Alerts and Updates
SEC Confirms Mutual Fund Governance Rules; Chamber of Commerce Promises Further Challenge
July 21, 2005
In an extraordinarily contentious end to the June 29, 2005, open meeting of the Securities and Exchange Commission (SEC) - the last open meeting under Chairman William H. Donaldson - the SEC, over strenuous objections by two Commissioners, voted not to modify the mutual fund governance rules it had adopted (over the same two Commissioners' objections) in June 2004. The SEC's action was in response to the decision of the United States Court of Appeals for the District of Columbia Circuit, issued just eight days previously, finding that the SEC had failed to appropriately consider the costs of, and certain possible alternatives to, two aspects of the governance rules. The U.S. Chamber of Commerce (Chamber), which had brought the litigation in the D.C. Circuit, promptly announced that it planned to continue its challenge to the governance rules.
Background
Mutual funds, which are regulated as investment companies under the Investment Company Act of 1940 (Company Act), are typically organized as corporations or trusts, with separate "advisers" which manage the investments and operations of the funds. The board of directors (or trustees) of a fund is charged with overseeing the relationship between the fund and the adviser. Because inherent conflicts of interest exist between the adviser and the fund's shareholders (for example, with regard to the fees paid by the fund to the adviser), the Company Act requires that at least 40 percent of the directors of a fund be independent of the adviser, or "disinterested."1 The Company Act also requires that certain transactions - such as the advisory agreement between the fund and the adviser - be approved by the disinterested directors. The Company Act outright prohibits certain transactions between a fund and its adviser or affiliates.
Under long-standing SEC rules, however, a fund may engage in certain transactions prohibited by the Company Act if the fund and the transaction meet certain conditions. These ten rules, known as the Exemptive Rules, permit funds to engage in certain transactions with affiliates of the adviser, such as paying commissions to affiliated brokers and merging with affiliated funds; using fund assets to pay distribution expenses; and purchasing liability insurance jointly with affiliates. The Exemptive Rules generally require that the disinterested directors approve or oversee the permitted transactions or activities. In practice, the SEC has estimated that approximately 90 percent of all funds rely on one or more of the Exemptive Rules.
In 2001, the SEC strengthened the Exemptive Rules by amending each to require that, for a fund to rely on the Exemptive Rules, the fund's board must include a majority of disinterested directors. In June 2004, believing that abuses in the mutual fund industry - including late trading, market timing and misuse of non-public information - showed that the 2001 amendments were insufficient, the SEC amended the rules to further strengthen the Exemptive Rules. The amendments require that a fund relying on the Exemptive Rules must meet certain "fund governance standards." Among other things, the fund governance standards require that (1) at least 75 percent of the fund's directors be disinterested directors and (2) a disinterested director serve as chairman of the board. Commissioners Cynthia A. Glassman (now Acting Chairman) and Paul S. Atkins strongly objected to these two aspects of the fund governance standards and they voted against the amendments, resulting in a relatively rare 3-2 vote.
U.S. Chamber of Commerce Challenge
The Chamber promptly filed suit in the D.C. Circuit Court of Appeals, challenging the 75 percent and disinterested chairman rules.2
The Chamber first argued that the SEC, in adopting the challenged rules, exceeded its authority under the Company Act. The Chamber contended that the challenged rules regulate the governance of funds, an area traditionally regulated by state law. The organization argued that the SEC could not leverage its authority to grant exemptions from the Company Act prohibitions (i.e., its authority to adopt the Exemptive Rules) to impose regulations that breach this traditional divide (particularly since the broad reliance of funds on the Exemptive Rule would force almost all funds to meet the governance standards). More specifically, the Chamber argued that the Company Act's requirement that 40 percent of a fund's directors be independent "ensured that independent directors would have a significant voice in fund management but that directors affiliated with the adviser could have a dominant role." The Chamber noted that Congress had considered and rejected a higher disinterested director requirement. The Chamber claimed that the challenged rules upset this "balance" chosen by Congress.3
The Court found, however, that the Company Act's purposes include "tempering the conflicts of interest 'inherent in the structure of investment companies,'" and that regulating fund governance is among the means Congress used for that purpose. The Court held that the SEC's expansion of the role of disinterested directors is consistent with Congress' reliance on those directors. The Court also held that the 40 percent disinterested director requirement is a minimum and does not limit the SEC's authority to "provide an incentive" for funds to have a higher percentage of disinterested directors.
