In the last two years, the Securities and Exchange Commission has proposed dozens of ambitious, complicated rules that go up against some powerful political constituencies. The upcoming election year could shake up the priorities of the rulemaking organization. In the meantime, drafted rules on artificial intelligence and climate disclosures hang in review.
What do investors need to keep an eye on as we head into 2024?
Aron Szapiro, Morningstar’s head of government affairs, sat down with the Big Picture in Practice podcast to share his perspective on SEC rulemaking.
Many of the commission’s most-anticipated rules are still in draft form. For those who don’t spend their weekends reading the Federal Register, here’s a primer on the process.
“Governmental agencies have processes they must follow when they promulgate draft regulations, and then finalize those regulations,” Aron says. “That takes a lot of time.”
The committee publishes drafts of proposed rules in the Federal Register. Most go through a notice and comment period, which gives interested parties the chance to review the draft, analyze the issues, and publicly submit their comments.
“Unlike in other jurisdictions, you tend to see pretty big changes between the notice of proposed rulemaking and the final rule,” Aron explains.
Under SEC chair Gary Gensler, the commission has issued 47 proposed or final rules, the same total as in the combined tenure of his two predecessors.
And recently, comment periods have grown shorter. Where in the past, Aron’s team might have had four months to comment, now they have 60 days.
Beyond the Dodd-Frank Act, Congress has made few changes to securities laws and the legislation that authorizes the SEC. That gives lawmakers limited avenues to challenge rules they oppose. However, recently the courts have gotten more aggressive in intermediating SEC rules. Rules have been tossed out in court as too arbitrary or capricious, creating uncertainty for investors.
On the podcast, Aron gives listeners a rundown on recent SEC drafts.
The SEC’s proposal on AI and technology
“If I had to pick one rulemaking that I think affects anybody listening to this podcast, I would go with the most recent one, on artificial intelligence,” Aron says.
The proposed rule would require broker-dealers and investment advisors to address conflicts of interest associated with their use of “predictive data analytics” to protect investors’ best interests.
“The rule would affect a lot of activity that may be currently regulated under the SEC marketing rule, but not to this degree,” Aron explains.
The draft covers any technology that uses an algorithm, model, or similar methods. That definition encompasses a broad set of technology, whether it’s a discounted cash flow model or an Excel spreadsheet, and affects broker-dealers and investment advisors alike.
Any firm that has investor interactions with covered technology would have to write policies and procedures reasonably designed to comply with the proposals.
From Aron’s perspective, the final regulation should make a distinction between different types of artificial intelligence. As an example, he talks about Monte Carlo simulations, which use a set of assumptions to randomly generate thousands of possible future return scenarios. The process starts with the same set of assumptions each time.
In contrast, think about a chatbot or machine learning model trained on continuously changing data. As time passes and the AI takes in more information, its answers will change. Without careful oversight, that type of AI can pick up and replicate biases in the dataset it’s learning from.
The comment period closed on the SEC’s proposed AI rule in October 2023. Investors should take note of how the rule progresses.
The SEC and ESG regulations
The ESG rule is one of the meatier pieces of rulemaking that will likely take shape before the election. But even if the disclosure rule is finalized, the ESG fight isn’t over. Industry advocates come with differing opinions about what companies should or shouldn’t have to disclose, how companies should talk about ESG, and what should fall under consideration.
Aron predicts efforts to adjust the proposed rule, whether it’s litigation or congressional action. To explain, Aron says we should start with ergonomic chairs.
Looming over this election cycle is the Congressional Review Act. Enacted in 1996, the law says that if Congress votes to disapprove a regulation within 60 days of its finalization with the Federal Register, the regulation is thrown out. The vote only requires a simple majority and cannot be filibustered.
There’s an added kicker. If Congress throws out a regulation, the agency can never issue a similar regulation again.
The act had never been used until 2017, when the Republican-led Congress debuted it on an ergonomic chair regulation. Since then, it’s been used almost continuously as a check on the SEC, and could affect the commission’s rulemaking abilities.
How does the election year shape the rulemaking agenda?
The cutoff date for new regulations falls in April or May 2024. Aron anticipates a slowdown in controversial rulings as the commission awaits the results of the election.
Currently, votes often split down party lines for the three Democrats and two Republicans that comprise the commission. If control changes to the Republican party, many current proposals may not pass out of the draft stage.
“The conventional wisdom is that you’d expect to see less regulation if there’s a Republican president,” Aron says. “If President Biden wins reelection or if there’s another Democrat in the White House, I think things will spin up again.”
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