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News May 7, 2018 Issue

Clayton and Blass Defend and Seek Input on Proposed Standards of Conduct

Proposing new standards of conduct may turn out to have been the easy part. The SEC now has to persuade the asset management community to buy into the proposals.

SEC chairman Jay Clayton and Division of Investment Management director Dalia Blass, in separate public forums, in recent days laid out the case for the Commission’s recent proposals for a stronger broker-dealer standard of conduct and an interpretation/clarification of the existing investment adviser fiduciary standard. At the same time, the agency plans to hold a series of roundtables in different parts of the country to gather information from those likely to be affected by its proposals.

While the Commission made clear when it proposed the measures at a public meeting on April 18 (ACA Insight, 4/30/18) that public input was strongly needed, there is also "a public relations angle to all of this because the proposals were so strongly criticized by the commissioners when they were proposed," said Proskauer partner and former SEC Division of Investment Management deputy director Robert Plaze. "Clayton needs to project these proposals differently from how they were projected at the open meeting. He needs to present them as protecting the Main Street investors, as he calls them."

"Clayton has managed to do something that three other SEC chairmen have tried and failed to do – get something on this topic to a proposal state," said Sidley Austin partner Hardy Callcott. "But he has a long way to go, so he and Blass are trying to generate support for it."

In regard to the public outreach, Clayton, in what he described as "one component of a broad engagement effort on this issue," on April 24 said that he had "asked the SEC to put together a series of roundtables, focused on the retail investor, to be held in different cities around the country – including Atlanta, Denver, Houston and Miami. These roundtables are intended to help us gather much-needed information straight from those who will be most directly impacted by our rulemaking. I intend to participate personally in many of these roundtables."

Clayton and conflict of interest confusion

Clayton made his comments as part of his April 26 testimony before a House subcommittee on the SEC’s proposed fiscal year 2019 budget, in which he explained just how the requested dollars would be spent. While much would go toward cybersecurity and technology costs, he also said that the FY 2019 monetary plan "would restore seven staff positions with the Division of Investment Management, which plays a critical role in protecting retail investors through its regulation of investment advisers, mutual funds, variable insurance products and ETFs, among other products." Among the uses for the resources, he said, would be advancing standards of conduct for investment professionals.

Seeking to clarify one point in the standard of care proposals, he said that, "with respect to an investment adviser’s fiduciary duty, let me be clear, because I believe there is substantial confusion in the marketplace. An investment adviser must seek to avoid conflicts of interest and at a minimum make full and fair disclosure of material conflicts. But it misstates the law and could mislead investors to suggest that investors currently have a legal right to conflict-free advice from an investment adviser."

The point here is that "no adviser can eliminate all conflicts, so the key is disclosure and client consent," said Plaze.

Broker-dealers, under proposed Regulation Best Interest, would have to put the interests of the client ahead of his or her own. "How would this new duty be discharged?" Clayton asked during his testimony. "First, broker-dealers would need to disclose material facts relating to their relationship with the customer. Second, broker-dealers would need to enhance their current compliance framework to meet the demands of a more rigorous best interest standard. Third, and most important, broker-dealers would need to eliminate, or mitigate and disclose, material conflicts of interest related to financial incentives. Disclosure alone would not suffice."

Blass and the adviser standard of conduct

Among the items that Blass, in an April 30 speech before the PLI Investment Management Institute, addressed was the agency’s proposed interpretation of the existing adviser standard of conduct. In particular, she noted that, in regard to conflicts of interest, the interpretation clarifies that disclosure of "a conflict of interest should be sufficiently specific so that a client is able to decide whether to provide informed consent."

The agency staff proposed the interpretation for the existing adviser standard of conduct "in order to draw together a range of sources and provide advisers with a reference point for understanding their obligations to clients," she said.

But was there confusion? "At the end of the day, I’m not sure who had the confusion about an adviser’s fiduciary duty," said Ropes & Gray partner Jason Brown. "Advisers understood what it meant, clients understood what it meant, and the SEC’s Enforcement Division understood what it meant."

If anything, he suggested, the SEC’s proposed interpretation on the adviser standard of conduct might be adding ambiguity. Since the December 1963 Supreme Court SEC v. Capital Gains Research Bureau decision, "it has been understood that an adviser’s fiduciary duty was met with advance disclosure, not by an unwavering requirement for advisers to always act in a client’s best interest," he said. "Enforcement cases are often about whether an advisory firm’s disclosure was timely, sufficiently specific and understandable."

