SEC’s authority called into question

WASHINGTON — The SEC can’t win for losing. As a result of judicial overrides of its major regulatory initiatives in the past year, the Securities and Exchange Commission is less likely to try bold new initiatives, experts on securities regulation say. “I could see the agency narrowing the type of rules that it undertakes,” predicted Barry Barbash, a partner in the Washington office of New York law firm Willkie Farr & Gallagher LLP who was director of the SEC’s division of investment management from 1993 to 1998. “Sometimes you know you’re on the edge,” he added. “It may well be prudent for the agency to stick to middle-range rules to make sure there’s no question about its authority.” In the future, the agency is going to have to pay closer attention to “make sure every i is dotted and t is crossed for rulemakings,” which will lead to a more drawn-out rulemaking process, Mr. Barbash said. Planned rules on mutual fund governance and a proposal aimed at preventing hedge fund fraud will be most carefully watched, according industry observers. SEC Chairman Christopher Cox on April 13 told a conference of independent fund directors that the agency intends to re-propose and finalize its mutual fund governance rule.
“Agencies typically do become concerned if their major rulemakings repeatedly are invalidated by the [U.S. Court of Appeals for the District of Columbia Circuit], where three major rules have been rejected in the past year], because courts, over time, come to view the agency’s action more skeptically than they otherwise might,” said Eugene Scalia, a partner in the Washington office of Los Angeles-based law firm Gibson Dunn & Crutcher LLP. “Over time, it’s going to be very much in the SEC’s interest, as well as the public’s, for the agency to be even more attentive to the text of the statutes that constrain its authority, and to careful consideration of the public comments that it receives,” he said. Mr. Scalia led the U.S. Chamber of Commerce’s successful challenge of the SEC’s mutual fund governance rule, which would have required that at least 75% of fund directors and fund chairmen be independent of the fund management company. In addition to the Chamber of Commerce, the fund governance rule was strongly opposed by the mutual fund industry. Both opponents argued that mutual fund boards, which already are required to have a majority of directors that are independent of the fund’s management, are in the best position to decide whether to have an independent fund chairman. The Washington appellate court overturned the rule last year. The SEC in December issued a pair of economic-analysis studies showing that there is little empirical evidence linking independent directors and chairmen with better fund performance. At the same time, however, the studies said that it may not be possible to prove economic benefits one way as a result of independent boards, but that boards that have a greater portion of independent directors are more likely to negotiate lower fees. Those studies will likely be used to challenge any attempt by the SEC to reissue a regulation imposing similar requirements as the earlier rule. “We’re very skeptical that the commission could support further regulation of mutual fund governance that bore any serious resemblance to what they proposed recently, particularly in light of the internal studies that the commission itself only recently released,” Mr. Scalia said. “The commission is definitely paying more attention to its rule writing,” said SEC spokesman John Nester. He would not comment further on the matter. Even industry observers who favored the original fund governance rule agree that the agency has suffered in its ability to promulgate rules. “The quality of the SEC’s work is what’s caused its problems,” said Mercer Bullard, president and founder of Fund Democracy Inc., an Oxford, Miss., group that advocates on behalf of mutual fund shareholders. “It needs to do a much better job thinking through its rulemaking,” he said. Fund Democracy supported the original mutual fund governance rule. “It is certainly wise for the SEC to look at a pattern of rulemaking and to see what needs to be changed,” said Duane Thompson, managing director of the Washington office of the Denver-based Financial Planning Association, which earlier this month won a challenge in the Washington appellate court against the SEC’s broker-dealer registration rule. While Mr. Thompson sees little connection between the SEC rulemakings that have been overturned in the past year, he predicted: “The SEC will do a gut check on how it drafts its rules.” Meanwhile, the question of SEC authority is already cropping up. After the appellate court struck down the SEC’s hedge fund adviser registration rule last year, the agency issued a new rule proposal to raise the wealth requirements for investing in hedge funds and take other steps to close what it views as a loophole that could leave hedge fund investors without protection from fraud by hedge fund managers. In comments filed on the rule proposal, the Chicago-based American Bar Association’s Committee on Federal Regulation of Securities argued that the SEC does not have authority to issue the rule as it is written. “We have criticized the rule as too broad” to be legal under the Investment Advisers Act, said Paul Roth, a partner at New York law firm Schulte Roth & Zabel LLP, who is chairman of the ABA committee’s subcommittee on private-investment entities. The SEC proposal would define accidental or negligent conduct by hedge fund advisers to be fraud, he said. The Advisers Act allows the SEC to specify only intentional wrongful acts as fraud, Mr. Roth said.