SEC Investment Advisory Committee Meeting on Growth and Oversight

Securities Exchange Commission

Investor Advisory Committee Meeting

Thursday, March 2, 2023

Topline

• The Investor Advisory Committee discussed the growth of private and public markets, the oversight of investment advisers, and open-end fund liquidity risk management.

Opening Statements

Chair Gary Gensler

In his opening statement Gensler thanked the Committee for recommendations on accounting standards available to the public at no cost. He said he is looking forward to the panelists providing their feedback on the public rule making process. Gensler noted that the Commissioners proposed a new safeguarding rule for investment advisors which will ensure that investors do not use customer assets inappropriately. Finally, he asked whether algorithms optimize for the investor’s or the advisor’s interest.

Commissioner Hester Peirce

In her opening statement, Pierce noted that the SEC plays a central role in whether a company decides to go public or private. She said she had particular interest in the third panel and the discussion surrounding the SEC’s most recent decision on retail investors. Peirce showed support for the SEC’s efforts to enhance the value of account investors.

Commissioner Caroline Crenshaw

In her opening statement, Crenshaw said she was most interested in the first panel’s discussion. She noted the SEC’s rulemaking determined the balance of today’s public and private markets. Crenshaw closed by highlighting the progress made by American public and private markets.

Commissioner Jaime Lizarraga

In his opening statement, Lizarraga noted that the start cap in capital raising in private versus public markets is well known. He reaffirmed that the SEC’s primary focus is to provide a voice to investors.

Panel I: Examining the Growth of Private Markets relative to the Public Markets: Drivers and Implications

Dr. Steven Kaplan, Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance and Kessenich E.P. Faculty Director at the Polsky Center for Entrepreneurship and Innovation

In his testimony, Kaplan discussed how private equity (PE) and buy-out companies are associated with increases in productivity and profitability. He said that the net effect is a significant increase in productivity. He noted that his own studies show that PE investors make companies more efficient and productive. He said value comes from financial engineering, governance engineering, and operational engineering. He recommended that the SEC increase the attractiveness of being a public company.

Dr. Elisabeth Fontenay, Professor of Law, Duke University

In her testimony, Fontenay noted that we are in a downward trend of public companies. She stated that public and private markets are both significant to the economy, and one of the greatest flaws within the regulations of the market is that we think of private and public markets as separate. She said the decline of public markets is due to the deregulation of private capital and increased regulation of public companies. She recommended that the SEC reduce the regulatory gap between private and public markets.

Mr. Tyler Gellasch, President and CEO, Healthy Markets Association

In his testimony, Gellasch said when considering private markets overall, all private factors need to be included. He repeatedly noted that investors get things wrong and mentioned the FTX situation. He stated that fraudulent firms are rare, but still exist. He closed by saying that if a company has public investors, they should be a public company.

Ms. Faith Anderson, Chief of Registration and Regulatory Affairs, Washington Department of Financial Institutions, Securities Division

In her testimony, Anderson said that what was intended as an exception for a general rule has now become the dominant form of capital formation. She stated that the Commission and Congress have allowed for companies to have unlimited investors. She noted that allowing companies to stay private limits the diversity and growth of public companies. She closed by stating that Congress and the Committee should design new legislation to allow for more investment in the public market.

Question & Answer

Moderator Leslie Van Buskirk asked panelists whether the accredited definition of “investor” discriminates against people of color and minorities. Gellasch said it is a discriminatory definition, as it is based on the discussion of wealth and income. Anderson said that investors in the public market are treated more equitably.

Van Buskirk then asked Kaplan what his thoughts were on making the pension funds industry more inclusive to investors. Kaplan said he has mixed feelings on the matter and noted that fees may need to be lowered for entry.

Panel II: Oversight of Investment Advisers: Can Regulators Keep Up with Growth in the Industry

Paul Roye, Retired Senior Vice President, Capital Research and Management Company

In his testimony, Roye discussed investor advisor oversight and regulation, which he said is bifurcated between the SEC and state regulatory authorities. He noted that as of 2021, there were over 35,000 investment advisers in the U.S. with almost 375,000 investor advisor representatives serving over 65 million clients. Roye said the number of registered SEC advisers has increased by 25% since 2016, now totaling over 15,000. He noted this growth rate far outpaces the rate of SEC staff increases. Roye also noted that the number of broker dealer firms has declined 18% since 2012. He discussed how the investment management industry is developing sophisticated trading and investment strategies, resulting in increasing complexity for compliance issues. Roye said Congress has responded to SEC investment adviser examination program capacity challenges twice, in 1996 with the passage of NISBIA and in 2010 with the enactment of Dodd-Frank. He said that effective oversight of the investment advisory industry is an important investor protection issue.

