Remarks to Investment Company Institute 2023 Investment Management Conference

Thank you, Susan Olson, for that kind introduction.  After graduating law school in 1995, I became an associate with the asset management practice of a law firm in Washington, D.C.  The following spring, I remember the partners getting excited about the Investment Company Institute’s upcoming conference in Palm Desert, California.  Since attendance was largely a “partners-only” affair, this conference carried a bit of mystique to the associates and as a native Southern Californian, this event was doubly intriguing to me.  Thus, I was quite honored to be invited to speak with you here today and share some thoughts.  My remarks reflect solely my individual views as a Commissioner and do not necessarily reflect the views of the full Commission or my fellow Commissioners.

There is a common theme running through the conference program.  For example, today, there is a panel on “Fund Governance in an Era of Regulatory Deluge.”  Tomorrow, there is a panel on “Addressing Compliance Challenges in Today’s Unprecedented Economic and Regulatory Environment.”  These titles aptly convey the sense of frustration in navigating the current regulatory challenges and what potentially may come. 

In the last 18 months, the Commission has adopted final rules affecting asset managers on:

• Shortening the trade settlement cycle;
• Additional proxy vote reporting requirements on Form N-PX;
• Tailored fund shareholder reports; and
• Proxy voting advice.

The Commission has further issued proposals on:

• Cybersecurity for investment advisers and investment companies;
• Amendments to Regulation S-P;
• Custody for investment advisers;
• Order competition;
• Regulation Best Execution;
• Open-end fund liquidity;
• Outsourcing by investment advisers;
• Environmental, social, and governance disclosures for investment companies and investment advisers;
• Investment company names;
• Short positions for institutional investment managers;
• Money market reform; and
• Reporting of securities loans.

Furthermore, the Commission has many other proposals affecting public company issuers for which the asset management industry is intended to be one of the primary beneficiaries because they will allow you to provide better returns and value for your clients – at least in theory.

That’s a lot of moving parts in a short period of time.  It makes you wonder whether the Commission believes that there is something fundamentally wrong with the markets in the asset management industry.  Because unlike the 2008 financial crisis, there has been no Congressional directive mandating our actions.

In the Commission’s rush to rulemaking, there is no question that significant compliance challenges and costs will result.  These costs are likely to disproportionately hurt smaller fund complexes and their advisers.  Raising the expenses to operate a registered investment company can make them less attractive as investment options for 401(k) and similar plans, which can choose less regulated vehicles that may also be cheaper, such as collective investment trusts (“CITs”).  While some might argue that the Commission should try persuade the banking regulators to improve their CIT regulations, after the events of the last several weeks, I suspect that they have more pressing issues on their minds.

I will begin my remarks by discussing my concerns with the Commission’s current regulatory approach and some significant regulatory topics, such as open-end fund liquidity, ESG, and fund names, before closing with some practical, common sense suggestions to improve the regulatory framework.

The Perils of Regulation by Theory and Hypothesis

This brings me to my first concern: the perils of regulation by theory and hypothesis.  The SEC has been focused on rulemakings based on unrealistic expectations of how the world functions and how it ought to be.  A good example is the proposal mandating that open-end funds institute swing pricing and a hard 4:00 pm Eastern Time close, among other requirements.[1]  This proposal looks to Europe and academic papers envisioning systems completely different from the U.S. experience. 

Many of the Commission’s rulemaking proposals are interrelated and interconnected, yet these proposals are not evaluated pragmatically and holistically.  Recent examples include the four equity market structure proposals[2] and the multiple proposals involving cybersecurity, such as amendments to Regulations S-P and SCI, and cybersecurity risk management programs for broker-dealers, funds, registered investment advisers, exchanges, and other entities.[3]  Notably, the economic analysis only considers the costs and benefits of each proposal in isolation, asking commenters to weigh in on any overlap.  Why should the Commission be asking the public to figure it out?  The SEC should publicly state its views on the overall problem being addressed and should not try to avoid its obligations under the Administrative Procedure Act to have a reasoned basis by dividing its regulatory response into small, compartmentalized proposals.

