SEC’s Open Meeting Provides Early Fireworks
"For people who are long-time SEC alums, it was a hard thing to watch," said Shearman and Sterling partner Barry Barbash.
He was referring, of course, to the SECís June 29 open meeting, held to address issues raised by the court opinion in the matter of the U.S. Chamber of Commerce v. SEC, released the week before. The meeting was one of the most acrimonious to date, up there with the bombastic October 2002 meeting to select William Webster as the PCAOB Chair ó a fiasco that led to SEC Chairman Harvey Pittís resignation just a few days later.
As you already may be aware, on June 21, the U.S. Court of Appeals for the District of Columbia granted the SEC a partial victory in the Chamber of Commerce case. In a written opinion, the court stated that the SEC was within its authority to adopt the independent chairman and 75 percent independent director rules and that the SECís policy rationale for adopting the rules was reasonable. However, the court found that the SEC had violated Section 2(c) of the Investment Company Act, which requires the agency to consider not only the protection of investors, but also whether a rulemaking will promote efficiency, competition, and capital formation. By violating that section, said the court, the SEC also violated the Administrative Procedures Act.
But the court didnít toss out the fund governance rules whole-cloth. Instead, the court remanded two issues back to the SEC for further consideration: first, the costs of compliance with the 75 percent independent directors and independent chair requirement, and second, a disclosure alternative to the independent chair rule. The court didnít give the SEC a deadline by which it must reconsider those issues. Nor did it tell the SEC how to go about addressing the "deficiencies," as it put it.
To Chairman William Donaldson, however, there wasnít a moment to lose. As you may recall, Donaldson had announced that he would step down from the SEC chairmanship by June 30. The court issued its opinion on June 21. Roughly ten and half hours later (according to Commissioner Paul Atkins), Donaldson had scheduled a meeting of the Commission to consider the issues remanded by the court.
Donaldson later denied that the quick decision to calendar the meeting represented a foreordained conclusion that the SEC would approve whatever revised cost-benefit analysis the SEC staff would prepare. The fact that the matter was calendared hours after the opinion was issued, he said, did not indicate a rush to judgment. "We had to put it on the agenda or else we could not have taken it up," said Donaldson. (For the record, 17 CFR 200.403(b) states that: "The announcement of Commission meetings . . . shall be made publicly available (and submitted immediately thereafter to the Federal Register for publication) at least one week prior to the consideration of any item listed therein, except where a majority of the members of the Commission determine, by a recorded vote, that Commission business requires earlier consideration of the matter.")
In any event, the announcement of the meeting in the SECís daily digest prompted a barrage of criticism from lawmakers and industry critics alike, who decried it as a Machiavellian, last-ditch effort by Donaldson to get his independent chairman rule nailed down.
At 10:00 am June 29, the SECís open meeting room ó the first time the agencyís new headquarters at 100 F Street had been used to host an open meeting ó was packed. The audience sat through two hours of Corp Fin rulemaking discussions. And then, it was showtime.
In a noticeably more emphatic tone than he had used during the Corp Fin portion of the meeting, Donaldson described the independent chair requirement as the "capstone" of the SECís mutual fund governance reforms. He pointed out that the court had agreed that "strengthening the role of independent fund directors was a reasonable response to the risks of further abuse in the mutual fund industry." Without a doubt, it was clear that Donaldson truly believed that he was doing the right thing for investors by calling the meeting.
What, exactly, was the SEC voting on? Depends who you ask. SEC Division of Investment Management acting director Meyer Eisenberg described the release as containing "sixteen pages of painstakingly-reviewed and detailed estimates of costs under various scenarios" by which funds may comply with the governance requirements. The "generous assumptions" used by the staff, he said, "very likely represent the high range of potential costs of compliance."
However, according to Commissioner Cynthia Glassman, who dissented from the approval, the Commission was voting on "an assembly of false statements, unsupported assumptions, flawed analysis, and misinterpretations."
Whatever it was, it was approved by a 3-2 vote, and is expected to be posted on the SECís website shortly.
