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Court Says SEC Must Consider Costs of Fund Independent Chair Rule

While the SEC is authorized to condition the ability of mutual funds to engage in exemptive transactions under the Investment Company Act on having a board composed of at least 75% of independent directors and headed by an independent chair, a federal appeals court ruled that the Commission failed to adequately consider the costs imposed on funds by the two conditions. The SEC's failure to consider the costs, as well as its failure to consider alternatives to the independent chair rule, violated the Administrative Procedure Act, according to the court. The matter was remanded to the SEC so that the agency can address the deficiencies in the rulemaking. (Chamber of Commerce v. SEC, No. 04-1300, D.C. Cir.).

In the court's view, the SEC's difficulty in reliably determining the costs to funds of electing the requisite number of independent directors did not excuse the agency from doing its statutory duty to best determine the economic implications of the rule. When faced with uncertainty in determining precise costs, the court said that an agency must use its expertise to determine ranges of the costs of compliance with the rule, even if the estimates are imprecise.

While the SEC may not have been able to estimate the aggregate cost to the fund industry of the independent chair rule because it had no way of determining the costs of additional staff the chair may decide to hire, the Commission could have estimated the cost to an individual fund. The appeals court reasoned that this estimate would have been pertinent to the SEC's assessment of the effect of the independent chair mandate on efficiency and competition, as well as on capital formation.

In addition, the SEC failed to adequately consider the alternative path, endorsed by two dissenting commissioners, of having funds disclose whether or not they have an independent chair. While the Commission is not required to consider every conceivable alternative, the court noted that disclosure is a familiar tool in the SEC's toolkit. Since the disclosure alternative to the rule that was adopted was neither frivolous nor out of bounds, the court said the SEC had a duty to consider it.

The court rejected the argument that a later decision by Congress directing the SEC to justify the independent chair requirement demonstrated the Commission's failure to adequately justify the rule. The court explained that Congress may require a more detailed explanation for a rule than what is required under the APA.

The appeals court also rejected the contention that the Investment Company Act left the SEC without authority to promulgate these corporate governance rules. The court pointed to the potential for abuse inherent in the way funds are structured, where directors authorized to operate the fund typically delegate their management role to a separate advisory company that may have interests inimical to fund shareholders. In the Investment Company Act, Congress employs corporate governance as one way to temper these inherent conflicts of interest, according to the court.

The SEC's effort to enlarge the role of the fund board of directors accords with the purpose of Congress to entrust independent directors with the primary duty of looking after the interest of the fund's shareholders. The appeals panel declined the invitation to second-guess the Commission's reasonable conclusion that raising the percentage of independent directors to 75% would strengthen their hand in dealing with fund management and that having an independent chair would lead the board to focus on long-term shareholder interests.

The provision of the Investment Company Act that mandates that a fund have 40% of independent directors does not prevent the SEC from giving funds incentives to enhance the role of independent directors. Section 10(a) states only that a fund may have no more than 60% of inside directors. In the court's view, this language means that at least 40% of the directors must be independent, but also strongly implies that a greater percentage may be independent.