As president Donald Trump enters his third year in office, the recent partial government shutdown vividly exemplifies the shift in power resulting from the Democrats' significant gains in the House. It also demonstrates the lack of bipartisanship that will permeate the 116th Congress. Given this new reality, the Securities and Exchange Commission's role in setting regulatory changes for the asset management industry will be of even greater importance.
Jay Clayton has now served as SEC chairman since May 2017. In 18 months, he has put an impressive team in place at the agency and is well down the road in constructing and pursuing an aggressive and extensive asset management rule-making agenda. All in all, it seems that Mr. Clayton is hitting his stride as we ring in the new year. So what are the main issues the SEC will consider for asset management firms during 2019?
For mutual funds and their boards, 2019 could be a banner regulatory year. The SEC already has taken steps to approve regulations that are long overdue. For example, the SEC approved Rule 30e-3 last summer, giving mutual funds the ability to offer shareholder reports via the internet — a sensible measure that will result in saving costs and trees. During 2018, the SEC's division of investment management, led by Dalia Blass, commenced a review of mutual fund board responsibilities — an undertaking that has been needed for many years. Perhaps representing a small but concrete first step in this important project, SEC staff recently issued a no-action letter to the Independent Directors Council that allows mutual fund boards to receive reports about affiliated transactions from the fund firm's chief compliance officer — rather than the board being required to approve every such transaction.
Let's hope this is just the tip of the iceberg and that other similar director duties will be scaled back by the SEC in the coming months. In December, the commission unanimously approved a proposed regulation that will streamline the process for most fund-of-funds arrangements. Mr. Clayton also has listed another important area for rule-making on the SEC's agenda for 2019: the use of derivatives by mutual funds. Before Mary Jo White's departure, the SEC narrowly approved a derivatives proposal that could charitably be described as controversial. As then-Commissioner Michael Piwowar noted at the time in casting his dissenting vote, SEC action clearly is needed in this area — but the proposal approved by the commission in December 2015 was not the right way to go about it. Mr. Clayton has put the derivatives/mutual funds rule-making back on the SEC's published agenda and it's likely that a new and improved proposal will be forthcoming during 2019.
The only notable exception to this upbeat regulatory assessment is the ongoing difficulty connected to implementing the liquidity risk management rule approved during Ms. White's tenure as SEC chairwoman. That rule, among other things, requires open-end funds and exchange-traded funds to classify holdings into various buckets. As the Investment Company Institute has written, "bucketing information is inappropriate as required public disclosure because funds will generate this information using complex and widely divergent methodologies, and such information by its nature is subjective, forward-looking and hypothetical." While Mr. Clayton's commission has extended effective dates and liberalized reporting requirements, the liquidity risk management rule goes into effect this year and remains of questionable value overall and a major operational headache for many mutual funds.
But back to the favorable prognosis. At least three other asset management rule-making decisions on Mr. Clayton's agenda deserve an honorable mention. First, the SEC approved a proposed rule in June to go out for comment that would create a regulatory framework specifically designed for approval of many ETFs. The SEC first proposed such a rule in 2008 and it has taken a decade to get back to this important topic. It's likely that the SEC will consider a much-needed final rule during the next few months.
Second, Mr. Clayton's short-term rule-making agenda includes considering amendments to the Advisers Act marketing rules. Current rules, which prohibit testimonials and past specific performance recommendations, could benefit from an extensive overhaul. While it's likely that the proposal will address social media and other electronic forms of advertising (none of which existed when the rules were originally approved), the most important reform the SEC could make would be to get rid of the current prohibitions and replace the rule with one which prohibits misleading or fraudulent advertising.
Third, Mr. Clayton has announced that the commission will take a hard look at the current proxy process. The SEC held a roundtable in November that examined the mechanics of the proxy process, shareholder engagement and the role of proxy advisory firms. Expect further action by the SEC as well as potential legislative interest by Congress.
As asset management firms focus on these significant rule-making decisions, perhaps the most important changes involve the Federal Stability Oversight Council and the sweeping powers granted to it under the Dodd-Frank Act to designate non-bank systemically important financial institutions. FSOC's use of these powers could threaten the critically essential elements of asset management regulation by imposing bank-style prudential regulations instead of principles-based regulations and requiring capital standards and stress testing — a potentially devastating blow to asset management firms and the clients they serve.
The good news is that FSOC is reconsidering how to use its non-bank designation authority. Pursuant to Mr. Trump's April 2017 executive memorandum, the Treasury Department issued a report late in 2017 that suggests a number of important reforms to FSOC's non-bank SIFI designation authority. Prudential's non-bank SIFI designation was rescinded by FSOC a few weeks ago — removing the final remaining non-bank designation. FSOC is now working to implement important procedural reforms outlined in Treasury's 2017 report. While some voices — primarily from across the Atlantic Ocean — continue to harp on the dangers of "shadow banking," it is encouraging to see the Treasury Department's focus on reforms to ensure that due process, accountability and transparency will be followed in any non-bank designation inquiry.
Of course, the X-factor could be the economy and stock market — or a potential Madoff-like or political scandal. If a significant external event takes center stage, it's certainly possible that the SEC's agenda may be sidetracked.
Stay tuned ... it should be a very interesting ride.