Unfortunately, the asset management industry will likely struggle to cope with the resource challenges and complexity of these multiple and overlapping rulemakings.  To what end?  What requires fundamental overhaul of all of these different areas at the same time?  Smaller firms, including many owned by women and minorities, are likely to be the hardest hit and it would not be surprising if the burdens cause some of these firms to stop doing business or seek to become acquired.  If the industry becomes smaller and less diverse, this could lead to a concentration of strategies, a decrease in choice for investors, and the potential for large financial monoliths that vote and invest the same way.   

Let me now turn to some specific areas of fund regulation.

Open-end Fund Liquidity

Since the 2008 global financial crisis, academics and prudential regulators around the world have been deeply concerned about the liquidity in open-end funds – and not solely money market funds – as a source of systemic risk.  Their narrative is that because open-end funds allow investors to purchase or redeem shares on a daily basis but hold assets that are generally less liquid (the so-called “liquidity mismatch”), these funds are engaged in “liquidity transformation.”  Liquidity transformation may incentivize investors to rush to the exits in market downturns to obtain the “first mover advantage” to redeem before other investors.  If the redemptions are sufficiently large, funds will engage in fire sales of portfolio assets.  These fire sales could adversely affect other market participants, such as through financial interconnections.  If conditions deteriorate, then central banks may have to intervene to restore financial stability.   The thought was that this type of run risk and threat to financial stability can only occur in open-end funds, but not banking organizations that are subject to prudential regulation.  Perhaps that now needs to be revisited. 

The liquidity transformation narrative for funds, which has been embraced by academics and organizations such as the Financial Stability Board and European central banks, has prompted certain policy proposals in the United States.  One SEC proposal would require mutual funds to engage in swing pricing, institute a 4:00 pm Eastern Time hard close, and implement restrictive liquidity requirements.[4]  As responsible regulators and market participants, we should want significant weaknesses in the system to be addressed – if they exist.  At the same time, however, we should be wary of unintended consequences of a prudential approach to fund regulation: if registered investment companies are regulated to the extent that they are less desirable options for 401(k) and other retirement plans, collective investment trusts and other less regulated investment options may fill the gap.  Importantly, investors will have fewer protections and will not have the robust fund disclosures, limitations on conflicts of interest, and board oversight that they do today – to name just a few of the substantive protections that fund investors receive.

In this regard, before the current system is completely changed, it is worth a closer look at the narrative and whether it stands up to scrutiny.  Here are a few concerns.

First, the academic studies postulating this narrative have certain limitations, such as the lack of U.S. regulatory data.  However, many of these papers use data sets that were incomplete.  A significant amount of this information is now publicly available on Form N-PORT, which the Commission adopted in 2016.[5]  In fact, one of the stated benefits of Form N-PORT was that “[m]ore timely portfolio investment information will improve the ability of Commission staff to oversee the fund industry by monitoring industry trends, informing policy and rulemaking, identifying risks, and assisting Commission staff in examination and enforcement efforts.”[6]  The Commission should be using this regulatory data to test whether the hypothesis is correct. 

Of course, information about fund trading activity and the prices at which funds purchase and sell each instrument are not publicly available – nor should they be.  Nonetheless, there is the ability to provide a more complete picture using this data that should be compiled, analyzed, and reviewed by the SEC.  In this regard, I appreciate the substantial effort that commenters have made in responding to the proposal on open-end fund liquidity, such as re-examining and questioning the academic hypothesis by incorporating data into the analyses, expressing their concerns as board members, and recommending certain improvements.

