Fifth Circuit: SEC Must Review Combined Economic Impact of Securities Lending and Short Sale Rules
Commentary by Steven Lofchie
The Fifth Circuit remanded, for further consideration by the SEC, two recent SEC rules on securities lending and short selling. The appellate court held that the agency failed to account for the combined economic impact of the rules.
As described in the decision, the SEC promulgated two rules under the Dodd-Frank Act. The first rule, the Securities Lending Rule, requires lenders and intermediaries to report the terms of securities loans to FINRA, with certain data made public on a delayed basis. (See previous coverage.) The second rule, the Short Sale Rule, requires institutional investment managers to report short position and activity data to the SEC’s EDGAR system, with that information disclosed to the public on an aggregate, monthly basis. (See previous coverage.) The SEC stated that the rules were adopted concurrently to increase transparency in securities markets.
The case came to the Fifth Circuit on petitions filed by associations representing private fund managers. Petitioners challenged the rules under the Administrative Procedure Act ("APA") and the Exchange Act. They argued that (i) the Securities Lending Rule exceeded the SEC’s statutory authority and was promulgated without adequate notice and comment; (ii) the Short Sale Rule was arbitrary and capricious because it used EDGAR rather than FINRA’s system; (iii) the Short Sale rule was arbitrary because it applied extraterritorially; and (iii) the rules, considered together, were contradictory and adopted without sufficient analysis of their combined economic impact.
The Court rejected most of these arguments. It found that the Securities Lending Rule was squarely authorized by Dodd-Frank § 984(b) ("Loan or borrowing of securities") and that the SEC’s changes to the reporting timeline were a reasonable outgrowth of the proposal and properly subject to comment. The Court also concluded that the Short Sale Rule was neither arbitrary nor overbroad, as the SEC had limited the rule’s reach to domestic securities already covered by Regulation SHO.
However, the Court concluded that the SEC acted arbitrarily under the APA by failing to analyze the "cumulative economic impact" of the two rules. The Court explained that, because the rules were adopted at the same meeting and regulate closely related activity, the Commission was required to account for their interplay in its economic analysis. The Court found that this omission left the rules insufficiently explained under both the APA and the Exchange Act.
Accordingly, the Fifth Circuit granted the petitions in part and denied them in part, remanding the rules to the SEC for further consideration of their combined economic effects.
Commentary
It will be interesting to see if the SEC has an interest in salvaging these rules by attempting the required cost-benefit analysis. Or, as is more likely, the SEC simply abandons them and moves on. The SEC has more important issues on its plate (digital assets, AI, cybersecurity, capital formation, clearing of US governments, CAT) than trying to fix yet another regulatory reporting requirement.
Even if one believed that there was some value to the extra disclosure of securities lending costs, the SEC could have gotten more benefit by limiting the price disclosure requirements to institutional transactions. The SEC's approach of requiring price reporting of every transaction completely muddies the water by commingling wholesale prices (lending agent to broker-dealer) with retail prices (broker-dealer to retail customer). It's as if the SEC tried to derive prices by averaging the price that Walmart paid for one million boxes of cereal from a producer with the prices that Walmart sold the boxes to individual customers. The SEC would have done better to try to determine an average institutional price, which would then have allowed retail customers to determine how much of a "markup" they paid above the institutional price. (For more on why the securities lending requirement was not well considered and poorly drafted, see Why Comment Periods Matter: The SEC Rulemaking on Securities Loans.)
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