Court Opinion

ID: 2998268
Source: CourtListenerOpinion
Date Created: 2015-09-24 19:42:18.222702+00
Date Added: 2024-06-11T13:13:52.290028
License: Public Domain

In the
 United States Court of Appeals
              For the Seventh Circuit
                        ____________

Nos. 04-2242 & 04-2487
DH2, INCORPORATED, an
Illinois Corporation,
                                                    Petitioner,
                              v.

UNITED STATES SECURITIES AND
EXCHANGE COMMISSION,
                                                  Respondent.
                        ____________
             Petitions for Review of an Order of the
       United States Securities and Exchange Commission.
                           No. 04 C 789
                        ____________
ARGUED NOVEMBER 29, 2004—DECIDED SEPTEMBER 7, 2005
                  ____________

  Before KANNE, EVANS, and SYKES, Circuit Judges.
  SYKES, Circuit Judge. These consolidated petitions for
review challenge certain rules releases issued by the
Securities and Exchange Commission (“SEC”) in the
wake of New York Attorney General Elliot Spitzer’s investi-
gation into abuses in the mutual fund industry. Petitioner
DH2, Inc., is an Illinois corporation that trades in mutual
funds and makes money by taking advantage of short-term
price/value discrepancies that occur when the current value
of a fund’s portfolio securities has changed and that change
is not yet reflected in the fund’s share price. That is, DH2
is a “market timer”—a firm that exploits mutual fund
2                                    Nos. 04-2242 & 04-2487

mispricing that occurs when market prices for the fund’s
underlying securities have become stale due to events after
the relevant trading market has closed.
  DH2 prefers the term “active trading” to “market timing.”
Whatever the nomenclature, the practice—a form
of arbitrage—is legal, but in an effort to curtail it, the
SEC changed its interpretation of the rules regarding
how mutual funds calculate their daily prices, and
DH2 brought this petition challenging the SEC’s actions. In
particular DH2 challenges statements made in rules
releases issued by the SEC in late 2003 and 2004 requir-
ing mutual fund companies to estimate the current “fair
value” of a security when the market price at which that
security closed has become unreliable. We conclude that
DH2 lacks standing to challenge the SEC’s releases and
accordingly dismiss the petitions.

                      I. Background
  A mutual fund’s share price does not fluctuate throughout
the trading day, but the prices of the securities held by the
fund do. The ever-changing portfolio security prices are
aggregated into a single daily fund price known as the net
asset value (“NAV”), which is generally fixed by a fund
when the major U.S. stock markets close at 4:00 p.m.
eastern time (ET). The Investment Company Act of 1940, 15
U.S.C. §§ 80a-1 et seq. (“ICA”), requires mutual fund shares
to be sold and redeemed at a price that:
    will bear such relation to the current net asset value
    of such security computed as of such time as the
    rules may prescribe . . . for the purpose of eliminating or
    reducing . . . any dilution of the value of other outstand-
    ing securities of such company or any other result of
    such purchase, redemption or sale which is unfair to
    holders of such other outstanding securities.
Nos. 04-2242 & 04-2487                                     3

15 U.S.C. § 80a-22(a) (emphasis added). For purposes
of computing NAV, the ICA defines “value” as follows: “(i)
with respect to securities for which market quotations
are readily available, the market value of such securities;
and (ii) with respect to other securities and assets, fair
value as determined in good faith by the board of direc-
tors[.]” 15 U.S.C. § 80a-2(a)(41)(B) (emphasis added). This
case concerns the circumstances under which mutual funds
use “fair value” estimates—as opposed to market quota-
tions—for purposes of calculating NAV and setting share
price.
  The SEC regulates mutual funds under the ICA and
investment advisers under the Investment Advisers Act
of 1940, 15 U.S.C. § 80b-1 et seq. (“IAA”). The agency is
empowered to make rules and regulations “to the same
extent, covering the same subject matter, and for the
accomplishment of the same ends” as the ICA, and to define
“accounting, technical, and trade terms used in this title.”
15 U.S.C. §§ 80a-2(c), 80a-37(a).
  To that end, the SEC has promulgated rules governing
portfolio valuation and share pricing. One of these rules
elaborates on the ICA’s definition of “value”:
    Portfolio securities with respect to which market
    quotations are readily available shall be valued at
    current market value, and other securities and assets
    shall be valued at fair value as determined in good faith
    by the board of directors.
    ....
    [C]alculations made as of the close of the New York
    Stock Exchange on the preceding business day may
    be estimated so as to reflect any change in current
    net asset value since the closing calculation on the
    preceding business day.
17 C.F.R. §§ 270.2a-4(a)(1), (c) (emphasis added). Another
4                                       Nos. 04-2242 & 04-2487

