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News October 4, 2004 Issue

SEC Fires Back in DH2 Lawsuit

On September 27, the SEC filed a response to DH2ís August 23 petition for judicial review of the SECís statements on fair valuation in the compliance program adopting release and the market timing disclosure proposing release.

"By bringing this lawsuit, DH2 seeks to protect the interests of market timers who profit by buying and selling fund shares when the prices of those shares are stale," said the SEC. "DH2ís real interest is to exploit the short term discrepancies between the current value of a fundís portfolio securities and its NAV, often to the detriment of fund shareholders. DH2ís actual objection to the challenged statements appears to be that fundsí use of fair valuation will reduce its opportunities to exploit share mispricing by engaging in market timing."

The SEC argued that its position on fair valuation is nothing new. In its brief, the SEC traced the history of the accounting releases, ASR 113 and 118, issued in 1969 and 1970, respectively, that underlie its current fair value positions, as well as the 1984 proposing release that provided guidance on valuation issues.

The SEC claimed that DH2 lacked standing to bring the suit. Since DH2 is neither registered as an investment company or an investment adviser, said the SEC, it has no obligation to comply with the compliance program rule or the disclosure rule, or with the fair valuation statements. The agency also argued that DH2 failed to show that the SECís fair value pricing statements have, or will, cause a "concrete, particularized injury-in-fact." Even if it is was harmed, added the SEC, the harm couldnít be fixed by a court decision in DH2ís favor.

The SEC also argued that DH2ís claims werenít "ripe" for review. "Any review of the challenged statements would be on much surer footing in the context of a real fundís actual application of fair valuation to a particular security, such as in an SEC action to enforce the fair valuation obligations," said the agency.

The SEC said that the fair value pricing statements are exempt from the Administrative Procedures Actís notice and comment requirements because they constitute an interpretation of the Investment Company Act (ICA), rather than a legislative rule. The statements are a "reiteration" of the SECís past interpretations, and "lack the force of law" and "create no new law," said the agency. The duty to fair value "when market quotations are not Ďreadily availableí," said the SEC, "is imposed by the ICA, not the challenged statements."

Lastly, the SEC said that even assuming DH2ís claims were entitled to judicial review, the fair value statements represent a "clearly permissible reading" of the ICA, consistent with the Actís basic objectives. The SEC, said the SEC, is "entitled to significant deference." Regulation of funds is "legally and factually complex," said the SEC, noting it has "over six decades of expertise" in the area. "The Court thus should not substitute its judgment for the SECís on the issues addressed in the challenged statements."