SEC chair Gary Gensler said last week that the regulator will delay progress on proposals to regulate artificial intelligence and expand custody rules covering investment advisers.
He also said the SEC would coordinate with banking regulators on possible changes to the liquidity risk-management rule that set off a firestorm of protest among fund boards after it was announced in November 2022, but left unclear whether those consultations would delay the rule’s finalization.
The SEC has received such “robust” feedback to the AI/predictive analytics rule it proposed in July 2023 and to Safeguarding Rule changes it proposed in February 2023, that Gensler has sent both proposals back to the SEC staff with instructions to evaluate whether they need to be rewritten and re-proposed later to allow public comment on proposals that had been significantly changed.
“I’ve asked staff to consider whether it would be appropriate to seek further comment, possibly, on a modified proposal,” he said of both proposals.
The decision appears to be an acknowledgment from Gensler of increasing resistance from the courts, White House and Democrats in Congress to what even supporters have said is an “aggressive” regulatory agenda.
AI/custody: Back to the drawing board
Gensler’s statements about the custody and AI/analytics rules heavily implied that intense public opposition had caused the SEC to pull both rules from immediate consideration while SEC staff attempt to resolve long lists of legal and procedural objections listed by rule opponents with the goals the SEC was trying to achieve with new regulations.
The AI/analytics rule proposed in July 2023 would require investment advisers to make sure they could demonstrate that any AI systems they use avoid conflicts of interest that could profit advisers at the expense of investors.
Critics charged that the rule, which Gensler has repeatedly described as targeting robo advisers, especially those at online-focused rather than traditional advisers, was written so broadly that it doesn’t limit restrictions to analytics powered by artificial intelligence or machine learning.
The ambiguity around which technologies are regulated and which are not would effectively have shut down innovation among investment advisers worried that the rule would apply a broad assumption of wrongdoing to every type of computer system an adviser might use, according to critiques from both the Investment Company Institute (ICI) and the Investment Advisers Association (IAA). both of which have demanded that the rule be withdrawn and rewritten.
“The SEC needs to withdraw this bad idea, go back to the drawing board and develop a narrow proposal that actually protects investors and addresses the issues chair Gensler laid out when the commission unveiled it,” ICI president and CEO Eric Pan said in March while praising the SEC’s role as a regulator but slamming the Gensler SEC’s approach to regulatory reform as sloppy, overly ambitious and, ultimately, harmful to the industry.
The AI/analytics rule was a missed opportunity for the SEC, according to IAA president Karen Barr, who reiterated the IAA’s demand that the AI rule be withdrawn days after a confrontation at an IAA conference March 8 during which Gensler avoided Barr’s questions about the practical use of AI and insisted the SEC needed a the new rule to enforce rules against conflict of interest.
Existing rules do that regardless of what technology is involved, Barr said. And, by focusing on one flawed rule, the SEC was ignoring the chance to build effective regulations using the answers from a recent examinations sweep that included detailed questions about how the industry is actually putting AI to use, and a whole host of problems to which AI could bring a unique twist, including data privacy, security, transparency, explainability, the use of copyrighted material and user-trust, Barr said.
Proposed changes to the Safeguard Rule drew similar accusations of sloppy language in the text of the rule, a broad-based assumption of wrongdoing and the need for costly changes in process, contract responsibility and the need for follow-through.
The language of the rule is so broad that it would force custodial responsibilities on many more companies than now have to fulfill those roles – which is a “major departure from current market practices” according to a 2023 analysis from Mayer Brown LLP.
“The custody rule would have enormous ramifications for the entire financial services industry, as the treasury department noted,” an Investment Company Institute (ICI) spokesperson wrote in reply to questions about Gensler’s changes to the regulatory agenda.
“It is entirely appropriate that the SEC receive more comments, and we feel confident that the facts and data regarding both these rulemakings lend themselves to a complete revision of the proposal.”
“Both of these proposals are significantly flawed,” Barr wrote in reply to emailed questions about the SEC’s decision to withdraw and reconsider the rule. “The SEC may be rethinking its fundamental approach to these issues, and it is appropriate that it provide the opportunity for all affected parties to analyze and comment on any new approaches.”
Liquidity rule: Closing regulatory gaps
The implications are less clear about Gensler’s statement that the SEC would consult with banking regulators about the widely despised liquidity/swing-pricing rule, which raised anxiety levels across the industry and prompted an unprecedented level of kickback from fund boards early last year.
Gensler did not address during his talk whether the consultation might delay progress toward final resolution of the controversial rule while the SEC consulted with banking regulators on whether to extend its requirements to the collective investment funds (CITs) that are managed by bank trust departments and about tax-qualified retirement funds.
“We know from history that financial fires can spread from regulatory gaps, including when regulations don’t treat like activities alike,” Gensler said during the May 16 event. “In considering possible next steps, I’ve asked staff to consult with bank regulators on how to best mitigate for regulatory gaps between collective investment funds and open-end funds.”
The $7trn held in CITs at the state and local level are exempt from SEC oversight and “lack limits on illiquid investments and minimum levels of liquid assets,” Gensler said.
“There is no limit on leverage, requirement for regular reporting on holdings to investors or requirements for an independent board,” Gensler said.
Adding the uncertainty of a possible delay raises the level of stress caused by a rule that is already near the top of fund directors’ list of worries, according to directors attending ICI’s Leadership Conference in Washington, D.C. this week.
Gensler refused to be any more specific about potential changes or delays even when asked to do so during a press event following his May 23 appearance at the conference.
“I chose my words carefully in that speech,” Gensler said. “We’re really thinking through how that $7 trillion in Collective Investment Trusts relate to this [open-end fund] space.”
“From [this] one commissioner’s perspective, this is like ensuring there’s not an arbitrage,” Gensler said. “This $33trn regulated investment company space is well regulated and has investor protection; I wouldn’t want to lose that.”
The most recent version of ICI’s Investment Company Facts Book estimated that U.S.-based open-end funds held $33.6trn under management at the end of 2023.
Ignoring that comparatively small segment of the market, while addressing the SEC’s concerns about fund liquidity in open-end funds and money-market funds, leaves a significant gap in the market that could create problems later, Gensler said in his original speech.
The SEC addressed those concerns previously in money-market liquidity rules it adopted in July 2023, and in similar rules proposed in November 2023 that would make swing-pricing mandatory for open-end funds.
There is no indication of how close to a decision the SEC may be to a decision about open-end funds, but many SEC watchers assume the March acknowledgment by deputy Division of Investment Management director Sarah ten Siethoff that swing pricing would be logistically difficult is a good indication that the SEC will avoid mandatory swing pricing for open-end funds just as it did with money-market funds.
“The infrastructure in the U.S. is just in the state that makes swing pricing very challenging,” ten Siethoff said during a March 18 panel session at an ICI conference in Palm Desert, Calif.
“That doesn’t mean it will turn out the way they want it,” Mutual Fund Directors Forum president Carolyn McPhillips told Fund Directions last week. “There were additional required fees in the money-market rule and there are some tough things in the open-end fund [proposal] that didn’t get a lot attention because people were talking so much about swing pricing.”
“People should never think any particular thing we do in one spot is going to mean that we’ll take a rinse-and-repeat approach to something else,” ten Siethoff said during the March 18 session. “We understand that money market funds and open-ended funds are not the same thing, and the lessons we take away differ in a lot of ways.”
