By Peter Wallison and Paul Atkins
Most observers of regulatory behavior would agree that before an agency takes an enforcement action against a firm it should lay down a rule that defines the conduct it is seeking to prevent and the punishment for violation of the new standard. In agencies, the new interpretation of an existing statute or rule should be embodied in notice and comment rulemaking under the Administrative Procedure Act, which gives the industry an opportunity to comment and conform to the new standard.
But agencies occasionally skirt this process. Instead, the staff adopt a new interpretation with little notice, and then charge violations for activity that occurred prior to that interpretation. The Securities and Exchange Commission enforcement division recently used the latter practice in its initiative charging financial advisors with failing to uphold their disclosure obligations under the Investment Advisers Act with respect to 12b-1 fees.
Rule 12b-1 under the Investment Company Act permits mutual funds to cover distribution and marketing expenses otherwise borne by the fund adviser. Because advisers have an inherent conflict of interest in collecting these fees from funds that they manage, the Securities and Exchange Commission required that advisers disclose to fund investors the conflict of interest associated with these fees. In 2010, the Securities and Exchange Commission began to consider changes to Rule 12b-1, but backed off because of public criticism and internal disagreement.
Recently, however, the enforcement staff began its share class selection disclosure initiative to charge financial advisors with violations of the Investment Advisers Act around alleged undisclosed conflicts that had been previously accepted practice for decades. The Securities and Exchange Commission did not cite a rule or regulation articulating any specific disclosure obligation that had been violated. Instead, the agency held financial advisors liable for not complying in from 2014 to 2018 with a standard that it did not attempt to articulate until 2018 if even then.
Securities and Exchange Commission member Hester Peirce lamented this approach in a speech earlier this year. “We spotted a problem and let it fester without a definitive reaction from the commission for five plus years,” she said. With no clear statutory direction from Congress or rules promulgated under the law, the enforcement division used prior settlements, which have never been tried before a judge, as the precedents that advisors violated their disclosure obligations. In effect, the agency short circuited the required rulemaking process by adopting a regulation through enforcement rather than through rulemaking.
Despite the failure of the Securities and Exchange Commission to conform to the requirements of the law, regulated firms are induced to agree to these enforcement actions because they are threatened with graver charges and more costly adjudication. This circular approach effectively gives settlements, particularly multiple ones induced from a host of defendants, the weight of a new rule, even though the agency has never actually taken the necessary steps to adopt it. In this case, almost 80 advisers settled with the agency for more than $125 million.
Despite the serious flaws of its process, the Securities and Exchange Commission enforcement division reportedly continues to pursue actions that are related to share class disclosures and has even branched out to other disclosures similarly not addressed by rulemaking. These actions come at a time of general debate regarding what regulatory agency pronouncements have the force of law, and the scope of deference that agency interpretations should receive from the courts.
The agency has clearly failed to communicate its concerns with existing disclosure practices when it had ample opportunity to do so. The remedy for its failure, however, is not to use its enforcement cudgel without prior notice to the industry. The agency sought, through an obscure footnote in an unrelated release, to provide some guidance for financial advisors concerning expected disclosures to clients. Even novice students of due process, however, understand that guidance provided earlier this year cannot be used in cases citing disclosures made before that time.
Rather than continuing or expanding its enforcement initiative, the Securities and Exchange Commission should take a different tack, consistent with its original regulatory mission and the history of this particular rule and halt the initiative. It is much more equitable, more investor focused, and a better use of federal resources for a regulatory agency to provide clear and forward looking guidance or rulemaking on an issue, particularly one that has been festering for years.
Paul Atkins is the chief executive officer of the financial services industry consulting firm Patomak Global Partners and is a former member of the Securities and Exchange Commission. Peter Wallison is the Arthur Burns fellow in financial policy studies at the American Enterprise Institute and was general counsel of the Treasury Department under President Reagan.
This op/ed originally appeared in The Hill.