Securities Industry Commentator by Bill Singer Esq

FINRA Taxonomy News Release Isn't Newsworthy (BrokeAndBroker.com Blog)

Accessing FINRA Test Center Launch Codes With Colonel Mustard (BrokeAndBroker.com Blog)

The Problem for A Merrill Lynch Registered Rep Seeking the Expungement of a Settled FINRA Arbitration (BrokeAndBroker.com Blog)

TD Ameritrade Customer Loses Incorrect Address FINRA Arbitration

(BrokeAndBroker.com Blog)

DOJ RELEASES

Former Credit Union employee who repeatedly stole from elderly woman's account sentenced to a year in prison / Over three years he stole more than $129,000 for his personal expenses (DOJ Release)

CEO and President of Hawaii Shipbuilding Company Charged with Securities Fraud (DOJ Release)

Three Men Convicted of $1 Million 'Upfront-Fee' Scheme (DOJ Release)

Former Raleigh Investment Advisor Found Guilty in Healthcare Fraud that Targeted the Elderly and Disabled (DOJ Release)

Sarasota Man Sentenced To 23 Years In Federal Prison For Running $80 Million "Oasis" FOREX Ponzi Scheme (DOJ Release)

Chesterfield Man Convicted in Scheme to Embezzle Funds in Law Firm Trust Account (DOJ Release)

SEC RELEASES

SEC Obtains Final Judgment Against Perpetrator of Boiler Room Scheme (SEC Release)

SEC Obtains Settlement Against Investment Professionals Charged with Cherry Picking (SEC Release)

SEC Charges Canadian Cannabis Company and Former Senior Executive with Accounting Fraud (SEC Release)

SEC Obtains Final Judgment Against Investment Advisers Charged with Defrauding Their Advisory Clients (SEC Release)

SEC Charges Mattel with Financial Misstatements and Former PwC Audit Partner with Improper Professional Conduct (SEC Release)

SEC Obtains Judgments Against Three Defendants in a Microcap Fraud Scheme (SEC Release)

SEC Grants Waiver for Deficient Form TCR and Awards Claimant Over $400,000 Whistleblower Award
Order Determining Whistleblower Award Claims

SEC Awards Two Claimants Over $1 Million and Over $500,000 in Whistleblower Awards
Order Determining Whistleblower Award Claims

SEC Adopts Amendments to Modernize Fund Shareholder Reports and Promote Transparent Fee- and Expense-Related Information in Fund Advertisements (SEC Release) 

Simplicity is a Goal Unto Itself: Statement on Tailored Shareholder Reports for Mutual Funds and Exchange Traded Funds; Fee Information in Investment Company Advertising by SEC Commissioner Caroline A. Crenshaw

Modernizing Mutual Fund and ETF Disclosures for Investors by SEC Commissioner Jaime Lizárraga

One Good Step, More to Go: Statement on Final Tailored Shareholder Reports for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements by SEC Commissioner Hester M. Peirce (SEC Release)

Statement on Final Rule Regarding Tailored Shareholder Reports for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements by SEC Commissioner Mark T. Uyeda

SEC Adopts Compensation Recovery Listing Standards and Disclosure Rules (SEC Release)

Statement on Listing Standards for Recovery of Erroneously Awarded Compensation by SEC Commissioner Caroline A. Crenshaw

Statement on Listing Standards for Recovery of Erroneously Awarded Compensation by SEC Commissioner Jaime Lizárraga

Erroneous Clawbacking: Statement at Open Meeting to Consider Listing Standards for Recovery of Erroneously Awarded Compensation by SEC Commissioner Hester M. Peirce

Statement on the Final Rule Related to Listing Standards for Recovery of Erroneously Awarded Compensation by SEC Commissioner Mark T. Uyeda

SEC Proposes New Oversight Requirements for Certain Services Outsourced by Investment Advisers

In Service of the Investor: Statement on Outsourcing by Investment Advisers by SEC Commissioner Caroline A. Crenshaw

Accountability in an Evolving Asset Management Industry by SEC Commissioner Jaime Lizárraga (SEC Release)

Outsourcing Fiduciary Duty to the Commission: Statement on Proposed Outsourcing by Investment Advisers by SEC Commissioner Hester M. Peirce

Statement on Proposed Rule Regarding Outsourcing by Investment Advisers by SEC Commissioner Mark T. Uyeda

Remarks at the Georgetown Law Hotel and Lodging Summit by SEC Commissioner Mark T. Uyeda

"Competition and the Two SECs" Remarks Before the SIFMA Annual Meeting by SEC Chair Gary Gensler

CFTC RELEASES

Federal Court Orders California Man and His Commodity Pool Operator and Introducing Broker to Pay Over $2.3 Million for Commodity Fraud and Making False Statements to the NFA (CFTC)

FINRA RELEASES

FINRA Fines and Suspends Rep for Excessive Trading
In the Matter of Nigel Ronald James, Respondent (FINRA AWC)

FINRA Fines and Suspends Principal for Supervision of VRSPs

In the Matter of Teresa Douberly, Respondent (FINRA AWC)

FINRA Fines and Suspends Rep for Forging Supervisor's Electronic Signature

In the Matter of Heather S. Skipper, Respondent (FINRA AWC)

FINRA Fines and Suspends Rep for Falsifying Rep Code

In the Matter of Robert Louis Takacs, Respondent (FINRA AWC)

FINRA Fines and Suspends Rep for Guaranteeing Customer Against Loss and Texting

In the Matter of Dennis David Karjala, Respondent (FINRA AWC)

FINRA Fines and Suspends Rep for PSTs

In the Matter of Chad M. Koehn, Respondent (FINRA AWC)

FINRA Fines and Suspends Rep for Excessive Trading

In the Matter of Stephen James Sullivan, Respondent (FINRA AWC)

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10/28/2022

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10/27/2022

ran Knightsbridge Capital Partners, which operated at least two boiler rooms, through which Lisser raised approximately $2.1 million from at least 71 retail investors and misappropriated approximately $900,000 of that amount. The complaint alleged that, from approximately October 2018 to March 2019, Lisser, and boiler-room salespeople whom he directed, solicited investors by misrepresenting that the Knightsbridge-managed funds had purchased "pre-IPO" shares in three well-known companies directly from employees of the companies. As the complaint alleges, Knightsbridge did not own any shares at the time it solicited investors, did not buy shares from employees, and never owned enough shares to cover the sales it had made to investors. The complaint further alleges that Lisser and his salespeople falsely claimed to investors that Knightsbridge only charged investors a fee based on the profits after the pre-IPO companies went public, despite significantly marking up sales and charging commissions. 