Second, this hypothesis generally has been focused on European funds and then applied to U.S. mutual funds with only glancing references to the fundamental differences that exist.  This is particularly true given the very different distribution channels, regulatory requirements, and types of investors between the United States and Europe.  The experience, for example, of swing pricing for Luxembourg funds during March 2020 may be applicable to fund regulation in Luxembourg and perhaps other parts of Europe, but the investor base, regulatory framework, and retirement plan channels in the United States are meaningfully different such that they should not be understated or assumed away.[7] 

I also am puzzled by some claims, such as in the SEC’s open-end fund liquidity proposal, that the events of March 2020 support the view that mutual funds present systemic risk and must be addressed through tools like swing pricing and more restrictive liquidity requirements.  The evidence that U.S. mutual funds as a whole were unable to meet their liquidity needs or that they transmitted systemic risk through interconnections in the financial system in March 2020 is questionable.  According to the proposing release, the Commission and its staff already had the tools to take emergency action, such as interfund lending and short-term funding, but they were not used.[8]

While the Federal Reserve intervened to establish the Secondary Market Corporate Credit Facility, among other actions, the events of March 2020 were due to a global pandemic that had – and continues to have – broad impacts on the economy.  Central banks were created to address severe crises in the markets – and one stemming from a global pandemic would qualify.  Notably, despite the vaunted use of swing pricing in Europe, the European Central Bank also intervened to provide liquidity to the fixed income markets.[9]  One wonders whether the events of March 2020 simply gave banking regulators an excuse to fulfill a longstanding goal to regulate the fund industry in a prudential manner.

ESG 

With respect to environmental, social, and governance (ESG) factors in investing, I have noted my concerns about ESG-related strategies, including their potential underperformance and premium costs for investors.[10]  Moreover, there are concerns as to whether the various regulatory attempts are intended to benefit the financial returns of investors or alternatively to force particular investment or operational outcomes.  Seemingly pushed aside is the notion that the existing disclosure regime works well in requiring funds to disclose information that is material to an investment decision from an economic standpoint.  Investors that wish to pay for ESG strategies should continue have that choice and the current disclosure regime provides them with sufficient information to do so.  

But continuing on with the theme of overlapping, complex proposals that are not grounded in practical reality – the Commission has proposed three rules that attempt to address ESG issues: one for corporate issuers,[11] one for investment advisers and funds,[12] and one for the use of “ESG” in a fund name.[13]  It is not surprising that some concerns have been raised about the effects that these rules would have, particularly when one considers the experience of the European Union’s approach to sustainable finance for non-financial and financial entities.  

The EU’s sustainability finance regime ought to be taken as a cautionary tale.  In particular, the European Union has taken a sprawling approach to sustainable finance.  These efforts include the expansive Corporate Sustainability Reporting Directive, which requires certain companies to disclose information about how environmental, social and human rights, and governance factors affect their operations and how their business model impacts those factors.[14]  In addition, the EU’s Sustainable Finance Disclosure Regulation (SFDR) mandates sustainability reporting by investment firms, including assessing sustainability-related risks in investments, and how ESG funds are marketed and sold.[15]  The EU Taxonomy Regulation – at more than 500 pages – attempts to create a common understanding for organizations to identify “environmentally sustainable” economic activities.[16] 

The EU’s ambitious plan has had significant implementation challenges, including conflicting standards and interdependencies, and not to mention a potentially large drag on the economy.  The Commission should be considering the experience in the European Union.  The Commission also ought to consider the potential limitations on its authority, including the major questions doctrine outlined in West Virginia v. EPA.[17]  On a practical level, the Commission should give significant thought to how it sequences any final rules.  Given that fund and adviser disclosure – as proposed – rely in part on corporate disclosure, the Commission should avoid making the same sequencing and other mistakes as the European Union.[18]  Arguably, the failure to consider how these three rules should be considered and interact could weaken any final Commission rules under the arbitrary and capricious standard required by the Administrative Procedure Act.

