(Article from Registered Funds Alert, February 2017)
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Inauguration Day 2017 would have marked a change in presidential administrations regardless of the outcome of the election, but it is safe to say that few predicted that the election would result in a victory by Donald Trump and Republican control of both houses of Congress. Thus, even though the Securities and Exchange Commission (“SEC”) is an independent federal agency with representation from both parties, we would expect there to be significant changes to the regulatory and policy priorities of the SEC. Precisely what those changes will be hard to predict, especially because President Trump has not shown himself to be tied to the Republican Party position on all issues, and the Republican Party has not indicated that it will accede to the President’s policy positions in every instance. This Alert nonetheless attempts to address what may lay ahead for registered funds and their sponsors.
Policy Initiatives of the New Administration and Nominee for SEC Chair
The SEC’s statutory mission is to: protect investors; maintain fair, orderly and efficient markets; and facilitate capital formation. It goes without saying that President Trump’s policy priorities fall largely in the third category—facilitating capital formation. Indeed, in the statement nominating a new SEC Chair, the transition team noted that “[w]e need to undo many regulations which have stifled investment in American businesses, and restore oversight of the financial industry in a way that does not harm American workers.”
It does not automatically follow, however, that emphasis on the third category of the SEC’s mission means that the former two will be ignored, In the same statement, the transition team also noted that “[r]obust accountability will be a hallmark” of the SEC. Ideologically, the view that markets should be lightly regulated but bad actors should be identified and punished—to maintain faith in markets—is one widely held by right of center economists and policymakers.
To accomplish these twin goals, President Trump has nominated Jay Clayton, a partner at a large NY-based corporate law firm, to succeed Mary Jo White as chair of the SEC. Mr. Clayton’s legal practice has focused on securities law, including mergers and acquisitions, capital markets offerings and regulatory and enforcement matters. His nomination has received a mixed reaction from Capitol Hill, as he has no government experience or prosecutorial background (although both factors were likely seen as assets, not liabilities, from the perspective of the President). While some media reports have focused on the fact that Mr. Clayton is likely to have significant conflicts and will need to recuse himself from matters involving any of his former Wall Street clients or his wife’s employer (a large investment bank), his conflicts do not appear to be any greater than those faced by Chair White, who previously represented Wall Street clients herself and who also had to recuse herself from matters involving clients of her husband’s law firm. There has been little debate, however, regarding the quality of Mr. Clayton’s intellectual, legal and securities bona fides.
Other than the statements from the transition team that suggest some indication of his priorities, little is known about Mr. Clayton’s personal policy views. Mr. Clayton has not made any significant statements regarding policy initiatives, although he did co-author an opinion piece in 2015 acknowledging the seriousness of cybersecurity threats and advocating for greater collaboration between government and the private sector, both domestically and internationally. His familiarity with cyber-security challenges will likely be helpful in this ever-evolving area. It is also likely to provide comfort to the dozens of industry representatives, including Simpson Thacher, who raised concerns about the expansion of information to be submitted to the SEC without standards for the appropriate safeguarding of that information by the SEC. But outside of that familiarity, there is not much that can be gleaned from his public record. We also note that his professional history has not involved significant representation of registered funds or their sponsors.
As of the date of this Alert, Mr. Clayton’s confirmation hearing has not been scheduled, although there have been reports that it could take place in early February. While it is possible that it could take several months for Mr. Clayton to be confirmed as SEC chair (Chair White’s confirmation took nearly four months), there do not appear to be any impediments to a swift confirmation.
Neither a new presidential administration nor a new SEC Chair necessarily augurs a change of key personnel at the SEC Division of Investment Management, since none of the positions, including Division Director, are political appointees. Given that Mr. Clayton, once confirmed, will need to find replacements for departing heads of the Divisions of Corporate Finance, Enforcement and Economic and Risk Analysis, and the office of Compliance Inspections and Examinations, we would not expect any imminent changes in key personnel at Investment Management. Division Director David Grim, who has been at the SEC through several SEC chairs, expressed his belief at the ICI’s December 2016 Securities Law Developments Conference that more things will stay the same than change under a new chair. The SEC is a large agency, with nearly 4,000 employees, and changing its direction is more like steering a freighter than a speed boat. Mr. Grim noted that the SEC Staff often spends a significant amount of time getting new appointees up to speed after an administration change, which may delay certain rulemaking and other initiatives.