Interestingly, in discussing the costs of compliance, several proponents of the rule seemed to argue that regardless of the costs, they would be dwarfed by the sheer size of the $8 trillion mutual fund industry. As Eisenberg put it: "under any reasonable scenario, the actual cost to an industry with $8 trillion of assets is certainly modest enough." Later in the meeting, Commissioner Harvey Goldschmid said: "Obviously for me, in an $8 trillion industry, the benefits of the two new governance provisions plainly and overwhelmingly outweigh their costs."
But wait a minute: how could the SEC whip up a cost-benefit analysis responsive to the court in just eight days, when it had previously claimed it had no reliable basis for estimating some of the costs? In response to that very question from Donaldson, SEC general counsel Giovanni Prezioso attempted to clarify what he characterized as "misinformation in some of the public commentary" on this point. The adopting release, he explained, did not say that the SEC had no reliable basis for making any kind of cost estimate. Instead, it said that the SEC did not have any reliable basis for how a fund would choose to satisfy the 75 percent independent director requirement (i.e., by allowing some interested directors to resign; replacing some interested directors with independent directors; or electing new independent directors). The court, said Prezioso, simply said that if the SEC could not make that determination, it could estimate the range of costs depending upon which method the fund chose to satisfy the requirement. "The Commission does, in fact, have a reliable basis to make those estimates," he added.
Prezioso also noted that the release had stated that the SEC had no reliable basis to estimate the aggregate costs to the mutual fund industry of implementing the independent chair requirement. However, the court concluded that the agency could have estimated the costs of doing so for an individual fund, rather than across the entire industry. According to Prezioso, "the Commission could readily estimate" that information.
As for the disclosure alternative to the independent chairman requirement, in which a fund would disclose whether or not they had an independent chairman, the court had chastised the SEC for not considering that approach, which it said "was neither frivolous nor out of bounds." Eisenberg said that the release under consideration extensively discussed the staffís belief that the disclosure alternative would not serve to protect investors. Investors, said Eisenberg, "are unlikely to understand the full implications of this disclosure." Goldschmid later echoed that view, saying it would be difficult to make the disclosure to 90 million plus shareholders of mutual funds "in a way that would allow them to digest and evaluate it effectively." Perhaps most convincingly, however, Eisenberg argued that actual structural change was necessary: "Knowing that your fundís chairman is not independent does not prevent him from putting his interest before yours."
As was clearly evident to many attendees, the true focus of the meeting was not on the SECís cost-benefit analysis or the merits of the disclosure alternative, but rather on the Machiavellian process by which Donaldson arranged to call the vote.
Incidentally, it was former Chairman Pitt who used the term "Machiavellian" in a letter urging Donaldson to rethink his decision to hold the meeting. And Machiavellian it was. Of course, whether the maneuvering should be construed as Donaldson playing games with the agencyís reputation, as some have alleged, or viewed as deft and courageous leadership in the face of opposition, depends on your view of the merits of the fund governance reforms.
From a technical standpoint, Donaldson undoubtedly confirmed that his maneuvering did not violate any law regarding SEC rulemaking. Indeed, he took pains to state that the Commissionís actions "are fully consistent" with the courtís opinion and with the legal requirements applicable to SEC rulemaking.
And clearly, his heart was in it. Donaldson cited "compelling policy reasons" to call the matter for vote quickly. Any further delay or ambiguity in the rulesí implementation, he said, would disadvantage investors, fund boards, and fund companies. "By acting swiftly and deliberately to respond to the courtís concerns, the Commission will facilitate better decision-making and ultimately serve the interests of fund shareholders." (Of course, since the Chamber of Commerce has declared its intention to sue the SEC on the basis of its June 29 actions, things are far from settled.)
In Donaldsonís view, undoubtedly informed by extensive discussions with the SECís Office of General Counsel, it was not necessary to seek additional public notice and comment before going out with the revised cost-benefit analysis. "The existing rulemaking record and other publicly available materials have permitted the Commission to address them in the manner contemplated by the court without further notice and comment," he asserted.