. . . 

On September 15, 2022, Lisser consented to the entry of a Commission order barring him from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization; and from participating in any offering of a penny stock. On May 12, 2021, Lisser pled guilty to securities fraud in the criminal action, and on July 25, 2022, he was sentenced to 24 months in prison and ordered to pay restitution of $1,486,772.02.

= = =

10/26/2022

[G]riffin had worked at the credit union for almost two years when he made his first illegal transfer from the elderly victim's bank account to a lender to pay off his $7,000 loan. Over the next three years, even after he had left the employ of the credit union, he made 65 additional transfers to do things such as pay his mortgage, pay for a new car and other personal expenses. The victim's account settings had been changed to stop the mailing of paper statements, and instead just sent electronic statements. However, the victim did not have computer access. The theft was discovered when the victim was hospitalized, and a nephew began assisting with her finances. He discovered the thefts from the account and worked at length with the credit union to ensure the funds were restored.

The SEC's complaint was filed in federal district court in Miami, Florida on June 11, 2021, and its amended complaint was filed on November 15, 2021. According to the SEC's amended complaint, Sugranes, through defendants UCB Financial Advisers, Inc. and UCB Financial Services, Limited (the "UCB Entities"), engaged in a cherry picking scheme to divert profitable trades to investment accounts held by Sugranes's parents, who were named as relief defendants, and to saddle other clients with losing trades. According to the amended complaint, the scheme resulted in approximately $4.6 million in unlawful profits. The amended complaint further alleges that Garcia, the President and Chief Compliance Officer of UCB Financial Advisers, enabled the scheme by, among other things, sharing broker-dealer trading platform login information with Sugranes, which he used to carry out the cherry picking scheme.

Without admitting or denying the allegations of the amended complaint, Sugranes and the UCB Entities consented to entry of a final judgment permanently enjoining them from violations of the antifraud provisions of Sections 17(a)(1) and (3) of the Securities Act of 1933, Section 10(b) and Rules 10b-5(a) and (c) of the Securities Exchange Act of 1934, and Sections 206(1) and (2) of the Investment Advisers Act of 1940, ordering Sugranes to pay disgorgement of $4,600,000, partially on a joint and several basis with the other parties, with prejudgment interest, and a civil penalty of $500,000, and ordering each UCB Entity to pay a civil penalty of $250,000. Without admitting or denying the allegations of the amended complaint, Garcia consented to the entry of a final judgment permanently enjoining her from violations of the antifraud provisions of Section 17(a)(3) of the Securities Act and Section 206(2) of the Advisers Act and ordering her to pay disgorgement of $225,718, jointly and severally with Sugranes, along with prejudgment interest, and a civil penalty of $100,000. The relief defendants consented to a final judgment ordering them to pay disgorgement of $2,255,672, jointly and severally with Sugranes, along with prejudgment interest. Collectively, these final judgments resolve all of the SEC's claims asserted in the district court litigation.

On October 24, 2022, the SEC instituted administrative proceedings barring Sugranes from association with any broker, dealer, investment adviser, municipal securities dealer, municipal adviser, transfer agent, or nationally recognized statistical rating organization, and suspending Garcia for a period of 12 months from associating with any such firm or from participating in any offering of penny stock and, for a period of three years, prohibiting her from acting in a supervisory capacity.

The rule amendments will require funds to provide concise, tailored shareholder reports that highlight key information, such as fund expenses, performance, and portfolio holdings. The instructions for the revamped reports will encourage the use of graphic and text features to make them more effective. Funds will be required to tag the information in their reports in a structured data format. Further, the rule amendments require funds to make certain information that may be more relevant to investors and financial professionals who desire more in-depth information available online and available for delivery free of charge to investors on request. That information will no longer appear in fund's shareholder reports but will remain available to investors on a website identified in the shareholder report and must be filed semi-annually with the Commission.

In addition to modernizing fund shareholder reports, the Commission adopted amendments to investment company advertising rules to require that fee and expense presentations in registered investment company and business development company advertisements and sales literature be consistent with relevant prospectus fee table presentations and be reasonably current. The amendments also address representations of fees and expenses that could be materially misleading.

Throughout history, some of the world's greatest minds have extolled the virtues of simplicity. Fryderyk Chopin is credited with saying, "Simplicity is the highest goal, achievable when you have overcome all difficulties."[1] "Brevity is the soul of wit," Shakespeare told us through Polonius in the second act of Hamlet.[2] And, of course, there is Occam's razor, which stands for the principle that a simpler explanation is preferable to one that is more complex.[3]

I view today's rule as one aimed at achieving this lofty goal of simplifying disclosures for investors without sacrificing the important information they need and on which they rely. With more of the investing public putting their hard-earned money in mutual funds and ETFs,[4] it is crucial that shareholder reports contain concise, salient and accessible information about their investments. The layered disclosure approach to shareholder reports adopted today strives to do just that.

As noted in the release, staff observed in a 2020 review that the average annual shareholder report was approximately 134 pages long, with some of the longest reports observed extending over 1,000 pages.[5] One thousand pages is, of course, more reading than can be found in the Iliad and the Odyssey combined.[6] Or perhaps more relevantly to some, that is about three Harry Potter books long.[7] So, depending on your frame of reference, before finishing some open-end fund shareholder reports, you can have either traveled from Troy to Ithaca, or have made it through the escape of the Prisoner of Azkaban. Either way, getting through a shareholder report under current standards may be no small feat for any investor.

The information contained in shareholder reports under this new rule will include targeted and key information about a fund. For example, shareholder reports will include a simplified expense presentation - a table showing the expenses associated with a hypothetical $10,000 investment in the fund during the preceding reporting period, both as an expense ratio and in dollars. The shareholder reports will include a more concise Management Discussion of Fund Performance, and additional performance-related data. And, the shareholder reports will include fund statistics (such as net assets and total advisory fees paid during the reporting period) and a graphical representation of categories of portfolio holdings. Different fund series and share classes will be required to have separate reports. This layered approach is expected to reduce the size of the shareholder report significantly.[8]

Today's rule also addresses fund advertising. It will require that the presentation of investment company fees and expenses in advertisements and sales literature be standardized, consistent with the relevant prospectus fee table, and be reasonably current. The rule also takes aim at funds that hold themselves out as being "no-expense" or "zero-expense" funds, but conceal other pertinent information about potentially hidden costs, or expenses that may be incurred in the future. Misleading expense presentations are anathema to transparent markets and can lead investors to make financial decisions that are against their interests, and I hope that today's rule will help remedy these deficiencies.

