SEC Rulemaking & Enforcement – Recent Past, Likely Future

Inaugural Issue: Welcome to the first issue of FS Spotlight, a report that summarizes select financial services regulatory developments, particularly those affecting SEC-registered investment advisers. Please see the note at the end for defined terms, and send feedback to (mscanlon@mpslgl.com). This is Issue #1, dated 2/26/2021.

Introduction. This issue summarizes SEC rulemaking and enforcement developments over the last few years and offers a view on what is likely going forward under new SEC leadership. In short, investment advisers, broker-dealers, public companies, and other market participants should expect increased focus on investor protection and less focus on deregulation and reducing barriers to capital formation.

SEC Commissioners. President Biden has nominated Gary Gensler to be the SEC’s next Chairman. Mr. Gensler was Chairman of the CFTC from May 2009 to January 2014, and in that capacity led the CFTC’s implementation of derivatives market regulation called for by the Dodd-Frank Act. Before becoming CFTC Chairman, he worked 20 years at Goldman Sachs. In 2016, Mr. Gensler was CFO of the Clinton presidential campaign. The Senate has not yet scheduled hearings on Mr. Gensler’s nomination, and it may take another two or three months for the Senate to approve the nomination.

In the interim, the senior Democratic SEC Commissioner, Allison Herren Lee, is serving as Acting SEC Chairwoman, having been appointed to this post by the President on January 21, 2021. The SEC currently has four commissioners: Republicans Elad Roisman and Hester Peirce, and Democrats Allison Herren Lee and Caroline Crenshaw.

SEC Rulemaking Under Chairman Jay Clayton. Jay Clayton, a corporate lawyer and political independent appointed by President Trump, was SEC Chairman from May 2017 to December 2020. Under Chairman Clayton’s leadership, the SEC was active on the rulemaking front. Some of the key rulemaking and related changes the SEC made in the last few years were as follows:

1. New Required Summary Disclosures for Retail Investors. In 2019, the SEC adopted Form CRS (Customer Relationship Summary) and related rules under the Advisers Act and the 1934 Act. Form CRS requires plain-English summary disclosure about the types of investment relationships and services broker-dealers and investment advisers offer, associated fees and costs, standards of conduct, conflicts of interest, and disciplinary history. Broker-dealers and investment advisers are now required to give Form CRS to retail investors, defined as natural persons who receive or seek services primarily for personal, family or household purposes.
   
   
2. Clarification and Reaffirmation of the Investment Adviser Fiduciary Duty. In connection with the adoption of Form CRS and Regulation Best Interest (see #3 below), the SEC issued an interpretive release describing in detail the investment adviser fiduciary duty to clients that exists under Section 206 of the Advisers Act. The interpretation did not seem to break new ground, but some in the investment adviser industry were surprised by the SEC’s expansive view of what the fiduciary duty requires. Others, including then-SEC Commissioner Robert Jackson, thought the fiduciary duty articulated in the release was too permissive, leaving open the door for investment advisers to provide conflicted advice and not put clients first.
   
   
3. A New Standard of Conduct for Broker-Dealer Recommendations to Retail Customers. In 2019, the SEC adopted Regulation Best Interest (Reg. BI) under the 1934 Act. Reg. BI establishes a standard of conduct that requires a broker-dealer to act in a retail customer’s best interest when recommending a securities transaction or investment strategy, including an account type or rollover recommendation. This new standard of conduct consists of specific disclosure, care and policy-and-procedure requirements, and goes above and beyond FINRA’s suitability standard, which continues to apply for institutional customers (under Reg. BI, a retail customer is a natural person who receives and uses a recommendation primarily for personal, family, or household purposes).
   
   Also, broker-dealers should be aware that Massachusetts and several other states recently have adopted fiduciary conduct standards for broker-dealers. These standards appear not to be preempted by federal law, and are more demanding than Reg. BI.
   
