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'Regulation by Enforcement' Battle Reaches Full Tilt

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There’s a new battle raging over so-called “regulation by enforcement.”

The Financial Services Institute has just launched a campaign to halt the Securities and Exchange Commission’s Share Class Selection Disclosure Initiative — which FSI along with former SEC Commissioner Paul Atkins argue is regulation by enforcement.

FSI’s online “Call to Action” encourages interested parties to contact Congress, stating: “It’s time for the SEC to return to required rulemaking to impose new regulations, rather than regulating without rules.”

Former SEC Chairman Harvey Pitt argues, however, that, while he’s not a fan of regulation by enforcement, the securities regulator has long employed the practice and through the share-class initiative is trying to get a handle on a widespread industry problem.

The initiative, FSI states, is the “kind of drive-by regulating without rules [that] harms independent financial services firms and American investors.”

Independent financial firms and advisors, FSI continues, “have a reasonable expectation the SEC will establish clear rules of the road before engaging in enforcement.”

In early March, the SEC announced that as a result of the share-class initiative, 79 investment advisors would return $125 million to clients as part of settled actions for directly or indirectly receiving 12b-1 fees for investments selected for clients without adequate disclosure, including disclosures that were inconsistent with the advisors’ actual practices.

The SEC enforcement division should “stay further enforcement actions” under the initiative, FSI argues, and not expand it further, “until appropriate rules addressing the Commission’s concerns have been adopted.”

With the initiative’s new focus on revenue sharing, “the SEC is compounding their mistake by extending the logic to other streams of revenue in phase two,” David Bellaire, FSI’s general counsel, told ThinkAdvisor on Friday in a statement. “It’s time for the SEC to call a timeout on regulating without rules. We are asking them to play the game fairly by proposing a rule and enforcing it prospectively.”

Atkins, CEO of Patomak Global Partners in Washington, noted in a recent ThinkAdvisor blog post that “alarmingly, in neither announcing the Initiative nor the subsequent settlements did the SEC cite violations of any particular rule or regulation as support for its view of the sufficiency of the disclosure — a disclosure that had long been standard in the industry — but instead referred to previously pressured settlements that do not carry the weight of law.”

Pitt, CEO of Kalorama Partners in Washington, told ThinkAdvisor in a Friday email message that he “understands fully” Atkins’ concerns. Many decades ago, Pitt said, he co-wrote a paper on the topic.

That being said, “the Commission has had a long history of tackling industry-wide issues by collective enforcement actions, so the current [SCSDI] effort is not new,” Pitt said. “The advantage of what the Commission has done here includes not singling out individual firms, which perhaps creates competitive dislocations, but rather treating an industry segment as a collective whole, and addressing an industry-wide problem.”

Further, Pitt said, “utilizing this type of global approach enables the Commission to tackle a broad issue in specific factual contexts. That makes the enforcement settlement process employed here a very effective tool to describe what it is the Commission finds problematic, and deal with the entire industry in one fell swoop.”

While it’s “always preferable that those subject to arcane legal requirements be advised of the nature of those requirements before those requirements are enforced,” the “establishment of an industry-wide segment enforcement program effectively concedes that the industry — as a whole — did not fully appreciate the nature of the obligations required.”

Because of this, “I do not think the Commission should be criticized for coming to grips with a broad problem.”

Pitt also stated that “Whether or not the SEC has previously indicated that certain conduct may violate the federal securities laws, Commission inaction cannot be relied upon as a defense if the conduct in question actually violates the federal securities laws. In fact, the securities laws make it a crime to argue that any Commission inaction somehow constitutes approval of any individual or entity’s misconduct.”

Barbara Roper, director of investor protection for the Consumer Federation of America, added that “If you support principles-based regulation, as FSI claims to do, you have to also support enforcement based on those principles, rather than only basing enforcement actions on clear rules. Otherwise, what you’re actually advocating is non-enforcement.”

This is significant in the context of SEC’s Regulation Best Interest, Roper said. “Reg BI doesn’t define best interest or clearly describe what brokers must do to mitigate conflicts,” she said. “Under FSI’s proposed approach — which would only allow enforcement where you can show a clear rule violation — the principles-based standards at the heart of the rule would be unenforceable. Calling for ‘a return to required rulemaking to impose clear regulation’ is pretty cynical coming from such staunch supporters of Reg BI.”

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