Agency Staff Regulatory Guidance

Financial Services Practice Group Teleforum

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Agency staff regulatory guidance, speeches, and settled enforcement actions can be helpful to the regulated community when seeking to comply with the law; but when agencies use those statements as if they are the law, thereby bypassing the Administrative Procedures Act, such actions can take the regulated by surprise and run afoul of due process. A recent example exists in the mutual fund industry with the SEC’s Share Class Selection Disclosure (SCSD) Initiative, which essentially holds investment advisors liable for not complying in 2013-2017 with a standard first articulated in 2018, but the use of regulatory guidance is being challenged across various agencies and jurisdictions.  In the face of congressional push-back, bank regulators and the SEC last year clarified that agency staff “guidance” is not a rule and claimed that they “do not take enforcement actions based on supervisory guidance.”  In connection with CFPB guidance regarding auto lending, the Government Accountability Office found that the guidance was a “rule” for purposes of the Congressional Review Act and thus subject to congressional disapproval.  The Supreme Court also is considering cases such as Kisor v. Wilkie regarding judicial deference to administrative agencies.  This panel will discuss the evolution of regulatory guidance, the limits on its appropriate role, and its current usage by administrative agencies.



Moderator: Paul Atkins, CEO, Patomak Global Partners

Barry Barbash, Senior Counsel, Willkie Farr & Gallagher LLP

Buddy Donohue, Mutual Fund Independent Director

Brian Rubin, Partner, Eversheds Sutherland

Event Transcript

Operator:  Welcome to The Federalist Society's Practice Group Podcast. The following podcast, hosted by The Federalist Society's Financial Services & E-Commerce Practice Group, was recorded on Friday, September 13, 2019, during a live teleforum conference call held exclusively for Federalist Society members.  


Micah Wallen:  Welcome to The Federalist Society's teleforum conference call. This afternoon's topic is on "Agency Staff Regulatory Guidance." My name is Micah Wallen, and I am the Assistant Director of Practice Groups at The Federalist Society.


      As always, please note that all expressions of opinion are those of the experts on today's call.


      Today we are fortunate to have with us Paul Atkins, who is the CEO of Patomak Global Partners. Paul will be our moderator for this afternoon and will be introducing our panel today.  After our panel gives their opening remarks, we will then go to  audience Q&A. Thank you all for sharing with us today. Paul, the floor is yours.


Paul Atkins:  Welcome to everybody today for our discussion. We want to talk about the SEC's Share Class Selection. So we're really thrilled today to have three experts with us. First is Barry Barbash, who, from September '93 until October '98 was Director of the SEC's Division of Investment Management. He's been Partner at Shearman & Sterling and currently Partner at Willkie Farr & Gallagher. And he has a number of clients who've been impacted in some way by this particular initiative of the Enforcement Division.


      Second is Buddy Donohue, who served as Chief of Staff to SEC's Chairman Mary Jo White from 2015 to 2017. And then before that, we were serving together at the time at the SEC. He was Director of SEC's Division of Investment Management from '06 to 2010. And in between, Buddy has advised clients at law firms and in-house at Oppenheimer, Goldman Sachs, and Merrill Lynch Investment Managers. And currently, Buddy is an Independent Mutual Fund Board Member.


      Last but not least, Brian Rubin, who is currently Washington Office Leader at Eversheds Sutherland's litigation group, and he's head of the firm's SEC's FINRA and state securities enforcement practice. He was former NASD, which is, of course, now FINRA, Deputy Chief Counsel of Enforcement for seven years there at the NASD, and then he was four years as Senior Enforcement Counsel at the SEC. And Brian has represented some of the firms involved in the SEC's Share Class Selection Disclosure Initiative.


      So first, let me give just a little bit of background about what we want to talk about today. So in 2018, the SEC Enforcement Division announced its launching of its Share Class Selection Disclosure Initiative. It gave investment advisory firms four months to voluntarily self-identify and report instances where the SEC may have deemed their disclosures inadequate relating to the selection of mutual fund share classes, paying fees that are known as 12b-1 fees, when a lower cost share class for the same fund was available to clients.


      So by way of background, in the 1980s, the SEC adopted a rule called 12b-1 that allows mutual funds to pay on an ongoing basis for distribution of their fund shares, provided that certain criteria were met. Those fees are known, interestingly enough, as 12b-1 fees, after the rule. At various times in the Commission's history, it's considered amendments to Rule 12b-1 because I think it's -- we can suffice it to say it was rather controversial at the adoption—and we'll talk about that in a bit—as well as considered other mutual fund fee disclosures. But despite these efforts, the SEC never proscribed a rule that would require disclosure in the specific manner that the Commission through settlement and the enforcement division had enumerated in this particular Share Class Selection Disclosure Initiative.


      The Investment Advisers Act of 1940 has broad prohibitions on fraudulent and misleading statements and also covers omissions that should've been made in order to keep information from being misleading. The SEC has adopted a number of rules under this provision over the years. So in carrying out this recent enforcement initiative, which to date has involved 79 investment management firms and has collected about $125 million in disgorgement, the enforcement division cited previous enforcement actions dating back to 2013 as well as the 2016 so-called risk alert that was issued by the Office of Compliance Inspections and Examinations, endearingly called OCIE, but the Enforcement Division could not cite a rule that had been violated with respect to the investment advisory firms in this initiative.