Natasha Greiner, Deputy Director, Division of Examinations; and National Associate Director, Investment Adviser/Investment Company (IA/IC) Examination Program, U.S. Securities and Exchange Commission.

In her testimony, Greiner discussed the history of the Division of Examinations, which she noted was created in 1995. She explained how the Division expanded their investment advisor and company examination programs in 2016 due to the significant growth of the asset management industry. Greiner said the Division is now the SEC’s 2^nd largest division, after the Division of Enforcement. She listed the Division’s four pillars: compliance, preventing fraud, monitoring risk, and informing policy.

Greiner highlighted the role of the Division’s Financial Systems Integration Office (FSIO) group, which is dedicated to the oversight of FINRA and the Municipal Securities Rulemaking Board. She said FSIO is critical to ensuring compliance in the securities industry. Greiner discussed the Division’s newest team, the Event and Emerging Risk team, which was formed a few years ago. She described them as the immediate response team. Greiner noted that the Division has achieved remarkable success despite continuing challenges across the industry. She said the Division of Examinations examined 15% of the registered investor adviser population in FY 2022. Greiner added that the Division hoped to maintain their coverage ratio through sustained investments in human capital and technology.

Stephen Brey, Corporations, Securities, and Commercial Licensing Bureau, State of Michigan

In his testimony, Brey discussed the North American Securities Administrators Association (NASAA), which he noted is the world’s oldest international organization dedicated to investor protection. He explained that NASAA members include the securities regulators in all 50 states, Canada, and Mexico. Brey said that while there are over 27,000 state-registered investment adviser firms, the overwhelming majority of these firms (81%) have two or fewer employees.

Brey discussed the NASAA Electronic Examinations Module (NEMO), a web-based software application available for use by state securities examiners to conduct examinations of state-registered investment advisers and broker-dealers within their jurisdictions. He added that NEMO coordinated examinations are fairly consistent across jurisdictions, and NEMO allows NASAA to advocate for investor protection policies informed by data. Brey said an educated investor is more likely to provide better services to the investing public. He also discussed NASAA’s proposed model rule to extend the validity of an Investment Advisory Representative’s (IAR) qualification exam when they are not employed or associated with an investment advisor. He added that NASAA provides resources and information to its members, including tools to form advocacy proposals and legislative solutions to ensure investor protections. Brey concluded by stating that continuing to share perspectives will benefit the investors they serve.

Karen Barr, President and CEO, Investment Adviser Association (IAA)

In her testimony, Barr explained that IAA’s membership includes a range of firms, from global asset managers to medium size firms. She said they strongly support efforts to enhance SEC examinations of advisors. Next, she provided data on the advising industry, including that most advisors are small businesses, most manage less than $5 billion, and the number of advisers and aggregate assets under management is consistently growing. Despite these trends, however, Barr said that adviser examination coverage has remained steady. She said IAA is pleased that the SEC has been able to keep pace with industry growth so far.

Barr recommended that the Division of Exams issue risk alerts with observations that distinguish between smaller and larger firms. She said it is vital to ensure the Commission has adequate resources and can continue to improve the examination program. Overall, she argued that the SEC is still in the best position to provide oversight of the advisory profession. The IAA has a long history of supporting efforts to increase exam frequency, Barr added, but they must be effective, substantive, and risk targeted. The quality of exams is as important as the number, in her view.

Additionally, Barr argued that proposed alternatives to the current model would not be a good substitute for the Commission’s own expertise. Specifically, the creation of an SRO for advisers is something the IAA strongly opposes, along with extending FINRA’s examination or rulemaking authority to advisors. She said that the cost of outsourcing regulation or oversight to an SRO would be far greater than enhancing the Commissions own program. There would also be substantial drawbacks to an SRO that outweigh any benefits. These drawbacks include minimal transparency, inefficient oversight by the Commission and Congress, and a lack of meaningful due process protections. Finally, Barr said that having an SRO would disproportionately affect small businesses.

