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Appeals Court Stays Effectiveness of SEC's Independent Chair Rule

The appeals court panel considering the validity of an SEC rule mandating independent board chairs for mutual funds has stayed the effectiveness of the rule pending further review. The rule, which also mandates that fund boards be comprised of at least 75% of independent directors, has been judicially challenged by the U.S. Chamber of Commerce, which was ordered to file a brief with the court by September 21, 2005. The court also ordered the SEC to file a brief by October 21, 2005. In its order, the court directed the parties to address the issue of whether the SEC had the authority to act on the court's remand prior to the issuance of the court's mandate. The court said that the Chamber of Commerce had satisfied the stringent standards required for a stay pending court review.

In its earlier ruling, the appeals court held that, 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, 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, the court held. 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. The matter was remanded to the SEC so that the agency could address the deficiencies in the rulemaking (Chamber of Commerce v. SEC, No. 04-1300, CA DC).

Acting swiftly on the remand, the SEC considered the issues identified by the court and determined that the rules required no modification (Rel. No. IC-26985). The SEC found that the potential costs to mutual funds of appointing independent chairs and ensuring that 75% of their directors are independent are minimal when compared to the substantial benefits that these governance rules can bring in terms of reducing conflicts of interest and protecting investors. In addition, in rejecting the disclosure alternative, the SEC said that a stronger approach was needed due to the structure of the typical mutual fund, which creates serious conflicts of interest between the adviser and the shareholders. The SEC believes that the independent chair condition will go a long way toward providing investors with assurances that their interests will be protected. Relying solely on disclosure, on the other hand, would allow a flawed governance structure to continue in many funds to the detriment of fund shareholders.

In a dissent against the SEC's action on remand, Commissioner Cynthia Glassman apologized to the court of appeals for the Commission's failure to respond appropriately to the court's directive to undertake a meaningful review. She also apologized to the public for having to live with the uncertainty surrounding the legality of a rule that was adopted in violation of the APA and that would most certainly be challenged again as a result of the SEC's action.

Finally, she questioned a footnote in the release responding to the remand in which the SEC, citing reports that additional legal proceedings may result from its action, instructed its Office of the General Counsel to take such action as it considered appropriate to respond to any proceedings relating to the rulemaking. Commissioner Glassman questioned the effect and meaning of the footnote.