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News April 2, 2018 Issue

SEC Commissioner Adds Her Voice to Call for Retrospective Rules Review

SEC commissioner Hester Peirce has made no bones about it: She wants the agency to conduct ongoing retrospective reviews of existing rules to see if those rules, both individually and collectively, "accomplish what they were designed to do."

In a recent speech at the 2018 Mutual Funds and Investment Management Conference, the new commissioner made clear where she stands on the issue: "We need to look at the actual cost – based on experience – of each regulation. If a rule’s costs outweigh its benefits, we should eliminate it and, if necessary, replace it with something more cost-effective."

In making her call, Peirce joined others who have pointed to a need for retrospective rule reviews. Those persons might well include agency chairman Jay Clayton, who, in a July 2017 New York City speech, said that "the Commission should review its rules retrospectively. We should listen to investors and others about where rules are, or are not, functioning as intended. We cannot be shy about being introspective and self-critical."

During his April 2017 confirmation hearings (ACA Insight, 4/3/17), Clayton testified that he has a problem with "unnecessarily complex" regulations and that, "to the extent possible, reducing complexity, clarity, are very important. If people know the rules, they can operate more efficiently."

Existing rules mentioned by industry participants as needing revision include the Advertising Rule and the Custody Rule.

"Once a rule is in place, the SEC should not stop looking at costs and benefits," said Peirce. "As is typical of most regulatory agencies, the SEC rarely puts on its hindsight glasses. . . . Nevertheless, perhaps the most important action the Commission can take to improve fund regulation is to conduct a retrospective review of our regulations."

"Commissioner Peirce is echoing a call that several recent Commissioners have made for such a review," said Willkie Farr partner and former SEC deputy chief of staff James Burns. "Given the willingness of Chairman Clayton to call on his colleagues to revisit a freshly promulgated rule (the Liquidity Risk Management Rule) out of the Division of Investment Management, there might be more appetite for a more holistic such review than in recent years."

"Peirce’s recommendation will likely be met with appreciation not just by many regulated entities, but also by regulatory divisions that have wanted to rethink some of the more shopworn rules on their books but who haven’t had the green light in recent years to do so," he said.

"Retrospective review of SEC regulations is long overdue," said Ropes & Gray counsel David Tittsworth. "The agency has never really taken a step back to assess whether its regulations are working as intended, what the costs are, and how various regulations interact with each other. Commissioner Peirce’s call for a retrospective review of fund regulations would be a welcome development."

Weighing the costs

The agency "tend[s] to underestimate the costs of individual rule changes," Peirce said. "The costs incurred by funds in complying with our rules overwhelmingly come out of investors’ pockets." Further, she said, there are several costs that rules entail beyond the direct costs of compliance. Those she listed included:

  • Time burden. "The reason for funds’ existence is to manager investors’ assets with an eye toward generating a return," she said. "The time consumed trying to comply with the rules translates into less time available to manage investors’ assets." She added that is particularly a problem with fund boards. "We need to let boards get back to their core functions."
  • Barrier to new fund sponsors. "While existing fund complexes continue to add to their offering menus, potential new fund sponsors are unable to meet the costs associated with entering the fund industry," Peirce said. "Investors lose when new competitors can’t come in to serve them."
  • Lost returns for investors. "As we place restrictions on what funds can do, we also make it harder for them to achieve returns for investors. Careful scrutiny of costs and benefits before adopting rules helps to ensure that investors are protected and able to achieve their reasonable investment objectives," she said.
  • Substitution of the Commission’s investment judgment for that of investors and investment advisers. "Our rules can have the effect of prejudging what is right for investors," Peirce said. "In other words, they shut off some options for investors. We must be exceedingly careful in taking steps that substitute our judgment for the judgment of investors."

The Liquidity Rule

Peirce was one of the three "yes" votes when the Commission proposed eliminating the Liquidity Risk Management Rule requirement that open-end funds publicly disclose, through the use of classification "buckets," their aggregate liquidity classification information about the securities in their portfolios (ACA Insight, 3/19/18). The Commission instead proposed that funds disclose a qualitative narrative about the operation and effectiveness of their liquidity risk management program in their annual reports to shareholders, as well as report on Form N-PORT their holdings of cash and cash equivalents.

She said then, as did commissioner Michael Piwowar, that while she was voting for the proposal, it did not go far enough, and she expanded on those comments in her speech before the conference.

"These changes are positive, but the bucketing elephant is still very much in the room," Peirce said. "We did not take the opportunity last week to ask whether we should eliminate the bucketing requirement altogether. We gave only a slight nod to the idea suggested by the Department of Treasury, that we look for a principles-based alternative to bucketing."

"Wouldn’t it make sense to ask for comment on whether bucketing remains a meaningful requirement?" she asked. "Failing to ask now – prior to full implementation – whether the benefits outweigh the costs virtually ensures that the bucketing requirement, as so many requirements before it, will become an everlasting fixture of our regulatory regime and another barrier to entry for new fund sponsors." She suggested that the other requirements contained in the Liquidity Risk Management Rule – a liquidity risk management program, qualitative liquidity disclosure, portfolio holdings disclosure, identification of the holdings that funds consider illiquid, the 15 percent limit on illiquid investments, and disclosure of cash and cash equivalents – provide sufficient information for a liquidity evaluation of a fund.

Other topics

Peirce used her speech to focus on several other topics, including:

  • International regulatory bodies. The role of international organizations, including the Financial Stability Oversight Council (FSOC), the Financial Stability Board (FSB), and the International Organization of Securities Commissions (IOSCO), came in for some criticism from Peirce. She noted that the SEC developed the Liquidity Risk Management Rule under pressure from FSOC and the FSB, "both of which view fund liquidity as a potential systemic risk." But, she said, "the Commission ought not to put on glasses that contain the distortive lenses favored by our international banking regulator friends. Funds are not banks and should not be regulated as if they were. . . . We stand on strong ground to argue in response that we have addressed liquidity issues in a form that is appropriate for funds."
  • Fund disclosure. Peirce urged the Commission to look toward technology when it comes to fund disclosure, including the not-adopted Rule 30e-3, which would have permitted funds to allow website transmission of fund shareholder reports. Doing so would not only have saved investors money, it was about "facilitating a larger effort of harnessing technology to provide investors with information in a way that they can better understand and analyze." In all of its fund initiatives, she said, "we ought to be thinking about how new technology can assist investors in viewing with greater focus and – dare I say, greater enjoyment – the information they need to make their fund investment decisions."
  • Exchange-traded funds. Peirce also lent her voice to one of the SEC’s current priorities: the development of a proposed rule for exchange-traded funds. In doing so, she appeared to be speaking in unison with Division of Enforcement director Dalia Blass, who spoke at the same conference (ACA Insight, 3/26/18). Like Blass, she noted that, for years, ETFs have been operating under individual exemptive orders, rather than pursuant to a rule. "Because of that, they are second-class citizens in the fund industry world," even though there are currently approximately $3.6 trillion in ETF assets (compared to $580 billion in assets a decade ago). "The make-it-up as you go approach to regulation and the virtual absence of the commissioners from the process is a real concern to me. . . . We need to normalize ETFs. That means adopting a carefully crafted rule that allows enough flexibility to accommodate a variety of models, while reserving the exemptive application process for ETFs with novel features in need of extra scrutiny."