As it relates to the imposition of user fees, Barr said that the IAA has supported the idea in the absence of Congressional funding for the oversight. She noted, however, that any legislation to do so should preclude an advisor SRO, clarify that user fees are dedicated to increased examinations, and make the fees appropriately apportioned to not hurt small advisors. Finally, she argued that third party exams have differences compared to Commission exams, should only be used to supplement the SEC’s own exams, and should be targeted, limited in scope, and narrowly tailored.

Micah Hauptman, Director of Investor Protection, Consumer Federation of America (CFA)

In his testimony, Hauptman stated that the lack of resources for the Commission to keep pace with the investor market is well documented. He said investment advisors provide asset management services to a significant number of retail investors, the bulk of whom are non-high net worth individuals. There has also been a growth in the number of advisors to private funds, who target services to retail investors. Furthermore, he said that the Divisions of Exam’s staff workload continues to expand to respond to evolving risks in the market, which suggests a need to examine investment firms much more comprehensively and rigorously. The exams should also focus on force arbitration clauses and hedge clauses.

Hauptman then discussed the variety of approaches to solving this resource problem. The first, and best, option would be funding the government fully, rather than farming out responsibilities to third party entities. He added, however, that the user fee approach offers the most optimal option for enhanced examinations outside of that. He noted that CFA used to be opposed to the idea of an SRO, but has recently been forced to reassess this position. As a result, he said that a properly designed proposal could be a solution. Furthermore, authorizing FINRA to examine registrations for compliance with the Advisers Act may make sense for multiple reasons and could ensure greater coverage of firms that provide services to retail investors that need help the most. However, he noted that it is still not clear if investors would be better off. Finally, Hauptman said that while it may be beneficial to have third party audits of investment advisors subject to the Commission’s oversight, whether it would actually be worth the costs and risks remains an open question.

Question & Answer

Moderator Paul Roye asked the witnesses if there is an optimal exam cycle or frequency. Barr said she does not have a specific number, but noted that what the SEC is doing to combine the various risk factors is what is important since some advisors pose less risk.

Committee Member Brian Hellmer noted that some people have argued that the solution is to redraw the line about which agency is going to do the examination, whether it should be the Commission or the state. Hauptman said that states are overburdened as is, so he questions whether they would have the capacity to do this as well.

Roye also asked if a properly structured third party exam program would be the best alternative in the absence of user fees. Hauptman said it could certainly help to have verification of assets as an exam step, but added that he does not have confidence in third party exams to make decisions about whether firms are compliant because they would be paid by the regulated entities. Barr raised similar concerns about determining who the entities would be and the SEC’s oversight.

Committee Member Christine Lazaro asked how the Division of Examination’s risk-based approach impacted how many exams are routine, versus the number of follow-up or cause-based exams. Greiner said the decision does not conduct routine exams. She said they follow the news and conduct exams on a cause basis.

Hellmer also asked if it is possible to increase the examination percentage without adding more employees, and Committee Chair Christopher Mirabile asked if more regionalization would increase examination rates. Greiner said more people would allow the Division to conduct more exams, adding that the SEC cannot keep asking more of its examiners. She said the Division is working to create efficiencies around limited-scope exams.

Greiner was asked about the SEC’s high attrition rate, and how the Commission is keeping and attracting personnel with the right skill sets. Greiner said keeping up with the industry is always a challenge, adding that attrition is out of their control. She said she hopes the job market stalls for the SEC so they can maintain their skilled staff.

Roye asked Brey how they avoid making the exams a check the box type exercise. Brey said that staff training is needed to make sure it does not become that type of exercise. He added that NASAA has seasoned IA examiners come in and share tips for newer examiners. Finally, Roye asked how NASAA is keeping up with the growth of advisors in Michigan. Brey said it remains to be seen. He noted that being remote during COVID-19 made things easier, but said that there are also some things that are lost by not being able to go in person.

Panel III: Open-End Fund Liquidity Risk Management/Swing Pricing Rule Proposal

Cien Asoera: IAC Investor-as-Purchaser Subcommittee Chair; Financial Advisor, Edward Jones

Asoera said the SEC would require a hard close on mutual fund orders for U.S. investors to effectively implement swing pricing. He explained that this requirement would mean retirement plan participants would need to have their buy or sell orders in several hours before market close. Asoera noted that this could be as early as 1 pm on the east coast, which would be 10 am Pacific Time. He concluded swing pricing and hard close requirements could be disruptive and confusing to retail and retirement investors.