rule establishes a requirement of “forward pricing,” prohib-
iting the issuance or trading of fund shares at any price
other than one “based on current net asset value of such
security which is next computed after receipt” of a purchase
or redemption order. 17 C.F.R. § 270.22c-1(a).
  “Forward pricing” was implemented by the SEC in 1968
in order to reduce riskless short-term trading in mutual
funds by eliminating the ability to use late-breaking
news to take advantage of NAVs fixed before that news was
released to the markets. See United States v. Nat’l Ass’n of
Sec. Dealers, Inc., 422 U.S. 694, 710 n.19 (1975); David
Ward, Protecting Mutual Funds From Market-Timing
Profiteers: Forward Pricing International Fund Shares, 56
HASTINGS L.J. 585, 594 (2005). The “forward pricing”
principle of Rule 22c-1(a) did not fully achieve its goal,
however. “As the number of mutual funds that offered
investors the chance to invest in overseas markets grew, a
new type of ‘backward pricing’ abuses began to emerge, one
that was possible because mutual funds were increasingly
investing in stocks that traded in markets outside the
United States.” Ward, Protecting Mutual Funds, at 594.
  For example, in the case of a U.S. mutual fund that
invests primarily in overseas securities trading on the
London Stock Exchange, the daily NAV would be set at
4:00 p.m. ET using stock prices from the close of the London
market at 11:00 a.m. ET—that is, stock prices that are five
hours old. In the event that favorable economic news
emerged during the interim, arbitrageurs could purchase
shares in the fund at an undervalued NAV that did not
account for the positive late-breaking news.1 See Kircher v.

1
 The potential for exploiting stale market prices increases as one
moves east, given the larger time zone disparities between eastern
                                                      (continued...)
Nos. 04-2242 & 04-2487                                     5

Putnam Funds Trust, 403 F.3d 478, 480-81 (7th Cir. 2005).
Under these circumstances, “[a]rbitrageurs . . . make profits
with slight risk to themselves, diverting gains from the
mutual funds’ long-term investors while imposing higher
administrative costs on the funds (whose operating ex-
penses rise with each purchase and redemption).” Id. at
481.
  In response to Attorney General Spitzer’s investigation
into illegal late trading in the mutual fund industry and the
accompanying growing public awareness of the practice of
“market timing” arbitrage, the SEC launched a reexamina-
tion of the rules governing mutual fund valuation and share
pricing. At issue here are certain statements made by the
SEC in rules releases issued in late 2003 and 2004 pertain-
ing to the circumstances under which mutual funds must
use “fair value” pricing. As described above, the ICA and
SEC regulations require funds to use current market
quotations in calculating NAV with respect to securities for
which such quotations are “readily available,” and in all
other circumstances to use “fair value” estimations. In
December 2003 the SEC adopted a new compliance rule
requiring mutual funds and investment advisers to adopt
and implement written policies and procedures “reasonably
designed to prevent violation of the federal securities laws,
review those policies and procedures annually for their
adequacy and the effectiveness of their implementation, and
designate a chief compliance officer to be responsible for
administering the policies and procedures.” 68 Fed. Reg.
74714 (Dec. 24, 2003) (the “Compliance Rule”). In April
2004 the SEC adopted a new disclosure rule requiring funds
to explain in their prospectuses “the circumstances under
which they will use fair value pricing and the effects of
using fair value pricing.” 69 Fed. Reg. 22300 (Apr. 23, 2004)

