FSI Whitepaper Urges SEC to Detect and Prevent Harmful Regulation by Enforcement

At FSI, our mission is to create a fair, business-friendly regulatory environment for our members. At the heart of this mission is to preserve Main Street Americans’ access to affordable, professional financial advice, products and services.

Indeed, most of you serve clients whose main objective is not to buy a yacht or join another country club. Rather, it’s to save for a dignified retirement and plan for major life events.

Role of Stakeholder Engagement in Rulemaking

So, when we engage in the rulemaking process it’s not because we are predisposed to think that all new rules are bad. Instead, it’s to make sure rules achieve their objective without detrimental unintended consequences.

Do they provide meaningful protections? Do they maintain investor access to financial advice? Do they treat all different business models with deference? These are the questions we think about when we engage regulators and provide them with feedback.

Frankly, it’s the type of constructive engagement by industry participants and stakeholders that is crucial to the rulemaking process. When experts weigh in on proposals and offer workable suggestions, their essential insight ensures the regulation truly has the intended positive impact on the market and investors.  

That’s why regulation by enforcement is so troubling: It circumvents the formal rulemaking process, denying industry stakeholders the opportunity to provide valuable expertise and insight. The practice has become so troublesome that we developed several recommendations to assist the SEC.

They are outlined in our recent white paper, Recommendations to the SEC to Modify its Procedural Framework to Prevent Regulation by Enforcement, which we unveiled at OneVoice 2024 earlier this year.  

By now, our members know what regulation by enforcement is. It’s when an enforcement action penalizes conduct that advisors or other market participants did not previously understand to violate federal securities laws despite reasonable efforts to understand them.

The Harm Done

Regulation by enforcement is harmful in a variety of ways. For one, it is fundamentally unjust. In our democracy, no one should be subject to government enforcement action without prior – and fair – notice of the standards, rules or laws that form the basis of an alleged violation.

Secondly, it sometimes yields unintended consequences. A big issue with de facto laws in our industry is that they ignore a crucial part of the rulemaking process: public feedback. Barring that, it’s far more likely that a new standard set by enforcement will result in actions that cause harm to the investing community, like higher fees for products and services.

Third, the practice weakens the public’s trust. It’s pretty simple: The SEC undermines its own mission and credibility with the investing public when it doesn’t engage with stakeholders properly.

Consistent and Predictable Rules

Financial services doesn’t just benefit from consistent and predictable rules – it needs them to operate properly and best serve Main Street investors. Yet the SEC, at times, has used enforcement actions to establish new regulatory requirements or fine-tune existing ones, leaving firms and advisors guessing.

Perhaps the most egregious example is the SEC’s Share Class Share Disclosure Initiative, launched in 2018. As we point out in our white paper, “[with] the benefit of hindsight and after over a hundred enforcement actions,” it’s become clear that the SCSDI has produced a “de facto regulatory presumption against the use of mutual fund A share classes and 12b-1 fees.”  

The presumption is so strong, in fact, that it can “only rarely be cured through disclosure and has essentially become a rule, though with no notice or comment or any other opportunities for industry input.”

In light of this – and other examples of regulatory overreach – we’re calling on the SEC to adopt a procedural framework to detect and prevent certain unfair enforcement practices. In our white paper, we’ve laid out several concrete procedures:

• Factors the Commission and its staff should consider before any novel enforcement action, such as evidence of prior notice, reasonable alternatives to enforcement action, and the extent of inaction by Commission staff despite awareness of the issue; 
• Discussion of these factors in recommendation or advice memos by the Division of Enforcement to the Commission; 
• Transparency on such deliberation, including references in public releases and public announcements on prior notices regarding the potential of such novel enforcement actions; 
• Incorporation of these procedures in the SEC Enforcement Manual; and 
• Periodic fairness audits by the Office of the Inspector General to ensure compliance with such procedures. 

None of the above should be controversial. Nor should any of them be difficult to adopt because the SEC has the proper infrastructure already in place to do so. And doing so would promote investor protection while creating a healthier, fairer regulatory environment for our members and the rest of the industry, an outcome that benefits everyone, including the Commission itself.