I would also like to highlight one key observation about the rule. Simply because information is not included in a streamlined annual or semi-annual report, does not mean that it is not material to investors. By today's action, we are not altering our bedrock materiality standards. Investment companies will continue to post detailed financial information about fund investments on the fund's website, through the filing of Form N-CSR on EDGAR, and for delivery to investors in paper or electronically upon request. This information will include, for example, financial statements, director compensation, and matters submitted for a shareholder vote, and it will be certified by a fund's principal executive and financial officers. I encourage interested investors to exercise their rights to access those materials for more details - details which may continue to be significant to their understanding of their investments.

It is my great hope that today's rule will make it easier for all investors to better understand and monitor their investments; to understand more fully the fees that they are paying in connection with those investments; and to invest their money in a way that is actually aligned with their goals - be they retirement, a child's or grandchild's education, buying a new home, starting a business, or taking a well-earned vacation - the myriad of life events that so many of us rely on our savings and investments in mutual funds and ETFs to do.

I also hope, beyond today's rule, that we will continue to look for other ways to streamline shareholder reporting. And, in particular, it is imperative that we continue to endeavor to make sure investors have the information they need to understand all of the fees and expenses they pay in connection with their investments.[9]

As Chopin, Shakespeare and others have acknowledged, striving for simplicity is no easy feat. This is reflected in the rule before us today. It took heavy-lifting and tireless work by the staff of the Division of Investment Management, the Division of Economic and Risk Analysis, our General Counsel's office, and in the Chair's Office. Thank you to all the members of those offices and others who worked on this rule, as well as the Office of the Investor Advocate for the performance of investor testing. And, I also want to thank those who took the time to comment on the proposal, and those who participated in investor studies and testing in relation to this final rule. Your participation has helped achieve important changes.

[1] See The Fryderyk Chopin Institute, available at Narodowy Instytut Fryderyka Chopina (nifc.pl).

[2] Shakespeare, William, Hamlet, Act 2, Scene 2, 86-92 (1601).

[3] Occam's razor, also known as the "Principle of Parsimony," is the problem solving principle sometimes expressed as "entities should not be multiplied beyond necessity." The saying is attributed to William of Ockham in the fourteenth century.

[4] Based on figures collected on Form N-CEN as of December 2021, assets in open-end funds (excluding money market funds) were approximately $26 trillion.

[5] Tailored Shareholder Reports for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, Release Nos. 33-11125; 34-96158; IC-34731 ("Adopting Release") at 14 and nn. 34-35.

[6] Homer, The Iliad, Translated by Robert Fagles, Penguin Books (1998); Homer, The Odyssey, Translated by Emily Wilson, W.W. Norton & Co. (2018).

[7] J.K. Rowling, Harry Potter & the Sorcerer's Stone, A.A. Levine Books (1998); J.K. Rowling, Harry Potter & the Chamber of Secrets, Scholastic, Inc. (2000); J.K. Rowling, Harry Potter & the Prisoner of Azkaban, Scholastic, Inc. (2001).

[8] See, e.g., Adopting Release at 164 (noting "investors will now receive a streamlined shareholder report that may fit on a trifold self-mailer that is delivered directly to them.")

[9] This is especially true in light of research indicating that retail investors may be overpaying fees. See, e.g., Comment Letter of Ed deHaan Yang Song, Chloe Xie and Christina Zhu, (September 29, 2020) (estimating that "retail investors could have saved $358M in 2017 alone by switching from high-fee to low-fee versions of S&P 500 funds that provide nearly identical pre-expense returns"). See also Adopting Release at 30 (noting that, although we are not adopting the proposed amendments to fund's prospectus fee disclosure summary, "[h]elping investors more readily understand fund fees and expenses is an important priority of the Commission" and that the comments we received "merit further consideration").

Today, the Commission is adopting key disclosure reforms for the approximately $26 trillion mutual fund industry and $5 trillion exchange-traded fund (ETF) industry. Because of these reforms, investors will now receive information about a fund's operations and activities in a more concise, engaging, and usable way.

Investing in a fund is relatively easy these days. An investor can call their financial professional or the fund company and make an investment, or the investor's employer selects the fund in which their 401(k) invests. In either case, the fund delivers a variety of lengthy, yet essential, fund disclosures about a fund's fees, investment strategies, and operations during a particular time period.

Currently, these disclosures can be overly lengthy, complicated, and overwhelming for retail investors to process. Some fund shareholder reports are over hundreds of pages and tens of thousands of words.

There are times when working families have to make critical, time-sensitive decisions such as covering unexpected medical or household expenses, paying for college tuition, or buying a home. Depending on their investment portfolios, some investors may need to review multiple fund reports. Having to process complex, lengthy and technical disclosures where the relevant investor-useful information is difficult to discern is burdensome under any circumstances, but particularly so for families operating under the short-term pressures that household budgets often demand. Financial decisions made in this context can sometimes be critical to a working family's financial future.

Modernizing disclosures goes to the heart of the Commission's mission to protect investors. Today's release does exactly that.

The vast majority of the respondents to the Commission's Request for Information on investor-facing disclosures preferred summary disclosures, with additional information upon request or available online. These investors also expressed concern about the length of fund disclosures and supported more concise reports.

It's important that enhanced disclosures are informed by the needs of investors, what's useful to investors, and how best to deliver those disclosures given the changing technological landscape. Appropriately tailored and continuous investor testing can significantly inform that understanding.

It is my hope that the investing public will soon benefit from meaningful changes in the format and content of fund disclosures as a result of today's release.

I am pleased to support these reforms and would like to thank the Commission staff, and particularly staff in the Division of Investment Management, who advanced this important initiative.

Thank you, Chair Gensler. This shareholder report rulemaking represents a worthwhile next step in the Commission's ongoing effort to improve the quality and usability of mutual fund disclosure. I have questions and reservations about many of the choices we have made and believe the step forward could have been bigger. Nevertheless, the good here outweighs the bad, so I support this rulemaking.