Congressional Legislation
When the Financial CHOICE Act of 2016 (“CHOICE Act”) was initially proposed by Congressman Jeb Hensarling in September 2016, many viewed the legislation as unlikely to be adopted. However, the results of the election—with Republicans set to control both houses of Congress and the White House—drastically improved the prospects for the CHOICE Act, or similar financial reform legislation. In fact, proposals similar to those found in the CHOICE Act have already appeared in separate bills, such as a recent bill that passed the House of Representatives that would require additional cost-benefit analysis for SEC rule proposals related to anticipated costs a rule would impose on the financial industry.
The CHOICE Act is a sweeping piece of financial reform legislation that would, among a myriad of other reforms, repeal portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), remove the power of the Financial Stability Oversight Council (FSOC) to designate non-bank financial institutions as systemically important, repeal the Volcker Rule and reform the Consumer Financial Protection Bureau. While the CHOICE Act is a long way from becoming law, if enacted, it would have significant effects on the SEC and its rulemaking process, as discussed further below. In addition, certain provisions would provide highly desired relief to certain funds and sponsors. For example, the CHOICE Act, as proposed, includes several amendments to the Investment Company Act of 1940 Act (“1940 Act”) that would allow business development companies (“BDCs”) greater ability to invest in certain types of unregistered vehicles and lower the asset coverage requirements for BDCs if certain conditions are met and to the Investment Advisers Act of 1940 (“Advisers Act”) that would provide an exemption from registration for certain private equity fund advisers. It is possible that additional amendments could be added during the legislative process.
SEC Rulemaking
As we have discussed in prior Alerts, in December 2014, Chair White announced a multi-part asset management rulemaking initiative. To date, the SEC has adopted new data reporting requirements for registered funds and advisers and liquidity risk management rules for registered funds. Additionally, the SEC has proposed rules for registered funds related to electronic delivery of shareholder reports and use of derivatives, plus a rule that would require registered advisers to develop and maintain written business continuity and transition plans. Based on when each rule was proposed, the rules relating to electronic delivery of shareholder reports and derivatives use would appear to be closer to adoption than the rule that would require business continuity and transition plans for registered advisers, and Mr. Grim confirmed this perception in remarks during December’s ICI conference. Additional rules that reportedly are being formulated by the SEC, but have not yet been proposed, include stress testing requirements, a rule that would require investment advisers to undergo an annual examination by a third party as a way to supplement SEC examinations, and a rule to promote diversity in the board room that could apply to fund boards.
While there have been no definitive statements from the incoming administration regarding the ultimate fate of pending SEC rulemaking initiatives, the White House issued a memorandum shortly after the President was inaugurated that directed all regulatory agencies to freeze all pending rulemakings until the incoming administration has an opportunity to fully review all pending rules and to delay for at least 60 days the implementation of rules that have been finalized but not yet implemented. SEC Commissioner Michael Piwowar, the sole Republican commissioner who was named interim chair as Mary Jo White left her post after the inauguration, has stated that due to the SEC’s limited resources he does not intend to “move forward with something that is going to be repealed or changed anyway.” While he has not specifically cited any asset management rulemakings as fitting that description, he has indicated that Dodd-Frank rulemakings fall into that category, which includes the stress-testing rule and arguably the transition-planning and derivatives rules. We also would not expect a board diversity rule to be a priority of the incoming administration. Commissioner Piwowar’s position that certain rules should not be adopted will carry even more weight given Chair White’s departure, as he and Kara Stein are the only two Commissioners remaining and any new rule will require that they both agree to its adoption.