   
4. A New Investment Adviser Marketing Rule to Replace Current Advertising and Cash Solicitation Rules. In December 2020, the SEC adopted a comprehensive investment adviser marketing rule under the Advisers Act. When this rule becomes effective, most likely in late 2022, it will replace the currently applicable advertising and cash solicitation rules and many related no-action letters the SEC Staff has issued.
   
   The new rule makes significant changes to the regulatory framework for investment adviser advertising and marketing, including for testimonials, performance advertising and paid solicitors, and specifically addresses a broad range of marketing practices. Investment advisers need to examine the new rule, and the 440-page adopting release, and determine what changes they need to make to their current practices to comply with the rule, as well as with related Form ADV and recordkeeping requirements the SEC also adopted.
   
   
5. Updates and Reforms to Investment Company Regulation. With respect to investment companies, the SEC in 2020 adopted new and amended rules (i) setting minimum standards for determining the fair value of investment company assets for which market quotations are not readily available, (ii) authorizing summary prospectuses for variable annuity and variable life insurance contracts (this was done for mutual funds in 2009), and (iii) relaxing restrictions on fund-of-funds arrangements, derivatives use, and closed-end investment company (including BDC) securities offerings.
   
   Also, in 2019, the SEC adopted a rule under the 1940 Act eliminating the need for most new ETFs to obtain an SEC exemptive order before launching.
   
   
6. Easing Access to Capital and Private Investments. In 2020, the SEC (i) amended Regulation D under the 1933 Act to expand the accredited investor definition to include certain credentialed, presumably financially sophisticated professionals without regard to income or net worth, (ii) adopted a rule under the 1933 Act to permit companies to gauge market interest in possible IPOs or other registered offerings (i.e., test the waters) via pre- and post-filing communications with institutional investors, and (iii) amended exempt offering regulations and adopted an integration rule under the 1933 Act to make it easier to raise capital in unregistered offerings.
   
   
7. Easing Public Company Burdens. In 2020, the SEC made more demanding the eligibility requirements (i.e., minimum ownership and holding period thresholds) for shareholder proxy proposals under the 1934 Act’s Proxy Rules, and made less prescriptive and more principles-based certain public company disclosure requirements under Regulation S-K.
   
   
8. Increased Regulation of Proxy Voting Advice. In perhaps the most striking rulemaking in recent years, the SEC in July 2020 adopted amendments to the 1934 Act’s Proxy Rules that require proxy advisory firms to (i) share their proxy voting advice with issuers no later than when they give the advice to their clients, many of which are investment advisers that use that advice to vote proxies for securities in their clients’ accounts, and (ii) establish mechanisms their clients can use to access any written statements issuers then make about such advice, in each case before voting deadlines.
   
   In connection with the amendments, the SEC issued guidance in 2019 and 2020 describing steps investment advisers should take if they use proxy advisory firms to assist with proxy voting. Some critics believe the guidance and amendments represent unwarranted micromanagement of how investment advisers must meet their fiduciary duty of care when using proxy advisory firms. Critics also believe the guidance and amendments unduly favor company managements and will stifle advice to vote against management-backed proxy items. Backers of the measures believe they will result in more accurate and complete information for investment advisers who receive voting advice from proxy advisory firms.
   

Many of these regulatory changes were controversial, with the Democratic SEC Commissioners dissenting from them, believing they tilted too much toward deregulation, capital formation and deference to company managements, at the expense of investor protection.

SEC Rulemaking Going Forward. In the next four years, it is possible the SEC will make significant changes to some of its recent rulemakings and interpretations. But outright reversals of recently-adopted rules and interpretations are unusual, and I expect the SEC will not seek to substantively revise Form CRS, Reg. BI, or the fiduciary duty interpretation but will instead continue to focus on compliance with these items in examinations. Change seems most likely in the area of public company disclosures, where the SEC probably will propose specific disclosure requirements with respect to climate change risk, human capital management practices, and other sustainability-related factors.

Additional areas of possible SEC rulemaking going forward include (i) cryptocurrency, with a focus on broker-dealer safekeeping of these digital assets, (ii) prime and tax-exempt money market fund regulation under the 1940 Act, (iii) market manipulation, and (iv) short selling.  