The centerpiece of this rulemaking is a requirement that mutual funds and Exchange Traded Funds ("ETFs") provide shareholders with "concise and visually engaging annual and semi-annual reports." In a nutshell, today's changes will result in shareholder reports that contain only information that we have determined is most important to investors. Other information that we have deemed less critical will be made available online, delivered free on request, and filed twice a year on Form N-CSR in EDGAR.

Determining where to draw the line between what investors should receive in the shareholder report and what should be purged is not easy. Despite persistent attempts to expand what should be deemed must-have information, the drafting team largely stood strong and stuck to what is important. The resulting layered approach highlights key information, yet still allows more inquisitive investors to get additional disclosure.

While in general, this rule should improve the investor experience, several policy choices cut against that conclusion. For example, these amendments will permit a shareholder report to cover only the class of a multi-class fund in which the shareholder receiving the report has invested. Shareholder reports showing the range of share class options would allow fund investors to see cheaper class options available to them. In light of the Commission's recent spate of enforcement actions against advisers for failing to place clients in the most appropriate share class, this change from the proposal is particularly hard to understand.

Another puzzling aspect of this rulemaking is its elimination of e-delivery under rule 30e-3, which took effect only last year. Rule 30e-3 allows investment companies, instead of mailing full reports to shareholders, to provide a notice stating that the reports are available online. Shareholders are still free to choose paper delivery. Rule 30e-3 has its flaws, but at the time of its passage, it represented a significant move toward a more rational approach to e-delivery.

I would have supported eliminating this option for funds if we were pivoting entirely to an access equals delivery approach. After all, after we adopted rule 30e-3, the pandemic hit, and people have become even more comfortable with receiving and interacting with everything online. The paper delivery default that riddles our rulebook belongs in the SEC archives.

Gutting rule 30e-3 is just the latest example of the Commission changing its mind about a new rule without any clear rationale for doing so. The Commission's reputation as a sober thoughtful regulator may suffer as the market learns to approach the implementation of new regulation with a jaded skepticism. "This time we mean it," is not a message we should find ourselves having to broadcast to allay the concerns of whipsawed compliance officers and bewildered investors. This Commission change of heart, which affects how funds communicate with their shareholders, is likely to be particularly confusing to investors.

We paired the cost-increasing decision not to let funds use rule 30e-3 with a decision not to adopt a cost-saving part of the proposal-proposed rule 498B. Proposed rule 498B would have required only new investors in a fund to receive a prospectus. Thereafter, funds would not have to send shareholders a copy of the prospectus. Existing shareholders would be notified of material changes and would be able to view the full prospectus online. Citing negative comments, we have decided to put this proposal on ice for "further consideration." From my review of the comments, many 498B supporters merely raised questions about particular aspects of the proposal - e.g., calls for greater flexibility on timing regarding notice of a material event - but would have very much liked to have the option of putting this alternative into practice. This new rule had the potential to cut down on disclosure duplication and reduce costs.[1] So why are we throwing this option out altogether?

A similar question could be asked regarding the decision to jettison the small but important proposal related to Acquired Fund Fees and Expenses ("AFFE"). The proposal would have allowed mutual funds and ETFs that invest no more than 10% of their total assets in acquired funds to omit the AFFE line item in the fees and expenses table. Current AFFE disclosure requirements have dissuaded funds from investing in business development companies ("BDCs") because the AFFE associated with BDC investments is often high and therefore would adversely affect the investing funds' expense ratios. Because of this effect, some index providers exclude BDCs from their indices. The AFFE issue is part of the reason BDCs have yet to live up to their potential as a source for small businesses capital. As one commenter noted, when the Commission adopted the AFFE disclosure, it specifically wanted to avoid any "adverse impact on capital formation."[2] This proposal would have gone some way toward achieving that goal by, for example, potentially facilitating the reintroduction of BDCs into indices.

Speaking of indices, as proposed, the final rule will require funds to compare their performance to "an appropriate broad-based index," which is defined as "one that represents the overall applicable domestic or international equity or debt markets."[3] On substance, I find myself on the side of commenters who argued that the "requirement to compare a fund's performance to an index that is both 'broad-based' and 'appropriate' may, at times, conflict."[4] As one commenter pointed out "requiring a real estate fund to compare [itself] to an S&P Index would be misleading to investors that are investing in funds to gain exposure to the real estate segments of the market."[5]

What troubles me most about these decisions, however, is that they were based largely on conclusions drawn from a study by the SEC's Office of Investor Advocate that was not published until September 2022, two years after we proposed this rule and just one month before we are adopting it.[6] In other instances, the Commission has made available research and data used to inform final rules and amendments after a proposal's publication in the Federal Register; but, in this instance, the ink on this report is barely dry. When commenters are struggling to respond to proposals within already truncated comment periods, should we be asking them to be prepared to review and rapidly comment on material published well after a comment period has closed?

I have other concerns, including the overlap between our amended investment company advertising rules and FINRA's communications rules, but I think you get the point that today's rulemaking is not perfect. I can ultimately support it, however, because fund shareholders will benefit from this trimmed-down, layered approach to disclosure. I hold out the hope that we look at these changes as the beginning and not the end of an ongoing process. I offer my thanks to the staff of the Divisions of Investment Management, Economic and Risk Analysis, and Examinations, the Office of the General Counsel, and other offices throughout the Commission. Rulemakings like this one are at the heart of the Commission's mission, and I look forward to seeing these changes reflected in the disclosures shareholders receive.

[1] See Comment letter from T. Rowe Price Group, January 5, 2021, https://www.sec.gov/comments/s7-09-20/s70920-8210190-227541.pdf ("We estimate that our funds and their shareholders will save approximately $5.4 million annually by relying on Rule 498B."). ("T. Rowe Comment").

[2] See Comment letter from Proskauer Rose LLP, January 4, 2021, https://www.sec.gov/comments/s7-09-20/s70920-8204291-227466.pdf.

[3] Proposal at 67.

[4] T. Rowe Comment.

[5] See Comment letter from Fidelity, January 4, 2021, https://www.sec.gov/comments/s7-09-20/s70920-8204333-227469.pdf.

