On October 7,  oral argument in the AIMA, NAPFM and MFA challenge to the SEC’s Securities Lending and Short Sale Rules (“SL/SS Rules”) took place at the U.S. Fifth Circuit Court of Appeals in New Orleans.  The panel hearing the case included Judges Cory Wilson, Dana Douglas and Wendy Baldwin Vitter (who is sitting by designation from the Eastern District of Louisiana).  Judges Wilson and Vitter were appointed by President Trump and Judge Douglas by President Biden, so two Republican appointees and one Democratic appointee. 

Below is an overview of the oral argument, an audio replay of which can be accessed here.  If you have any questions, please reach out to Daniel Austin. 

Petitioners’ Presentation (NAPFM, AIMA and MFA)

• Jeff Wall (counsel for Petitioners) began his presentation by highlighting the connection between customer loans and short sales and how the SEC adopted two inconsistent disclosure frameworks without an explanation of the inconsistencies. 
• Judge Wilson asked whether there was a harm to Petitioners’ members to convey standing to challenge the rules.  Mr. Wall responded that the harm – which the SS Rule highlights in detail – is that too much disclosure of short positions can lead to reverse engineering of strategies/positions and therefore be subject to front-running or short squeezes.  In turn, this makes short selling more expensive and harms price discovery and market efficiency generally.  Mr. Wall further explained the disclosure framework in the SL Rule, juxtaposing it with the harms described in the SS Rule. 
• Judge Wilson noted that the SEC asserts several distinctions between the two rules.  Mr. Wall said that there is nothing in either rule about the inconsistencies between the two.  The 20-day delay in the dissemination of the loan size element in the SL Rule is still inconsistent with the SS Rule and fails to address the other ways in which the SL Rule discloses information on short sales.  Moreover, SEC fails to explain why its decision to delay the dissemination of loan size is a silver bullet, and commenters did not have an opportunity to comment on the 20-day delay.
• Judge Vitter asked whether the SEC considered or ignored comments on the relatedness between the two rules.  Mr. Wall explained that the SEC reopened the comment period for the SL Rule when it proposed the SS Rule, specifically soliciting comments on how the latter impacts the former.  He said there is no explanation in either rule that directly responds to commenters concerns on the interrelatedness between the rules; the Commission incorrectly believes that the delay in loan size dissemination is a cure-all to commenters’ concerns.
• Judge Wilson asked for an explanation why the rules are arbitrary and capricious under the Administrative Procedure Act (“APA”)?  Mr. Wall said that the SEC has a practice – as discussed in the amicus curiae brief submitted by former SEC chief economists – that related rules should be addressed and considered together, which was not done here.  Here, the SEC has related rules that adopted inconsistent approaches, and it failed to explain the inconsistencies, despite comments highlighting the inconsistencies and the harms.  
• Judge Vitter asked about the idea of “best practices” for rulemaking.  Mr. Wall reiterated that if an agency engages in related rulemakings, those combined costs and effects should be considered.  He explained that the SEC intentionally adopted the SL Rule first (on the same day and at the same open meeting) so that it did not have to consider its inconsistencies with the SS Rule, which was finalized minutes later.
• Judge Wilson questioned whether there is anything in the record to confirm the intentional sequencing of the rules’ adoption.  Mr. Wall said that the SEC did not find any costs in the SL Rule, so when it bakes those non-costs into the SS Rule’s baseline, they find there are no costs there either.