1
  (...continued)
time and the Japanese or Hong Kong markets.
6                                   Nos. 04-2242 & 04-2487

(the “Disclosure Rule”).
  The Compliance Rule and the Disclosure Rule are them-
selves silent regarding the circumstances under which
funds should or must use fair value pricing in calculating
daily NAV, but the releases issued in connection with the
promulgation of the rules contain statements by the SEC
that DH2 contends amount to “a new, mandatory require-
ment—the ‘Fair Value Rule,’ ” promulgated in violation of
the requirements of the Administrative Procedure Act
(“APA”) and contrary to the ICA. The challenged language
pertains to the circumstances under which current market
quotations are not “readily available” so as to trigger fair
value pricing:
    When fund shares are mispriced, short-term traders
    have an arbitrage opportunity they can use to ex-
    ploit a fund and disadvantage the fund’s long-term
    investors by extracting value from the fund without
    assuming any significant investment risk. Mispricing
    occurs with respect to portfolio securities traded on a
    foreign market that closes before the time at which
    the fund prices its shares. If an event affecting the
    value of the portfolio securities occurs after the foreign
    market closes but before the fund prices its shares, the
    foreign market closing price for the portfolio security
    will not reflect the correct current value of those
    securities when the fund prices its shares. In 1984, we
    stated that, in these circumstances, a fund “must, to the
    best of its ability, determine the fair value of the
    securities, as of the time” that the fund prices its
    shares.
68 Fed. Reg. 74718 (Dec. 24, 2003) (emphasis in original)
(footnotes omitted) (the “Compliance Rule Release”). The
SEC further stated:
    We believe that funds that fail to fair value their
Nos. 04-2242 & 04-2487                                       7

   portfolio securities under such circumstances may
   violate rule 22c-1 under the Investment Company Act.
   Fund directors who countenance such practices fail
   to comply with their statutory valuation obligations and
   fail to fulfill their fiduciary obligations to protect fund
   shareholders. Accordingly, rule 38a-1 [the Compliance
   Rule] requires funds to adopt policies and procedures
   that require the fund to monitor for circumstances that
   may necessitate the use of fair value prices; establish
   criteria for determining when market quotations are no
   longer reliable for a particular portfolio security; provide
   a methodology or methodologies by which the fund
   determines the current fair value of the portfolio
   security; and regularly review the appropriateness and
   accuracy of the method used in valuing securities, and
   make any necessary adjustments.
Id. (emphasis added) (footnotes omitted).
 In a release proposing the promulgation of the Disclosure
Rule, the SEC reiterated that:
   When market quotations for a portfolio security are not
   readily available (including when market quotations are
   unreliable) a mutual fund is required to calculate its
   NAV by using the fair value of that security, as deter-
   mined in good faith by the fund’s board. In a separate
   release adopting rule 38a-1 under the Investment
   Company Act [the Compliance Rule], we are reempha-
   sizing the obligation of mutual funds to fair value their
   securities under certain circumstances. If a mutual
   fund misprices its shares by failing to use fair value
   pricing when market quotations for its portfolio securi-
   ties are unreliable, an investor may take advantage of
   the disparity between the portfolio securities’ last
   quoted price and their fair value. When mutual fund
   shares are mispriced, short-term traders have an
   arbitrage opportunity that they can use to exploit the
8                                    Nos. 04-2242 & 04-2487

