SEC Commissioner Speaks on Finding Balance at the SEC

The ’40 Acts

Prior to the 1929 stock market crash, a budding asset management industry was taking shape – smaller investors were invited to pool their assets with the assets of others, mostly in closed-end funds.[3] As former Commissioner Robert Healy observed, these funds were promoted as providing “security for old age and for emergencies” through “expert management and diversification of risk” – much as they are perceived by us today.[4] But, left unchecked, fund sponsors locked investors out of management and engaged in self-dealing and fraud with little transparency or recourse.[5] As Paul Cabot, founder of State Street, observed prior to the crash in March 1929, two major abuses proliferated in the industry: first, companies operated out of self-interest rather than shareholder-interest; and second, investment companies were used as repositories for otherwise unmarketable securities.[6]

Following the 1929 crash, Congress mandated that the Commission promulgate a study of investment trusts and investment companies. The Commission’s study confirmed these ills, describing practices relating to, not only “outright embezzlement,” but also “to the unloading of worthless securities and other investments of doubtful value upon the [investment] companies; to loans which investment companies have been caused to make to insiders; to the bail-outs of insiders from dubious and illiquid investments.”[7]

But, from these pernicious practices, legislation that governs much of our work today was born: the Investment Advisors Act and the Investment Company Act, both passed in 1940. Stemming from the foundation laid out in the Commission’s study – these Acts were the product of cooperation between industry participants and the Commission in furtherance of a shared goal of building robust markets.[8] Indeed, the 1940 Acts largely had the support of industry leaders, many of whom urged for their passage because they understood that building successful markets would require eradicating harmful practices and rebuilding investor trust. The overall collaboration and mutual support for the legislation were heralded as nothing short of miraculous, and the 1940 Acts passed unanimously in Congress.[9] Upon signing the legislation into law, President Roosevelt observed that it was his “Administration’s purpose to aid the honest businessman and to assist him in bringing higher standards to his particular corner of the business community.”[10]

And that is where our journey began. The Investment Company Act serves as a basis for full and fair disclosure to fund investors, and comprehensively regulates investment companies through prescribed governance mechanisms, reflective of the characteristics of the fund. For example, it prescribes requirements relating to valuations, redemptions, service provider relationships, and limitations on leverage, and imposes restrictions on affiliate transactions.[11] These and many other requirements aim at safeguarding assets of investors as they seek to diversify their savings. The Investment Advisers Act is more principles-based and imposes on advisers a heightened obligation to serve investors with loyalty and care.[12] Importantly, these requirements aim to decrease the incidence of the abusive practices that led to the passage of the Acts.

These seminal laws have served as the foundation for a fund industry that people trust. The numbers bear that out. In 1940, when the Acts became law, registered management investment companies held slightly more than $1 billion in assets.[13] Now, there are over 16,000 U.S. registered investment companies with nearly $34 trillion in total net assets, largely invested on behalf of more than 120 million U.S. retail investors.[14] More than 71.5 million U.S. households own U.S. registered funds – which is more than half of all U.S. households.[15]

The Current Environment

Against this historical backdrop, there are a few things that that we should all keep in mind in the current climate.

First, democratic institutions matter. The Securities and Exchange Commission as an institution matters. When Roosevelt signed the 1940 Acts into law, he noted the industry’s recognition of the importance of the agency:

[I]t deserves notice that the investment trust industry insisted that the Congress grant to the Securities and Exchange Commission broader discretionary powers than those contemplated in the original regulatory proposal. Not only is this a tribute to the personnel of the SEC and an endorsement of its wisdom and essential fairness in handling financial problems, but it serves well to indicate that many businessmen now realize that efficient regulation in technical fields such as this requires an administering agency which has been given flexible powers to meet whatever problems may arise.[16]

We find ourselves in a unique moment in history where our executive agencies and departments are being . . . reconceived and, in some cases, potentially dismantled. Unequivocally, we are seeing transformation.

But, what the Commission does – in concert with investment companies that you all represent – is nothing short of enabling the American Dream. We write rules that allow your investment products to go to market, so that millions of our neighbors and community members can save for retirement, building their 401(k) and IRA accounts with transparent products appropriate for their risk tolerances and goals. Our rules reduce the cost of capital, lead to higher quality disclosures, and build investor confidence.[17] Markets are built on trust. I cannot emphasize that enough. That trust comes when industry and regulators work together to make and live in a system that is fair, transparent, and that holds participants accountable for misdeeds that harm investors and the markets alike. That’s what started in 1940. And we need a strong Commission to continue to carry out this mission.

Over the past few months, I have seen trends that undermine the strength of the agency and the markets. There is of course the constant job insecurity felt by the staff that you have been reading about in the newspapers. There have been prominent critiques of staff for doing their jobs – tasks which were performed in line with directives given by presidentially-appointed commissioners. And, we have seen instances of lawyers and issuers effectively disregarding the comments and concerns of staff before going live with their investment products.

Such behavior is harmful. It may be expedient, or even business-enhancing in the short term, but it is anathema to our democratic institutions and the markets in the long run. We must forge a path forward together.[18]

And lest we forget, our institution is currently strong and flexible in the manner conceived by Roosevelt. We are an agency that listens to the industry and the investors that we oversee and serve. Over the last four years, we saw an ambitious agenda that attempted to address issues in the asset management industry such as shareholder dilution, custody, and digital engagement practices. We made proposals and opened (and sometimes reopened) notice and comment periods, and took many meetings with stakeholders. We listened. I listened. For example, many of you in this room sat down with me and discussed the operational and fairness concerns raised by our proposal relating to swing pricing and the hard close. These types of discussions matter.

This leads into my second point. Mistakes get made when we move too quickly. Agency deliberation should be thoughtful, measured and data driven. The rulemaking process may be cumbersome, but the results benefit from the input of industry participants, investors, advocates, lawmakers, and experts.

What we are seeing right now at the agency, I fear, is a sort of “deregulation by guidance.” Over the past weeks we have, without Commission vote, notice or comment, or (I would argue) due economic consideration to the costs and benefits: changed the guidelines concerning engagement with management for purposes of Schedules 13D and 13G;[19] refashioned verification requirements for accredited investors;[20]changed the rules of the road for proxy proposals in the middle of proxy season;[21] and, issued a blanket opinion – without due consideration of facts and circumstances – that a famously volatile class of tokens were not securities.[22] Just to name a few.

Many of us in this room have had discussions about the cumulative impact that our proposed rulemakings may have on market participants. But here, I wonder what will be the cumulative impact on investors and the markets for rushed policy changes, not subject to APA rigors or Commission-level deliberations?

Finally, one last trend that I’ll mention – intertwined with the more broadly deregulatory posture is a rush to expose retail investors to riskier or less liquid markets through an ETF wrapper. I here too would urge caution and deliberation as we take products that retail investors traditionally view as plain vanilla and materially change the risk profile – especially where the products typically go automatically effective and don’t receive the benefit of Commission-level approval. Perhaps not everything is an ETF.[23]

Conclusion

There are lessons to be applied today from the foundational work that went into the two Acts of 1940. There was a partnership and an alliance that formed around the passage of those Acts that should be valued. A strong and flexible regulator can work with industry to create market strength and trust. But that trust is maintained by sound deliberation on both the part of the regulator and the industry that it regulates. Too easily it can be eroded or eliminated, potentially leading to an unfortunate cycle of de-regulation and re-regulation. When we move too quickly, the pendulum tends to swing back. I hope we keep the lessons of the past in our minds as we rush toward the future.

ENDNOTES

[1] William Shakespeare, The Tempest, Act 2, Scene 1