Academic journal article Journal of Corporation Law

Shooting from the Hip: The Invalidity of SEC Rule No. S7-03-04

Academic journal article Journal of Corporation Law

Shooting from the Hip: The Invalidity of SEC Rule No. S7-03-04

Article excerpt


In the past few years, the investment company industry has endured a series of scandals that have raised some serious questions about its fundamental structure.1 Spurred into action by the Attorney General of New York, the Securities and Exchange Commission (SEC) uncovered widespread abuses within the mutual fund industry.2 In response to the public outcry concerning the mutual fund scandals, the sec proposed a new rule that became a final rule on July 27, 2004.3

SEC Rule No. S7-03-04 requires that investment companies relying upon certain exemptive rules within the Investment Company Act of 1940 (ICA) must have an independent chairperson of the fund board.4 The new rule applies to 90% of the investment company industry.5 This Note will examine the rule to evaluate its legality and consider its policy implications.

Part II of this Note scrutinizes the basis of the SEC's power to regulate investment companies by examining the ICA. After tracing the development of the ICA to its present-day status, the focus narrows to the specific rulemaking process within the SEC. This Part puts the new SEC rule under the microscope and analyzes its basic statutory components, including a dissent by two of the Commissioners.

Part III begins with a critical analysis of the legality of the SEC's new rule. This Note examines whether the SEC wields the statutory power under the ICA to enact such a sweeping regulation. In addition to the question of its authority, this Note subjects the procedural aspects of the SEC's rule to careful observation.

The second part of the discussion focuses on the policy considerations of the new rule. This Note explores the implications of the rule and whether it is consistent with the SEC's mandate under the ICA. The policy discussion considers the role of the sec and Congress's intent as expressed through the ICA.

Part IV responds to the sec rule by advocating the elimination of the independent chairperson requirement in its entirety. The SEC would be ill-advised to continue its implementation of this rule because of the effect it will have on the industry and the motivation for its creation. Instead, the SEC should implement a rule that requires the creation of a lead independent director for a fund board.


When Congress enacted the Investment Company Act of 1940, the amount of money invested in mutual funds in the United States was around $450 million.6 As of 2003, mutual funds accounted for approximately $7.4 trillion of invested capital in the United States.7 Mutual funds, a type of investment company, have become one of the most popular forms of investment available to the average person. To properly understand the impact of the SEC's recent regulatory action, a historical examination of the ICA and its development is necessary.

A. Investment Company Act of 1940

When Congress enacted the Securities Exchange Act of 1934, it created the Securities and Exchange Commission (SEC).8 The regulatory authority Congress granted to the SEC expanded to cover the investment company industry with the passage of the ICA.9 Prior to the passage of the ICA, investment companies were not required to register with the SEC.10

1. The Legislative History

By the 1930s, the corruption and misconduct within the investment company industry provided the impetus for Congress to create the ICA.11 In a situation reminiscent of the recent mutual fund scandals. Congress enacted the ICA to respond to the substantial losses incurred by shareholders and to prevent future losses.12 A proposed version of the ICA incorporated two protective layers for mutual fund investors.13 The first layer required investment companies to register with the SEC and disclose all pertinent information to the agency.14 The second layer of protection "sought authority to enforce a standard of fairness for shareholders regarding the structure and operation of investment companies. …

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