Why Dodd-Frank Rules Keep Losing in Court
October 4, 2012
The Wall Street Journal
Since the mid-2000s, regulations of the Securities and Exchange Commission have been challenged six times in the federal court of appeals in Washington, D.C. The SEC lost every time. I brought four of those lawsuits, and sometimes am asked why the agency has such difficulty defending its rules.
Some former SEC staffers and investor advocates now claim to have the answer: It's the court's fault. In a media campaign that appears to have been launched in anticipation of challenges to rules implementing the Dodd-Frank financial reform, the judges of the U.S. Court of Appeals for the D.C. Circuit—among the most respected courts in the country—are being characterized as judicial activists. Wall Street has "backup on the bench" from a bevy of judicial conservatives, claims the New York Times. Other news outlets are taking up the cry.
In truth, these decisions against the SEC have been joined by judges appointed by Democratic and Republican presidents. All but one was unanimous. The exception is a case where a Democratic appointee dissented from an opinion written by another Democratic appointee. The commission's rule in that case was deregulatory—the agency had provided regulatory relief that the court said it could not. (A Republican appointee joined the decision striking down the rule.)
The opinion in another high-profile SEC loss—involving mutual-fund "governance" requirements—was written by a Republican appointee joined by two Democratic appointees. In several cases, the court has rejected broader challenges made to the commission's authority and bent over backward to give the SEC a chance to correct its error.
The "blame-the-Republican-appellate-judges" theory suffered its latest setback Friday, when a judge appointed by President Obama, in the district court in Washington, struck down the controversial rule of the Commodity Futures Trading Commission (CFTC) that placed new "position limits" on amounts of commodities investors could hold.
The truth is that the D.C. Circuit is an admirably nonideological court that applies principles of administrative law evenhandedly. The judges know, even if their critics do not, that a decision striking down increased environmental regulation today could be a precedent tomorrow for rejecting a rule favored by business.
Here, then, are the real reasons for the courtroom travails of the SEC (and, now, the CFTC):
• Congress and President Clinton. In 1996, Bill Clinton signed legislation requiring the SEC to consider the effect of its rules on "efficiency, competition, and capital formation." The CFTC has a similar obligation. Other agencies don't have this heightened responsibility.
• Weak economic analysis. Despite its heightened duty, at times the SEC has been inattentive to economic analysis. In one case, a former SEC chairman cast aside an economic study because, he said, "there are no empirical studies that are worth much. You can do anything you want with numbers." The court saw it differently.
The SEC's defenders bridle at the requirement for cost-benefit analysis—it's so hard! The lament is curious. Financial regulators should be particularly attentive to the financial consequences of their actions. Other agencies have conducted sophisticated cost-benefit analyses for decades, and these are reviewed (and sometimes rejected) by a special White House office of regulation. As an independent agency, the SEC is exempt from that external expert review. Its rules have suffered as a result.
• Disrespect toward the court. Former SEC Commissioner Harvey Goldschmid, now a Columbia law professor, is a vocal critic of the D.C. Circuit. He masterminded what became the SEC's greatest debacle before the court. The court had invalidated the SEC's mutual-fund governance rule, returning it to the agency for reconsideration with just eight days left in Mr. Goldschmid's term. He persuaded two commission colleagues to "reconsider" the rule in little more than a week—without public comment—so they could readopt the rule unchanged on his last day. The charade made headlines and earned a swift rebuke from the court.
• The importance of process. I once debated a former SEC staffer who accused business of using procedural maneuvers to defeat salutary regulations. Yet proper procedure is one of Congress's principal means of ensuring regulatory quality. The law authorizing courts to review agency rules is the Administrative Procedure Act. In court, the ends don't justify the means.
The SEC (and, lately, the CFTC) often does a poor job with the hard work of the rule-making process. Under law, an agency must listen carefully to what the public says about a proposed regulation, reconsider its approach in light of that public input, and then cogently explain (not merely assert) why it made the regulatory choices it did in crafting the final rule.
Take the court of appeals' rejection last year of the SEC "proxy access" rule that made it easier for certain large shareholders to nominate corporate directors. That decision has become Exhibit A for the argument that the court has set too high a bar.
Yet in adopting the proxy rule, the commission ignored one of companies' main objections to it: that the proxy procedure would be used mostly by labor-union and government pension funds whose interests diverge sharply from those of other shareholders. The SEC's final rule never even mentioned labor unions or government pension funds. Under clear Supreme Court precedent, when an agency ignores the public's concerns on a central issue like that, the rule will be struck down.
• Misplaced modesty. The SEC and CFTC are expert agencies blessed with immensely capable professionals. Judges value and defer to that expertise—when it's exercised to make the hard decisions that Congress entrusts to an agency.
The CFTC's recently invalidated "position limits" rule is an example of an agency failing to deploy expert judgment. When the rule was adopted, a majority of CFTC commissioners said it was likely to harm consumers. But the commission adopted it anyway, saying that Dodd-Frank required it. The court disagreed and faulted the agency for failing "to bring its expertise and experience to bear."
Regulations of other federal agencies are challenged in court all the time, by groups representing business, employees, consumers and environmental interests. Congress designed our administrative state that way, to ensure meaningful public participation in the regulatory process, which produces smarter regulation.
For the SEC and CFTC, this sort of litigation is relatively new. Until recently, their rules were seldom challenged. Congress's calculation, though, is that public participation and judicial review will make those agencies better regulators. Given the important Dodd-Frank rule-makings that lie ahead, that's a good thing.