An Uncomfortable Wake-Up Call For Dodd-Frank Regulators

Jane C. Luxton of Pepper Hamilton LLP

Late last year, the Court of Appeals for the District of Columbia Circuit jolted the Securities and Exchange Commission (SEC or Commission) with a strongly worded opinion, vacating one of the first rules issued pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act [1] (DFA). In Business Roundtable v. Securities and Exchange Commission, [2] the D.C. Circuit made clear that rules promulgated under the Securities Exchange Act of 1934 [3] and the Investment Company Act of 1940 [4] require a far more rigorous economic analysis and cost-benefit justification than the SEC had assumed was necessary to satisfy statutory criteria directing consideration of the rule's effects on efficiency, competition, and capital formation. [5] Finding the SEC's "proxy access" rule [6] deficient in multiple respects, the court set it aside as arbitrary and capricious under the Administrative Procedure Act (APA), [7] forcing the SEC and other regulators poised to issue a wave of DFA rules to take a whole new look at their rulemaking processes.

The Lead-Up to Business Roundtable

In retrospect, the Business Roundtable decision should not have come as a big surprise. Twice in recent history, the D.C. Circuit has chastised the SEC for cost-benefit analyses that were inadequate to determine whether a challenged rule was in the public interest as promoting efficiency, competition, and capital formation. In its 2005 decision in Chamber of Commerce v. SEC, [8] the court gave deference to conclusions on matters it viewed as within the SEC's technical expertise (for example, the minimum percentage of independent directors needed for investment companies), but flatly refused to "excuse the Commission from its statutory obligation to do what it can to apprise itself - and hence the public and the Congress - of the economic consequences of a proposed regulation before it decides whether to adopt the measure." [9] Signaling that cost-benefit analysis is in a different category from specialized agency expertise, the court rejected both the SEC's claim that estimating the cost of new requirements was too difficult to determine reliably and its disinclination to address a less burdensome alternative proposed by commenters on the ground the Commission was "not required to discuss every alternative presented." [10] The court held that these shortcomings rendered the rule arbitrary and capricious in violation of the APA, and remanded with instructions to address the deficiencies in the cost estimates and consider alternatives proposed by commenters that were "neither frivolous nor out of bounds." [11]

Four years later, in American Equity Investment Life Insurance Company v. SEC, [12] the court once again deferred to the SEC's expertise on the technical issue of whether a fixed indexed annuity (FIA) qualified as an annuity contract within the meaning of the Securities Act of 1933. [13] At the same time, however, the court closely examined and harshly criticized the Commission's various defenses of its economic analysis of the impact of a rule making FIAs subject to federal regulation. In turn, the court rebuffed the Commission's claims it did not need to examine the effects of the rule on efficiency, competition, or capital formation or, if it was required to do so, had sufficiently justified the rule's benefits by asserting the resulting clarity would lead to greater competition. This latter argument could apply equally to any rule that resolved a previously unsettled issue, the court said, providing no insights into whether this particular rule would actually promote competition. [14] Similarly, the Commission's failure to assess the "baseline level of price transparency and information disclosure" under the existing state regulatory scheme prevented any accurate evaluation of the potential benefits to competition and the overall economic implications of the rule. [15] The court identified comparable flaws in the SEC's efficiency analysis, which carried over to any assessment the Commission might have conducted of effects on capital formation. [16] With some asperity, the court pronounced the rule arbitrary and capricious and vacated it.

The Court's Concerns in Business Roundtable

Judge Ginsburg, who wrote the opinion in Chamber of Commerce v. SEC and was on the unanimous panel in American Equity Investment Life Insurance Company, plainly felt he was covering familiar ground with the SEC in Business Roundtable: "We agree with the petitioners and hold the Commission acted arbitrarily and capriciously for having failed once again - as it did most recently in American Equity Life Insurance Company v. SEC …and before that in Chamber of Commerce … - adequately to assess the economic effects of a new rule." [17] Going point by point through the SEC's claims that it had properly examined costs and benefits, the court variously faulted the Commission's analysis as: (i) based on "mere speculation" and insufficient empirical data; (ii) lacking in efforts to estimate and quantify certain costs; (iii) flawed by improper disregard of a plausible cost study; (iv) dependent on internally contradictory criteria; (v) inconsistent, in discounting costs but not benefits; and (vi) subject to inadequate consideration of other factors significant to the analysis. [18]

The court did not stop there, however. Saying that the rule was arbitrary and capricious on its face, the court took a prophylactic approach to future SEC efforts: "Lest the Commission on remand apply to the investment companies a newly justified version of the rule, however, only to be met in court again by valid objections, we think it prudent to take up the more serious of the concerns posed by investment companies but left unaddressed by the Commission." [19] Under this heading, the court identified additional problems, including the SEC's lack of explanation for its assumption that the rule would be likely to yield the same benefits for investment companies as for operating companies, despite their structural and regulatory dissimilarities, and failure to assess the different costs that would apply to the two types of entities. In a final fit of exasperation, the court characterized as "an unutterably mindless reason for applying the rule to investment companies" the Commission's reasoning that the rule would "not entail costs if it is not used, or at least not used successfully to elect a director." [20] With that, the court vacated the rule.

What Happens Next?

Reports are circulating that regulators responsible for the substantial collection of DFA rules that must be promulgated in the near term are uniformly worried about the tough judicial scrutiny they now need to expect on the economic justifications of these rules. For agencies accustomed to judicial deference and some degree of litigation restraint from regulated entities, the Business Roundtable opinion is a rude awakening that they may be in for more of the rough-and-tumble common to cost-benefit analyses in other regulatory arenas, such as environmental law, for example. There is little question that those subject to the new rules are prepared to do battle, as evidenced by a December 2, 2011, complaint filed by the International Swaps and Derivatives Association and Securities Industry and Financial Markets Association against the Commodities Futures Trading Commission's derivatives contract "Position Limits Rule," [21] which attacks the CFTC's economic justification for this DFA-based regulation. [22] With agency budgets already strained, it will be difficult for them to staff up quickly with additional economists who are comfortable with these issues.