With respect to the electronic delivery rule, which is widely seen as pro-industry but has been subject to significant resistance from the paper industry, Commissioner Piwowar has been a strong advocate. Given strong support from Republicans, one would normally expect a version of the rule to be adopted either under Commissioner Piwowar’s interim chairmanship or shortly after there is a full complement of Commissioners. However, the paper industry employs many American workers in communities that voted for Donald Trump. That rule may be an area where President Trump’s views depart from Republican orthodoxy.
With respect to the derivatives rule, while there are many who would prefer all rule-making be shelved, there are significant industry voices who would prefer some level of certainty with respect to derivatives rules, as opposed to being subject to the vagaries of the disclosure review process to work through technical issues. Commissioner Piwowar supported the proposal of a derivatives rule that focused on asset segregation and did not have a limitation on notional derivatives exposure (as contained in the proposed rule issued last year). It would not be surprising to see a re-proposal, or potentially even an adoption, of a derivatives rule that limited undue risk solely through an asset segregation approach. These two examples exemplify the complexity of predicting rule-making developments—in some cases Republicans and President Trump will have different priorities, in some cases different industry participants will have different priorities. It is extremely unlikely that rule-making will cease simply because the prevailing sentiment is to lessen the regulatory burden on industry participants.
There may also be influences from Capitol Hill that have direct bearing on the SEC. The CHOICE Act includes several provisions that could slow down the SEC rulemaking process (and may impact other financial regulators as well). One of these provisions would establish a minimum comment period of 90 days for public comment on any proposed rulemakings. Currently, the SEC typically allows between 30 and 60 days for public comment. The SEC would also be required to submit any agreements on international or multi-national securities standards to a public notice and comment process. Additionally, all new “major” SEC rules (for example, those with a $100 million annual anticipated impact on the U.S. economy) would need to be presented to Congress, and both houses of Congress would need to issue a joint resolution approving the rule before final implementation. If Congress does not issue the required joint resolution, a rule simply would not go into effect. Congress would also have a mechanism to disapprove of non-major rules. Furthermore, the CHOICE Act would provide a specific private right of action for anyone adversely impacted by a final rule to bring a court challenge within one year from the publication of the final rule in the Federal Register. The CHOICE Act also requires the SEC to do a five-year retrospective analysis of the impact of new rules (and a review of current rules).
SEC Interpretive Guidance and Exemptive Relief
There are several reasons to believe that the SEC may increase its issuance of interpretive guidance and exemptive relief as a result of the current political climate. If the new administration takes the approach of reducing regulatory burdens, one way of accomplishing that goal is to utilize the SEC’s interpretive and exemptive authority. We anticipate that funds and their advisers will approach the SEC Staff for novel relief with less hesitation, as the new administration could present an opportunity to seek clarity with respect to certain gray areas of the 1940 Act and Advisers Act (and their respective rules). Additionally, if the CHOICE Act or similar legislation is passed and contains a requirement for a joint resolution of Congress approving any new rule, as noted above, it is possible (or even probable) that the SEC and its Staff would turn to their interpretive and exemptive authority to enact regulatory reform and bypass political logjams that could gum up the rulemaking process.
SEC Examinations and Enforcement
The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) officially announced its 2017 examination priorities on January 12, 2017. Notably, the examination priorities release explicitly states, for the first time, that OCIE’s objectives are to be “data-driven and risk-based” and it has incorporated data analytics into examination initiatives “to identify industry practices and/or registrants that appear to have elevated risk profiles.” Additional discussion of the SEC’s increasing use of data analytics can be found later in this Alert, but it is clear that data analysis is now driving examinations.
The examination priorities do not include many specific initiatives targeting registered funds and their advisers, other than cybersecurity policies and controls. The lack of discussion around funds and advisers belies what the SEC has emphasized in other contexts. For instance, in its 2017 Budget Justification to Congress (which is now unlikely to be approved), the SEC requested funding to hire 127 additional examiners for OCIE, of which 102 would have focused primarily on conducting additional examinations of investment advisers and investment companies. Some insight regarding OCIE’s asset management priorities was provided by representatives from OCIE and the Division of Enforcement (“Enforcement”) at the December ICI Conference. The asset management priorities that they cited included valuation, affiliated transactions (including cross-trades and principal transactions) and the advisory contract renewal process for registered funds under Section 15(c) of the 1940 Act.