    fund and disadvantage the fund’s long-term investors
    by extracting value from the fund without assuming
    any significant investment risk, through market-timing.
    Mutual funds that fair value their portfolio securities
    consistent with their obligations can effectively reduce or
    eliminate the profit that market timers seek to exploit.
68 Fed. Reg. 70403 (Dec. 17, 2003) (emphasis added)
(footnotes omitted) (the “Proposed Disclosure Rule Re-
lease”). Finally, in a release in connection with the final
adoption of the Disclosure Rule, the SEC explained that:
    [A]ll mutual funds . . . are required to explain briefly in
    their prospectuses both the circumstances under which
    they will use fair value pricing and the effects of using
    fair value pricing. We are adopting these amendments to
    clearly reflect that funds are required to use fair value
    prices any time that market quotations for their portfolio
    securities are not readily available (including when they
    are not reliable).
69 Fed. Reg. 22304-05 (Apr. 23, 2004) (emphasis added)
(footnotes omitted) (the “Disclosure Rule Release”).
  DH2 initially challenged the Compliance Rule Release
and the Proposed Disclosure Rule Release in the United
States District Court for the Northern District of Illi-
nois, which transferred the case to this court. See 15 U.S.C.
§ 78y (review of final orders of the SEC may be obtained by
petition for review “in the United States Court of Appeals
for the circuit in which [the person aggrieved] resides or has
his principal place of business, or for the District of Colum-
bia Circuit”). This court then construed the original com-
plaint as a petition for review pursuant to § 78y. DH2
eventually filed a second petition challenging the Disclosure
Rule Release and the petitions were consolidated. We now
conclude that DH2 lacks constitutional standing to bring
this challenge.
Nos. 04-2242 & 04-2487                                       9

                      II. Discussion
  DH2 attacks the foregoing actions by the SEC on sev-
eral grounds. It contends that the cited language in the
Compliance Rule Release, the Proposed Disclosure Rule
Release, and the Disclosure Rule Release establish a
mandatory “Fair Value Rule,” promulgated in violation of
the APA’s notice-and-comment rulemaking requirements.
See 5 U.S.C. § 553. DH2 also argues that this new “Fair
Value Rule” conflicts with the plain language of the ICA
and is arbitrary and capricious. On the merits, the SEC
defends the releases as mere interpretive statements not
subject to the APA’s notice-and-comment requirements
and also argues that the releases merely reiterate, albeit
with somewhat different language and emphasis, its prior
interpretation of the fair value pricing requirements of the
ICA.
   As a threshold matter, however, the SEC argues that
DH2 lacks constitutional standing to bring the current
challenge. We agree. Standing is “an essential and unchang-
ing part of the case-or-controversy requirement of Article
III.” Lujan v. Defenders of Wildlife, 504 U.S. 555, 560
(1992). The burden to establish standing is on the party
invoking federal jurisdiction—here, DH2—and the elements
it must show are:
    (i) an injury in fact, which is an invasion of a legally
    protected interest that is concrete and particularized
    and, thus, actual or imminent, not conjectural or
    hypothetical; (ii) a causal relation between the injury
    and the challenged conduct, such that the injury can be
    fairly traced to the challenged action of the defendant;
    and (iii) a likelihood that the injury will be redressed by
    a favorable decision.
Lee v. City of Chicago, 330 F.3d 456, 468 (7th Cir. 2003)
(citing Lujan, 504 U.S. at 560-61). To satisfy the injury-in-
10                                   Nos. 04-2242 & 04-2487