The relationship summary

Blass also used her speech to offer her views on the other proposals addressing standards of conduct, including enhancing the standard of conduct for broker-dealers, and the importance of providing clarity to retail investors about investment professionals. Part of the effort providing clarity about investment professionals under the proposed rules, she said, is requiring that each firm "be direct and clear about whether it is a registered investment adviser, a registered broker-dealer, or both in its communications with investors and prospective investors."

In that regard, the proposals would require advisers and broker-dealers to provide investors with an under-four-page "relationship summary" that would make clear what each firm is and what it does. "I think it is a good sign that substantive debate around this proposal has already started," she said. "Some have asked, would the relationship summary really be that helpful to investors? Could the design of the relationship summary be improved?"

Defending the proposal, Blass said, "I do believe a relationship summary would serve as a valuable tool for investors. It would highlight key differences between broker-dealers and investment advisers, including 1) the principal types of services offered, 2) the legal standards of conduct that apply to each, 3) the fees the customers would pay, and 4) certain conflicts of interest that may exist. Advisers and broker-dealers would also need to include relevant questions for investors to ask."

As for whether there is room for improvement, she said "that is exactly what we want the public to help answer."

She also used the speech to elaborate on the Division’s current position regarding liquidity rule management.

Clayton’s budget testimony

Each year, the SEC commissioner speaks before Congress as part of an effort to justify the agency’s budget proposal for the coming fiscal year. If there was any difference this year, it was that the FY 2019 SEC budget seeks to restore approximately 100 positions, comprising about 25 percent of the positions that became vacant during a hiring freeze that took place in late FY 2016.

Filling those 100 positions would allow the SEC to "address current critical priority areas and enhance the agency’s expertise in key areas, such as retail investor protection and oversight of our equity and fixed income markets," Clayton said in his testimony. "These 100 positions would result in SEC staffing at approximately the same level as in FY 2014. The FY 2019 budget request also relies on the SEC having continued access to the Commission’s reserve fund to fund information technology improvements, including those related to cybersecurity."

The FY 2019 budget request is for $1.658 billion and, as such, represents a slight increase over the FY enacted level of $1.652 billion. Following is a summary of some of the key points that Clayton made in breaking down the funding proposal request:

  • Leveraging technology, cybersecurity and risk management. Key current and FY 2019 SEC priorities in this area include investing in information security to improve monitoring, protecting against advanced persistent threats and strengthening risk management; retiring antiquated legacy IT systems; expanding data analytic tools to facilitate earlier detection of potential fraud or suspicious behavior and better identify high-risk registrant activities deserving examination; and modernizing the EDGAR electronic filing system to make it more secure, more useful for investors and less burdensome for filers. With regard to EDGAR, Clayton referenced his disclosure in September 2017 of an EDGAR hack (ACA Insight, 10/9/17) and the agency’s ongoing investigation of it. "I am focused on getting to the bottom of the matter and, importantly, using the information gained from the investigations to strengthen our cybersecurity efforts moving forward."
  • Facilitating capital formation. Sounding a theme he has publicly championed as far back as his confirmation hearing, Clayton said that he believes "the SEC can and should do more to enhance capital formation in our public and private capital markets and, particularly, for small and emerging companies. Fewer emerging companies are choosing to enter the public capital markets than in the past, and, as a result, investment opportunities for Main Street investors are more limited." The agency’s FY 2019 budget request will "further enable the staff to develop and present to the Commission rulemaking initiatives aimed at promoting firms’ access to capital markets to generate economic growth while continuing to foster important investor protections," he said.
  • Protecting Main Street investors and markets. The FY 2019 budget would restore seven staff positions with the Division of Investment Management, and would be used to "enhance Investment Management’s monitoring and disclosure programs, as well as advance key investor-focused rule-writing priorities, such as [the] standards of conduct for investment professionals," Clayton said. Separately, the FY 2019 budget proposal would continue to fund the Division of Enforcement’s efforts by restoring 17 positions, including expanding the Cyber Unit and Retail Strategy Task Force. Finally, the budget proposal would address examination issues. "More needs to be done to continue to increase investment adviser examination coverage levels, while at the same time being careful to avoid decreasing examination quality," Clayton said. The FY 2019 budget request would restore 24 positions within the agency’s National Examination Program.
  • Effective oversight of changing markets. The FY 2019 budget request would recruit 16 additional professionals "to expand the agency’s depth of expertise in vital areas such as equity and fixed income market insight and analysis, clearing agency oversight, broker-dealer operations, cybersecurity and electronic trading," Clayton said.