Future of Indy Chairman Rule Unclear: Critics Seek Compromise; Proponents Say, No Way'
April 17, 2006
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.