Securities and Exchanges Commission (SEC): Investor Advisory Committee Meeting

Securities and Exchanges Commission (SEC)
Investor Advisory Committee Meeting
Thursday, March 7, 2024

Topline

Panelists debated the SEC’s equity market structure and engaged in a discussion around materiality guidance.
Panelists voted favorably on recommended changes to the SEC’s predictive data analytics proposal.

Witnesses

Christopher Mirabile, Chair, Investor Advisory Committee, Senior Managing Director and Board Member, Launchpad Venture Group
Gina-Gail Fletcher, Professor of Law, Duke University School of Law; Vice Chair of the Investor Advisory Committee Market Structure Subcommittee
Andrew Park, Senior Policy Analyst, Hedge Funds and Private Equity, Americans for Financial Reform; Chair of the Investor Advisory Committee Market Structure Subcommittee
Mehmet Kinak, Vice President and Head of Global Equity Trading, T. Rowe Price Group, Inc.
Dave Lauer, Chief Executive Officer, Urvin Finance; co-founder, We The Investors
John Ramsay, Chief Market Policy Officer, IEX Exchange
Professor Chester Spatt, Pamela R. and Kenneth B. Dunn Professor of Finance, Tepper School of Business, Carnegie Mellon University
Anna Ziotis Kurzrok, Managing Director, Jefferies LLC
James Andrus, Vice President, Sustainability Global Markets, Franklin Templeton; Chair of the Investor Advisory Committee Investor as Owner Subcommittee
Professor Preeti Choudhary, Professor of Accounting, Eller College of Management, University of Arizona
Professor George Georgiev, Associate Professor of Law, Emory University School of Law
Professor Joseph Grundfest, Professor of Law & Business, Emeritus Senior Faculty, Stanford Law School
Lynn Turner, Senior Adviser, Hemming Morse Forensic and Financial Consultants
John White, Partner & Chair of Corporate Governance and Board Advisory Practice, Cravath, Swaine & Moore LLP
Mr. Paul Roye, Senior Vice President, Fund Business Management Group of Capital Research and Management
Cristina Martin Firvida, Director, Office of the Investor Advocate
Mr. Brian Hellmer, Chief Investment Officer, Mendota Financial Group
Ms. Leslie Van Buskirk, Vice Chair, Investor Advisory Committee

Opening Remarks

Chair Gary Gensler

Chair Gensler began by thanking retiring members of the IAC for their time on the Committee. He first brought up the equity market structure panel discussion and said the SEC finalized a rule shortening the settlement cycle and noted that the IAC recommended this rule nearly nine years ago. Gensler said that this rule is vital and that it lowers risks in the system and helps investors. He also noted the finalization of updates to rule 605 done the day prior in light of the equity market structure panel and said staff are still considering changes to the other equity market proposals. Gensler said that one of proposals makes changes to the national market system to bring greater competition to the market. Another proposal is designed to establish the best execution standard, which currently only exists at the SRO level. Gensler said he was shocked to see the SEC did not have a best execution proposal and that it would in effect require advisors to seek the best execution for their clients. The final two rules dealt with an auction system to replace deals for order flow, and a more recent rule on volume-based pricing.

Gensler moved on to the panel discussion on materiality and highlighted the SEC’s finalization of the climate disclosure rule and supported the materiality standard. He said it is a standard that appears in numerous rules, including in the climate rule that was just finalized. Gensler noted that materiality is standard in international law, as well as US law.

Turning to the digital engagement practices recommendations discussion, Gensler said that AI is the preeminent technological development of our era and noted that the robo-advisers and other technology must only take into account the interests of investors rather than the interests of the platform they are housed on. He closed by highlighting that the SEC proposed a rule to deal with conflicts of interest in technology last year.

Commissioner Hester Pierce

Peirce said that she agrees with Chair Gensler on at least one issue, noting that they both voted to advance updates to rule 605 and she believes the data from that update should be the basis for any equity market structure changes. She said that the SEC must identify that there is a problem before moving forward with any of the other equity market structure proposals.

Peirce then spoke to the materiality panel and said that she does not support the climate rule that was finalized in part because she does not believe it is based in materiality. She said if the SEC moves away from materiality, then you’ll end up with a hodge podge of immaterial information that firms are forced to produce at a cost to investors. She asked the IAC to consider their opinions on materiality in the context of greenhouse gas emissions. Peirce questioned the changes in draft recommendations for digital engagement practices and said she had hoped the IAC would have allotted more time to discuss the new recommendations.

