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News September 6, 2004 Issue

Fund Governance Rules Arbitrary and Capricious, Says Lawsuit

The SECís rulemaking process has come under legal attack yet again.

On September 2, the U.S. Chamber of Commerce filed a complaint in the U.S. District Court for the District of Columbia as well as the U.S. Court of Appeals for the D.C. Circuit (the courts will decide jurisdiction, but both are fairly deregulatory and therefore tough for the SEC) alleging that the SEC exceeded its statutory authority in adopting the independent chair and 75 percent independent director requirements for registered funds.

"The Commission employed a statutory authority it does have ó to grant exemption from certain statutory prohibitions ó as a mere artifice and pretext for exerting far-reaching, non-statutory authority over the governance of virtually all mutual funds," said the suit. The Commissionís exemptive authority, it added, "is not a license to impose a raft of new and unrelated obligations on mutual funds." The Chamber also argued that the SEC failed to justify the need for the rules, calling the rulemaking "arbitrary, capricious, and not in accordance with the law."

The suit asks the court to declare that the SEC did not have legal authority to adopt the requirements, to declare the rules unlawful, and set them aside. Moreover, it asks the court to permanently enjoin the SEC from achieving the same ends by other means.

Why does the U.S. Chamber of Commerce care about fund governance? The complaint notes that some Chamber members, or their subsidiaries, are fund advisers. Moreover, the Chamber is a fund shareholder itself, and will be "directly affected" by the rules because it invests in funds that will be compelled to change the composition of their boards. (That, according to Fund Democracy founder Mercer Bullard, who knows a thing or two about standing, is "smoke.")

On the Chamberís legal team: respected securities lawyer John Olson of Gibson, Dunn. Signing the brief: Olsonís partner, Eugene Scalia (yes, his son).

ICI spokesperson Chris Wloszczyna said that the ICI is not involved in the suit. While he noted that the ICIís position on the fund governance rules during the comment period "is pretty well known," he said the groupís current position is that "the SEC has made its decision" and that the ICI is "prepared to help the industry comply with the rule." Wloszczyna said he first learned of the Chamberís suit when he started getting press inquiries about it.

Consider this: when Congress enacted ICA Section 15(f), it included a post-reorg 75 percent independent director requirement. In 1980, the SEC followed Congressís lead by including a requirement that independent directors nominate other independents in Rule 12b-1. In 1995, the SEC adopted Rule 18f-3, which also contained a fund governance piece. And then, in 1999, under the leadership of Arthur Levitt, the SEC creatively proposed to amend a broad swath of ten exemptive rules (the very ones amended in the last go-round) for the express purpose of enhancing the effectiveness of independent directors. The amendments were adopted in 2001.

All along, no one sued.

What does Scalia have to say to that? "When you read the comments that were filed by a broad spectrum of the public, there are many people and institutions expressing concern that with this rulemaking, the SEC intruded into mutual fund investment options and governance far more than what it had done before, and in a way that far exceeded what Congress expected and intended it to do." And, he added, the SEC "did so in a way that those accustomed in participating in federal rulemaking found to be very inconsistent with normal practice in promulgating agency rules."

Stay tuned.