      The use of regulatory guidance and settled enforcement actions as precedent for enforcement activity has been a topic of interest in Washington lately with SEC Chairman Jay Clayton and numerous other heads of regulatory and financial services administrative agencies clarifying in statements over the last couple years that these tools do not carry the weight of an actual law or rulemaking. The Administrative Procedure Act sets out steps that must be taken by regulatory agencies before undertaking rulemakings.


      The process, I think all of us would agree, is cumbersome, and litigation against agencies for failing to comply with those requirements has increased the amount of time that it takes for agencies to adopt or amend a rule in the proper way. This creates a real challenge for a regulator that spots a behavior it does not like but for which a rule has not been adopted. How can it nimbly, effectively, and legally communicate with and set expectations for the regulated community? Barry and Buddy have been on both sides of this dilemma, and this is one topic that we will explore today in the context of this latest enforcement initiative.


      But before we get into the discussion, I want to note that no one on this panel thinks that investors deserve less than full disclosure about advisory practices that may present conflicts of interest. However, the adequacy of disclosure is often in the eyes of the beholder, and what may be adequate to some may be less so for others. In this case, Commissioner Hester Peirce recently remarked about this Share Class Selection Disclosure Initiative that the SEC, quote, "spotted the problem and let it fester without a definitive reaction from the Commission for five plus years," unquote. So taking as a given that we all agree that advisers have a fiduciary duty to their clients, this discussion is going to revolve around whether, given the SEC's staff silence on this particular disclosure language for years, and I should imagine the Commission -- add the Commission as well, whether enforcement was the appropriate step for the Commission to take once it decided on a policy change.


      So let's maybe start with some of the background of Rule 12b-1. So I was going to touch on -- you, Barry, maybe if you want to start about -- briefly touch on the history of 12b-1 from your experience, and Buddy, you too, while you were director of the division, both while I was there and then afterwards, you had to wrestle with some questions around 12b-1.


Barry Barbash:  Well, I think the history of 12b-1 traces out from the operation of mutual funds and the selling of mutual fund shares. One of the issues that had come up early on in the mutual fund business -- I think you can see it probably as far back as the 1940s, but clearly, it started to show in the 1960s is that mutual fund shares aren't really bought by investors. They're a complicated product. You need sellers to go out and find particular buyers or find investors.


      And one of the issues that arose early was in that kind of context when you have a mutual fund, can the mutual fund take some of its assets and use some those assets to pay for marketing? It can certainly help a mutual fund to be bigger. On the other hand, if you're an existing mutual fund investor, not having the biggest fund out there may be fine because you're getting the service that you want. And so there's always been this debate -- historically, there was a debate. Should a fund that's registered under an investment company subject to the SEC jurisdiction, should it be able to use its assets to pay for distribution? And that question was working out there.


      And as the mutual fund world went through different kinds of markets, over the course of time, the issue became more significant to answer and to deal with. And ultimately, it started to come to a head in the 1970s when the mutual fund business had some difficulties. You saw some redemptions or some questions about whether there were net redemptions in the mutual fund business or not, but the point was mutual fund companies were looking for ways to juice up sales. And the question was could you use assets of the fund to do that?


      And your history -- Buddy, I think, can give you a little bit more detail, but there's a history over the next few years, running from the mid part of the 1970s up until early 1980s, of a debate within the Commission of whether assets should be allowed—of mutual funds—to be used to pay for distribution. And ultimately, with the adopting of Rule 12b-1, the answer became yes, a mutual fund could use its assets to pay for distribution if it went through a series of measures, if it met certain conditions. And so it became Rule 12b-1.


Paul Atkins:  Yeah. And so, Buddy, I know you know some of the background about the exemptive orders and whatnot that helped to spawn 12b-1.


Buddy Donohue:  Yeah, I'm happy to discuss them. I'll try and go through them quickly because many folks are not all that interested in how we got where we are. Traditionally, the SEC and its staff had taken the position, really, that funds shouldn't pay for distribution. I will point out that, actually, the prohibition in Section 12 actually is that funds can't pay in violation of any rules. And so, Barry -- there's always been this interesting debate: if there wasn't a rule, you couldn't violate that provision of Section 12. So there really was—and you may disagree with me, Barry—but there really was no prohibition, if you would. It really was just a position that had been taken and, I think, generally agreed to by the industry that that was the appropriate response.


      During the '70s, though, a number of things were developing. You had the advent, really, of Vanguard, which was an internalized management company that was owned by the funds, so the SEC had to wrestle with. And I think in 1975 permitted the ownership, really of the adviser by the funds, and therefore for the funds essentially paying for distribution, not just for those funds, but for any funds in the group.


      At the same time, you had the emergence of money market funds and a couple of no-action requests that had been requested of the SEC. One that was done in 1976, a group called Armstrong had no-load funds that really weren't going anywhere and requested from the Division of Investment a no-action position that they wouldn't be violating the act if they took half of their management fee and essentially gave it to brokers who were selling the fund. The Commission, that level staff thought that it's their resources. The management fee hadn't been inflated to do that, and they could spend the money as they wished, so granted that no-action relief.


