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July 2005

StayCA Clientu Alertr fromr Paule Hastingsnt

SEC Re-Adopts Controversial Rule After Court Questions Analysis

From the Practice Group

On June 21, 2005, the Court of Appeals, determine whether an action is consistent with the public District of Columbia Circuit (the “Court”) in a lawsuit interest” and to “ … consider … whether the action will brought by the U.S. Chamber of Commerce (the promote efficiency, competition, and capital formation.”6 “Chamber”)1 challenging the SEC’s adoption of what The Court then concluded that the SEC violated the are known as “the governance rules” (the 1940 Act and thus, the Administrative Procedure Act “Rule”)2, ordered the Securities and Exchange Commission (the “APA”), by “failing adequately to consider the costs (the “SEC”) to reconsider certain provisions of the Rule. imposed upon funds” by the implementation of the new In its opinion, the Court ruled that although the SEC had fund governance requirements.7 Additionally, the Court the authority to adopt the Rule, it had failed to adequately ruled that because the SEC failed to consider alternatives consider (i) the costs associated with compliance with two to the requirements, such as the “disclosure alternative” provisions of the Rule and (ii) any alternatives thereto. proposed by two SEC commissioners, it again violated In response to the Court’s ruling, Chairman William H. the APA.8 As a result of its ruling, the Court remanded Donaldson quickly scheduled a meeting of the SEC to the Rule to the SEC “to address the deficiencies with the consider the matters remanded to it by the Court. On June 75% independent director condition and the independent 29, 2005, the SEC, over the strenuous dissents of two of chairman condition.”9 its commissioners, once again voted to adopt the rule in its current form, leaving the two provisions challenged by the On the last day of Chairman Donaldson’s tenure at the Chamber in tact and unchanged. The compliance date for SEC, the SEC re-adopted the controversial Rule without the fund governance Rule remains January 16, 2006. making any significant modifications or new findings. Most industry observers, however, agree that the battle is Since its adoption on July 24, 2004, the SEC’s new far from over. Already, the Chamber has vowed publicly fund governance Rule has stirred great debate within to continue its fight against this second rule making that the industry and has faced formidable challenges. In still imposes the 75% independent director requirement particular, there has been much controversy surrounding and the independent chairman requirement on mutual two provisions of the Rule that will require nearly all funds. The arrival of Chairman Donaldson’s successor, registered investment companies3 to (i) increase board Rep. Christopher Cox (R-California), may also affect the independence requirements to 75% and (ii) appoint implementation of these hotly contested provisions. an independent board chairman.4 The most significant challenge so far came on September 2, 2004, when the Chamber filed suit against the SEC, claiming that the Paul Hastings’ SEC overstepped its authority by imposing the 75% Group ranked 5th in 2004 by net of independent director requirement and the independent chairman requirement on mutual funds. The Court in all fund clients in The American Lawyer’s the Chamber case ruled that the SEC had authority Corporate Scorecard. We have appeared under the Investment Act of 1940 (the “1940 Act”) to adopt the new fund governance Rule and that in the top five for the past two years and the adoption of such Rule was not “arbitrary, capricious, our representation by assets has jumped an abuse of discretion or otherwise not in accordance with law.”5 The Court, however, noted that Section 2(c) 35% from 2003 to 2004. of the 1940 Act does require the SEC “to consider or StayCurrent

