Trying to halt the SEC

Some of the SEC rule proposals generating the most withering criticism are among those that would have the biggest impact on financial advisors. But the widespread opposition won’t necessarily influence the SEC to revise them substantially before they become final regulations.

Financial industry trade associations, bipartisan lawmakers on Capitol Hill and even some investor advocates are strongly resisting SEC proposals on mutual fund reform, advisor custody of client funds and conflicts of interest related to advisors’ use of artificial intelligence and predictive analytics.

Many opponents want the SEC to withdraw those proposals. Although the agency has modified to some extent most of the nearly two dozen final rules it has promulgated since Chair Gary Gensler was sworn in in April 2021, taking a proposal off the table would be an extraordinary step.

“Very seldom does a rule proposal go out there and wither on the vine,” said Jay Gould, special counsel at Baker Botts and a former staff attorney in the SEC Division of Investment Management, where he participated in rule writing. 

“The thrust of the rule, the reason for the rule, is going to be adopted,” Gould added. “They may make a few concessions here or there, but if they believe the investor-protection element is significant, they will move forward with it.”

Before the most controversial proposals ultimately become final rules, a plethora of critics are trying to shape them through the rulemaking process.

During recent congressional hearings, Gensler has been taken to task by Republicans and Democrats about the mutual fund proposal, which would implement swing pricing and daily trading deadlines that opponents say would roil fund operations and diminish their value for retirement savers and other investors.

The custody proposal has raised a number of concerns, including worries that it would deem advisors to have control of client funds if they make trades on behalf of clients. It also would extend custody obligations beyond securities and funds to sweep in private securities, real estate, derivatives and some crypto assets.

In addition to industry groups, Democratic and Republican lawmakers have expressed qualms about the custody proposal. The SEC reopened the comment period on the measure earlier this year.

The pushback may be strongest on a proposal designed to address potential conflicts of interest for investment advisors and brokers who use artificial intelligence or other predictive data analytics in interactions with clients and customers.

Under the proposal, advisors and brokers would be required to “eliminate or neutralize” conflicts arising from the technology optimizing advisors’ or firms’ revenue interests over investors’ interests in achieving the highest returns possible.

The proposal has ignited a firestorm across a wide range of interest groups — from trade associations that represent the brokerage industry to the major trade group for investment advisors — and from congressional Republicans.

The SEC has heard a litany of criticisms about the proposal.

For instance, opponents worry that the “covered technology” to which it would apply could range far beyond AI and predictive data analytics and encompass even formulas plugged into Excel spreadsheets. They also have asserted that the proposal overlaps with Regulation Best Interest, the broker-dealer standard of care and also with the fiduciary duty that advisors owe to their clients.  

Opponents are trying to stop the proposal dead in its tracks. During the public comment period, which ended Oct. 10, several groups called on the SEC to withdraw the rule. They included the Investment Adviser Association, the Investment Company Institute, the ERISA Industry Committee, the American Securities Association and the Insured Retirement Institute.

“There’s nothing for the chairman to do other than throw it in the garbage,” said ASA CEO Christopher Iacovella.

Usually, resistance to a proposal translates into comment letters that suggest how the SEC can improve the measure. But on predictive data analytics, there wasn’t so much a prescription for making it better as a list of reasons why it should die.

The tone was “we’re not going to suggest changes because the industry can’t work with the rule as proposed,” said Ben Marzouk, a partner at Eversheds Sutherland. “That’s a pretty stark message.”

The Investment Company Institute, which represents mutual funds, has called on the SEC to abandon the swing pricing, custody and predictive data analytics proposals.

“ICI has serious, fundamental disagreements with the nature and direction of multiple rulemakings on the SEC agenda,” ICI spokesperson Stephen Bradford wrote in an email. “They will hurt the very investors the SEC serves and are simply not fit for purpose.”

He pointed out that under the Administrative Procedure Act, agencies must consider public input as they draft regulations.

“The extent to which they make changes is where the rubber hits the road,” Bradford said. “We are seeing an extremely active SEC agenda under Chair Gensler. He has closely held ideas about how regulations should be updated—and doesn’t propose rules simply to do a 180. His office has been receptive to hearing our thoughts and to meeting with our staff.”

Of course, the SEC also is getting a lot of encouragement for the dozens of proposals it is pursuing.

“The SEC’s track record overall so far is to issue proposals and final rules that substantially increase investor protection, market integrity and market stability,” said Stephen Hall, legal director and securities specialist at Better Markets, a nonprofit public interest organization that leans to the left. “There is nothing to suggest the SEC should withdraw any of its proposals or weaken them.”

Hall foresees the SEC standing tough on the predictive analytics proposal.

“I don’t expect the SEC to withdraw that proposal just because some sections of the industry are lodging alarmist and exaggerated objections to it,” Hall said.

The SEC is taking note of the vociferous input.

In a Sept. 12 appearance before the Senate Banking Committee, Gensler said the SEC has promulgated more than 20 final rules so far in his tenure and has modified most of them as they advanced to final rules.

“Nearly all of them have changed based on public feedback,” Gensler told lawmakers.

It remains to be seen how the SEC will react to calls for withdrawal of some of the biggest proposals.

“The SEC benefits from robust engagement from the public and will review all comments submitted during the open comment period,” an SEC spokesperson wrote in an email. “Generally, we respond to comments received as part of the final rulemaking and not beforehand.”

Gould has seen from the inside how the SEC must strike a delicate balance between investor protection and not putting too big a regulatory burden on financial advisors and firms.

“I think [Chair Gensler] has very good judgment in that regard," Gould said.

The fact that the SEC is making a point of revising proposals in response to criticism “shows the [rulemaking] process is working,” said Kurt Wolfe, counsel at Quinn Emanuel Urquhart & Sullivan.

But the fiercest critics of the predictive data analytics, custody and mutual fund reform proposals are likely to be disappointed in the extent to which they are modified. They might have to turn to a lawsuit as their next option.

“I have to believe these rules will be challenged in court, if the final rule is substantially similar to the proposal,” Wolfe said. “The re-write that would be required to get industry comfortable is more than the commission is willing to do.”

Political pressure on the SEC has been growing over the last decade as the regulatory process has become a more efficient way to introduce industry reforms than legislative process, which is subject to gridlock with closely divided control of Capitol Hill. It’s a trend that’s likely to continue.

The SEC is now the target of Republican ire in a way that used to be directed at the Consumer Financial Protection Bureau, said Michael Canning, principal at The LXR Group, a government relations consulting firm.

“This is the first time you’ve seen the SEC play that role,” Canning said. The agency “is taking up more political oxygen than it has in a long, long time. Everything about the commission’s rulemaking has become more politicized.”

In fact, the next election may help determine when the SEC proceeds with some rules, including predictive data analytics.

If final regulations are promulgated after a certain point next year — probably in the late spring — they are vulnerable to being overturned by the next Congress, if Republicans take control of the House, Senate and White House.

On something as explosive as the predictive data analytics rule, the SEC may hold off on issuing a final regulation until the political landscape is clearer.

“I can’t imagine a world in which they try to finalize this rule until after the election,” said a financial industry lobbyist who asked not to be identified in order to speak candidly about rulemaking timelines. “There is widespread opposition. There are a lot of practical problems.”

By next spring critics and supporters of pending SEC rules should know how far the agency is willing to bend without breaking.