Wall Street Braces for More SEC Scrutiny of AI, Private Funds

The Securities and Exchange Commission is racing to safeguard its most consequential rules from any future changes in the administration or in Congress.

The SEC is targeting April to finalize almost two dozen rules, including those related to climate disclosure, according to the Biden administration’s regulatory agenda. More than a dozen other rule proposals are also in the works.

The anticipated activity builds on previous busy months, in which the SEC has adopted rules that include requiring funds to disclose more information about their fees and about short-sale transactions.

The commission and other agencies have until early-to-mid 2024 to adopt regulations that would be protected from getting overturned by a Republican-controlled House and Senate in the next Congress using the Congressional Review Act.

“The SEC probably wants to get the bulk of its rulemaking done by the spring so that the window for having Congress override those rules expires before there’s a new Congress,” said Michael G. Doherty, a Ropes & Gray LLP partner and co-head of the firm’s registered funds practice.

Business interests and some Republican lawmakers argue the proposed climate rule exceeds the SEC’s authority. Other rulemaking efforts have been criticized as ill-considered or likely to result in higher costs to retail investors.

Here are the rules that are most likely to transform how private funds and investment firms do business.

Safeguarding Rule

The SEC has proposed overhauling its “Custody Rule,” which requires investment advisers who store clients’ assets to segregate and safely hold them with “qualified custodians,” such as banks.

The purpose of the long-standing rule is to protect those assets if the investment adviser collapses, and prevent them from being lost or stolen.

The agency’s proposal would expand the rule’s requirements to cover a range of assets, including crypto. It would also impose new requirements, including added record-keeping duties.

Another significant change would be to amend the definition of “custody” to include discretionary authority to trade client assets. Many advisers have discretionary authority, meaning they don’t need the client’s consent for each trade.

The rule would help ensure that “advisers don’t inappropriately use, lose, or abuse investors’ assets,” SEC Chair Gary Gensler said in announcing the proposal.

But more than a dozen industry groups, including the American Bankers Association, the Investment Adviser Association, and the Managed Funds Association, said in comments to the SEC the proposal would “drastically and permanently alter the custody business model.”

The measure was targeted, at least in part, at the crypto market, which has been reeling from a broader regulatory crackdown. But the impacts of the proposed changes would be wide-ranging, and force money managers to re-evaluate many of their custodial agreements, attorneys say.

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It “will throw a lot of the current custody and deal flow and trade processing into disarray if it is adopted as it was proposed,” said Marc E. Elovitz, a Schulte Roth & Zabel LLP partner who co-chairs the firm’s investment management regulatory and compliance group.

AI Conflicts

The SEC, like many regulators, is stepping up its oversight of artificial intelligence. In July, it proposed a rule requiring broker-dealers and investment advisers to assess whether their use of predictive data analytics poses conflicts of interest. They would then have to eliminate any conflicts.

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The proposal would also require, among other things, covered firms to maintain written policies and procedures to prevent violations and ensure compliance with the rule.

Supporters of the rule, including the Washington-based group Better Markets, which generally advocates for tougher financial rules, said the proposal is necessary to keep pace with technological innovations and make sure firms don’t use technology to prioritize their own interests over investors’ interests.

But some industry lawyers question whether the proposal is workable.

Seward & Kissel LLP in comments to the SEC urged the agency to withdraw it. The proposal is “overly broad and, in certain respects, too vague,” departs from a well-established framework, and would dissuade advisers from innovating, said the law firm, which represents investment advisers.

“The Proposed Rule would result in costs that we believe are not warranted given the lack of evidence of actual harm to investors,” the firm added.

Climate Rules

The SEC is expected to issue early next year what is seen as Gensler’s signature regulation: the proposed requirements for public companies to report their greenhouse gas emissions and other climate matters.

See also: SEC Weighs Weakened Climate Disclosure Rules as Release Nears

Along with those requirements, the SEC has a separate proposal that would force investment funds to disclose their portfolio companies’ greenhouse gas emissions.

“ESG encompasses a wide variety of investments and strategies,” Gensler said in announcing that proposal, using an acronym for environmental, social, and corporate governance. “I think investors should be able to drill down to see what’s under the hood of these strategies.”

As proposed, the investment rule could sweep in much of the industry, covering any funds that consider ESG factors, attorneys said.

Final rules for both the public company and private fund disclosures are targeted for April. Outside observers expect the SEC to first put in place the the public company disclosure requirements, or at least finalize the rules at the same time.

But there’s a chance the funds rule could be finalized first, something that would be “unworkable,” said Ethan D. Corey, senior counsel at Eversheds Sutherland LLP.

“They have to wait to figure out what they’re going to do on the climate rule” first, he said.

Private Funds Rule

Another of Gensler’s signature proposals are rules adopted in August that will change how private funds, including hedge funds and private equity, deal with investors.

The rules require private funds to provide investors with quarterly details on fees, expenses, and performance. Funds also are restricted in giving preferential treatment to certain investors, among other things.

Those final rules already are facing a legal challenge.

The Managed Funds Association and other groups sued the SEC, arguing the agency overreached and adopted rules that are unworkable.

They filed the case in the US Court of Appeals for the Fifth Circuit, which has already found problems with an unrelated SEC rule on stock buyback disclosures and is generally seen as more skeptical of agency authority.

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If the rules withstand the challenge, funds have until September to comply with some of the main requirements.

“We’ll all be watching that closely,” Ropes & Gray partner Nicole Krea, who advises private fund sponsors and investors, said of the trade groups’ litigation.