After months of tossing a string of new rules and regulations at mutual fund advisors, the Securities and Exchange Commission has suddenly found itself playing defense in a unusual lawsuit being driven by staunch members of the mutual fund industry.

The lawsuit, filed on Sept. 2 by the U.S. Chamber of Commerce in the United States District Court for the District of Columbia, charges that the SEC overstepped its rulemaking authority. The U.S. Chamber of Commerce, the nation's largest non-governmental federation of three million business companies, alleges that the SEC's June vote approving new corporate governance rules for mutual fund boards was not in keeping with the spirit or intent of Congress' adoption of the Investment Company Act of 1940.

The new rule, originally proposed January 2004, became effective Sept. 7 and mandates full compliance by January 2006. It requires, among other things, that the chairmen of all mutual fund boards of directors be independent and unaffiliated with management and that a 75% supermajority of board members also be independent.

The 40 Act governs the operations of registered investment companies and stipulates that 40% of a mutual fund's board must be independent, with no requirement for independent chairmen. That 40% independence rule was first changed by the SEC in 2001 to require that a simple majority of fund directors be independent of the management company.

The U.S. Chamber of Commerce charges that when Congress was formulating the original provisions of the 40 Act, it specifically considered and rejected a suggestion that a majority of board members be independent, except in specific certain circumstances. "Each of these new requirements upsets the balance Congress established in the Investment Company Act of 1940 for the governance of mutual funds, and improperly usurps states' role as the primary authority on matters of corporate governance," noted the lawsuit. "The new Commission requirements are arbitrary, capricious, and contrary to law." The lawsuit also charges that the SEC failed to consider alternatives to these mandates, paid insufficient attention to the comments of dissenters and gave short shrift to empirical evidence of the new rules' value.

That's a sentiment originally claimed by SEC Commissioners Cynthia Glassman and Paul Atkins, who were the two of five Commissioners to vote against adopting the stricter corporate governance rules. They argued that the SEC hadn't studied or assessed the effects of its previous requirement that increased the percentage of board members who needed to be independent before upping the ante. Nor, they said, did it consider the actual costs involved with an estimated one-half of funds having to revamp their board ranks. The two argued that the 75% independence threshold is unnecessary and that the mandating of an independent chair is simply unwarranted.

The lawsuit against the SEC essentially charges that the SEC did not provide the necessary proof before instituting the new mandates, said Stephen Bokat, general counsel to the U.S. Chamber of Commerce. "It is no secret that the SEC has become increasingly aggressive in enforcements and regulations in the last couple of years, driven in part by malfeasance in businesses," he said.

The lawsuit seeks to have the new rule declared unlawful and overturned, or at the very least put on hold until the lawsuit can be decided, which could take 120 days or longer, Bokat explained. "We have asked [the SEC] to voluntarily stay the rule, but we have not heard back," he continued. He noted that the Chamber of Commerce had also filed a two-page petition for review with the Court of Appeals asking for the court to also review the SEC's rulemaking authority in this instance.

"The Commission carefully complied with its legal obligations in adopting these rules, and we expect to defend them vigorously," said Giovanni Prezioso, general counsel to the SEC, in a statement.

"It is quite likely that the SEC has done its research and homework in adopting this rule," said David Ruder, professor of law at Northwestern School of Law in Chicago, former SEC chairman and current chairman of the Mutual Fund Directors Forum, which backs the SEC's plans for independent fund board chairmen. This is not unusual, nor is it the first time that the SEC has used its exemptive powers under the 40 Act, granting it broad regulatory authority to impose new rules, he said. The SEC used these same powers in 2001 to adopt the requirement for a majority of board members to be independent, he noted. What is unusual is that it is the Chamber of Commerce that brought this suit, Ruder added.

This is in fact, the first time that the U.S. Chamber of Commerce has sued the SEC. But, Bokat said, this is far from the first time the group has duked it out with regulatory agencies. "We have sued practically every other agency in Washington and have prevailed in many cases," he said. So what made the U.S. Chamber of Commerce step into the fray now, considering that the independence of both board members and board chairmen has had the investment management industry deeply divided for many months?

"Pressure from our members," Bokat said. Although he declined to specifically name those members, he acknowledged that several mutual fund companies, including one small fund group, brought their concerns to the U.S. Chamber of Commerce. The fact that mutual fund company executives have leaned on the Chamber of Commerce to further this case, a group perceived as being an independent third party, may prove that the Investment Company Institute has a tarnished reputation, noted industry insiders. "Their reputation has been compromised," said one insider, who spoke on condition of anonymity.

The ICI, which had originally opposed the independent board chair requirement, has since switched gears a bit in light of the recent SEC rule change and will help funds comply with the new rule, said ICI spokesman John Collins. But the ICI is taking no position on the merits of this lawsuit, he said. "The ICI was not consulted in advance of the suit and is not a party to this lawsuit," Collins added.

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