Commissioner Caroline A. Crenshaw

Crenshaw began by thanking various members of the Committee for their service to the SEC. She said that she supports the Commission’s efforts on its equity market structure proposals and said their goal is to increase competition in the market and ultimately benefit investors. Crenshaw also said that she urges the discussion on materiality and SAB 99 to highlight SAB 99 as a bedrock of securities law and its importance.

Panel Discussion: Discussing the U.S. Securities and Exchange Commission’s Proposals to Improve Equity Market Structure

Gina-Gail Fletcher, Professor of Law, Duke University School of Law; Vice Chair of the Investor Advisory Committee Market Structure Subcommittee

Fletcher explained that equity market structure has a significant impact on all market participants. She said that most equity market structure rules were made with Regulation NMS and noted that there have been very few changes to market structure since that regulation. Fletcher said that the lack of updates to market structure are concerning considering the vast technological changes that have occurred, highlighting some complaints she has heard including that transaction fees are too high, order routing issues, and others. Fletcher said that the five equity market structure proposals from the SEC would have drastic changes to the market.

She began the discussion by mentioning the recently finalized reforms to rule 605. Fletcher said the final rule expands who files the reports to include large retail brokers, requires brokers that operate ATSs to file separate reports, contains new time stamp conventions, and has order execution time buckets. She emphasized that the final rule, unlike the proposal, does not require the reports to be filed into a central database and asked the panel for their thoughts.

Dave Lauer, Chief Executive Officer, Urvin Finance; co-founder, We The Investors

Lauer noted that it has been time to update these rules for over a decade and said he is glad the SEC is making these changes. He explained that transparency within itself can lead to changes in behavior and noted that the current rule 605’s first time bucket is 0-9 seconds, which in today’s markets is an eternity. He also said new order types will be captured by this rule which will allow for more visibility into how a market center is processing these order types. Lauer said this is especially great for smaller firms who don’t have large quant arms to analyze broker-order execution.

Fletcher then asked where and to whom the new rule 605 reports will be most useful.

Anna Ziotis Kurzrok, Managing Director, Jefferies LLC

Kurzok said that transparency and information will be useful to all investors, but the most direct uses will be to retail investors who don’t have the transparency that broker-dealers have. Kurzok said that she is very curious to see what these reports will look like in its current framework, and to see how this report will show the market has evolved.

Mehmet Kinak, Vice President and Head of Global Equity Trading, T. Rowe Price Group, Inc.

Kinak said he thinks its imperative for the SEC to do these kinds of engagements with industry and that the SEC should do these more often. He noted that his firm, T Rowe. Price has $1.4 trillion under management and manages money for individual investors. Kinak said it was great to see 605 get passed and that we are all supportive of additional transparency. He referenced Lauer’s comment about how transparency will bring changes in behavior and said that we need to be aware that reforms to rule 605 will have an impact on market participants and that any changes to equity market structure after rule 605 should be incremental and based on new 605 data. He said 605 provides better measures for the SEC to use. Kinak said that he is not sure that T Rowe Price would use the data as they have access to other data, but that this is really for individual investors. He also noted that he had never heard of individual investors making use of 605 data in the past, so he’s not sure how much use it will receive.

Fletcher then asked how the lack of centralization of these reports will affect their usefulness.

John Ramsay, Chief Market Policy Officer, IEX Exchange

Ramsay said he does not think the centralization of these reports would make them significantly easier to use. He said he expects that as is currently the case, individual brokers and advisers will pull the data and provide it to their investors in forms that are most useful. He also pushed back on Mehmet’s point of view on using 605 as a predicate for any other equity market structure reforms. He said that 605 was never intended to provide a primary data source of what other market reforms were necessary, and that some pieces including the tick size proposal do not need to wait for whatever information 605 reports might glean. Ramsay said that this is an attempt to avoid more changes to equity market structure.

Lauer added he believes some on the panel are under selling the 605 data and that he thinks that the new reports will lead to retail brokers having to publish summary reports and other sites that aggregate and visualize that data for use by investors.

Fletcher asked what Spatt’s overall thoughts on 605 are.

Professor Chester Spatt, Pamela R. and Kenneth B. Dunn Professor of Finance, Tepper School of Business, Carnegie Mellon University

Spatt said he thinks the adoption of 605 was a good thing that will result in improved disclosure. He said that there is a lot to be learned from more informative disclosures and noted that he reached out to some brokers to provide data about their order routing that he wrote an academic paper on which found that brokers do recognize that they need to hold the feet of the wholesalers to the fire and that the data on that is striking. He said brokers reroute orders often for better execution and that the extent to which that type of data is shown is positive. He noted that this data he collected was specific to the equity space.