Prezioso endorsed Donaldsonís view, stating that seeking additional public comment on the rulemaking could result in "significant harm" to investors. "Engaging in additional notice and comment does risk additional harm ó significant harm ó to investors without corresponding benefits, given the adequacy of the information that the Commission can currently rely upon," he said.
That, of course, was the key: had additional notice and comment been required, there would have been no way that the SEC could have completed the process before Donaldsonís June 30 departure date.
Donaldson and other proponents of the rule attempted to downplay the fact that the staff worked at a breakneck pace to complete the necessary work in time for the meeting. Donaldson said it was "in the best tradition" of the SEC and "not at all unusual" for the agency "to act swiftly on important initiatives in response to market developments and other factors." Prezioso echoed that view, noting that following the enactment of the Sarbanes-Oxley Act, the SEC was churning out rulemakings at a rate of three a week.
Although few would question his investor protection motivations, wasnít the real reason Donaldson wanted to move quickly because he feared that pro-business incoming SEC Chairman Christopher Cox would allow the independent chair and 75 percent independent director requirements to wither on the vine?
If it was, Donaldson didnít admit it.
"Our failure to act would, I fear, throw the future of this rulemaking into an uncertain limbo until a new Chairman is confirmed and the new Chairman is able to familiarize himself with the rulemaking record and the policy considerations weighing for and against the decision that we made last year," he said. "Today, however, we have intact the full complement of Commissioners who have spent the last year-and-a-half thinking about the issues raised in this rulemaking, and with my imminent departure from the Commission, today is the last opportunity to bring the collective judgment and learning of we five Commissioners to bear on the important questions presented to us by the court."
And then, Glassman, who is now the SECís acting Chairman, began her dissent.
And what a dissent it was. Based on Glassmanís account, it appears that Donaldson made a calculation that in order to push the release through before he left, he had to keep Glassman out of the loop as much as possible.
Glassman recounted that she received an e-mail from Donaldsonís chief of staff "informing me, without prior consultation," that the staff had reviewed the opinion and concluded that the courtís concerns could be addressed on the basis of the record already before the agency. The meeting clearly was intended to be held before Donaldsonís departure, she said. "What is not expressly stated in the release, but is equally clear," she added, "is the majorityís view that in the absence of the Chairmanís participation, the rule will not be implemented. This concern, whether real or imagined, does not justify ignoring the Commissionís obligations to address properly the APA deficiencies found by the court."
She then strongly insinuated that Chairman Donaldson went behind her back to sign a form to authorize the controversial open meeting, even though she was the SEC duty officer assigned to sign such forms during that time. "To the best of my knowledge, the Chairman has never previously served as duty officer during his tenure and his decision to do so in this matter only is without precedent," she said.
Later in the meeting, Goldschmid attempted to clear the matter up: "Is there any problem with the Chairman serving as duty officer?" asked Goldschmid. "No," replied Prezioso. "It is specifically contemplated under our rules that the Chairman may designate the duty officers among the Commissioners."
Glassman called Donaldsonís argument that the full complement of current Commissioners was necessary to approve the release "ludicrous." She challenged the notion that the SECís existing information was adequate. "It strains all credibility to believe that the Commission, professing for the last year and a half its lack of a reliable basis, has mystically, within the past week, been able to conclusively estimate costs associated with the rule," said Glassman. In particular, the SEC has never solicited comment on the costs associated with hiring additional staff or on whether the disclosure alternative was a viable alternative, she said.
Perhaps her most compelling argument: by pushing ahead without notice and comment, the SEC would be disregarding the now-available actual cost data that could be mined from the fund complexes that already have put independent chairs in place and reconstituted their boards to be 75 percent independent. "The purported basis to exclude actual data rests on the theory that our estimate of costs is on the Ďhigh end of the range,í rendering an examination of actual data unnecessary," said Glassman. "This logic is backwards. It is the actual data that makes estimates unnecessary." In her view, the SEC should have seized the opportunity to use actual data that is "readily available and can easily be obtained through a request for comment."