      Shortly thereafter, there was a request from about a year later from a group called Mutual Liquid Assets that was really seeking to form, really, a new money market fund. And what they'd like to do there is to pay half of their management fee to brokers that were distributing that product. And the staff once again issued a no-action letter permitting that. Thereafter, there was a new fund, I think may have been around the same time, that had filed a registration statement and said, "Listen, we're not going to even call this a management fee. We're going to be direct with our investors and tell them we're going to charge 25 basis points for our management fee, and then we're going to charge another 25 basis points that we're going to give to dealers." And that really caused a fair amount of consternation.


      The combination of those three, and I think it came to the attention of a whole range of folks, and the Commission actually -- I don't know whether they revoked it or whether they told the staff to revoke the no-action letter that they had provided, really, to Mutual Liquid Assets. And at the same time, they, in 1976 in October, the Commission said that it was going to hold a hearing and requested comments in November of '76 at a five-day hearing relating, really, to distribution related type matters for funds. May of '78, they did advanced notice of proposed rulemaking on the same topic. September of '79, they had a rule proposal out, which was the 12b-1, and then in 1980, Rule 12b-1 was ultimately adopted, which permitted funds to bear distribution expenses subject to a number of conditions.


Paul Atkins:  That ties into our theme, then, because finally the Commission did the right thing not going through the staff gray area rulemaking and did it according to the APA.


Barry Barbash:  But it I think what's significant from the history I just went through is from the get-go, you had a contentious issue which is should, as a matter of policy, the SEC allow assets of mutual funds to be used for distribution? And what was the basic concern? There was a conflict of interest because as funds get bigger, it can be the case, or it may not be the case, that individual shareholders of the funds are benefitted. As a shareholder of a fund, I'm benefitted by excellent performance. If the fund is bigger, I may get a benefit, but I may not get a benefit. But what does get a benefit, or who gets a benefit as assets go up, and the answer is mutual fund managers.


      There was a conflict, whenever you have distribution, mutual fund managers versus the shareholders. But what 12b-1 represented was a policy decision made at the Commission level that notwithstanding the conflict, the practice should be allowed. Notwithstanding the practice, so long as there were conditions which included disclosure, then the practice would go on. So it's not as if from the get-go a decision hadn't been made at the Commission level.

Paul Atkins:  Well, the good thing, though, was it was a policy decision at the Commission level after notice and comment.

Barry Barbash:  Right.

Paul Atkins:  And through that whole apparatus of due process that is established by the APA, and giving a lot of publicity, and then allowing that argument between economies of scale of a bigger fund and savings that then get passed on, presumably, lower costs to shareholders and then, of course, the conflict of interest with management.

Barry Barbash:  And you had a rulemaking procedure where comments were aired. The industry allowed its comments. The SEC had a chance to contemplate it and made a considered decision.

Buddy Donohue:  Before we move on, Barry, what I've always found interesting was that before 12b-1, while it was a position that was taken that funds couldn't bear distribution expenses, there was no law that prohibited it.

Barry Barbash:  I think that's true. I think that the staff had come up with policy positions of no-action letters, or refusing to give no-action letters, but there hadn't been, I think Buddy's right, law to the extent that Boyd hadn't decided and the Commission hadn't concluded at its level that there was a legal prohibition.

Paul Atkins:  Well, one thing. So let's then go -- let's fast-forward from the '70s until more recent times. And so at various times, as I mentioned before in the Commission's history, it's touched on 12b-1, and especially in the last, well, 15 years for example. So when I was the Commissioner in 2004, the Commission considered changes to 12b-1 and basically actually adopted an amendment to prohibit direct brokerage in respect to selling fund shares.

      And in 2007, Buddy, you were Director of Investment Management, and we had a round table to discuss 12b-1, a lot of issues that didn't really go anywhere. And then finally in '09, I was no longer there but you were still there. The Commission adopted a rule that required then an express notification to investors that a conflict may exist regarding broker dealers' recommendations, but the SEC rejected comments that it should consider additional disclosures.

      Then in 2010, there was a proposal with sweeping changes, but the Commission did not adopt those and backed away. So with those sorts of things that were going on, what do you in the Commission coming close, backing off, discussing all of this, why are we at this position that we are today? What's the -- with respect to an enforcement initiative, and this controversy that's been engendered?

Buddy Donohue:  This is Buddy. If I could jump in with a thought that people should keep in the back of their minds as they think about this. One of the things in the mutual fund space is that the underwriter for the mutual funds really decides the pricing of the product, of the shares that will be paid by investors. So absent some creation of share classes or whatever, it wouldn't matter if you went to buy shares from Merrill Lynch or if you went to Charles Schwab. The same share class would cost you the same amount. So regardless of whatever services were being provided by the broker to you, however you valued those, that value was being, in a way, determined by the underwriter for the funds.  Now, that was a concept that was put in there, I think probably in 1940.

      But as distribution changed, and as you came up with a variety of different channels, '75, you wound up with the advent of discount brokers. You wound up with, really, the markets changing significantly. You wound up with the use of mutual funds changing significantly. And I think everyone was struggling with how to deal with this. I don't think dealers, the underwriters for the funds necessarily were concerned that someone buying through Charles Schwab might have a different arrangement than an investor coming in through Merrill, but they were limited, really, by the provisions of the securities laws that basically shareholders and investors in a fund were all paying the same amount.