Notes: If you have any questions concerning the matters discussed in this Alert or any other matter, please do not hesitate to contact any of 1. This Court ruling was in connection with a lawsuit brought the following attorneys in our Investment Management Group: by the Chamber against the SEC (Chamber of Commerce of the United States of America v. Securities and Exchange Commission, 2005 WL 1430551 (D.C. Cir.)). In Los Angeles In New York (cont.) 2. Governance, SEC Release No. IC- 26520 (July 27, 2004) 69 FR 46378 (August 2, 2004) (“Adopting Robert E. Carlson 213-683-6299 Christopher Tafone 212-318-6713 Release”). [email protected] [email protected] 3. These new fund governance requirements would apply to most, if not all, funds since almost all funds rely on at least Laurie Dee 213-683-6163 Brian Hurley 212-318-6531 one or more of the SEC exemptive rules. The exemptive rules [email protected] [email protected] are: Rule 10f-3 (permitting funds to purchase securities in a primary offering when an affiliated -dealer is a Michael Glazer 213-683-6207 Matthew van Wormer 212-318-6962 member of the underwriting syndicate); Rule 12b-1 (permitting use of fund assets to pay distribution expenses); Rule 15a- [email protected] [email protected] 4(b)(2) (permitting fund boards to approve interim advisory contracts without shareholder approval where the adviser George P. Hawley 213-683-6142 Michael Giordano 212-318-6735 or a controlling person receives a benefit in connection with [email protected] [email protected] the assignment of the prior contract); Rule 17a-7 (permitting securities transactions between a fund and another client of Ethan Lipsig 213-683-6304 In Palo Alto the fund investment adviser); Rule 17a-8 (permitting mergers [email protected] between certain affiliated funds); Rule 17d-1(d)(7) (permitting Thomas S. Wisialowski 650-320-1820 funds and their affiliates to purchase joint liability insurance Arthur L. Zwickel 213-683-6161 [email protected] policies); Rule 17e-1 (specifying conditions under which funds may pay commissions to affiliated in connection with [email protected] the sale of securities on an exchange); Rule 17g-1(j) (permitting In San Francisco funds to maintain joint insured bonds); Rule 18f-3 (permitting In New York funds to issue multiple classes of voting ); and Rule Julie Allecta 415-856-7006 23c-3 (permitting the operation of interval funds by enabling Anthony Dreyspool 212-318-6601 [email protected] closed-end funds to repurchase their shares from ). [email protected] In addition, proposed rule 15a-5 would also be included in this Nicole Gerrard 415-856-7086 list if it is adopted in its current form. Kathleen D. Fuentes 212-318-6569 [email protected] 4. The Adopting Release sets forth five new fund governance [email protected] requirements (listed below) although it was only the first two that were the subject of the lawsuit brought by the Chamber: David A. Hearth 415-856-7007 Lawrence J. Hass 212-318-6401 [email protected] • At least 75% of the directors/trustees on a mutual fund’s [email protected] board must be independent from fund management. Alex Y. Kymn 415-856-7046 • The chairman of the /trustees must be Michael R. Rosella 212-318-6800 [email protected] an independent director/trustee. [email protected] • The board of directors/trustees must assess its Mitchell E. Nichter 415-856-7009 effectiveness at least once a year. Domenick Pugliese 212-318-6295 [email protected] • Independent directors/trustees must meet in a separate [email protected] session, without fund management and the interested directors/trustees, at lease once a quarter. Adam Mizock 415-856-7094 • Independent directors/trustees must be permitted to Jacqueline A. May 212-318-6282 [email protected] employ staff and hire experts. [email protected] 5. Chamber of Commerce, 2005 WL 14300551 at page 5. Gregory T. Pusch 415-856-7067 6. Id. at page 6 (internal citations omitted). Thomas Rao 212-318-6838 [email protected] 7. Id. at page 9. [email protected] 8. The “disclosure alternative” referred to by the Court in In Washington, D.C. its opinion was presented by dissenting SEC Commissioners Gary D. Rawitz 212-318-6877 Cynthia Glassman and Paul Atkins. As an alternative to the [email protected] Wendell M. Faria 202-508-9574 requirement that every fund have an independent chairman, these commissioners proposed that a fund be “required [email protected] prominently to disclose whether it has an inside or an Joshua H. Sternoff 212-318-6011 independent chairman and thereby allow investors to make an [email protected] informed choice.” Id. 9. Id. at page 10.

StayCurrent is published solely for the interests of friends and clients of Paul, Hastings, Janofsky & Walker LLP and should in no way be relied upon or construed as legal advice. For specific information on recent developments or particular factual situations, the opinion of legal counsel should be sought. Paul Hastings is a limited liability partnership. Copyright © 2005 Paul, Hastings, Janofsky & Walker LLP.

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