Some signs that the SEC and others are working to buttress the administrative records for new rules can be seen in the SEC's extended rulemaking timeframe and October 2011 Roundtable, an effort to hear from stakeholders, on the proposed "Conflict Minerals" rule. [23] The rule, statutorily prescribed for final promulgation in April 2011, has now also missed an internal end-of-year deadline, but its economic analysis has already attracted strong negative comments, setting the stage for a likely appeal. These include a letter filed by the Small Business Administration's Office of Advocacy, the agency responsible for advancing the views and concerns of small business within the federal government, which argues the SEC has significantly underestimated the costs of the rule and the number of small businesses that will be affected. [24] In another example of new agency concern about APA issues and cost-benefit substantiation, the proposed "Volcker Rule," [25] now out for comment in the form of a Notice of Proposed Rulemaking, includes a lengthy section that solicits comment on expected economic impacts of the rule on regulated entities.

Without a doubt, the regulated community has strong legal support in the Business Roundtable decision for challenging new rules if regulators give short shrift to a thorough and reasoned economic analysis. Based upon practice and precedents in the battlegrounds of environmental law, the SEC and financial services regulatory agencies would be well-advised to adopt approaches that quantify or "monetize" costs and benefits as much as possible and include such features as: (1) establishing a baseline, to allow a meaningful comparison of both costs and benefits under the status quo and a new rule; (2) a serious evaluation of the alternatives, including reasonable, non "frivolous" options put forward by commenters and the agency; and (3) clear explanations of the assumptions, methodology, and reasoning on which the agency relies, particularly in cases in which the agency says a quantitative analysis is not feasible. [26]

For its part, industry must focus on efforts to document its cost and burden arguments and critiques of the agency's cost-benefit analysis, submitting credible economic assessments to the administrative record and clearly laying out objections to the agency's rationale, in order to preserve its ability to challenge a rule it feels is unjustified. In short, all players in the upcoming rulemakings should hear the wake-up call for a far more rigorous economic analysis than may have been the custom in the past.

[1] Pub.L. No. 111-203, 124 Stat. 1376 (July 21, 2010).

[2] 647 F.3d 1144 (D.C. Cir. 2011).

[3] 15 U.S.C.A. § 78a.

[4] 15 U.S.C.A. § 80a-1.

[5] See 15 U.S.C.A. at §§ 78c(f) and 80a-2(c).

[6] SEC, Facilitating Shareholder Director Nominations: Final Rule, 75 Fed. Reg. 56,668 (2010).

[7] 5 U.S.C.A. § 551.

[8] 412 F.3d 133 (D.C. Cir. 2005).

[9] 412 F.3d at 144.

[10] 412 F.3d at 144.

[11] 412 F.3d at 145.

[12] 613 F.3d 166 (D.C. Cir. 2009).

[13] 15 U.S.C.A. § 77c(a)(8).

[14] American Equity Investment Life Ins. Co. v. SEC, 613 F.3d at 177-78.

[15] 613 F.3d at 178.

[16] 613 F.3d at 179.

[17] Business Roundtable v. SEC, 647 F.3d at 1148. (Citations omitted.)

[18] 647 F.3d at 1150-54.

[19] 647 F.3d at 1154.

[20] 647 F.3d at 1156.

[21] CFTC, Position Limits for Futures and Swaps; Final Rule and Interim Final Rule, 76 Fed. Reg. 61,626 (2011).

[22] Complaint, International Swaps and Derivatives Ass'n v. U.S. Commodities Futures Trading Commission, Case No. 1:11-cv-02146 (D.D.C. Dec. 2, 2011). The Commodity Exchange Act, 7 U.S.C.A. §§1 et seq., includes language requiring consideration of the costs and benefits of a rule, comparable to provisions in the Securities Exchange Act of 1934 and the Investment Company Act of 1940, supra n.6.

[23] SEC, Conflict Minerals: Proposed Rule, 75 Fed. Reg. 80,948 (2010).

[24] See Letter from Winslow Sargeant, Ph.D., Chief Counsel for Advocacy, Small Business Administration, to Elizabeth Murphy, Secretary, SEC (Oct. 25, 2011), available at See also Chris Bayer, A Critical Analysis of the SEC and NAM Economic Models and the Proposal of a 3rd Model in View of the Implementation of Section 1502 of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, (unpublished report, Tulane University Law School's Payson Center for International Development) (Oct. 17, 2011), available at Conflict_Minerals.pdf.

[25] Office of the Comptroller of Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and SEC, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds: Notice of Proposed Rulemaking, 76 Fed. Reg. 68,846 (2011).

[26] The Office of Management and Budget (OMB) has provided useful guidance on how agencies should develop a cost-benefit analysis, see OMB, Regulatory Analysis, (Circular A-4) (Sept. 13, 2003), available at

Jane C. Luxton, Partner,

Jane C. Luxton is a partner in the Environmental Practice Group of Pepper Hamilton LLP, resident in the Washington office. She is chair of the firm's Sustainability, CleanTech and Climate Change Team. Ms. Luxton concentrates her practice on environmental matters.

Ms. Luxton has extensive experience in environmental regulatory and litigation matters, with an emphasis on metals production and processing, and products containing metals. Her experience includes federal and state environmental laws as well as international environmental regimes.

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This article was published in the January 2012 issue of the Futures & Derivatives Law Report (Vol. 32, Issue 1).