      And so you wound up with a range of different arrangements that they would enter into, which became extraordinarily complex, and in many cases, very, very difficult to understand, for investors to understand, and for the dealers to implement. So during this period of time, you wound up with, and I'll go back, there were a number of the larger broker dealers that wound up no having provided break points to investors, and in many cases because there was no uniform way that break points were done. So you wound up with a very convoluted system.

      And so what happened over time is the way that the industry, and the industry meaning both mutual funds and the broker/dealer community and the adviser community, the way they dealt with this was creation of different share classes and the disclosure in terms of -- but it became extraordinarily complicated. And bargaining positions over time changed significantly, so that, I think, is a good backdrop. There were a lot of things going on at the same time.

Barry Barbash:  In an effort to try and provide investor choice, the industry came out with share classes which allowed an investor to participate in the same portfolio but buy the shares subject to different arrangements, get different services. So you end up in a situation where shares of the same fund could be subject to different charges. And I think that's what the SEC --

Paul Atkins:  -- So the SEC, through rulemaking, allowed that to happen, to have multifarious sort of share class system to give more flexibility to investors, but then that sets up the issue about disclosure. And some investors are eligible to buy certain share classes, but they may not buy others, like institution only share classes. So it became very complex. So how, then, have we arrived now where the enforcement division as we're understanding it through the grapevine is actually suggesting that some of the managers should have put shareholders who are ineligible for certain share classes into those share classes as part of this settlement? How does that --

Brian Rubin:  But what—this is Brian—what the staff is saying is that managers would make exceptions, although nobody knew that they were making exceptions. So they're saying you had to reach out and say, "Can this non-institutional client get this lower class share class?" And a lot of the premise for the settlements is based on that thinking.

Paul Atkins:  I see. Okay. All right. Well, so then, as far as in this type of situation that we're in, with respect to the SEC's makeup, is there something that has led to this situation where we have, arguably, the rulemaking division doing one thing, enforcement doing another, and perhaps examinations doing a third? Is there some aspect to it?

Barry Barbash:  Well, I think it's important to note that when the SEC allowed share classes to go forward, by rule, there was provision for disclosure. That came out of a rulemaking and out of a rule. What you have over time is the division of enforcement creating different units to focus on certain areas, including an Asset Management Unit. And that Asset Management Unit is behind the Share Class Initiative. The Asset Management Unit focuses on that area.

      And I think it's fair to say that the reason why you had so many cases in part is because you have a unit that focuses all its time and attention on that particular area. In older days in the enforcement business, it was a situation where the SEC wanted to make a statement about a particular bad practice, so it would bring a case. Maybe it would bring two cases. But I think it's the formation of the unit that leads to 79 cases.

Paul Atkins:  I see. Well, so part of this—and Brian, maybe you can address this—was when the SEC Enforcement Division announced this initiative, they couched it in terms of an amnesty, so, "Come all ye hither and tell us your problems that there might be more of a benign type of end to it." But then there's been talk about baiting and switching and that sort of thing. But what do your clients talk about with respect to this particular situation, or what surprised them about how these cases are being brought?

Brian Rubin:  Well, they sort of went through the five stages of grief: denial, anger, bargaining, depression, and then acceptance of the cease and desist order as the ultimate resolution. First, their impression was everybody does it. Everybody looks at all the other firms' disclosures. Everybody uses the same law firms within their range. They use the same consulting firms. And how could it be wrong if everybody does it? So that was the first impression.

      The second impression is that a lot of firms were examined by OCIE, and OCIE never pointed that out. As you mentioned, the Commission or the staff had concerns about it for years, but nobody knew that they had concerns. I actually had one client that was examined a few months before the initiative and the staff didn't say boo about the issue.

      The third issue is that in 2011, the DOL said that collecting 12b-1s was prohibited transactions on qualified accounts, and if the SEC or the staff had concerns at that point in time, they should have raised those concerns. Most firms abided by what the DOL said. They changed their disclosures accordingly. They stopped collecting 12b-1s. So clearly, it was on the radar of the SEC, but they didn't say anything about it.

      And the fourth point I would make is that the SEC staff's position doesn't make a lot of sense. One of the arguments they made was that firms couldn't use the word may, that they may collect 12b-1 fees, when, in fact, it was true for a lot of firms because they weren't collecting them from qualified accounts, but they were collecting them from non-qualified accounts.

      And before today's presentation, I did a quick word search. In the initiative, it used the word may 13 times. In the FAQs, they used the word 10 times. And there was also a Sixth Circuit case where a private litigant said that the use of the word may in a prospectus was fraudulent, and the Sixth Circuit said, "We are unpersuaded by this semantic quibble." So I think bottom line is firms were surprised and shocked, and saying, "You know, it's nice you're calling it an amnesty, but we're going to be subject to an SEC order." And as we'll talk about in a minute, there are collateral consequences to that, plus we're paying [inaudible 28:03] dollars.

Paul Atkins:  So you have one thing in the ADV. In the prospectus though, you also have a fee schedule.

Brian Rubin:  Right.

Paul Atkins:  That discloses fully what fees are being paid with respect to that particular thing that the investor is buying.

Brian Rubin:  Right. And a lot of firms said, "We're relying in part on the prospectuses." And the staff said, "We don't care what the prospectuses say. It's what the ADV says."

