(CN) - The D.C. Circuit found the Securities and Exchange Commission "abdicated" its responsibility to a "systemically important" options clearing firm after a petition by market participant Susquehanna International Group LLP and others sought to trash Options Clearing Corporation's new Capital Plan, arguing that the SEC rubber-stamped it.
Chief Judge Merrick Garland wrote that the SEC "granted approval without itself making the findings and determinations prescribed by the Securities Exchange Act of 1934.
OCC, a Delaware corporation and clearing agency that facilitates trades in options and other financial instruments, is the only clearing agency for standardized U.S. options listed on the U.S. national securities exchanges, and has been designated a systemically important financial market utility closely regulated by the SEC, Merrick wrote.
In 2014, OCC determined it needed to significantly increase its capital to address business, operational, and pension risks, and submitted proposed rule changes to the SEC, to implement a new "Capital Plan," OCC wrote in its statement supporting approval of the plan.
On top of its existing capital reserves of $25 million, OCC found it needed an additional $222 million of capital immediately on hand, plus another $117 million in backup "Replenishment Capital" that it could call upon if necessary, according to the SEC's Notice of Proposed Rule Change.
The plan, if approved, would alter how fees and refunds are calculated to increase capital reserves, the SEC wrote.
Under the plan, OCC's five shareholder exchanges would make immediate capital contributions to reach OCC's current target and also pledge to replenish it on request, according to the SEC order. Dividends paid out of OCC's fees would be given in exchange.
Specifically, after fees are applied to OCC's operating expenses, and then used to restore capital reserves if they have dipped, the remaining unused fees are split between dividends and refunds. Approximately half of the unused fees go to shareholders as dividends; approximately half are refunded to clearing members, the SEC order states. In other words, whereas clearing members previously received all of the excess fees as refunds, the plan diverts roughly half of those refunds to dividends, according to the order. The plan makes other changes to OCC's fee practices as well.
The SEC's order continues:
"The buffer used to calculate each year's fees -- that is, the amount by which that year's projected expenses are inflated to arrive at the amount to be charged as upfront fees -- decreases under the plan from 31% to 25%. And the plan provides for a permanent end to refunds (but not dividends) if replenishment capital becomes necessary and is not repaid in 24 months or if the target capital requirement is not restored within that period."
"After evaluating alternate sources of capital funding, including increasing fees or suspending refunds to clearing members, the board approved the proposed capital plan," the SEC says of its work.
The SEC also said it had "considered the impact of the Capital Plan on efficiency, competition, and capital formation under Section 3(f) of the Exchange Act," before approving the proposal.
The D.C. Circuit, on the other hand, said the SEC simply stated that certain factors were "considered or found," without considering or finding those factors.
For example, the court found that the SEC's order stated "the dividends represent a reasonable return on the shareholders' capital contribution," relying on OCC's statement that "the plan is 'designed to set the dividends ... at a level that [OCC's] board, with the assistance of independent outside financial experts, has determined to be reasonable for the costs and risks associated' with the shareholders' obligations."
"Who were those independent experts? How does the SEC know they were independent? What analysis did they and OCC's board perform?" Garland wrote. "The SEC candidly admits that it simply 'rel[ied] on the board's analysis' of the 'the rate of return the stockholder exchanges were receiving for their capital investment. (Citation omitted.) That is, to decide whether the dividend level was reasonable, the SEC took OCC's word for it.
"This is not the reasoned analysis that the Exchange Act and the APA (Administrative Procedure Act) require. ... Nor may the SEC reach a conclusion that is 'unsupported by substantial evidence' or 'arbitrary [and] capricious.'"
"SEC's unquestioning reliance on OCC's defense of its own actions is not enough to justify approving the Plan. Instead, the SEC should have critically reviewed OCC's analysis or performed its own."
"The SEC's Order is arbitrary and capricious, unsupported by substantial evidence, and otherwise not in accordance with law," the ruling states.
Garland remanded the case "to give the SEC an opportunity to properly evaluate the plan," citing case law for "remanding rather than vacating 'because of the possibility that the commission may be able to justify the rule, and the disruptive consequences of vacating.'"