April 8, 2005

U.S. Chamber of Commerce v. SEC Mutual Fund "Governance" Litigation

Introduction
The case of U.S. Chamber of Commerce v. SEC will be argued in the U.S. Court of Appeals for the D.C. Circuit on Friday, April 15.  The case involves two provisions of a mutual fund "governance" rule adopted by the Securities and Exchange Commission in August 2004.  The provisions require that: 

• the chair of a mutual fund's board of directors be independent of the "adviser" that manages the fund; and
• 75 percent of the mutual fund board also be independent of the fund adviser. 

Background:  Mutual Funds and the SEC's New "Governance" Rule
Mutual funds - which currently hold more than $7.5 trillion in assets - are investment vehicles that pool assets of numerous investors to purchase stocks, bonds, and other financial instruments.  A mutual fund typically is established and managed by a separate company known as the "adviser."  An adviser will often create a range of mutual funds to provide a variety of investment alternatives - the ACME Aggressive Growth Fund, for example, the ACME International Fund, etc.  Investors typically invest in a fund based in large part on the adviser's reputation for delivering strong financial performance.  

A mutual fund ordinarily is organized as a corporation or trust, with its own board of directors or trustees whose responsibilities include contracting with the adviser to manage the fund.  The interests of the fund and the adviser can sometimes diverge, and for that reason Congress provided in the Investment Company Act of 1940 that a certain number of a fund's directors should be independent of the fund adviser.  Congress also recognized, however, that people often choose a particular investment because of the adviser's reputation for asset management.  Therefore, rather than require complete separation of the fund and the adviser, Congress provided that generally only 40 percent of a fund's directors must be independent of the adviser.  That way, independent directors provide independent scrutiny, but investors who buy a fund because of the reputation of the adviser are still assured that the adviser is playing a leading role in determining the fund's direction. 

In adopting its "Investment Company Governance" rule last summer in response to concerns with late trading, market timing, and other misconduct in the mutual fund industry, the SEC deliberately shifted the control of mutual funds to independent directors.  Amending ten pre-existing rules that are commonly relied on by mutual funds, the Commission provided that, in the future, funds wishing to rely on those rules would have to satisfy the new governance requirements.  These include having a chair of the board who is independent of the adviser, and that 75 percent of the directors be independent.

Two of the Commission's five members filed a rare written dissent from these two requirements of the rule.  They questioned the requirements on both policy and legal grounds, and charged the three-member majority with "acting by regulatory fiat . . . simply to appear proactive."
 
The Lawsuit
In September 2004, the U.S. Chamber of Commerce filed a lawsuit challenging the independent chair and 75 percent independence requirements on essentially three grounds: 

• In adopting the two requirements, the Commission exceeded its authority under the Investment Company Act.  The SEC does not have statutory authority to regulate the corporate governance of mutual funds, yet regulating "investment company governance" is the purpose and indeed the very title of the rule.  Moreover, as explained above, Congress purposely provided in the Investment Company Act that mutual fund boards generally must have 40 percent independent directors, but no more.  By raising that requirement to 75 percent, and requiring that the chair be independent, the SEC overrode Congress's conscious decision to enable investors to choose an investment company where the fund adviser plays a dominant role on the board. 

• The Commission offered inadequate justification for the two provisions at issue.  The SEC admits it lacks general authority to regulate the governance of mutual funds, but says it may impose these new requirements through its power to exempt funds from certain provisions of the Investment Company Act.  The disputed provisions of the rule, the Commission claims, are merely conditions designed to ensure the exemptions are not misused.  There are significant problems with this argument, the most obvious being that during the rulemaking the Commission scarcely even mentioned the ten exemptions that it now claims are the rule's sole objective.  In addition, while the Commission adopted the requirements in response to late trading and market timing, there is no evidence that those abuses occurred more frequently at funds that have management chairs or fewer than 75 percent independent directors. 

• The Commission violated basic requirements of the Administrative Procedure Act.  In addition to exceeding its statutory authority, the Commission repeatedly cut corners on federal rulemaking requirements.  For example, the Commission was required by law to consider the effect of the new rule on competition, efficiency, and capital formation.  A study showing that funds with management chairs out-perform funds with independent chairs was submitted during the rulemaking, yet the Commission gave the study no weight at all.  The Commission also ignored other important submissions from the public, and gave insufficient consideration to less intrusive alternatives to the independent chair and 75 percent independence requirements that could have been adopted instead. 

If the Chamber's challenge is successful, the court will invalidate the disputed provisions of the rule, while leaving the rest of the rule in place.  A decision is expected before summer.
 

Chamber of Commerce of the United States v. SEC is being handled by the law firm of Gibson Dunn & Crutcher LLP in conjunction with the National Chamber Litigation Center (NCLC), the Chamber’s public policy law firm.  For further information, please contact Eugene Scalia (202.955.8206) at Gibson Dunn or Steve Bokat (202.463.5337) at NCLC.