Paul Atkins:  Yeah, right. Well, that ADV is much more complicated these days that when it used to be just a check the box type of thing. Now, one thing when you said that nobody knew about what the SEC was thinking -- I guess the SEC's retort would be, "Well, in 2016, OCIE issued this risk alert, and we did have, after all, a couple of settlements out there." What do you say to that?

Brian Rubin:  Well, a lot of firms reacted to that. And some firms disagreed and said, "We are different from the settlements in X, Y, and Z ways." And they didn't change their practices because of that.

Paul Atkins:  Are those risk alerts and settlements, are those actionable rulemaking, or…

Brian Rubin:  Technically, no. But I think a lot of firms clearly read them carefully because they want to know what the staff is thinking because of cases like this.

Barry Barbash:  There are clearly some practitioners out there who look at settled case documents and say, "Look, it was negotiated. So I don't know exactly what the facts were, but the facts are not my facts." And there's an essence in there that's right. Settled action is settled. You don't know what the negotiation was. You don't know everything that was said or not said. And people will, as a result, pay more or less attention to settled cases. And I think legally, that's right. I think Brian's right.

      Over the course of time, there are plenty of companies in the industry that would take a look at the initial settlements that came down, and there were settlements. He's right. There were settlements. And I think some companies changed up their disclosure, but I think some of those companies found that when the SEC came back, the SEC didn't like that disclosure. And in a lot of respects, as you're advising corporate clients in that kind of context, you're divining what's in a settlement. What is it that the settlement wanted? What's the kind of disclosure? What's the language? And it's not necessarily the easiest task to define what the right answer is on disclosures.

Brian Rubin:  Well, what's interesting too, these 79 settled cases so far -- I challenge anyone to go through and figure out what that disclosure was and what good disclosure would be because these are very thumbnail types of settlements. So I think, arguably, it's hard now to even define what is, to your point, Barry, what the best --

Barry Barbash:  -- The number 79, or any kind of number like that, resonates with me in a particular way. I look at that and I say, "You're dealing with a highly regulated industry." Ray Garrett, who was the Chairman in the SEC a long time ago in the '70s, called the mutual fund business one of the most highly regulated businesses in American business life. It's highly regulated, and those participants who are in the business understand regulation, and they try to comply.


      The fact that you have 79 companies with the same violation, to my mind, raises the issue why? Doesn't that suggest that there was a bigger picture issue if it happened 79 times? If it happened once or twice, okay, you have outliers. But 79 times suggests that there's a major issue out there. And couldn't it be that there's something fundamentally wrong with what's been conveyed to the industry?

Brian Rubin:  And it's actually more than 79 because there are pre-initiative cases, and there are cases that started before the initiative which are settling now. We'll see a bunch by the end of this month. And then there are other firms that didn't choose to self-report for whatever reason. So it's going to be in excess of 100, easily.

Paul Atkins:  And what I think is important to note is that actually, the securities laws contemplate a way for the SEC to do this in the enforcement context, but to kind of set a bar, and that's 21(a), to do a 21(a) report. And interestingly enough, a couple years ago, the SEC did do that in the cryptocurrency area with basically its VO report that came out where they said, "Stop, look, listen. What you're doing here has securities law implications, so you better toe the line." So that sent out a message to the industry here, arguably, with 79 plus cases that the same thing probably would have been more appropriate.

Brian Rubin:  And the other problem with the initiative -- I had a few clients that were being investigated before the initiative started. Those firms are going to be subject to a monetary penalty, and it's just bad luck of the draw they got examined six months or a year before the initiative. And they view that as unfair as well.

Buddy Donohue:  Paul, if I could ask a question or make an observation, I looked at them and I said, "Seventy-nine cases. I'd really like to have a better appreciation." So I looked at it from a different perspective, and these things don't happen in a vacuum. There's other things going on. What surprised me was that 46 of the 79 cases involved dual registrants, involved firms that were registered both as an adviser and as a broker dealer.

      If you look at the universe of advisers that are registered with the SEC, and there's over 12,000 of them, less than 4 percent of them are dual registrants. But of them, of the dual registrants, 10 percent of the dual registrants got caught up in this. So you wound up -- there's less than 500 dual registrants from information that I could obtain, but 58 percent of the firms settling actually were dual registrants. And they only represent less than 4 percent of the universe.

      So it makes me wonder -- I mean, there's a lot been going on in that space with the investment adviser and the broker dealer community in terms of trying to navigate their way through, really, both regulatory regimes. And I do wonder—and I think, Barry, you and Brian probably have much better insight into this than I do, although I spent most of my life at dually registered firms—on whether or not that might have had something to do with the issue.

Barry Barbash:  I'm not sure that it does structurally, but I think it raises an interesting question. So take Buddy's numbers. If those are the numbers, and I have no reason to question them, then as a policy maker, why don't you take a step back and say, "Is there something wrong with how we're regulating these kinds of companies? Is there something that is not working the way we thought it should work?

Brian Rubin:  Do you get to rake the eye then?


Paul Atkins:  So could this be -- one thing I wanted to ask about is the siloization of the SEC. So over time, at least when I was there regularly in cases like this, the Division of Investment Management, for example, would be at the table at closed meetings along with the general counsel and things like that.

