A U.S. Court of Appeals has dropped the independent chairman rule back in the Securities and Exchange Commission's lap, but whether the legal circus surrounding the controversial mandate is nearing an end is anyone's guess.
Equally uncertain is the impact that any reaffirmation, compromise or renunciation of the rule might have on the mutual fund industry.
"In all practical terms, although it is an interesting result, it isn't terribly groundbreaking," said Mike Rosella, a partner in the investment management practice of Paul Hastings in New York. "Those that have begun complying with the rule will stay the course and continue to do so, and those that haven't will also stay the course and see what happens next."
While the recent spate of regulations from the SEC in the wake of the market-timing and late-trading scandal has presented unique challenges to the industry, perhaps none of the regulations has been quite as polarizing as the independent chairman rule.
The rule, which was first approved in 2004, requires that the chairman of a fund's board be entirely independent of the fund complex. It also says that at least 75% of the board's directors must be independent. The rule was crafted because many of the scandal's illegal market-timing deals were approved by fund directors or carried out with their knowledge. It has drawn cheers from investor advocates, who claim that it would ensure that decisions are made in the best interests of shareholders and not the fund company.
"It's a good rule in its current form," said Barbara Roper, director of investor protection at the Consumer Federation of America in Washington. "It strengthens the hand of fund boards to police against conflicts of interest."
But mutual fund companies, including industry kingpin Fidelity Investments, have argued that it's much too costly and would remove the industry's sharpest minds from key decision-making.
The industry created such a clamor that last year the U.S. Chamber of Commerce filed a lawsuit on its behalf. The court decided in favor of the Washington lobbyist and sent the rule back to the Commission for further cost analysis. But just eight days after the court's remand, the rule's champion and former SEC Chairman William Donaldson called a new vote just a few hours before his departure. It passed by a 3-2 margin with significant dissent from Commissioners Cynthia Glassman and Paul Atkins, who complained that they weren't given sufficient time to reconsider the rule or offer additional input.
So the Chamber filed suit again, arguing that the Commission did not perform sufficient cost analysis, as mandated by the court. The Chamber also won a stay of the rule, which was supposed to go into effect on Jan. 1. The most recent opinion from the court agrees with the Chamber, too.
The opinion from U.S. Court of Appeals Judge Judith Rogers states that a "combination of circumstances suffices to show that the Chamber has been prejudiced by the Commission's reliance on materials not in, nor merely supplementary to, the rulemaking records."
In other words, said U.S. Chamber of Commerce General Counsel Stephen Bokat, "The SEC relied on information in issuing the rule that was not in the record and the public did not have an opportunity to comment on."
For example, in arriving at cost estimates for the independent chairman and a board that's comprised of at least 75% independent directors, the Commission relied on a privately produced bulletin from the Stamford, Conn.-based consulting firm Management Practice and a nonpublic survey of compensation and governance practices in the fund industry that was summarized in one of those bulletins.
"Neither the bulletins nor the survey were part of the rulemaking record," Rogers wrote. "Yet these extra-record materials supply the basic assumptions used by the Commission to establish the range of costs that mutual funds are likely to bear in complying with the two conditions [of the rule]."
Rogers' opinion further suggests that it appears that the Commission might have relied on what it characterized as supplementary information as primary information. Primary information would have to be included in the rulemaking record.
Whatever the case, Bokat said, "People ought to have the opportunity to comment on whether they think a survey or a study is good, bad or indifferent."
The SEC couldn't provide a timetable for putting the rule back into the comment phase, where the general public would again be able to voice their opinion, but the court has given the regulator 90 days to perform more cost analysis and file a status report. Rogers said in her opinion that it would be appropriate to vacate the rule entirely, but so much of the industry has already moved toward compliance with the rule that it would be too disruptive.
Rosella said many of his clients have done just that by appointing an independent lead director who could readily assume the chairmanship if the rule is reaffirmed. That could prove prescient, as Rogers also wrote that just because the Commission relied so heavily on supplementary information, it doesn't necessarily mean that the cost estimates are incorrect.
Current SEC Chairman Christopher Cox said in a statement provided to MME that the Commission intends to comply with the court's decision in every respect.
"We take seriously our responsibility to subject all of the Commission's proposed rules to public notice and comment, and to apprise ourselves, the public and the Congress of the economic consequences of proposals before we decide whether to adopt them," Cox said. "I am confident that the result of the process that the court has prescribed will be final mutual fund governance rules that protect the interests of the funds and the fund shareholders they serve."
James Angel, an associate professor of finance in the McDonough School of Business at Georgetown University and a former visiting fellow at the NASD, said the Court's decision shouldn't be entirely surprising.
"Generally, the courts back up the SEC because they think the SEC usually knows what it's doing, but this rulemaking just smells bad," said Angel, who doesn't think the rule, whatever its future might be, will upset the industry. Asked if, given Donaldson's record for 3-2 votes, Cox might seek a unanimous decision if it comes before the Commission again, Angel said, "It depends how passionate he is about it. He hasn't said anything that would lead me to believe that he is passionate about it."
However, a compromise similar to what occurred with the SEC's controversial redemption fee rule, could be in the works, Angel said. Bokat said the Chamber's membership would be happy if the rule were to demand that a fund indicate in its prospectus whether an independent chairman and a mostly independent board of directors governed the fund. But if similar circumstances were to play out as they did under Donaldson, Bokat said additional legal action is possible.
Roper, whose organization filed an amicus brief in support of the rule, dismissed talk of a compromised rule.
"A compromise just isn't there," said Roper, who expects that rule will remain intact. "This is not a radical requirement. Mutual funds are supposed to be run in the best interests of their shareholders, not the fund companies, and that clearly hasn't been the case."
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