With respect to cryptocurrency, the SEC issued a statement in December 2020 saying, for five years, it would not enforce the broker-dealer customer protection rule’s physical-possession-or-control requirement against broker-dealers that maintain custody of digital asset securities (i.e., cryptocurrency or other digital assets that meet the definition of “security” under the federal securities laws) in accordance with certain specified conditions.

With respect to prime and tax-exempt money market funds, the SEC in February 2021 requested public comment on potential additional regulatory changes, in light of the March 2020 need for two sponsor firms to intervene to prevent certain of these funds from breaking the buck and for the Federal Reserve to establish a liquidity facility to support these funds.

SEC Enforcement Activity – Past, Present & Future. Under Chairman Clayton, vigorous SEC enforcement activity continued across the spectrum of unlawful securities-related behavior, aided by an increasingly productive SEC whistleblower program. As usual, the enforcement focus was on the steady torrent of fraudulent behavior targeting retail investors, much of which took place in connection with securities offerings, including cryptocurrency offerings.

The SEC also continued to target illegal insider trading and FCPA violations, and continued to bring enforcement actions against public companies, broker-dealers, investment advisers and other market participants. In addition to charging public companies, broker-dealers, investment advisers and other firms, the SEC charged individual employees in some cases, including busines executives and, in one recent enforcement action, an investment adviser CCO (see #5 below).

Notable SEC enforcement activity involving investment advisers included:

1. Selection of Mutual Fund Share Classes. In 2018, the SEC announced an initiative allowing investment advisers to self report in exchange for advantageous settlement terms if they had violated their fiduciary duty by (i) investing client assets in mutual fund share classes that were more expensive than other available share classes of the same          fund (thereby violating their duty to seek best execution), and (ii) not adequately disclosing the 12b-1 fee compensation they received as a result and the related conflict of interest. Nearly 100 investment advisers self reported and were censured by the SEC. Also, these firms paid compensation of more than $139 million to affected clients.
   
   Some investment advisers that were eligible to self report did not do so, and the SEC (as it had said it would) subsequently brought enforcement actions against these firms, imposing harsher penalties than were imposed on the firms that self reported.
   
   
2. Trading Practices. In 2020, the SEC brought an enforcement action against a wrap fee program sponsor for misleading retail clients about trade execution services and costs, highlighting the need for accurate disclosure of trading practices. The sponsor had disclosed that it executed most trades in its wrap fee programs and that any commissions charged by other brokers selected to execute trades would be disclosed.
   
   For some clients, however, most or even all trades were executed by brokers other than the sponsor, and some of these brokers charged commissions that were not disclosed, but instead were embedded in the prices of the securities purchased or sold. In addition to finding the sponsor’s trading-related disclosures misleading, the SEC found its trading-related policies and procedures deficient and imposed a $5 million penalty.
   
   
3. Prevention of Unsuitable Investments. In 2020, the SEC brought an enforcement action, and imposed a $35 million penalty, against two affiliated investment advisers (that were also broker-dealers) for failing to reasonably supervise their personnel who recommended single-inverse ETF investments to retail clients, and for lacking adequate policies and procedures with respect to the suitability of those recommendations.
   
   The SEC brought similar enforcement actions in 2020 against three investment advisers, finding they failed to adopt and implement policies and procedures reasonably designed to prevent unsuitable investments in volatility-linked exchange-traded products (ETPs). In each case, the firm invested in such ETPs, which were designed to manage daily trading risks, and held them longer than was appropriate, causing clients to suffer losses. The SEC imposed $600,000 penalties on two of the firms and a $500,000 penalty on the third firm.
   
   
4. Material Non-Public Information (MNPI). The SEC brought enforcement actions against two investment advisers subject to heightened risk of receiving MNPI because of the nature of their business activities, finding they violated Section 204A of the Advisers Act by failing to adopt or implement policies reasonably designed to prevent misuse of MNPI.
   