Fletcher then moved the panel on to the SEC’s tick size proposal. She asked how what impact disclosing the value of fees before a trade occurs instead of after to have on the market.

Ramsay said that he believed that this is one part of the proposal that was less controversial. He said the idea around the proposal is just to say that whatever the economics are around a trade, if it’s a tier trade you use last month’s volume instead of current volume, so at the time a trade happen anyone who wants to trade can know what the economics are around a trade.

Kinak pushed back on those assertions and maintained that knowing what the fees of a particular transaction are before or after would not change anything and that most brokers do not route orders based on incremental fees. He said that at T Rowe Price and many other institutions like it, he has not heard of anyone routing orders based on rebates or fees.

Fletcher brought up another part of the proposal, the reduction of tick sizes, which proposes four pricing increments and asked what thoughts panelists thought.

Kurzrok said that some of the ticks are a bit too granular because depending on how the stock trades, firms may not want to cross the spread and that firms may wait to trade a block off exchange. She said there are real concerns with the potential outcome of this proposal. Kurzrok said that new round lot sizes may change tick sizes so they aren’t in sync with each other, and that there could be some confusion and harm.

Lauer said that the problem the SEC is trying to solve is that there are stocks that are highly tick constrained and that this partially drives trading that takes place off exchange. He noted that many commenters agreed with aspects of the rule. He also said this rule will remove some of the advantages off-exchange trading has.

Ramsay noted that the one cent standard the SEC established is outdated and the market has changed drastically. He said there are a lot of stocks that would benefit from more granular tick sizes. Ramsay said the real question is what is the level that would benefit investors and that he believes investors would be interested in a half a cent increment but that one tenth of a cent increments are likely too granular.

Kinak said we shouldn’t assume dark trading is bad trading and that dark venues exist because certain industry participants can find better execution on those venues because they can place large orders while remaining hidden from the market. He said that if he placed 100,000 orders on a stock, it would impact that stock. He said quotes are important, but so are trades and that each trade goes to the tape. He said when someone trades 100,000 trades on a stock that is better price discovery than a quote. Kinak then said that when you are tick constrained, you can’t narrow that price anymore. He said if you narrow the tick, you will see a significant decline in displayed liquidity as those tick sizes. Kinak said when it comes to half a penny, you should find the correct stocks that are actually tick constrained. He explained that a stock with a 4-cent spread is not tick constrained as the current tick increment in 1-cent.

Spatt said that on the issue of dark vs lit, firms that are not accepting payment for order flow are routing similar to the ways firms that do accept payment for order flow route. He said that off exchange is not necessarily nefarious, and that it provides a clear advantage in some cases. He also voiced support for Kinak’s position on this specific point.

Fletcher then asked about reduced fees under the proposal, and asked what the right access fees are in the panel’s opinion.

Ramsay said that when the SEC created this structure, exchanges would have the benefit of protected quotes and so access fees were capped. He said there is wide consensus of shrinking that cap and that access fees currently serve as a hidden tax on trading for investors.

Lauer said that he believes the SEC should remove the access fee cap and that getting rid of rebates and payment for order flow would allow for that. He said this is an example of handcuffing the on-exchange players for the benefit of off-exchange trading.

Kinak said that regulations require that brokers go to exchanges with the best quotes for trading and so access fee caps exist to prevent exchanges from forcing brokers to pay whatever fees they want if they have the best price.

Fletcher then asked about the panel’s thoughts on the order competition rule.

Spatt said on the issue of order-by-order auctions, brokers look at history from wholesalers and route based on that history and that the data he got from brokers confirms this theory. He said that he believes that traditional market makers would likely pull back as a result of this rule.

Kurzrok said that the rule is well-intentioned but that the number of venues that would qualify as an auction is so limited that competition would be diminished significantly.

Kinak said this is a one sized fits all approach. He said you don’t want an OCR coming in as a held order, and no one is obligated to be there. He explained liquidity will be a big issue for many market participants. He also said the SEC should not change all aspects of market structure and should incrementally make changes.

Lauer said off-exchange trading is not competitive and that this rule seeks to improve market quality. He said the auction element is likely not necessary but a trade out rule would be very helpful to improving market quality.

