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Appeals Court Considers Mutual Fund Rules

By Carrie Johnson
Washington Post Staff Writer
Saturday, April 16, 2005; Page E01

A lawyer for the U.S. Chamber of Commerce told a federal appeals court yesterday that the Securities and Exchange Commission overstepped its authority and refused to consider opposing views when the agency approved new mutual fund rules last year.

The chamber is urging the U.S. Court of Appeals for the D.C. Circuit to toss out controversial rules the SEC passed during revelations of widespread trading abuses in the mutual fund industry. The rules, which are designed to prevent conflicts of interest that could hurt investors, mandate that mutual fund board chairmen and at least 75 percent of directors be independent of management.

Eugene Scalia, representing the U.S. Chamber of Commerce, argued that the SEC rules are "extraordinary." (Department Of Labor)

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"What the commission is doing here is extraordinary," argued Eugene Scalia, a lawyer for the chamber. "It's changing the management structure in 80 percent of the industry."

The rules drew particularly vocal criticism from Vanguard Group Inc. and Fidelity Investments, whose leaders also were chairmen of their funds' boards. They also triggered dissent from two Republican SEC commissioners, Paul S. Atkins and Cynthia A. Glassman, who argued the three-member majority offered little if any evidence that the rules were necessary to stamp out fraud.

The energetic argument, which included frequent interruptions by Chief Judge Douglas H. Ginsburg and judges Judith W. Rogers and David S. Tatel, lasted about 45 minutes.

Among the spectators was Glassman, who laughed when SEC lawyer Giovanni P. Prezioso said, in response to a judge's question, "I certainly wouldn't characterize anything any of my commissioners does as frivolous."

Prezioso maintained that the agency had moved properly to address "an overwhelming breakdown" in the mutual fund industry that has cost investors more than $1.5 billion to date. Investigations by the New York attorney general and the SEC exposed instances in which fund managers and their favorite customers personally profited at the expense of average investors. The disclosures touched off outrage on Capitol Hill and in the investment community.

Prezioso defended the agency's rulemaking process, including its review of nearly 200 public comment letters and research, arguing that SEC leaders followed the law and relied on both the agency's and outside expertise.

But Ginsburg repeatedly challenged Prezioso to point to places in the agency's formal written record that responded to criticism from the two dissenting commissioners. The judge also expressed concern about a statement made by SEC Chairman William H. Donaldson in June 2004, at the time of the agency vote, in which he said he did not value empirical studies because they could be manipulated to achieve a desired result.

"It's essentially like saying logic doesn't matter," Ginsburg said. "It's like saying we're going to banish data from now on."

Scalia, the chamber's lawyer, said the SEC lacked authority to make such wholesale changes in the mutual fund sector. He argued that the case is an example of "in just how pretextual a manner [the SEC] can seize power and use it as a ploy to regulate other activities."

Under questioning from the judges, however, Scalia said previous SEC revisions to mutual fund rules, in 2001, had not been the subject of legal challenge by the chamber or other groups even though they required at least 50 percent of mutual fund board members to be independent.

The appellate panel did not provide a timetable for its ruling, but lawyers involved in the case say they expect a decision by the summer. The appeals court could rule that the SEC acted properly and leave the rules in place, throw out the rules, or send the issue back to the agency for more study and analysis.

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