The United States Court of Appeals for the District of Columbia ruled that the SEC did not undertake appropriate "reasoned analysis" in approving a rule change relating to fees by the Options Clearing Corporation ("OCC"), a self-regulatory organization ("SRO").
In a decision by Chief Judge Merrick Garland, the Court determined that the SEC did not meet the necessary standard of evaluation when it granted approval to a rule change proposed by the Options Clearing Corporation ("OCC"). The ruling came in relation to a challenge from two nonshareholder options exchanges, a clearing member, and a market participants (collectively, the "petitioners") that the SEC had improperly approved a capital plan proposed by the OCC to alter its fee practices, including distribution of excess fees, in an attempt to "boost its capital reserves." The petitioners argued that the rule violated Exchange Act provisions by (i) imposing an unnecessary burden on competition by overcompensating shareholders, (ii) failing to protect investors by increasing customer fees, (iii) unfairly discriminating against nonshareholders by depriving them of the opportunity to contribute capital and receive dividends, and (iv) not complying with the OCC's own rules.
Rather than addressing each specific allegation, the Court instead found that the petitioners were correct in alleging that SEC approval of the proposal did not adhere to requirements that the SEC conduct an independent evaluation of SRO proposals. Instead, the Court determined, the SEC "abdicated that responsibility to OCC," the organization that developed, proposed, and sought to implement the rule change. The OCC claimed that "independent outside financial experts" affirmed the reasonableness of certain aspects of the proposal and, the Court said, the SEC relied on this unsubstantiated information. As such, the Court determined that the SEC should have either "critically reviewed" OCC's representations or undertaken its own "reasoned analysis." The Court also found that the SEC approval order was "arbitrary and capricious."
Instead of vacating the SEC approval order, the Court ordered that the SEC conduct a more thorough analysis of the proposal before allowing its implementation.
Commentary / Nihal Patel
The decision in this case has the potential to increase procedural hurdles imposed on all SEC approvals of SRO rulemaking orders. In practice, given the large number of rulemaking changes that the SEC must address, the analysis in the orders tends to be brief and conclusory. If the SEC is required to provide a "reasoned analysis" on every single SRO rule change, the SEC could find that the staff will be substantially burdened, which would, in turn, slow down the rulemaking process.
As a practical matter, only a small number of SRO rule changes generate controversy like the OCC fee change at stake in this case. This can generally be seen by looking at the number of comment letters submitted on any particular rule change. Quite often, the number is zero. However, in those cases where there is a controversy and market participants submit comment letters, the SEC is the entity best suited to address the controversy, not the SRO itself. Currently, market participants who find an SRO action inappropriate are often left making arguments to an entity that already feels its proposal is justified. (The tension in the SRO playing the role of arbiter over the rulemaking process is increased in circumstances, such as the instant case, where either regulatory fees are at issue or there is otherwise significant money at stake.)
The Court makes clear that going forward the SEC cannot simply rely on the SRO's analysis being correct. Judge Garland stated that the SEC cannot simply "trust the process" of an SRO, see fn. 3 of the decision, and market participants may have more reason to trust the process from the SEC.
It is important to note that the rulemaking at stake in this case is unusually complex. As the Court notes, the reason the OCC sought to make this rule change was that it needed to increase capital on hand. What the Court does not mention is that much of what led to the OCC rule change is a consequence of statutory and regulatory developments that are driving changes to the way clearing agencies protect themselves from failure. Due to changes in the regulation of such entities made by Title VIII of the Dodd-Frank Act, the OCC is subject to enhanced oversight as an FSOC designated "systemically important financial market utility." As such, in addition to the SEC, under Section 802 of Dodd-Frank, the Board of Governors of the Federal Reserve System is an interested party in the raising of capital by the OCC, though it is not the entity that is directly responsible for approving the entity's rule changes.
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