11th Circuit Strikes Down SEC Rule on CAT Cost Allocation
Commentary by Steven Lofchie
The United States Court of Appeals for the Eleventh Circuit vacated a 2023 SEC regulation that established a new funding model for the Consolidated Audit Trail ("CAT").
The rule established a cost allocation of one-third each to the buy-side broker, the sell-side broker, and the self-regulatory organizations ("SROs") and expressly permitted SROs to pass their entire share of the costs on to their members—effectively shifting the full financial burden of the CAT system to broker-dealers.
In American Securities Association v. SEC, the petitioners challenged the 2023 CAT Funding Order on three grounds: (i) that the CAT itself was unlawful; (ii) that the cost allocation structure was arbitrary and capricious in violation of the Administrative Procedure Act ("APA"); and (iii) that the SEC relied on outdated 2016 cost projections, despite increased implementation and operating costs.
The petitioners argued that the SEC unjustifiably reversed course by allowing SROs to pass 100% of their CAT costs to broker-dealers—contradicting the original cost-sharing model—and failed to update its economic analysis despite costs ballooning far beyond original estimates. In response, the SEC maintained that it had always permitted SROs to recover costs from members subject to review, and that the 2023 rule merely allowed, rather than required, such pass-throughs. The SEC further asserted that a new economic analysis was unnecessary since the CAT itself was not being reconsidered and the agency had supplemented the 2016 analysis with updated information.
The Court agreed with the petitioners and held that the 2023 Funding Order was "arbitrary and capricious." It found the SEC failed to reasonably justify its shift in cost-allocation policy and neglected to account for the perverse incentives created by allowing full cost pass-through. The Court also concluded that relying on an outdated economic analysis, without addressing the significant increase in CAT costs, violated the APA’s requirement for reasoned decision-making. Because it found the petitioners two arguments sufficient to vacate the rule, the Court declined to address the broader challenge to CAT’s legality.
As a result, the Court vacated the 2023 Funding Order and remanded the matter to the SEC for further proceedings consistent with its opinion.
Commentary
An egregious failing in SEC rulemaking under the previous administration is the consistently flawed analysis on the costs of proposed rules. Beyond its conclusion that the rulemaking in this case exceeded the SEC's statutory authority, the 11th Circuit Opinion found that "the annual cost of operating the [CAT] system going forward appears likely to exceed the Commission's 2016 estimate by nearly four times."
A main concept underlying the Administrative Procedure Act is that the relevant regulator should determine that the benefits of any proposed regulation exceed its costs. If the regulator is underestimating its costs by 4x, there is a good chance that the entire basis on which the rule is deemed worthwhile is wrong. And if the regulator underestimated costs by 4x, that might be a good sign that the regulator more than likely overestimated benefits by the same amount.
The SEC's underestimation of costs was not unique to this rulemaking. An even more egregious example was the SEC's "estimation" of the costs as to the dealer registration rule, where the agency simply ignored the capital charges resulting from forcing entities holding illiquid positions to be required to register as dealers. That cost alone would have many times outweighed the costs that the SEC acknowledged in that rulemaking.
This raises the question of how can aggressive regulators be kept honest on their cost-benefit analyses. Clearly the APA did not do the job. (What's that famous saying about statistics?)