Panel Discussion: Examining the use of Materiality as a Disclosure Standard — Can the Definition be Improved to Better Serve Investors?

James Andrus, Vice President, Sustainability Global Markets, Franklin Templeton; Chair of the Investor Advisory Committee Investor as Owner Subcommittee

Andrus said the panel would focus on materiality and its impact on securities law and regulation. He noted that this year is the 25th anniversary of SAB 99. Andrus said that the SEC’s Climate Disclosure rule contained the word materiality more than 1000 times. He said in today’s rapidly evolving business landscape, the role of materiality and guidance provided by SAB 99 is more important than ever.

Andrus asked John White to share initial thoughts on materiality.

John White, Partner & Chair of Corporate Governance and Board Advisory Practice, Cravath, Swaine & Moore LLP

White said that consistent, comparable, and reliable disclosure is at the heart of our securities laws and that materiality is a vital piece of that. He referenced a statement from Chair Gensler earlier in the day who called materiality the “bedrock” of securities law. He said that information is material if there is substantial likelihood that a reasonable investor would consider it important in making an investment decision. White said the Supreme Court decisions that established materiality stand the test of time and are the law of the land today. He said that it is a company specific standard meaning that the facts of a particular firm matter when determining whether information is material or not. White said that SAB 99 provided guidance on materiality in financial statements and builds off the Supreme Court cases while adding that the size and magnitude is only the starting point meaning that qualitative factors had to also be taken into account. He said he felt that SAB 99 stood the test of time and that he has not heard anyone say that the factors in SAB 99 are outdated. White said there is some implementation guidance that may help, but that he does not feel it needs big changes.

Professor Joseph Grundfest, Professor of Law & Business, Emeritus Senior Faculty, Stanford Law School Grundfest said that he has vast experience with the concept of materiality and that most importantly, he has learned when to ignore the concept of materiality and not care whether something is material at a particular moment in time. He said that many material problems start small and grow, but if you catch a problem while it’s sub-material you can prevent it from becoming a material problem. Grundfest said he sees this as an issue frequently, where firms find sub material problems and do not stop them from becoming material problems. He noted that sometimes employees hide sub materials problems from their management and the board because those problems are not material which is very disastrous thinking. Grundfest said he feels that when you think of materiality in such absolute terms, you often miss the opportunity to solve sub material problems before they become material.

Professor George Georgiev, Associate Professor of Law, Emory University School of Law

Georgiev said that the concept of materiality is fundamental to securities law but its meaning is always dependent on context. He said we shouldn’t look at the succinct definition the Supreme Court put out and think that can answer the question of whether or not the SEC can require something to be disclosed. Georgiev then pushed back on arguments that the SEC should only require disclosure for issues that are material to all firms, and said that all companies face different material problems that likely require different disclosures.

Professor Preeti Choudhary, Professor of Accounting, Eller College of Management, University of Arizona

Choudhary said her views on materiality are formed by looking at large data sets and noted she shared four studies with the panel from which she had a series of observations. She noted that materiality judgements are substantially pervasive in financial reporting. Choudhary then said that the discretion in materiality largely stems from the notion that this judgement requires context and because of that it can be exercised opportunistically. She continued saying that small and immaterial errors do grow in significance over time and increase the likelihood of material errors. Her final observation was that there is a pattern of managers not addressing immaterial errors when identified allowing them to come back to haunt them.

Lynn Turner, Senior Adviser, Hemming Morse Forensic and Financial Consultants

Turner said that he agreed with everything that Grundfest said and emphasized that most issues with materiality are issues of oversight, governance, accountability, and enforcement. He explained the history behind materiality, and said that vitally, material information is information that would affect investors decision making. He said that the SEC at the time of SAB 99’s release met with 50 different groups, and he said that FASB more than two decades ago expressed the same concerns that Grundfest expressed prior. Turner said there is language on the books that says that firms can’t ignore sub material information that could become material information.

Andrus asked Lynn what he would improve or change about SAB 99.

Lynn said he would require disclosure of a company’s significant accounting policy for materiality. He said the UK started requiring disclosure of how firms determine materiality and the quantitative magnitude of it. He applauded this rule and said that disclosures in the UK work well.

White added that he agreed with Grundfest on his point. He referenced Georgiev’s points on materiality in agency rule making and said that many rules as a package are material while having individual pieces that aren’t material. White then brought up Choudhary’s study about fraud and said that SAB 99 addresses immaterial statements that are intentionally made which is fraud. He also said that her data on auditors may be outdated and that her points on auditors waving errors might be overstated.