[6] See Alycia Chin, Jonathan Cook, Jay Dhar, Steven Nash, and Brian Scholl, How Do Consumers Understand Investment Quality? The Role of Performance Benchmarks, Office of the Investor Advocate Working Paper 2022-01 ("Chin, et al."), available at https://www.sec.gov/files/performance-benchmarks-2022-01.pdf. See also Press Release, SEC, Office of the Investor Advocate Releases Research Study on Fund Performance Benchmarks (September 19, 2022) https://www.sec.gov/news/press-release/2022-165.

Thank you, Chair Gensler. Today, we are voting on the recommendation to finalize rule and form amendments intended to require mutual funds and exchange-traded funds ("ETFs") to transmit concise and visually engaging reports to shareholders.

In 2009, the Commission adopted amendments to require mutual funds and ETFs to include a summary section at the front of the statutory prospectus.[1] These funds were also permitted to provide a summary prospectus containing "streamlined and user-friendly information that is key to an investment decision," with more-detailed information available online.[2] At the time, the Commission stated that the layered disclosure framework that "we are adopting has the potential to revolutionize the provision of information to the millions of investors who rely on mutual funds for their most basic financial needs."[3]

It was a privilege to be part of the team within the Division of Investment Management that worked on the summary prospectus. After that project, we started working on making the shareholder reports more effective for investors. Unfortunately, the financial crisis and the subsequent efforts to implement the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act[4] ("Dodd-Frank Act") delayed those efforts, but I am pleased we ultimately were able to return to that work.

Today, the Commission is expanding the layered disclosure framework to funds' shareholder reports. My expectation is that fund investors will benefit from the ability to monitor and assess their ongoing investments in a concise, easy-to-understand format. Importantly, fund investors will not lose access to the information that no longer will appear in funds' shareholder reports, such as the financial statements and accompanying notes. This information will be available on a fund's website and in its Form N-CSR filing, and fund investors also may request paper copies of this additional information by mail.

Section 912 of the Dodd-Frank Act authorizes the Commission to engage in investor testing programs for the purpose of evaluating any of its rules or programs.[5] Under this authority, the Commission staff engaged in investor testing with respect to shareholder reports in 2011. I am pleased that the features of the streamlined shareholder reports introduced by today's amendments are responsive to the feedback that we received in connection with that prior testing.[6] Additionally, when the Commission proposed these amendments in 2020,[7] it published a hypothetical annual report[8] to illustrate what a more concise, tailored shareholder report could look like. One commenter engaged a market research firm to distribute the hypothetical report to individual mutual fund and/or ETF investors.[9] The commenter reported that - of the more than 2,000 investors who provided responses to a feedback flier that accompanied the hypothetical report[10] - at least 91% stated that the streamlined shareholder report format was useful for monitoring their fund investments.[11] I am encouraged by the results of this empirical testing.

Open-end funds will no longer be able to rely on Rule 30e-3 under the Investment Company Act of 1940.[12] Rule 30e-3, adopted in 2018, permits funds to satisfy applicable shareholder report delivery requirements by sending paper notices that a shareholder report is available at an identified website address, unless an investor has instead consented to electronic delivery of the notice.[13] While I appreciate the industry efforts to implement Rule 30e-3, that rule was adopted at a time when form requirements caused shareholder reports to be quite voluminous.[14] Because today's amendments contemplate shareholder reports that are 3-4 pages in length, the underlying conditions have fundamentally changed. Accordingly, the significant reduction in the size of shareholder reports ultimately justifies the rescission of Rule 30e-3 with respect to open-end funds and ETFs.

Finally, the Commission today is adopting amendments to investment company advertising rules designed to promote transparent and balanced presentations of fees and expenses in advertisements. These amendments will apply to all investment companies that are subject to the Commission's advertising rules, including mutual funds, ETFs, registered closed-end funds, and business development companies. An understanding of a fund's fees and expenses - both on a standalone basis and in comparison to other funds - is an important consideration when making an investment. Accordingly, I am pleased that today's amendments regarding investment company advertising will empower investors to make more informed investment decisions.

For these reasons, I support today's amendments, although I agree with Commissioner Peirce that the Commission should address concerns regarding the disclosure requirements related to acquired fund fees and expenses.[15] I thank the staff in the Divisions of Investment Management and Economic and Risk Analysis, as well as the Office of the General Counsel, for their efforts. I also want to acknowledge the staff's efforts in preparing a comprehensive summary of the public comments received on the proposal, which was very helpful in reviewing the staff's recommendation.

[1] See Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, Investment Company Act Release No. 28584 (Jan. 13, 2009) [74 FR 4545 (Jan. 26, 2009)], available at https://www.sec.gov/rules/final/2009/33-8998.pdf.

[2] Id.

[3] Id.

[4] Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[5] Id. at § 912, 124 Stat. 1376, 1824.

[6] For example, we had identified that shareholder reports for certain types of funds - such as index funds that track a total stock market index - can be quite lengthy due to the large number of entries on the schedules of investments.

[7] Tailored Shareholder Reports, Treatment of Annual Prospectus Updates for Existing Investors, and Improved Fee and Risk Disclosure for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, Investment Company Act Release No. 33963 (Aug. 5, 2020) [85 FR 70716 (Nov. 5, 2020)], available at https://www.sec.gov/rules/proposed/2020/33-10814.pdf.

[8] See Hypothetical Streamlined Shareholder Report, available at https://www.sec.gov/files/final_2020_im_annual-shareholder%20report.pdf.

[9] Comment Letter of Broadridge Financial Solutions, Inc. (Jan. 4, 2021), available at https://www.sec.gov/comments/s7-09-20/s70920-8204380-227517.pdf.

[10] See Shareholder Report Feedback Flier, available at https://www.sec.gov/rules/proposed/2020/im-shareholder-report-ff.html.

[11] Comment Letter of Broadridge Financial Solutions, Inc., supra note 7.

[12] 17 CFR 270.30e-3.

[13] See Optional Internet Availability of Investment Company Shareholder Reports, Investment Company Act Release No. 33115 (June 5, 2018) [83 FR 29158 (June 22, 2018)], available at https://www.sec.gov/rules/final/2018/33-10506.pdf.

[14] The adopting release for today's amendments notes that an analysis conducted by the Commission's staff reveals that the average annual report is approximately 134 pages long, and the average semi-annual report is 116 pages long. See Tailored Shareholder Reports for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, Investment Company Act Release No.34731 (Oct. 26, 2022), available at https://www.sec.gov/rules/final/2022/33-11125.pdf.