      I'm not sure what exactly happened in this case, but I wonder -- you now have this Asset Management Unit enforcement. You have OCIE doing its things where they used to be part of the -- Barry, when you were there, for a while it was part of Investment Management, and then it got split out. And then also you have the Division of Investment Management. Is there a lack of coordination and discussion and learning among the various aspects of the agency?

Barry Barbash:  It's a hard one without being there and having any idea what's going on. I'm pretty certain that if you asked current SEC staffers who are involved with these cases, "Were the other units involved?", it was overseen by -- if you had an enforcement person, if you asked, "Was somebody from OCIE involved and somebody from Investment Management involved?", I'm sure the answer is yes.

      I think there is a question, though, each one of the -- you talk about these silo. I think there is some of that just generally at the SEC. And each one of those areas looks at issues differently. I think Investment Management tends to look at matters through a rulemaking kind of perspective. OCIE looks at it from an examination standpoint. And Enforcement looks at it from a we want to mandate compliance and we want to go after companies. We want to look at things like conflicts of interest.

      But the point is I think what you have here is one of those three's approach actually coming to the fore, namely enforcement. That doesn't mean you couldn't deal with this particular problem by having OCIE go out and do a study of its records and come to a conclusion of what's what. Or OCIE feeds data to the Division of Investment Management, takes a look at dual registrants or whatever to try to take a rulemaking look. My sense is none of that's going on right now. This is being viewed as this is an enforcement type matter. Let's go down that route.

Brian Rubin:  And they did say that they consulted with other firms when we complained and asked to meet with people and things like that. Not surprising.

Paul Atkins:  Right. All right. So there's consultation, and then there's consultation.


      So anyway, let's move on and talk maybe about some of the things that drive a decision as to whether to litigate with the SEC or settle because there are some -- we know that there are some out there who are in active litigation now with SEC. So there are issues of disqualification that come from the statute of the Investment Company Act for some of this. Can you all talk about that? Barry, maybe if you want to talk about the Section 9 implications of this and how that feeds into it?

Barry Barbash:  Well, you're alluding, I think, to two more recent situations where the SEC has gone into federal court against dual registrants, looking not really at 12b-1 exactly, but looking at the practice that's known as revenue sharing, which is a sharing of monies that a service provider gets with another party. And in two revenue sharing cases, the SEC has concluded to try to deal with the issue by going into court.

      My understanding, just from what I've read because I'm not involved with the cases, but some of what's been out there about the cases indicates that what happened was there were tolling arrangements involving the enforcement staff. And at some point in time, a decision was made to stop the tolling arrangement, and the result was that the SEC decided that it needed to go to court in that kind of situation and bring a case. In one of the cases, the case against Commonwealth Financial, one of the areas of relief that the SEC wanted was a permanent injunction.

      That raises a real issue to a company that's involved in investment management business because there's a provision of the Investment Company Act, Section 9, that says if you are a party and a service provider, you're a distributor or investment manager, to register your investment company that you're subject to certain kinds of court injunctions. You're out of the business unless you get an exemption form the SEC. And in today's SEC, there is generally a view that Section 9 orders that give you exemption are really hard to come by.

      And Kara Stein, when she was an SEC Commissioner, pretty clearly came out not in favor of Section 9 orders. And I think that notion still permeates part of the SEC. So getting an order to be able to continue in the business is difficult. So you're put in a very hard position if you're a provider of services to funds.

Brian Rubin:  And even firms that settled had to deal with WKSI waiver issues and statutory disqualification issues. So there are real implications, even if you don't litigate.

Paul Atkins:  And even for a major firm like one of the largest asset managers would face the same as the small one, meaning that that firm could be completely out of the business of advising mutual funds.

Buddy Donohue:  Now, one of the things, and I think Mary Jo had made this clear in a talk that she had given, the disqualification issues unrelated to the bad actor provisions are not an enforcement remedy. They're really a consequence of events. And so providing waivers shouldn't be viewed in that context. And I think that's part of the debate that goes on about that is, "Boy, they did something bad. Why are you letting them off?", as opposed to, "Wait a minute." But what they wound up being agreed -- the violation that they had was unrelated to whether or not they might -- whether we should rely on them as a WKSI. It was unrelated to whether or not they should be allowed to continue to manage money.

      And so you can have the response of, "Oh, you shouldn't be giving waivers," as opposed to looking at it and saying, "Okay, why is that? Why does the Commission have the authority to provide the waiver?" Which is what really was the violation, and is it related to what we're -- the prohibition, if you would, that's being imposed on them because of that. I think that's the interesting debate that winds up happening, but it frequently isn't positioned that way.

Paul Atkins:  Right. Well, even DOJ has to deal with -- in their charging guidelines and sentencing and all that, with respect to judges' collateral consequences being taken into account. A question for each of you all that what could have been differently here? Or what can be done differently going forward as far as this situation goes, given this is clearly trying to achieve and end of rulemaking without having gone through the process? How would you all assess the situation?

Barry Barbash:  To my mind, but my background is generally when I was at the Commission of looking at things as a rule maker. To my mind -- take the recent cases of revenue sharing. There are a lot of people who think revenue sharing is not a great practice. There are some people who say that revenue sharing is completely appropriate. It's part of American business life. So you have both views.