And what did Glassman think of Donaldsonís claim that expedited action was necessary to protect investors? That argument, she said, was "completely disingenuous," adding that "the case has never been made to my satisfaction that the benefits of this rule are more than cosmetic." The protection of investors "compels that we carefully consider the costs and alternatives before rushing to judgment," she said. "To allow this open meeting to proceed as if the Commission can simply fill in the blanks for APA deficiencies, without requesting public comment on these significant issues, makes a mockery of the process."
At the end of her dissent, Glassman offered a public apology to the court and the public, as well as to the SEC staff members "who were uncomfortable having to participate in this exercise."
She noted that the release contained a footnote stating that in light of an anticipated legal challenge to the rulemaking, "we are instructing our Office of the General Counsel to take such action as it considers appropriate to respond to any proceeding related to this rulemaking." She noted that she had not previously seen this language, and asked Prezioso if the Commission had done this before.
Prezioso replied that he was not aware of any outside party stating that it was planning to sue the SEC over a rulemaking that had not yet been released.
"So weíve never done this before," Glassman said. "What does it mean?"
"I think it speaks for itself, Commissioner Glassman," Prezioso replied.
"Actually, no I donít," responded Glassman. "Iíd like you to tell me what it means," she insisted.
"I really canít elaborate," Prezioso replied.
Glassman immediately characterized Preziosoís response as "just one more example of an atypical and completely inappropriate maneuver" associated with the rulemaking. In a note to her written dissent, she noted that footnote 15, which has been renumbered footnote 14 in the final draft, was the one "that the general counsel refused to explain in response to my questioning at the open meeting."
By the way, hereís what that footnote really means: Itís an authorization for Prezioso to plow ahead to vigorously defend the U.S. Chamber of Commerceís anticipated lawsuit, even after Donaldson departs. But for that footnote, any decision to defend the rulemaking against the anticipated lawsuit would be subject to a Commission vote. And, without Donaldsonís participation, the likely vote would be 2-2.
Following Glassmanís remarks, Prezioso emphasized that the rulemaking was undertaken with "very careful compliance" with the SECís procedural rules. "I think it is very important that no one have the misimpression that you, Chairman Donaldson, somehow told the staff immediately ĎThis is what we are going to do.í" Added Prezioso: "I am quite confident based on my relationship with you and my knowledge of how you operate that you did not make a decision on whether to proceed today in this manner until after you had reviewed the work of the staff and felt confident that you could proceed."
Then, it was Goldschmidís turn. "As has just been demonstrated by Commissioner Glassman, emotions have run extremely high in this area," he said. Goldschmid said that there has been too much "confusion and hyperbole" surrounding the rulemaking, adding that "Ďhyperboleí is the most gentle word I can use." He criticized those who he said have shed "crocodile tears" about the need to not move forward in order to respect the courtís opinion. "If we are wrong about being fully responsive, the court will certainly tell us so. But if we are right about being fully responsive, we will have ensured an enormously better day for investors and mutual fund shareholders."
Of course, Atkins also dissented, complaining that he was not provided with ample time to review the draft release. To illustrate, he created a visual aid: "The SECís Race to Beat the Clock," a timeline that chronicled ó hour by hour ó the events leading up to the SECís open meeting. According to an SEC source, however, the timeline left off the fact that three senior members of the IM Division personally delivered copies of the draft release to the Commissionerís homes early Saturday morning, before coming in to work the rest of the weekend on the release.
Atkins echoed many of Glassmanís arguments, at one point stating that the majority had demonstrated a "profound disrespect for the rule of law." Interestingly, Atkins announced that the fund industry need not comply with the fund governance rules, at least until the SEC remedies the deficiencies in the rulemaking. Until then, he said, "the rule is not in effect."
Commissioner Roel Campos noted that opponents of the rule were hoping to delay the final effectiveness of the rule in the hopes that a different set of commissioners would consider it. "Delay often means death," he said. In his view, there was no basis for calling the SECís process illegitimate. "The Commission," said Campos, "is not doing anything under the cover of darkness."