the commission’s authority. This substance/ procedure distinction actually augers well for the fate of proposed Rule 14a-11, if it were ever adopted, because that proposed rule fundamentally simplifies the procedures for the nomination of directors, allowing shareholders in certain limited circumstances to place their nominations on the corporation’s own proxy statement. But the same cannot be said for the commission’s new fund-governance rule, which is clearly substantive in character, not procedural. Still, before one concludes that that rule therefore fails the Business Roundtable test, one must first consider whether the SEC’s powers are broader under the Investment Company Act of 1940, which regulates mutual funds, than under the 1934 act. The commission has rested its fund governance rule on its power under � 6(c) of the 1940 act, which authorizes the commission to “conditionally or unconditionally exempt any person, security, or transaction, or any class of persons, securities or transactions, from any provision of this title.” Structurally, � 6(c) of the 1940 act parallels earlier-noted � 19(c) of the 1934 act in that on their face they both grant the commission sweeping authority. Much like � 19(c), however, � 6(c) requires that any exercise of authority by the commission under it must be “in the public interest and consistent with the purposes fairly intended by the policy and provisions of this title.” Thus, the critical question becomes what “purposes” were “fairly intended” by the 1940 act. Do they justify rules requiring a 75% supermajority of independent directors and/or an independent chairman? Here, the similarities between the two statutes end. While an intent of the 1934 act was to assure fair corporate suffrage, but only by providing shareholders with full disclosure and fair procedures, the 1940 act is primarily focused on restricting conflicts of interest. To this end, � 10(a) of the 1940 act mandates for all funds that at least 40% of the fund’s board be composed of independent directors. Other provisions of the 1940 act provide for even greater percentages of independent directors in defined circumstances. The 1940 act also imposes prophylactic prohibitions on certain transactions involving significant conflicts of interest. But, for nearly 50 years, the commission has waived these prohibitions if the mutual fund complies with a series of exemptive rules that have been promulgated pursuant to � 6(c). Indeed, the current extension of the independence requirement to the 75% level only marginally surpasses an amendment of these rules in 2001 that imposed a majority independence requirement. Central to the 1940 act’s design was Congress’ decision to require independent directors to play the role of “independent watchdogs” to monitor conflicts of interest. See Burks v. Lasker, 441 U.S. at 484. Drawing distinctions between the two cases In this light, the critical difference between the Business Roundtable decision and the Chamber of Commerce’s current suit is that in the former case the SEC had adopted a wholly new and unprecedented rule that altered the balance between state and federal law over an issue of substantive corporate governance. In contrast, the SEC’s latest mutual fund governance rules are simply the most recent installment in a long-standing SEC effort to subject conflicts of interest to the close scrutiny of independent directors. The federal intrusion into the world of state corporate governance began with the language of the 1940 act itself and has been implemented for many years through the use of exemptive rules adopted under � 6(c). Nor does � 6(c) have any other real purpose, whereas � 19(c) was mainly intended to authorize all the rules necessary to create a national market system of competing exchanges. In response, the Chamber of Commerce can still argue that the 75% requirement goes well past the 40% standard in the 1940 act and thus upsets the long-established balance set by Congress. But this ignores that the purpose of � 6(c) was to permit the SEC to impose additional conditions from time to time for those mutual funds that wish to engage in otherwise prohibited conflict transactions. By analogy, if the 1934 act had mandated a specified minimum voting percentage that common shares had to collectively possess and had also granted the commission an exemptive power that could raise that percentage for issuers wishing to engage in certain transactions, then the SEC would have been in the same position in the Business Roundtable case that it occupies in the current litigation. But, on these different facts, the SEC might well have won. This does not mean that the SEC will necessarily prevail. Conceivably, the D.C. Circuit could find that the agency was using its broad exemptive rules impermissibly or that it lacked a sufficient record to determine that its rules will truly reduce the conflict problems it discerned. The commission has recently encountered a hostile reception in the D.C. Circuit and has seen its traditional authority curtailed. See, e.g., WHX Corp. v. SEC, 362 F.3d 854 (D.C. Cir. 2004). It is also possible that the SEC itself could back down in light of recent congressional action which requires the SEC to conduct a further study and report its findings to Congress next year. Business groups may target other agencies’ powers What the foregoing analysis does imply, however, is that a defeat for the SEC in the Chamber of Commerce case would be far more intrusive and confining than its loss in the Business Roundtable case. If the Chamber of Commerce case is litigated to a final result, it will likely serve as a dress rehearsal for a new style of litigation against the SEC (and other federal agencies) by business groups challenging these agencies’ rule-making powers. Should it succeed, the traditional idea of Chevron-style deference to the agency’s own definition of its jurisdiction may well become honored more in the breach than in the observance. See Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc., 467 U.S. 837 (1984). Whatever the merits of the independent chairman rule, the greater casualty would be the potential crippling of the SEC in the post-Enron world. John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and director of its Center on Corporate Governance.

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