Fund Names  

In keeping with the theme of Commission proposals that have significant challenges, let’s turn to the “Fund Names” proposal.  In May 2022, the Commission proposed extensive changes to Rule 35d-1 under the Investment Company Act of 1940.[19]  The existing Fund Names Rule requires that funds with certain names adopt a policy to invest 80 percent of their assets in the investments suggested by that name, among other conditions.  The current rule applies to names that suggest (1) a particular type of investment, (2) a particular industry, or (3) a particular geographic area.  The proposal would significantly extend the Fund Names Rule to names that imply investments that have, or investments whose issuers have, “particular characteristics.”  While the Commission did not define the meaning of “particular characteristics,” it used the terms “value,” “growth,” and “ESG,” among others.  

These terms, among other aspects of the proposal, would rely on subjective judgments.  Are the investor benefits, if any, worth the significant implementation costs?  For example, the SEC has estimated astounding costs of up to $5 billion, or $500,000 per fund, which likely be passed down to investors.[20]  The supposed benefits to investors – which include the presumption that investors solely look at the fund’s name in choosing an investment – do not appear compelling, at least as presented in the current proposal.  The Fund Names Rule would also provide no benefits to the vast majority of investors who rely on an investment adviser or a broker to select their funds for them.  Accordingly, it is difficult to understand why the proposed changes are needed to the Fund Names Rule in light of its supposed benefits and extraordinary costs.  Further, if the amendments are adopted, there will likely be a significant burden on staff resources to process the amended prospectus disclosures that will result.  I very much appreciate the comments that have been submitted on this proposal.

Practical Areas for Improvement

Having noted my concerns with an asset management rulemaking agenda that seems dominated by more theoretical concerns, are there other areas – which I call “good government” projects – that the Commission should be working on?  In other words, what should the Commission be doing as a careful steward of its resources?

Commission efforts should be focused on projects that provide tangible improvements for investors by providing clear guidelines to firms in meeting their regulatory obligations.  In considering areas of improvement, the Commission should be sensitive to the current economic environment, where investors and their investment advisers are struggling to cope with the effects of the pandemic and high inflation.  Crippling firms with new regulatory burdens may cause them to exit and/or increase costs, thus reducing investment returns and choices for investors and making it more difficult for investors to achieve their financial goals.  It is particularly important that in times of high volatility and uncertain markets, that the efforts of asset managers are focused on their core service – providing high quality investment advice to their clients.

In particular, the Commission should review the current rulebook to see what is not working, including issuing concept releases on important topics, producing thoughtful analysis of the data currently gathered by the Commission, holding public roundtables, and publishing views for public comment, rather than proceeding immediately to rulemaking. 

The Commission could seek to improve fund disclosure for investors, including through the use of investor testing, so that disclosure policy can be informed by data indicating how investors will use and benefit from changes.  For example, there are several outdated and dense fund forms that are likely information overload for investors and costly for funds to complete.  These include filings such as Form N-14, which is used by funds in certain reorganizations and often includes hundreds of pages of dense financial information, and Form N-2 for closed-end funds.  It should not take an act of Congress before the Commission makes efforts to tailor its registration forms for financial products of interest to investors.[21]

In this regard, I supported the Commission’s adoption of rule and form amendments to create streamlined shareholder reports for ETFs and mutual funds.[22]  This rulemaking was backed by an effort over the past 10 years to engage in investor testing on shareholder reports.  These types of rulemakings can yield big benefits so long as they are carefully calibrated, including staggered compliance dates for smaller entities.

In closing, I strongly believe that the regulatory approach to mutual funds, closed-end funds, and ETFs is not broken.  If the Commission continues on its current regulatory path, however, I am concerned that investors, and the markets as a whole, may be worse off.  The Commission’s thinking must be grounded in practical, real world costs and benefits that are informed by data and experience – not hypotheses.  The Commission should expose its views to public review through published guidance, rather than in remaining in a state of seclusion and isolation.  Finally, many of you have taken a significant amount of time and effort to comment on the multiple rulemakings, including providing data and suggestions for improvement.  Thank you – I very much appreciate your efforts and insights.