Regulating without Rules: FAQs

What is the initiative?

The SEC enforcement division launched the Share Class Selection Disclosure Initiative in 2018. It gave advisory firms four months to voluntarily identify and report fee disclosure and share class recommendations where the SEC may have deemed those disclosures to have failed to adequately disclose certain fees investors pay and recommendations of higher cost share classes when lower cost shares of the same investments were available.

But the SEC announced settlements, so isn’t it completed?

The original announcement for the initiative indicated that the staff expected to recommend stronger sanctions in any future actions against investment advisers that it alleges has engaged in the misconduct but failed to take advantage of the initiative.

According to news reports, some firms that did not self-disclose during the first initiative are already receiving document requests from the SEC. Industry experts are warning that the agency staff are likely emboldened by the recent initiative effort and will expand their scope to other areas that were not identified in the original initiative announcement or since.

What is the SEC regulation in question under the initiative?

In the 1980s, the SEC – by rule – allowed mutual funds to pay for their distribution provided certain criteria were met. Those fees are often referred to as 12b-1 fees, after the rule permitting these payments to intermediaries who sell fund shares. Not all mutual funds impose 12b-1 fees. The SEC enforcement initiative centers on advisers’ failure to adequately disclose conflicts of interest related to recommending mutual fund shares with 12b-1 fees for its clients when clients were eligible to own mutual funds without 12b-1 fees. In the vast majority of the cases the advisers provided robust disclosure, but these disclosures fell short of the SEC’s expectations. Advisers, however, were never alerted to these expectations because the SEC never set forth guidance or adopted regulations announcing these requirements. In fact, the SEC had performed numerous examinations of the investment adviser firms without raising concerns with their disclosures.

Weren’t these advisers overcharging investors? What’s wrong with putting a stop to that?

Companies should disclose any conflict of interest with enough specificity, and in plain and understandable English, to provide clients with the information that is important to their investment decisions. Over the years, the SEC has reviewed the practices in question during inspections and generally did not raise objections, leading the industry to believe that the practices were permissible and the disclosure surrounding them sufficient.

Investor fees are a serious matter that should be reviewed; however, the initiative effectively imposed new regulations on firms who were never notified nor given the chance to comment on these new requirements.

Why would nearly 80 investment advisers settle if they did nothing wrong?

Companies often “choose” to settle under coercive pressure from the SEC staff to either accept the terms being presented or possibly face more expensive – in terms of dollars and reputation – formal proceedings with the agency.

When the Commission votes in favor of settlements predicated on the violations contained in prior settlements – essentially agreeing to hold prior settlements as normative guidance – this circular approach allows the SEC to completely bypass the rulemaking requirements under the APA, including the process of consultation and notice to potential affected entities, and it effectively gives settlements the weight of a new “rule.”

If the SEC has issued guidance on issues wouldn’t it be within its jurisdiction to take actions to ensure it is being followed?

Businesses and individuals rely on certainty and the regulated have a right to participate in the process of making those rules and having sufficient notice to adapt their business practices. The Supreme Court has upheld the principle that due process requires fair notice of agency interpretations in its decisions in Christopher v. SmithKline Beecham Corp. and FCC v. Fox Television Stations, Inc.

Why doesn’t the SEC just change the regulation?

The SEC has had many opportunities to establish clear rules of the road regarding the extent of the disclosure it believed was required when an adviser recommends a mutual fund with a 12b-1 fee. It could have engaged in broad rulemaking or engaged in rulemaking that would have added specific instruction in the Form ADV – the form which serves as the basis of an adviser’s disclosure obligations – setting forth the required disclosure. Either one of these routes would have established clear rules of the road for advisers.

What can be done to end regulation by enforcement through this initiative?

The Commission should review the initiative and the facts. We believe such an examination would justify calling for an end to the initiative.

If the Commission has lingering concerns with the disclosure provided by advisers regarding their receipt of 12b-1 fees or other types of compensation received by advisers, the SEC should either engage in broad rulemaking or through rulemaking to add specific instructions on the Form ADV. In either case, it should halt current enforcement efforts.

Does regulating without rules, or regulation by enforcement, occur at other agencies?

Yes, unfortunately the SEC is not alone in this practice. On April 30, the U.S. Senate Committee on Banking, Housing and Urban Affairs held a hearing examining precisely this issue, focusing on the prudential banking agencies. Also, in January 2018, in a Department of Justice memo, the Associate Attorney General emphasized that “[g]uidance documents cannot create binding requirements that do not already exist by statute or regulation” and “Department litigators may not use noncompliance with guidance documents as a basis for proving violations of applicable law…”

Historically, the SEC has been a principles-based regulator in this area. Isn’t it better to give firms flexibility, rather than impose rules for every situation? Isn’t the industry always arguing against heavy-handed rulemaking anyway?

The SEC has engaged in recent rulemaking in connection with its Form ADV on several occasions. During any of those efforts, it could have set forth the appropriate level of disclosure that should be provided by advisers to their advisory clients. This guidance from the Commission could have been done in a principles-based manner. As SEC Chairman Jay Clayton said himself, guidance:

  • Is the opinion of the staff
  • Should only be used to clarify rules and not to establish new regulatory obligations
  • Should not be used to coerce non-governmental parties into taking action beyond what is required by the rules