      But rather than try to deal with it by saying, "Look, there's a conflict of interest with revenue sharing. Let's see what the disclosure is like," why not take a step back and say, "Revenue sharing, what do we think about it? Is it something we want to promote? Is it not something we want to promote? But let's go through a rulemaking type procedure, see where things are in the use of revenue sharing, see what possible ways there are to deal with it if we think it's a problem." I just think that that's a better way to try to deal with a regulated area as we have here.

Paul Atkins:  Well, and Buddy, you attempted to do a rule that didn't go through, whatever was going on there at the time. So how do you view it now in retrospect?

Buddy Donohue:  Well, as I tell some of my colleagues in the industry, I said, "If you guys has signed on, you wouldn't have had some of these issues," because I was trying to get, really, directors out of the -- I was trying to get, really, the firms to be able to have, if you would, a uniform way that they would charge their clients. I mean, if you think about it, if you were at Merrill Lynch, as an example, and depending on which fund group you're in, you're paying a different amount. The firms get different amounts. It's a huge conflict. And I thought years ago that that's crazy. They should get away from that conflict that they have and agree with their clients what they're going to charge them, and basically charge the same for all of the type of funds that they wind up having or the products that they have and remove that.

      And that was part of what was behind, really, the proposal in 2010 which was to get the funds out of being in that position of dictating. And so you wouldn't have had all the different share classes that way, and the firms themselves probably would have had clearer disclosures with their clients about what they were charging and the ability, really, to control it themselves.

      But I would point out—and I think, Barry, you did an excellent piece on this about 10 years, I think it was over 10 years ago—which is that this is the history of the Advisers Act. This is how the anti-fraud provisions have essentially been interpreted over the years, not by rules, but by rather, really, by cases where something was deemed to be fraudulent. And this is where you have cases like this where they're all joined together. It's that, essentially, on steroids. But that's been the history of the evolution.

Paul Atkins:  But in fairness there, if the SEC has gotten its fingers in the pot, and then taken them out, put them back in, taken them out, it's rather incumbent on it to --

Buddy Donohue:  -- Oh, no, no. And Paul, don't misinterpret what I was saying. I wasn't saying that that is the right way, but rather that part of what is going on here isn't new.

Paul Atkins:  Right, but it also isn't proper. It happens to be illegal, frankly, but…

Buddy Donohue:  Go look at all the rules that are under 206(4) that hang as fraudulent practices partly because—and Barry, you probably know this better than I do—but there was a lack of authority for rules in the Advisers Act.

Barry Barbash:  The Advisers Act doesn't give the SEC authority to come up with substantive rules for advisers, so it does give the SEC authority to define fraud. So rules are promulgated in the form of, "If you don't do X, if you don't have this procedure or that procedure, then you're going to be deemed to engage in fraud," which means that if you violate even a simple operational rule, you're violating a fraud rule. It looks bad, and it's hard to say because when advisers, generally speaking, as fiduciary, don't want to be found to have engaged in fraud. It doesn't go very well with the business. That's not right.

Paul Atkins:  Well, so on that note -- because, obviously, you have the APA superseding all of that.

Brian Rubin:  One little thing. I mean, the system is kind of broken because you would think that firms would be able to litigate these issues if they need to, but there are so many disadvantages, costs involved in litigating, bad press involved in litigating, that unfortunately, you have to try to persuade the staff or do the kind of things that we're doing, publicizing these issues and hoping that the commissioners will ultimately react.

Paul Atkins:  Right. Okay. I wanted to maybe ask you, Barry, since you brought it up, as far as the duty of an adviser to make an inquiry as to whether institutional shares are available to non-institutional customers, what's the basis of that duty? I think you brought this up before, but this is an emailed question in from the audience.

Barry Barbash:  I think to the extent that's an obligation, it's to -- as a fiduciary adviser, letting a potential client or customer know what the options are. It's providing that person or that entity with material information in terms of making an investment decision. I think that's the theory for why you would do it. And I think the counterargument is, "Well how can that be material information if one of the classes is unavailable to an investor? How could that be of consequence to the investor?"

Buddy Donohue:  I think it goes back to the view of a duty of care and a duty to monitor. But I agree with you. If you don't know it's available, and I think there were probably some of the firms had even asked but been maybe told that it wasn't yet available, and it's always a question of what is the frequency with which one has to do that?

Brian Rubin:  Yeah, and the staff's position was, "You should have asked. And if you didn't ask, you're breaching your fiduciary duty."

Barry Barbash:  The staff takes a very big view of what's material to an investor, and it's essentially anything of interest. If an investor could be interested in it, then it should be disclosed. And I think, generally speaking, on the outside, the view of what materiality is, is probably narrower. And I think when you look at court decisions, it's probably narrower.

Paul Atkins:  And you mentioned Commissioner Peirce. She dissented from a number of the cases. There were a number of firms that did disclose there were differences in share classes, but they didn't go far enough according to the Commission.

Barry Barbash:  That's one of the issues. Brian makes a good point. That's one of the issues that works out there is the degree of specificity of disclosure, because in a lot of instances, there was disclosure. But the SEC's view was it wasn't good enough, it wasn't specific enough, and therefore it was misleading, or it omitted information. And I think the SEC view on disclosure in that context doesn't necessarily meet what outsiders view as the court developed disclosure obligation and the degree of specificity. And I forget whether you raised it or Brian raised it, but there's at least one court case that goes contrary to where the SEC is with respect to the breadth of disclosure and the specificity of that you don't need as that much to comply with the applicable securities clause.