SEC Presentation

• Emily Parise (attorney for respondent SEC) began her presentation emphasizing that the rules exemplify reasoned decision making.  They are different, apply to different markets (securities lending versus short interest reporting) and are generally consistent.  She added that they apply to different regulated entities and require the reporting of different data.
• Judge Wilson asked if the rules are so different, why did the SEC reopen the SL Rule comment period to solicit comments of the SS Rule’s impact on it?  Ms. Parise said the rules are independent of each other, and it is not clear in the record that there are effects on each other.  In both rules, the SEC was balancing the policy goals of increased transparency with not disclosing too much information too quickly.
• Judge Wilson asked where in the rules the SEC analyzed their cumulative effect, highlighting the inconsistencies between the rules.  Ms. Parise said this was done in both rules.  She said the SL Rule was considered in the baseline of the SS Rule, thereby ensuring that no costs were left out, adding that the APA does not require their costs/effects be considered in tandem.  She said that there could be additional costs because of overlapping compliance periods, which the SEC considered.  The SEC believed that loan size information is the closest proxy for disclosing short sale information, so delaying that data point 20 days demonstrates a balancing of transparency with mitigating harm from too much disclosure.
• Judge Douglas asked whether the delay in disseminating the loan size information alleviates concerns of reverse engineering and other harms.  Ms. Parise explained that the loan size information would be less timely than short sale data currently published by FINRA.  She said that the SL Rule acknowledges that an aggregate approach like in the SS Rule would reduce the risk of exposing short sale strategies, but an aggregate approach would reduce the benefits of additional transparency.  The Commission is weighing competing policy interests and make policy tradeoffs.
• Judge Vitter mentioned the former chief economists brief and their comments that the approach taken by the SEC in these two rules differs from what the Commission typically does with related rules.  Ms. Parise said that the rulemaking examples cited in that brief are different from what is at issue here.  Their examples are of rules that directly rely upon each other to operate/function, whereas the two rules here can operate independently of each other.
• Judge Wilson asked how often comment periods are reopened to solicit feedback on how another rule impacts the former.  Did the Commission sufficiently explain the inconsistencies between rules that are so interrelated?  Ms. Parise said that the SEC will reopen comment periods to ensure that regulated parties have an opportunity to comment.  She said that commenters noted that the rules are inconsistent but did not talk about the effects of one on the other.  She added that the loan size delay mitigates commenters’ concerns and that there is nothing about the sequencing of the rules’ adoption that leaves out any costs.  Ms. Parise reiterated that the Commission has the discretion to make policy decisions like it did here.
• Judge Vitter noted that the SEC highlights several differences between the rules and asked for an explanation on how the rules are related.  Ms. Parise said that the aggregate customer loan size data element is the mostly closely related point because this data could be used to gain insight into short sale strategies/positions; however, the loan size data is a “noisy approximation” of short sale activity.  The loan size was delayed in response to commenters; the Commission did not ignore anything about the costs or benefits.
• Judge Vitter asked whether the Commission acted differently in promulgating these two rules than it has with other rules.  Ms. Parise said there are examples where Petitioners assert the Commission acted differently, but those examples are distinguishable from the rules at issue here because the rules cited in their examples require the other to function; these rules are independent of each other.
• Judge Wilson asked if the Commission completely siloed these two related rules and did everything required by the APA in both rulemakings and they were not considered together, would that be arbitrary and capricious.  Ms. Parise said it would depend on whether the siloing missed any interactions between the rules.  If the siloing did not impact anything, then it would not be arbitrary and capricious; it depends on how the rules interact.  She explained that Petitioners fail to show that if the SS Rule were adopted first, the outcome would be different; it is just two different ways to get to the same place with the same costs and benefits.  She added that if the rules are truly separate, then it would not be arbitrary and capricious.  It depends on how related the rules are.

Petitioners’ Rebuttal 

• Mr. Wall began by emphasizing the SEC’s acknowledgement that the customer loan market is tightly linked with the short sale market and that there is a close correlation between the two.
• Judge Douglas asked for a response to the SEC’s comments on the differences between the two rules.  Mr. Wall reiterated that the customer loan markets is highly correlated to the short sale market.  He explained that the SL Rule gives out a lot of individual data that conflicts with the rationale in the SS Rule that highlights the harm that can come from individualized data.  The SL Rule fails to provide any analysis/explanation of the harm that can occur from market participants being able to track modifications in a particular loan over time and see how other market participants are building or reducing a short position.  This level of disclosure reduces the value of developing proprietary investment theses because those trades could be front-run and their value diluted, as well as other harms to the market.  The Commission recognized this in the SS Rule and put blinders on in the SL Rule. 
• Judge Wilson asked how the SEC’s consideration of the SL Rule’s costs in the baseline of the SS Rule makes the rules arbitrary and capricious.  Mr. Wall said that the SEC did not consider the individualized disclosure costs of the SL Rule in the baseline of the SS Rule; these costs are more than zero, but they treat them as zero in the baseline of the SS Rule.  There is no discussion of the rules’ cumulative effects.  The SEC did two different things and did not explain why; instead, they claim the rules are related but not interrelated, i.e., one is not required for the other to function.  This has not been the SEC’s practice, as outlined by the former chief economists, and no court has taken a narrow view.  The right test is are they related rules, is the agency aware of their relationship and are they contemporeanously adopted.