[15] See Hester M. Peirce, One Good Step, More to Go: Statement on Final Tailored Shareholder Reports for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements (Oct. 26, 2022), available at https://www.sec.gov/news/statement/peirce-statement-shareholder-reports-102622.

The new rules implement Section 10D of the Securities Exchange Act of 1934, a provision added by the Dodd-Frank Wall Street Reform and Consumer Protection Act. New Exchange Act Rule 10D-1 directs national securities exchanges and associations to establish listing standards that require a listed issuer to: (1) adopt and comply with a written policy for recovery of erroneously awarded incentive-based compensation received by its current or former executive officers in the event it is required to prepare an accounting restatement due to its material noncompliance with any financial reporting requirement under the securities laws, during the three completed fiscal years immediately preceding the date that the issuer is required to prepare an accounting restatement; and (2) disclose those compensation recovery policies in accordance with Commission rules, including providing the information in tagged data format.

Further the final rules require specific disclosure of the listed issuer's policy on recovery of incentive-based compensation and information about actions taken pursuant to such recovery policy. The amendments also require all listed issuers to: (i) file their written recovery policies as exhibits to their annual reports; (ii) indicate by check boxes on their annual reports whether the financial statements included in the filings reflect correction of an error to previously issued financial statements and whether any of those error corrections are restatements that required a recovery analysis; and (iii) disclose any actions they have taken pursuant to such recovery policies.

This rulemaking is straightforward and long awaited. It was over a decade ago when Congress mandated that the Commission promulgate rules related to the recovery, by issuers from its executives, of erroneously awarded incentive based compensation.[1]

The rulemaking would require an issuer to have in place a policy for mandatory recovery of compensation based on materially misreported financials. The principle is simple: if an executive was paid too much based upon incorrect accounting, then the executive should not get to keep that money. In such an event, the portion of compensation attributable to that incorrect accounting would be recovered, or "clawed back," by the issuer.

Other components of the rule would require disclosure to investors of the recovery policy itself, additional disclosures when it has been determined pay should be recovered, and also, in the event there is a restatement of financials but no recovery necessitated, an explanation of why that is the case.[2] Further, the rule would require a check box on the cover of annual reports to provide investors with clear and accessible notice of when there is a correction of an error to previously issued financial statements and whether any such corrections are restatements that trigger a recovery analysis.[3]

Additionally the rulemaking would require recovery policies to be triggered by material errors defined to include both "Big R" and "little r" restatements.[4] As the adopting release notes, "little r" restatements accounted for 76% of all restatements in 2020;[5] and scoping such restatements into the rule is consistent with the relevant legal precedent,[6] statutory language and mandate,[7] accounting literature,[8] provisions of U.S GAAP and IFRS,[9] and staff guidance regarding accounting errors and materiality determinations.[10]

Both the scope and the design of the rule were carefully calibrated to incentivize higher quality financial reporting and to hold executives and issuers alike accountable by returning erroneously awarded incentive based compensation.[11]

Thank you to members of the public who submitted comment letters in connection with this rulemaking. Thank you also to the staff of the Division of Corporation Finance, the Office of the Chief Accountant, the Division of Economic and Risk Analysis, the Office of the General Counsel, and also the staff within Chair Gensler's office for your hard work.

[1] Listing Standards for Recovery of Erroneously Awarded Compensation, Release No. 33-11126 (October 26, 2022) (the "Adopting Release") at 1 (citing Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act"), which added Section 10D to the Securities Exchange Act of 1934.).

[2] Id at 109-14.

[3] Id at 109.

[4] Id at 35 (noting that "restatements that correct errors that are material to previously issued financial statements" are commonly referred to as "Big R" restatements, whereas "restatements that correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period" are commonly referred to as "little r" restatements.).

[5] Id at 36 n.108.

[6] Id at 27 n.74.

[7] Dodd-Frank Act Section 954. See also Adopting Release at 34.

[8] Adopting Release at 34 n.103.

[9] See id at 27 n. 73, 34 n. 103, & accompanying text.

[10] See Staff Accounting Bulletin No. 99, Materiality (Aug. 12, 1999) and Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (Sept. 13, 2006). See also Statement of Acting Chief Accountant Paul Munter, Assessing Materiality: Focusing on the Reasonable Investor When Evaluating Errors (Mar. 9, 2022).

[11] See Report of the Senate Committee on Banking, Housing, and Urban Affairs, S.3217, Report No. 111-176 at 135- 36 (Apr. 30, 2010) ("The Committee believes it is unfair to shareholders for corporations to allow executives to retain compensation that they were awarded erroneously.").

Today, the Commission adopts a rule that implements a key Congressional mandate under Section 954 of the Dodd-Frank Act: requiring public companies to recover incentive-based compensation that is erroneously paid to executives if the company restates its financial statements due to material errors.

To be clear: this is money that the executive was not entitled to, and would not have received, if the financial statements had been prepared accurately.

This rule is about fundamental fairness and integrity: Congress' intent was for shareholders to avoid costly litigation to recoup unearned executive compensation, preserving funds that, from a shareholder's perspective, could be put to more productive uses.

As I noted when the Commission voted on the Pay versus Performance rule this past September, a key factor driving the 2008 global financial crisis was the stark misalignment of incentives that led executives to take excessive, catastrophic risks.

In my previous role as a congressional staffer, I had a front row view of the fallout from this reckless behavior on the financial futures of working families. The result? Trillions of dollars of avoidable losses in household wealth; taxpayer-funded bailouts to the tune of hundreds of billions of dollars; millions of foreclosures; and a substantial loss of confidence in our markets.  

This gap in corporate governance guardrails particularly harmed long-term investors like pension funds and working families saving for retirement. Those choosing to invest in their long-term financial security are more likely to bear the costs of reckless actions by executives that temporarily increase share prices in the short-term but that lead to accounting restatements in the longer-run. To decrease the risk of these disruptions, Congress directed the Commission to adopt today's rule.

The rule will ensure that executives are incentivized to produce high quality, accurate financial statements, which investors rely on to make informed investment decisions.

Some have indicated that the rise in voluntary clawback agreements in recent years makes this rule unnecessary. To me, this trend makes the case for the rule even more compelling. Currently, there is significant variation in the types of clawback agreements used by issuers. By providing for standardized criteria, the rule gives investors greater assurances that all issuers face similar incentives to produce quality financial statements.