Paul Atkins:  Right. Brian, you brought up the whole may and the mobile auxiliaries that are used in disclosure. Have you seen this in other contexts? Because I know when I was on the Commission, the market timing cases that were brought, that was an issue in some of them. And then, of course, in reg BI, the Commission sort of after the fact has Footnote 60 where they talk about may versus will, or shall, or could, or might could, or whatever that is, but how have your clients seen that? Because there's really still no rubric for that.

Brian Rubin:  Yeah, it's tough. And when we're giving legal advice on the kinds of disclosures that appear to be required, we're sort of going above and beyond and pounding clients on the head with regard to what's going on. But as a matter of law, as I mentioned, there's a Sixth Circuit case which suggests or says that may is a silly thing to be charging fraud about.

Barry Barbash:  The distinction between may and will, it's been working out there in the SEC for a long time. OCIE exams, for many, many years, that was one of the issues, may versus will. And people would go back and forth with OCIE to explain why use of the word may was appropriate. The issue has been there for a long time.

Paul Atkins:  And as I said, here, a lot of firms thought may was appropriate because they were receiving it for non-qualified but were not for qualified. But the SEC staff, once you say we're receiving these accounts but we're not receiving these accounts, how does Robert, the recent case, affect this?

Brian Rubin:  That goes to willful as opposed to the may issue. That's ultimately where the court ended up, although that was argued before DOJ, the Commission, and the Court of Appeals.

Paul Atkins:  Well, we have about a minute left, so maybe, here, for the final type of viewpoint, how would you advise people -- do you feel on firm ground, you all, in advising people how to proceed with disclosure now, or are things murkier than they used to be, or how should one proceed?

Barry Barbash:  I think as a practical matter, if you're advising clients that are subject to SEC jurisdiction, you need to look at the settled cases and try to divine what the SEC staff and the Commission is looking for and do your best to move towards that because -- I always tell clients when the balk at that, I say imagine yourself being in a sporting event where the other side set the rules, brings the ball, and sets the time. They have everything at their disposal. You don't. And I think you really have to play ball the way they're suggesting.

      Companies don't want to get involved with disputes with the SEC. They have a business to run, and it's really costly. And I think what happens is you don't argue the law. You argue where the SEC is, and you try to comply. It's like dealing with an umpire and strike zone you happen to think it's off about three inches, or however many inches. It's the umpire, and you have to try to --

Brian Rubin:  -- I would add not just settlements in this context because you have the two complaints out there which are taking it in a new direction. So I think you have to look at those carefully as well.

Paul Atkins:  Well, but one other thing, and Barry, I think you brought this up, that people have gone back and forth with OCIE regarding disclosure and what's appropriate or not. So if you -- and I understand perhaps in some of these cases, OCIE, after having gone back and forth with the firm, then closed out an exam where they were the first objecting to disclosure. How does that then enter into what you were saying there, Barry, as far as appropriate?

Barry Barbash:  It gives you a degree of comfort, but it doesn't provide you with assurance because you can go through that. And whenever OCIE closes out anything, you'll say you're closed out, but understand that issues could come up in the future, and what we've told you now doesn't really protect you down the road. And you're faced with that. So I think you get, as a practical matter, some comfort from going through an OCIE exam and getting a good result, but you have to, I think, on a regular basis, go back and take a look at what your disclosure is like and see if any needs tweaks. That's clearly what we try to do is we try to look at the settlement orders, see what's new, and try to advise clients accordingly.

Brian Rubin:  Or as Commissioner Peirce said, maybe you should adopt a rule that kind of sets things out in a less murky fashion. Sorry, Buddy.

Buddy Donohue:  Yeah, I just had one comment I'd like to make because I obviously have given advice in the area of advisers for almost 40 years on an in-house basis. The best way to describe the Advisers Act and the challenges, I think, for the businesses and for the lawyers, is that it's non-scienter fraud that is based -- is going to be judged based on what happened, not what you reasonably anticipated might happen, and the impact that it had on your clients.

      And clients frequently end up being overly conservative. It's better to disclose more than to disclose less. It's frequently, "Am I okay?" The question is how did it turn out, so whether or not you're going to be okay. And a lot of it's going to be whether or not your disclosures were adequate will be determined after the fact based on information that you may not have had access to.

Paul Atkins:  Yeah, but that's why your former boss, Chairman White, talked about disclosure overload. That's what leads to that.

Barry Barbash:  I was going to say, what's ironic is on the regulatory side, the SEC in the fund area has, over the course of time, said that too much disclosure really doesn't work for retail investors, and you want to get it down, distill it down so it's understandable. But a lot of the disclosure, if you look at the cases and you look at the settlements, you're going with bulk load disclosure.

Paul Atkins:  I think we're going to have to bring this to a close. We could probably go on a lot longer, but I really appreciate Barry, Brian, and Buddy, your all participating here, and I'm sure The Federalist Society does as well.


Micah Wallen:  On behalf of The Federalist Society, I would like to thank our all of experts for the benefit of their valuable time and expertise today. We welcome listener feedback by email at [email protected]. Thank you all for joining us. We are adjourned.


Operator:  Thank you for listening. We hope you enjoyed this practice group podcast. For materials related to this podcast and other Federalist Society multimedia, please visit The Federalist Society's website at