Choudhary responded to White’s points about her data. She said that 41% of audits waved all errors which informed her point about pervasive waving of errors by audit firms. She said the sample did end in 2015, but that Sarbanes Oxley was meant to solve many of these issues and did not. She also noted that she hasn’t found any evidence that these errors have changed over time.

White said that many of the errors are not as serious issues based on a collection of uncaught errors gathered by audit firms. He explained that many errors are self-correcting, and another large portion come from sample estimates that could be corrected or be corrected at a later date.

Grundfest jumped in and agreed with White that many sub material errors like this are reasonable and said that it is important to see whether these errors are always trending in the same direction to ensure there is no fraud or serious issues.

Turner said he has seen some of what Choudhary is reporting in his own work and referenced a speech done by the Chief Accountant of the SEC in 2022 that confirmed some of what she is saying. He also noted that training to become an auditor is limited on materiality.

Choudhary disagreed with White’s points about sample estimate errors as errors are only determined based on information known at the time of estimate. She said this would mean the scenario White pointed to, likely would not wind up in her numbers.

Andrus asked if the reasonable investor standard has changed since it was introduced.

Georgiev said that the definition has not changed but that reason able investor behavior has changed. He said that if more investors have become interested in sustainability, then we should seek to accommodate that as behavior changes. White noted that the rule was changed significantly from proposal to finalization and Georgiev asked the question of whether that was done for political expediency or because of the comment file.

Discussion of a Recommendation Regarding Digital Engagement Practices

Mr. Paul Roye, Senior Vice President, Fund Business Management Group of Capital Research and Management

oRoye said the new draft of the new recommendations are a result of fine tuning by members of the IAC following the December meeting. He said that while many industry commenters recommended the SEC abandon the proposal, the IAC’s recommendation does not recommend the SEC withdraw the proposal. He said that the proposal should be modified, and key terms narrowed to avoid unintended consequences and adverse effects on investors while not impeding the adoption of new, beneficial technologies. He said the recommendations would be an overlay over existing requirements but be designed to align with existing requirements like Regulation Best Interest and the Adviser fiduciary duty interpretation. Roye said that their recommendations would narrow the definition of covered technologies to target the unique risk of AI and predictive data analytics. He also said that they would narrow the definition of investor interaction to include technologies that interact directly with investors or that aid in an interaction with investors. He said the recommendation also proposes using the existing framework to mitigate or eliminate conflicts of interest when disclosure is inadequate. Roye said these changes would substantially increase investor protection. He noted that the PDA proposal pulls away from disclosure, but that a number of IAC members felt a one size fits all shift from disclosure was a bridge too far.

Christopher Mirabile, Chair, Investor Advisory Committee, Senior Managing Director and Board Member, Launchpad Venture Group

Mirabile said that he believes that the SEC should take a heightened regulatory approach to deal with these emerging and powerful technologies but also noted that these tools have the ability to bring the cost of investing down and allow for access to the market for retail investors. Mirabile expressed support for the recommendations as they acknowledge the dangers of AI while still allowing technology to continue to be developed and used.

Cristina Martin Firvida, Director, Office of the Investor Advocate

Firvida said that she is glad these recommendations were reworked following a lack of consensus on them in the prior meeting. She said that the added clarity of the new recommendations is important but that she does not support the recommendations. Firvida noted that the covered technology definition in the recommendations is not broad enough and that in her view firms should not be able to address conflicts of interest through disclosure alone. She said this is the more effective approach to protecting investors as many of the technologies at hand are highly complex and opaque, and disclosures would likely not be adequate. She also said that due to the scalability of covered technologies, that a much greater scale of investor harm is now possible.

Hellmer clarified that they pulled the vote because they thought they could do better, not because there wasn’t consensus.

Ms. Leslie Van Buskirk, Vice Chair, Investor Advisory Committee

Van Buskirk said that she cannot support the recommendations because she agrees with the SEC’s approach of keeping a broad approach toward DEPs. She said she believes that the SEC is attempting to address conflicts at the earliest opportunity, whereas these recommendations would not be helpful to that end and harm investors, industry, and markets. Van Buskirk also said that the final rule should cover both direct and indirect investor interactions.

Vote

The motion passed and the recommendation was approved.

For more information on this meeting, please click here.

For an archive of past SIFMA hearing coverage, please click here.