Yiming Ma, PhD, Assistant Professor of Finance, Columbia Business School

In her testimony, Ma explained that very few people paid attention to swing pricing until COVID-19, when the fixed-income mutual fund sector suffered exceptionally large outflows. She noted outflows at equity funds were much smaller. Ma said swing pricing can prevent fund runs and allows funds to adjust their net asset values to proportionally distribute the costs from investor redemptions. She acknowledged that there are concerns about unintended consequences, but noted these concerns neglect the equilibrium effect of swing pricing on fund asset holdings.

Ma said swing pricing can help the capacity for liquidity provision, noting swing pricing enhances liquidity provision for the majority of corporate bond funds. She said there is no need to worry that investors are getting less, as a cap on the swing factor essentially makes swing pricing ineffective after that cap is reached. Ma discussed how several EU jurisdictions lifted caps and saw funds apply higher swing factors during COVID-19. She said outflows and inflows must reach a certain threshold before the swing factor is applied, adding that the presence of a threshold could be a trigger for investors. She concluded by emphasizing her strong support for the implementation of swing pricing for open-end funds, while suggesting a careful design surrounding the specifics.

Shelly Antoniewicz, Senior Director, Industry and Financial Analysis, Investment Company Institute (ICI)

In her testimony, Antoniewicz said ICI cannot support the SEC’s swing pricing proposal. She explained ICI’s concern that the 100+ million investors who use mutual funds to save for their financial goals will be adversely impacted. Antoniewicz added that the proposed swing pricing mandate would force all mutual funds to swing their price, fundamentally changing how mutual funds are priced and how investors purchase and sell their shares with a hard close. She alleged the proposal’s prescriptive requirements are ill-suited and harmful to investors.

Antoniewicz said the swing pricing proposal lacks evidence about the need for minimizing dilution. She noted that mutual funds’ net sales of corporate bonds in March 2020 had little effect on bond markets. Antoniewicz explained how the proposed bucketing would confuse investors by making highly liquid funds look illiquid. She offered the examples of CVS Health Corp., UnitedHealth Group Inc., Broadcom Inc., and Comcast Corp., as large cap stocks that would be deemed illiquid under the proposal. Antoniewicz  concluded that the proposal would be extremely costly to implement and disruptive for investors, while the bucketing scheme would reduce returns, increase expense ratios, and give investors unwelcome tax bills.

Tim Rouse, Executive Director, SPARK Institute

In his testimony, Rouse said that the proposal does significant harm to workers saving for their retirement and those living on retirement savings. He highlighted four key negatives, including that:

• It will turn 130 million American savers into second class investors and favor Wall Street investors over Main Street investors;
• It will make everyday retirement plan transactions extremely difficult if not impossible;
• It will undermine the investment architecture system; and
• It will erode retirement savers’ confidence in the system, since the timeliness of prices will not be entirely available or understood.

Rouse concluded by arguing that any perceived benefits of the swing pricing proposal are vastly outweighed by the harm, disruption, and costs that would fall on retirement savers because of the hard close.

Peter Mahoney, Principal and Head of Global Fund Accounting, Vanguard

In his testimony, Mahoney said that while swing pricing is utilized as an option method of minimizing dilution in Europe, meaningful differences exist between the European and U.S. operating environments which negates any potential benefit in the U.S. Specifically, he highlighted transaction cutoffs and fund valuation points, distribution infrastructures, client treatment, timing of cash flow receipts, and mid-pricing versus bid-pricing as differences in the operating environments. As it relates to client treatment, Mahoney said that under the proposal there would be a difference between direct investors and those using an intermediary. Additionally, even with a hard close, he said that it is not a guarantee that all cash flows will be known. He also highlighted bid-pricing as a mechanism to estimate and replicate replacement costs is a viable methodology for pricing the funds, negating the need for a swing factor.

Finally, Mahoney highlighted a few additional considerations, including the optional application across Europe and the impact that full swing pricing has on investor costs. He added that accuracy is incredibly important with swing factors, as incorrect information increases likelihood of an incorrect swing factor. Mahoney also said that swing factors do not eliminate dilution, but rather minimize the ups and downs of dilution and keep it within balance. Finally, he said that from a NAV timeliness perspective there is a considerable impact, and the need to apply the swing factor will push the NAV timeframe out, resulting in individuals/intermediaries receiving prices later.