The President has not made any detailed statements regarding enforcement goals for the SEC under his administration, other than generally noting accountability for Wall Street as a focus. Some SEC observers have commented that the transition in administrations could result in lower financial penalties associated with SEC enforcement actions, citing a statement published by the SEC in 2006 when Paul Atkins was a commissioner. Mr. Atkins is a key member of the President’s transition team, and likely was very involved in the selection of Mr. Clayton as the nominee for SEC chair. The 2006 SEC statement raised concerns that financial penalties against companies posed a risk of shifting the burden of wrongdoing to its shareholders, and stated that the “likelihood a corporate penalty will unfairly injure investors, the corporation, or third parties weighs against its use as a sanction.” Additional support for a possible reduction in corporate-level enforcement penalties can be found in the fact that the CHOICE Act includes a requirement for SEC economists to analyze the potential impact of a financial penalty on a company’s shareholders in connection with an enforcement action.
While this potential shift in the SEC’s approach to enforcement penalties would be welcomed by operating companies, it does not appear that funds and advisers would benefit to the same degree. When the SEC brings an enforcement action for a violation involving an operating company, the penalties are usually borne by the company directly, and its shareholders indirectly. In the fund context, however, the SEC typically brings an enforcement action against the fund’s sponsor or adviser, sparing the fund and its investors. Thus, even if the SEC begins to reduce enforcement penalties against operating companies, it is unclear whether advisers can expect similar treatment (except to the extent the advisers themselves are public companies).
Many industry observers have speculated that a Republican-controlled government and SEC may lead to fewer enforcement actions. For evidence, they point to a provision of the CHOICE Act that proposes to raise the SEC’s burden of proof in administrative proceedings from a “preponderance of the evidence” standard to a “clear and convincing evidence” standard. This change would mean that the SEC must prove that it is substantially more likely than not that an allegation is true, as opposed to it being only more likely than not. In practice, it remains to be seen whether there is a material distinction between these standards that will impact the SEC’s enforcement decisions, but legislation that proposes to raise the SEC’s burden of proof certainly indicates a desire to reduce enforcement actions, or a desire to encourage more litigation of such actions.
As discussed in more detail later in this Alert, with the finalization of new data reporting requirements for registered funds and advisers, OCIE and Enforcement appear poised to have access to significantly more information that can be analyzed to unearth “red flags” for further inquiry. SEC Staff members have stated that registrants can expect to be contacted when such a red flag arises, but have tried to emphasize that such red flags may be related to filing errors or other mistakes and will not trigger immediate opening of investigations without a registrant having the opportunity to explain or correct any issues.
The SEC’s efforts at data analysis may be hindered, however, as the CHOICE Act proposes to abolish the SEC’s reserve fund housed within the U.S. Treasury. The Dodd-Frank Act established the reserve fund, which allows the SEC to deposit up to $50 million in registration fees per year and hold a balance of up to $100 million. The SEC has discretion in how it uses the reserve fund, but requires reporting to Congress regarding any disbursements. The SEC has used the reserve fund primarily to upgrade and modernize its technology systems, including its data analytics capabilities. Abolishing the reserve fund could hinder the SEC’s ability to analyze data, and could increase the risk of cybersecurity attacks targeting the confidential information that the SEC collects from registrants. The elimination of the reserve fund is somewhat at odds with the CHOICE Act’s proposed requirements for the SEC to develop comprehensive risk control mechanisms to safeguard confidential data held by the agency, as it eliminates a potential source of funding for the SEC to enhance its cybersecurity preparedness.
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It is difficult to predict with certainty how the regulatory landscape will change for registered funds and their sponsors during the tenure of the new administration. With weeks or months to go, in all likelihood, before a new chair is confirmed, and with two commissioners of opposing political parties currently in place, one should not expect any significant developments for some time.