The rule also prevents the abuse of a potential loophole by incorporating what are referred to as "little r" restatements. "Little r" restatements correct errors immaterial to previously issued financial statements but that later become material to future reporting. Empirical evidence suggests that managers may try to use the discretion built into accounting standards to re-classify "Big R" restatements to "little r" restatements.

These types of restatements have made up an increasingly high share of all financial restatements in recent years. The final rule appropriately incorporates both "Big R" and "little r" restatements, ensuring that executives do not have an incentive to opportunistically classify material errors. 

I'm pleased to support the final adoption of today's rule. I would like to thank all of the Commission staff, and particularly staff in the Division of Corporation Finance, who worked so diligently to craft this thoughtful rule that will reduce incentives to engage in excessive risk-taking, provide investors with more confidence in board oversight of executive management, and promote financial stability.  

What we are doing today-implementing the statutory clawbacks mandate-is commendable. But how we are doing it-expansively, inflexibly, and impractically-is not. Accordingly, I cannot vote to adopt this rule.

Section 954 of the Dodd-Frank Act generally requires the Commission to direct exchanges to require listed companies to "develop and implement a policy" for disclosing how they handle incentive-based compensation tied to reported financial information and, when that reported information has to be restated, a policy for clawing back related erroneously awarded compensation.[1] Congress did not prohibit us from allowing listing exchanges and issuers some flexibility in crafting, respectively, the required listing standards and policies and procedures. Nor did Congress, in adopting this provision, prohibit us from using our exemptive authority under Section 36 of the Exchange Act, which allows the Commission to tailor the implementing regulations if doing so is "necessary or appropriate in the public interest, and is consistent with the protection of investors."[2] Instead of taking advantage of this statutory flexibility, the release before us adopts a prescriptive approach that, because of its breadth and inflexibility, in some cases, could impose costs on shareholders greater than the benefits they derive from the clawbacks.

Had we built flexibility into the rule, listing exchanges and companies could have developed sensible approaches to achieving the laudable goal of clawing back compensation paid on the basis of subsequently restated financial metrics. The adopting release, however, fails to permit listing exchanges to craft workable listing standards and enforce them in a common-sense manner. Likewise, the final rule does not permit company boards, guided by their fiduciary duty, to determine when clawing back compensation makes sense. Such an approach would have served shareholders by ensuring that companies claw back erroneously awarded compensation when doing so yields a net benefit to shareholders.

The Rule's Scope is Too Broad

This rule is unnecessarily broad in at least four ways. First, the rule is not limited to "Big R" restatements, which restate historical financial statements to correct errors that were material to those previously issued financial statements. The final rule explicitly also requires clawbacks based on so-called "little r" restatements, by which companies restate prior period information in the current period comparative financial statements. Issuers use "litte r" restatements for errors that are not material to previously issued financial statements, but would result in a material misstatement if either the errors were left uncorrected in the current report or the error correction were recognized in the current period. Section 954, which looks to when an "issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws," does not force the inclusion of "little r" restatements. Including them unnecessarily complicates the rule and may require clawback analysis when the error did not lead to erroneous compensation during the three-year period, or require a clawback of de minimis amounts. The Commission explained in 2021, when it reopened comment on the 2015 proposal, that it was concerned about opportunistic behavior by companies when choosing between a "Big R" and "little r" restatement.[3] The release does not substantiate these concerns, but if companies and their auditors are misjudging the materiality of financial statement errors, a compensation clawback rule is not the proper remedy.[4] A better approach-and one that would be easier to apply-would have required clawbacks only when a company has to "prepare a financial restatement to correct a material error of the type required to be reported under Item 4.02(a) of Form 8-K."[5]

Second, the rule applies to too many company employees. Section 954 requires clawbacks from "executive officers," but leaves the term undefined. After quoting from the Senate Banking Committee Report that the clawback provision "is required to apply to executive officers, a very limited number of employees, and is not required to apply to other employees,"[6] the Commission adopts an intentionally broad definition of "executive officer."[7] Affected employees would include anyone who performs a policy-making function for the issuer regardless of involvement with the events leading to the restatement. By one count, the rule will apply to as many as 50,000 public company employees.[8] Better approaches might have been to limit this definition to the company's top five executives,[9] to claw back compensation only from people with a material role in the events leading to the restatement,[10] or to allow exchanges or compensation committees the flexibility to define the term.

Third, the rule applies to all listed issuers, including emerging growth companies ("EGCs"), Smaller Reporting Companies ("SRCs"), and Foreign Private Issuers ("FPIs"). The Commission "acknowledge[s] that SRCs and EGCs may face disproportionate costs of compliance as compared to other companies," but also speculates that they "may realize disproportionate benefits."[11] The Commission does not show that those benefits will outweigh the costs, and the Regulatory Flexibility Analysis does not seriously assess ways to ease the burden for small issuers. The Commission should have used its exemptive authority to exempt EGCs or SRCs from the rule, tailor it for these companies,[12] provide them with a more extended compliance period, or delay their XBRL tagging implementation period.[13] The Commission also could have permitted listing exchanges to make reasonable accommodations for FPIs subject to different clawback regulations.[14]

Fourth, the definition of "incentive-based compensation" is too broad. We reasonably could have limited the definition to accounting-based metrics. Instead, the Commission is requiring companies to claw back compensation based on stock price and total shareholder return ("TSR"). Whereas Section 954 requires clawing back compensation that is "based on financial information required to be reported under the securities laws," stock price and TSR are market-driven metrics of how the stock performs that reflects "many factors beyond its reported financial information."[15] Although "affected by accounting-related information," stock price and TSR are not "accounting-based metrics," which the release acknowledges.[16]

The Rule is Unnecessarily Prescriptive

The rule's broad scope is paired with an unduly prescriptive attempt to deprive listing exchanges and companies of any discretion. The Commission allows the exchanges to play only an essentially ministerial role in crafting listing standards and similarly seeks to direct the manner in which exchanges conduct oversight and enforcement. The rule also limits boards' ability to tailor their policies to their unique facts or to determine when clawing compensation back is worth the effort. Allowing boards to decide to whom the policy should apply, when it should apply, and when attempting recovery does not make sense would fall comfortably within the discretion normally afforded to boards, a discretion that is bounded by directors' fiduciary obligation under state laws to exercise their authority properly.[17]