Question and Answer

Committee Member Paul Sommerstad asked if there are any pieces of the proposal that are helpful to investors. Mahoney said that theoretically there is merit in swing pricing, but the upheaval, cost, and impact on the U.S. market is where Vanguard struggles. Ma replied that there are always operational challenges changing from one system to another. She said that those challenges are a necessary investment, but the benefits of swing pricing would accrue over time. Antoniewicz recommended letting funds decide on their own whether there is material solution that needs to be addressed and allowing swing pricing to be an option along with other anti-dilution tools. She stated that this seems to be a one size fits all approach and not appropriate for the vast majority of mutual funds out there.

Committee Member Jamila Abston asked what the Commission should be doing during crisis time. She said that when there is a run on a fund, she thinks this would be a good to have a way to control things. Rouse replied that fund managers have indicated that this run did not have to do with liquidity. He said they are generally in support of the swing pricing, but indicated that there were times when they had large transactions and did not know about them in advance. Rouse added that it is possible to address those notices in advance and not cause problems for the fund. He recommended discussing those solutions.

Hellmer asked if the panel would agree that holding off on the proposal until there is close to equal treatment of all investors in a given mutual fund would be a good idea. Ma replied that unfairness should not be left untreated, but added that it is something that should be addressed in implementation. She also said unfairness is a problem now, even without swing pricing. She recognized that the hard close would potentially create further differences, but said that is not reason enough to not continue. She warned that the next time there is an event like Covid, there will be strains in these markets again.

Committee Member Andrew Park asked how else the committee should address the liquidity mismatch in many of these funds. Mirabile agreed. Antoniewicz said liquidity in the markets cannot be addressed by putting constraints on mutual funds. She said that even direct investors in securities want to sell when there is a shock because of macroeconomic or financial market developments. She recommended that the SEC focus on making the markets more resilient to supply liquidity during stress periods.

Discussion of a Recommendation on Customer Account Statements

Lazaro introduced the proposal and said that, while firms and regulators have tried to help investors understand their account statements, the guides are somewhat generic because the appearance of statements varies from firm to firm. She said that given the importance of account statements, the rules governing them should be reviewed. She said they are making nine recommendations that the SEC and/or FINRA should consider taking:

• Survey investors to understand how they use their account statements;
• Consider what amendments would be appropriate to align requirements with what investors think is important;
• Focus on standardization and simplification of statements;
• Standardize core terminology;
• Develop model account templates that are tested;
• Propose a rulemaking to require that advisors provide account statements;
• Require annual performance reports in a standardized format;
• Allow firms to include additional information; and
• Continue using paper as the default delivery method, but encourage the use of technology and electronic delivery methods.

She concluded by noting that the recommendation recognizes the need to understand what investors are looking for in account statements, ensure consistency, meet investor needs and expectations.

Mirabile said that he is concerned about annual performance versus the requirement to provide performance on ongoing basis. He also asked how to approach the tradeoffs of innovation versus standardization. Lazaro said there are differing opinions on how to capture performance on an account statement. She admitted that statements may not be the right place to track performance, but argued that investors should receive a document on a regular basis that captures performance over time. She said there should be a basic level of information that all investors are getting, especially if they have accounts at multiple firms.

Roye said that account statements have been overlooked for too long, and argued that the IAC is pointing out a gap in disclosures through this recommendation. He noted that there is some basic information that should be highlighted upfront, and it is time for SEC/FINRA to address it.

Asoera said that he is a firm believer in fee transparency, but noted the inclusion of both direct and indirect costs. He said that indirect cost is not exactly available right now, and it is hard to show the total cost. He recommended focusing on what the particular intermediary or firm is charging.

Committee Member Nancy LeaMond supported the recommendation, and said there needs to be a better way to communicate clear, concise information to people. Member Brian Schorr also thought it was critically important because it is impossible to compare statements from accounts with different statements. Member Ted Daniels said the recommendation is worthy of moving forward as well.

The recommendation on Customer Account Statements was approved by all members except Asoera. The recommendation will progress towards issuance of publication.

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