The Chamber had greater success with its argument that the SEC had violated the Administrative Procedure Act (APA) in adopting the challenged rules. Although the Court rejected the Chamber's claim that the SEC's action had been arbitrary and capricious,4 it agreed with the organization that the SEC had not adequately addressed the costs of the rules, and thus had not met the APA's requirement that the SEC consider whether its action would "promote efficiency, competition, and capital formation."5 The SEC had described three methods by which funds could comply with the 75 percent independent director condition - adding additional, disinterested directors; replacing interested with disinterested directors; or reducing the number of interested directors by resignation or other means - and had said it had no "reliable basis" for determining which alternative funds would choose. Thus the SEC said it could not estimate the costs funds would incur in complying with the rule. Similarly, the SEC said it could not determine what percentage of disinterested chairmen would choose to hire additional staff, and thus could not estimate the costs of the disinterested chairman rule. The Court, though, held that the SEC's "difficulty" did not excuse the SEC from its obligation under the APA to "determine as best it can" the costs of its rules. Specifically, the Court held that the SEC's inability to determine how funds would comply with the rules prevented the SEC from making industry-wide estimates, but that the SEC could - and thus was required to - estimate the costs for an individual fund.
The Court also agreed with the Chamber that the SEC had failed to adequately consider an alternative to the disinterested chairman condition. Several commenters suggested that the choice between an interested and a disinterested director should be left to the market, and, in their dissent, Commissioners Glassman and Atkins raised the possible alternative of enhanced disclosure of whether a fund's chairman is disinterested. The SEC did not address this alternative in the release adopting the governance rules. Although the Court agreed that the SEC was not required to consider every possible alternative, it found that the disclosure alternative - particularly in light of the comments of Commissioners Glassman and Atkins - was a serious alternative. Further, the Court held that the fact that the Company Act requires more than just disclosure in certain areas does not demonstrate that Congress found disclosure insufficient in all areas. Thus the Court held that the SEC had been required to consider the disclosure alternative.
The Court then remanded the governance rules to the SEC to "address the deficiencies" with the challenged rules.
SEC Reconsideration
The Court rendered its decision in the morning on Tuesday, June 21, 2005. By the end of that day,6 Chairman Donaldson had placed consideration of the Court's decision on the agenda for the June 29 open meeting. The Chairman's chief of staff explained in an e-mail that "the staff had 'concluded that the court's concerns can be addressed on the basis of the record already before the Commission.'" The next day, the SEC issued public notice of the open meeting. The Staff circulated a draft release on Friday, with significant revisions circulated on the following Monday and Tuesday. On Monday, Commissioners Glassman and Atkins requested that the recommendation be removed from the calendar and that the SEC seek additional comment on the 75 percent disinterested director and the disinterested chairman rules. However, Commissioner Atkins stated that a meeting of the Commissioners' staff on Tuesday made it "clear that there [was] no hope to change the recommendation."
In the meantime, the SEC received a number of letters and e-mails concerning the recommendation. While a few favored the SEC proceeding to reconsider the rules, many - including former SEC Chairman Harvey L. Pitt; two other former SEC Commissioners; the Chairman of the Senate Committee on the Budget; and eight other Republican Senators - urged the SEC not to act without further review.
The majority was not dissuaded, however. At the open meeting, Chairman Donaldson called the governance rules "a critical component of the [SEC]'s reform efforts." He argued that the SEC's "actions today are fully consistent with the opinion of the Court . . . The issues raised by the Court are clearly defined, and the existing rulemaking record and other publicly available materials have permitted the [SEC] to address them . . . ." He also noted that this was the last opportunity for the five Commissioners who had been involved with the rulemaking to act, and that failing to act would "throw the future of this rulemaking into an uncertain limbo until a new Chairman is confirmed . . . ."
In unusually strong language, Commissioner Harvey J. Goldschmid, concurring with Chairman Donaldson, described the objections to the SEC proceeding as "hyperbole" and "crocodile tears," and Commissioner Roel C. Campos called objections that the SEC's actions were sneaky or devious "absurd."