fact requirement, DH2 “must establish that [it] has sus-
tained or is immediately in danger of sustaining some direct
injury.” Wis. Right to Life, Inc. v. Schober, 366 F.3d 485, 489
(7th Cir. 2004) (quoting Tobin for Governor v. Ill. State Bd.
of Elections, 268 F.3d 517, 528 (7th Cir. 2001)). “Mere
speculation is not enough to establish an injury in fact.” Id.
  DH2 is neither an investment company nor an investment
adviser and is therefore not subject to the requirements of
the Compliance Rule, the Disclosure Rule, or any of the
terms of the accompanying rules releases. “[W]hen the
plaintiff is not himself the object of the government action
or inaction he challenges, standing is not precluded, but it
is ordinarily ‘substantially more difficult’ to establish.”
Lujan, 504 U.S. at 562 (quoting Allen v. Wright, 468 U.S.
737, 758 (1984)). Where, as here, the asserted injury “arises
from the government’s allegedly unlawful regulation (or
lack of regulation) of someone else[,] . . . causation and
redressability ordinarily hinge on the response of the
regulated (or regulable) third party to the government
action or inaction—and perhaps on the response of others
as well.” Id. In this situation “much more is needed” to
establish standing, and “it becomes the burden of the
plaintiff to adduce facts showing that those choices have
been or will be made in such a manner as to produce
causation and permit redressability of injury.” Id.
  DH2 asserts that the “Fair Value Rule” contained in the
SEC rules releases “will require the investment companies
in which DH2 invests to engage in subjective, estimated
pricing of their securities, which, in turn, will cause eco-
nomic harm to DH2.” That is, the language in the
SEC releases will have the general effect of increasing the
use of fair value pricing—which DH2 argues is less accurate
than market quotations—and the corresponding reduction
in the use of market quotations will produce an “economic
injury” to DH2’s interest as a mutual fund investor. This is
Nos. 04-2242 & 04-2487                                     11

not an injury-in-fact within the meaning of Lujan. The
interest asserted is not a legally protected one, and the
alleged harm is only generalized and conjectural.
  Without commenting on the merits or sincerity of
DH2’s argument that market quotations produce a more
accurate NAV than fair value pricing, we are compelled
to note the obvious incongruity here: DH2 makes money
by exploiting short-term inaccuracies that result from
market quotations that have become stale due to interven-
ing events. The interest DH2 actually seeks to protect
boils down to a purported right to profit by trading in
mutual funds based on a particular method of fund
valuation—one that gives rise to occasional short-term
price/value discrepancies. Of course there is no such right.
DH2 does not have a legally protected interest in the
perpetuation of a fund valuation formula that preserves its
ability to make money in market-timing arbitrage.
  Moreover, DH2’s asserted injury is not “concrete and
particularized,” nor is it “actual or imminent.” DH2 does not
claim that fund shares it now holds are or will become
mispriced or diluted as a result of the SEC’s actions. DH2
identifies no concrete, particularized injury, relying instead
on abstractions about the subjectivity in valuation it
believes will flow from fair value estimation. It does not
describe its asserted injury beyond characterizing it as
“economic” in nature. But the only “economic injury” even
arguably at issue here is the diminished availability of a
certain sort of arbitrage opportunity, which (to the extent it
is an injury at all) is a diffuse and speculative harm that
cannot support standing.
  Finally, DH2 has not met its burden of establishing
the causation and redressability elements of standing. With
or without the challenged statements in the SEC releases,
mutual funds have the discretion to use fair value pricing
in lieu of market quotations when circumstances warrant
12                                   Nos. 04-2242 & 04-2487

the conclusion that market quotations are no longer
current. See 15 U.S.C. §§ 80a-22, 80a-2(a)(41)(B); 17 C.F.R.
§ 270.2a-4(a)(1), (c). Thus, to a significant degree, the injury
DH2 complains of hinges on the decisions of independent
actors whose discretion— though subject to securities laws
and regulation by the SEC—is nonetheless quite broad. See
Lujan, 504 U.S. at 560 (“there must be a causal connection
between the injury and the conduct complained of—the
injury has to be ‘fairly trace[able] to the challenged action
of the defendant, and not . . . th[e] result [of] the independ-
ent action of some third party not before the court”) (quot-
ing Simon v. E. Ky. Welfare Rights Org., 426 U.S. 26, 41-42
(1976)).
  Accordingly, because DH2 has not established constitu-
tional standing to bring this challenge to the SEC rules
releases, the petitions for review are DISMISSED.
Nos. 04-2242 & 04-2487                               13

A true Copy:
      Teste:

                     ________________________________
                     Clerk of the United States Court of
                       Appeals for the Seventh Circuit

                 USCA-02-C-0072—9-7-05