When lawyers for the Securities and Exchange Commission march into a federal courthouse in Washington this morning, they could be defending more than just the commission’s recent misguided attempts to regulate mutual funds. They will be defending the SEC’s entire way of doing business. Judges appear set to weigh whether the commission is living up to requirements Congress set in 1996. If that’s the standard, the SEC faces serious trouble – and a ruling that could undermine a lot of its recent regulatory adventures.

Today’s case, U.S. Chamber of Commerce v. SEC, challenges the commission’s mutual fund rules. In August 2004, the SEC pushed through a rule ostensibly cleaning up the fund industry by diluting the influence of the advisers who direct the funds’ investing strategies. If the commission gets its way, the chairmen and 75% of the members of the boards of mutual funds would have to be independent of the fund’s management.

As in the hedge fund case we described in our editorial “The SEC Goes to Court” of December 9, 2005, this case centers on an SEC attempt to expand its authority beyond what Congress has explicitly allowed. The Chamber argues that the SEC failed to perform an adequate cost-benefit analysis of the mutual fund rule before it pushed the regulation through by a 3-2 vote. On June 21, 2005, an appeals court agreed and sent the SEC back to the drawing board. But the SEC re-issued the exact same rule on June 29, claiming that it had performed sufficient analysis in that eight-day period.

Why the haste? William Donaldson, who was then the chairman of the commission and had cast the deciding vote on the rules, was set to leave office the next day to be replaced by a chairman who seemed likely to oppose the rule. The Chamber has taken the SEC back to court claiming that the commission had thumbed its nose at the first court order.

This case could run deeper than even its immediate impact on the tens of millions of American small investors who put their money in mutual funds. The Court has seemed especially interested in one aspect of the Chamber’s argument: that the SEC broke the 1996 National Securities Market Improvement Act. The law requires the SEC not just to look out for investors but to ensure that it promotes “efficiency, competition, and capital formation” in financial markets. Although the SEC always pays lip service to studying how well its rules fare under this triple test, it certainly looks to us like the commission isn’t taking the Congress’s dictate seriously.

Today’s case could change all that. If the three judges hearing the argument – Karen Lecraft Henderson, Judith W. Rogers, and Janice Rogers Brown – credit the Chamber’s argument on this score, it will set a precedent for challenging a host of regulations. The commission could have to reconsider its insistence that foreign companies adhere to American Generally Accepted Accounting Principles in addition to foreign standards, making companies doing business here prepare two sets of books. It could force the SEC to make its enforcement procedures less arbitrary, to reconsider outdated rules governing how market data are distributed, and to tone down its over-aggressive interpretation of sections of the Sarbanes-Oxley law.

The SEC is playing a high stakes game today. Which is why its lawyers have cause to be nervous when they walk into court. Less than a month ago, three different judges on the same appeals bench literally laughed at the commission’s arguments in the hedge fund case, and that hinged on the commission’s interpretation of a fairly narrow law. Now the commission has to defend an even more sweeping interpretation of legislation in a case that could ripple through much of what the SEC does. That’s bad news for the commission, but good news for investors.