   One firm had access to MNPI because an employee was a member of a portfolio company’s board and the firm was a lender to the company (this firm also purchased large amounts of the company’s stock). The other firm specialized in thinly-traded stocks and often communicated directly with company insiders and others likely to possess MNPI. The SEC imposed penalties of $1 million and $150,000 on these firms, even though no illegal trading was found.
   
   
5. Honesty is the Best Policy.The SEC recently reminded market participants and their personnel of this saying in an enforcement action brought against an investment adviser and its CCO for failing to comply with policies and procedures requiring compliance reviews of commissions the firm charged to client accounts. The CCO had failed to conduct the reviews and then altered documentation before giving it to SEC examiners and enforcement staff, so it looked as if the reviews had been completed. The SEC uncovered the attempted subterfuge and imposed monetary penalties on the firm and CCO, and also barred the CCO from the industry.

While SEC enforcement activity under Chairman Clayton was robust, it is likely to become even more aggressive under the new SEC leadership. Acting Chairwoman Lee recently made two changes in February 2021 that signal a tougher approach. First, she empowered more than 30 senior officers in the SEC’s Division of Enforcement to authorize investigations. Previously, only the Division’s two Co-Directors had this power, which likely reduced the number of investigations in recent years. 

Second, Acting Chairwoman Lee announced the SEC Division of Enforcement will no longer recommend enforcement action settlements that are contingent on granting a waiver from securities law disqualification provisions – for example, Regulation D’s disqualification provisions. Instead, the SEC will now consider requests for waivers separate from, and independent of, the enforcement process. Commissioners Roisman and Peirce dissented from this decision, believing it will make settlements of enforcement matters more difficult to achieve.

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In summary, it seems to matter to both SEC rulemaking and enforcement which political party is in charge. But particularly with respect to enforcement, the differences are likely to be around the edges and more procedural than substantive. Former SEC Chairs from past Republican and Democratic administrations have consistently expressed support for an aggressive SEC enforcement program, and an activist approach targeting fraud, non-compliance and other unlawful conduct is likely to continue.

Investment advisers, broker-dealers, public companies and other market participants should continue to make sure they understand and comply with applicable securities laws and regulations, as those laws and regulations change from time to time. This will enable them to stay on the right side of the law and continue meeting the important obligations they have to their clients, employees, shareholders and other stakeholders.  

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© MPS Legal, 2021.

NOTE: This report is for general informational purposes only and is, or may be, attorney advertising. It is not intended as legal advice and should not be relied on as such. The author believes statements of fact in the report are correct as of the report date, but this is not guaranteed and the author has no obligation to update or correct any statement. To save space and enhance readability, the report uses the following abbreviations: “1933 Act” is the Securities Act of 1933, as amended; “1934 Act” is the Securities Exchange Act of 1934, as amended; “1940 Act” is the Investment Company Act of 1940, as amended; “Advisers Act” is the Investment Advisers Act of 1940, as amended; “BDC” is business development company; “BSA” is the Bank Secrecy Act, as amended; “CCO” is Chief Compliance Officer; “CEA” is the Commodity Exchange Act of 1954, as amended; “CEO” is Chief Executive Officer; “CFO” is Chief Financial Officer; “CFTC” is the Commodity Futures Trading Commission; “CIO” is Chief Investment Officer; “DOL” is Department of Labor; “ERISA” is Employee Retirement Income Security Act of 1974, as amended; “ETF” is exchange-traded fund; “FCPA” is the Foreign Corrupt Practices Act of 1977, as amended; “FDIC” is the Federal Deposit Insurance Corporation; “FINCEN” is the Financial Crimes Enforcement Network; “FINRA” is the Financial Industry Regulatory Authority; “MSRB” is the Municipal Securities Rulemaking Board; “NFA” is the National Futures Association; “OCC” is the Office of the Comptroller of the Currency; “OFAC” is the Office of Foreign Assets Control; “Reg. 9” is OCC Regulation 9; and “SEC” is the Securities and Exchange Commission.