In at least equally heated language, Commissioners Glassman and Atkins complained of the SEC's "rush to judgment." Commissioner Glassman termed the Chairman's notion that it was important for the five sitting Commissioners to address the Court's issues "ludicrous." Both objected strenuously to the "unique" procedures employed in connection with the consideration of the Court's opinion, with Commissioner Atkins in particular presenting a detailed timeline of the "peculiar sequence of events" preceding the open meeting. They also contended that the SEC, having repeatedly said that it had no reliable basis for estimating costs, could not now suddenly discover that basis, and that the majority's attempt to do so demonstrated its "cavalier attitude" to its obligations.
In its release following the open meeting (which was posted on the SEC's Web site the next day, unusually quickly), the SEC estimated costs for an individual fund for the various means by which it could comply with the 75 percent disinterested rule. The release also discussed costs of additional staff and compensation for a disinterested chairman, as well as costs of potential increased reliance on outside counsel. The release characterized these costs as "minimal," even at the high end of the estimated ranges. The release also argued that the utility of disclosure, as an alternative to requiring a disinterested chairman, would be "limited" and "insufficient to adequately protect . . . against . . . self-dealing," and that meaningful disclosure would be difficult in any case. Finally, the release sought to respond to the dissenters, stressing the need to act "swiftly and deliberately" to respond to the Court's decision.
Further Litigation?
It is likely that the SEC's actions at the open meeting are not the end of this saga. Even before the open meeting, the Chamber had reportedly said it would sue if the SEC confirmed the governance rules.7 The Commissioners clearly anticipated that such a challenge would indeed ensue; Commissioner Goldschmid, for example, said that "This matter will quickly be back before [the Court]. If we are wrong about being fully responsive, the Court will certainly tell us so." Within hours after the meeting, the Chamber issued a press release, calling the SEC's actions "outrageous" and "reckless," and stating that the Chamber would again challenge the rules; and on July 7, 2005, the Chamber filed a petition for review with the Court. In its petition, the Chamber contended that the SEC has re-adopted the rules "without adequately addressing the deficiencies identified by the Court . . . ." The SEC has not yet filed its response.
For Further Information
If you have any questions regarding the new rules, including how they may affect your company, please contact one of the attorneys of the Duane Morris Securities Practice Group or the lawyer in the firm with whom you are regularly in contact.
- More specifically, an "independent" director may not be an "interested person" as defined in the Company Act. "Interested persons" are persons with certain relationships with the fund or its adviser.
- The Chamber also sued in the District Court, as there was some uncertainty regarding where jurisdiction lay. The SEC agreed that jurisdiction lay in the Court of Appeals. The SEC did challenge the Chamber's standing to bring suit; however, the Court easily found that the Chamber had standing.
- The Chamber did not explain why this was not also true of the 2001 amendments requiring a majority of disinterested directors as a condition of reliance on the Exemptive Rules.
- The Chamber argued that the SEC had not shown a connection between the challenged rules and the Exemptive Rules, pointing out that none of the abuses the SEC had used to justify the rules involved transactions covered by the Exemptive Rules. The Court found that the SEC was reasonable in its determination that those abuses revealed a broader issue of conflicts of interest and that the challenged rules are a reasonable prophylactic measure to address those issues.
- The Chamber also argued that the SEC had failed to develop empirical data comparing the performance of funds led by disinterested directors to that of those led by interested directors and had ignored such data presented during the comment period. The Court found that the SEC was not required to develop such data and that, although the SEC may have "betray[ed] a dismissive attitude" toward empirical data, it had considered the data presented and found it unpersuasive.
- Except for references to public actions, descriptions of the events leading up to the June 29, 2005, open meeting are based on the dissents by Commissioners Glassman and Atkins. Although disagreeing with the dissenters' characterization of events, Chairman Donaldson, the other Commissioners, and the Staff did not contradict the dissenters' factual descriptions of those events.
- In fact, the SEC's release contained an unusual footnote, noting those reports and stating that "we are instructing our Office of the General Counsel to take such action as it considers appropriate to respond to any proceedings relating to this rulemaking." When Commissioner Glassman asked for clarification of the meaning of this statement, SEC General Counsel Giovanni P. Prezioso said that the statement spoke for itself and declined to clarify it further.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.
