Donaldson in the Dock

Fourteen judges currently sit on the federal Court of Appeals for the District of Columbia Circuit, and eight of them have ruled against William Donaldson in the past year; one of those has done so twice. If Mr. Donaldson thought his tenure as chairman of the Securities and Exchange Commission was going to mark a new era in corporate reform, he was wrong. His real legacy is shaping up to be a series of embarrassing court defeats and, in one case, a slow bureaucratic death.In Mr. Donaldson’s latest loss, the appeals court struck down an attempt to regulate hedge funds that he had pushed through in the waning days of his chairmanship. By creatively redefining the word “client” in a statute, a 3-2 majority of commissioners had tried to bring the funds under the agency’s watchful eyes for the first time.That ruling arrived on June 23, a year and two days after Mr. Donaldson’s first defeat, when a different three-judge panel ruled that the agency had violated the normal procedures for making new rules when it tried to impose new regulations on mutual funds. In that case, opponents of the rule argued that the SEC had failed to measure adequately the costs of requiring mutual fund boards and chairmen to be “independent” from the funds’ management. And between the first mutual fund ruling and the hedge fund ruling, yet another three-judge panel had voted against the commission a second time on mutual funds. Mr. Donaldson had tried to enact exactly the same rule after it was struck down the first time in a frantic effort to beat the clock before his term ended on June 30, 2005.The legal issues in the mutual and hedge fund cases have been different, but they share one thing in common. They were pushed through very quickly by Mr. Donaldson over vehement opposition from the two dissenting commissioners. The lawyer representing the chief opponents of the mutual fund rule, Eugene Scalia, suggests that this aspect is the particular oddity of these rules. That, in turn, might have caught the attention of the judges. They’re no strangers to regulatory appeals since the D.C. circuit plays referee for most disputes between federal regulators and the regulated, and the law grants regulators like the SEC fairly broad latitude in setting rules.Typically, however, the agencies before the judges have followed a slow and steady course toward the contentious rule. In contrast, the judges appear to be growing impatient with the Donaldson SEC’s slipshod rulemaking. “You [the SEC] don’t have the authority to act just because you exist,” Judge Harry Edwards, a Carter appointee, interjected in exasperation as a commission lawyer was presenting the SEC’s argument in the hedge fund case. Likewise during the hearing for the second mutual fund case, Judge Janice Rogers Brown, a George W. Bush appointee, hit a commission lawyer with a pointed question about whether the court’s earlier ruling on the matter had had any effect.The net result is that the agency is in trouble if it doesn’t shape up quickly. If the commission under the new chairman, Christopher Cox, doesn’t start behaving more rationally, the court will start viewing the SEC as unreliable, Mr. Scalia says. The commission’s lawyers could find themselves confronting an ever more skeptical bench each time they head to court to defend a commission action.That fate is not inevitable, however, and Mr. Cox at least is starting to take steps in the right direction. He has said he thinks the SEC needs to set up a better process for evaluating the economic rationale for potential new rules. Had Mr. Donaldson bothered to do something like that, the commission would not have been reprimanded twice by the court for its failure to consider the costs of its mutual fund rule.The current chairman also appears to understand that one of the biggest problems at the SEC can be its own staff. One veteran SEC watcher, a scholar at the American Enterprise Institute, Peter Wallison, notes that Mr. Donaldson’s controversial rules sprang from the SEC bureaucracy’s power lust. As New York’s attorney general, Eliot Spitzer, zeroed in on mutual funds, SEC staffers wanted a piece of the action. It was similar with hedge funds, which have grown in recent years. Another contentious rule, Regulation NMS, was an effort to substitute the SEC’s judgment for that of investors in deciding at which price to execute transactions on electronic markets, such as the NASDAQ.Mr. Donaldson was often egged on by the staff, giving little indication that he understood his underlings’ own biases, which always veered toward more power for themselves. Mr. Cox, in contrast, has already demonstrated willingness to stand up to his staff in several high profile instances, as when he quashed the enforcement division’s subpoenas of several journalists in a short-selling probe.All of which will come as comforting to the investing public, which has an interest in sanity at the SEC. As for Mr. Donaldson, the legacy from his tenure at the commission is steadily going up in smoke. His attempt to regulate hedge funds is dead in its tracks. His mutual fund rule is now undergoing its second court-ordered reconsideration and is unlikely to survive another vote of the current commissioners. Regulation NMS has been deferred to at least 2007 and looks increasingly likely to die a quiet death inside the SEC’s offices before it’s implemented.Mr. Donaldson can count one achievement, though. One Carter appointee, one Reagan appointee, two George H.W. Bush appointees, two Clinton appointees, and two George W. Bush appointees have voted against his rules. At a time when some might have thought legal bipartisanship in Washington was dead, Mr. Donaldson found two issues on which judges from both ends of the spectrum could agree.

Donaldson in the Dock

Donaldson in the Dock

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