A few examples illustrate the rule's unnecessary prescriptiveness. First, the rule's impracticability standard is itself impracticable. The rule requires a company to recover erroneously awarded compensation unless: the direct expense it would have to pay to a third party to help would exceed the amount to be recovered; recovery would violate a home country law that was adopted before this rule was finalized; or recovery would jeopardize a broadly-available tax-qualified retirement plan.[18] To qualify for the first exception, the company has to "make a reasonable attempt" to claw back the compensation and document its efforts.[19] Moreover, internal costs like "resources required to work with, manage, or monitor the third party's efforts" or those "associated with defense of counter-claims" do not count in the cost-benefit analysis.[20] A de minimis threshold under which companies would not need to attempt to recover compensation would have been a more practicable approach.[21]

Another example of the rule's over-prescriptiveness is its disclosure mandates. Companies must disclose: their clawback policies as a tagged exhibit to their annual reports[22]; the amount of erroneously awarded compensation attributable to an accounting restatement[23]; an analysis of how the erroneously awarded compensation was calculated[24]; the estimates used to determine the amount of erroneously awarded compensation linked to stock price or TSR and an explanation of the methodology used for such estimates [25]; amounts recovered[26]; amounts still owed[27]; and amounts forgone.[28] The rule could instead have required website disclosure of policies and procedures and provided for streamlined, fully anonymized disclosure about amounts recouped, owed, and forgone.[29]

The release strains to read inflexibility into the statutory language, but Section 954 affords the Commission discretion to craft a workable standard. The statute requires only that a company "develop and implement" a clawback policy, not that every company adopt an identical policy or that companies recover all erroneously paid compensation from employees. As one commenter suggested, the Commission could have "simply direct[ed] the exchanges to require companies to adopt clawback policies and then provide annual disclosure in their proxy statements that describe the rationale for the company's clawback policy, any revisions to that policy, and the role of the compensation committee in making clawback decisions."[30] An approach that afforded greater discretion to exchanges and boards could have been less costly and yet still effectuated the statutory purpose. Some companies might make the same choices the Commission is making here, but affording companies discretion would best protect shareholders.

Shareholders Will Pay for the Rule's Complexity

Balanced clawback policies can benefit shareholders, which is why many companies already have implemented such policies. Now the Commission is upsetting the balance by dictating a new approach that will require many companies to replace their existing policies and renegotiate contracts with affected employees in a fairly short time period.[31] Almost every one of the Commission's discretionary choices increases the complexity and cost of the rule as compared to the statutory baseline. The Commission instead should have used its discretionary authority to ensure that clawback policies would yield a net benefit for shareholders.

Again, a few examples illustrate how shareholders will pay for this rulemaking more than they benefit:

• The release does not provide a de minimis threshold. As one commenter noted:

[I]t hardly seems worthwhile for a board to have to "make a reasonable attempt to recover" an excess incentive compensation amount of $100. Even spending time discussing such a matter is not in the shareholders' best interests, no less the fact that the value of any amount of time spent pursuing such amount would far exceed the recovery.[32]

• Because of the broad scope of covered executives,[33] companies likely will spend too much trying to recoup compensation from lower level executive officers. As Professor Fried noted, "below-5 executives pay packages are much smaller than top-5 executive pay packages."[34] Recovering compensation from lower-level executives will likely be as costly as recovering from their more senior counterparts, but less lucrative.
  
  
• Clawbacks associated with "little r" restatements are likely to involve lower dollar amounts than "Big R" restatements given the immaterial nature or prior year adjustments. To ease the burden of clawing back compensation after "little r" restatements, the Commission could have provided Boards with more discretion to determine when it would be too costly to attempt a recovery effort or could have exempted compensation based on TSR.
  
  
• More generally, compensation returned could be extremely minimal and recoupment costs very high for a significant portion of TSR-related clawbacks, so the Commission's decision to require companies to conduct these clawbacks may not benefit shareholders.[35]
  
  
• Finally, this rule opens up companies to new forms of litigation risk.
  
  
• The Commission acknowledges that its decision to include a trigger date-"the date that the issuer's board . . . concludes, or reasonably should have concluded, that the issuer is required to prepare an accounting restatement"[36]-"creates some risk that the board's conclusions will be subject to litigation."[37]
• The rule requires that companies must recover the money "reasonably promptly,"[38] which also invites litigation risk and may discourage recovery practices that could mitigate costs to companies, like netting overpayments with other incentive-based underpayments, or set-offs.[39]

Conclusion

A seemingly simple mandate-make sure companies claw back compensation when they restate their financials-is not, as it turns out, so simple when a Commission with a penchant for prescription is charged with putting it into practice. The passage of time has not been shareholders' friend. As we did in implementing the pay versus performance rule under Section 953 of Dodd-Frank, we have added complexity at every stage of the rulemaking process. Rather than scoping the rule appropriately to meet the statutory objective and affording listing exchanges and companies reasonable discretion in applying the rule, our path will cost shareholders more and benefit them less.

While I take issue with a number of the policy decisions the Commission made, the staff has worked very hard on this rule. Seven years between proposal and adoption is a long time, so I know this day is particularly welcome for many in the Division of Corporation Finance, the Division of Economic and Risk Analysis, the Office of General Counsel, and other staff who have worked on this rule. I appreciate your hard work and lively engagement with me and my staff. Special thanks go to Luna Bloom, Steven Hearne, Brian Galle, and Jessica Barberich for answering my many questions on the release, along with Lindsay McCord and Jonathan Wiggins for lots of time patiently discussing the fine points of "little r" restatements.

[1] Pub. L. No. 111-203, § 954, 124 Stat. 1376, 1904 (2010) (codified at 15 U.S.C. § 78j-4).

[2] 15 U.S.C. § 78mm. In other places, Congress did prohibit the Commission from exercising exemptive authority. See, e.g., Dodd-Frank Act § 772 (prohibiting invoking the Commission's exemptive authority in connection with security-based swaps reforms).

[3] Reopening of Comment Period for Listing Standards for Recovery of Erroneously Awarded Compensation, Rel. No. 34-93311, 86 Fed. Reg. 58232, 58234, Oct. 21, 2021 ("Since the Commission issued the Proposing Release in 2015, concerns have been expressed that issuers may not be making appropriate materiality determinations for errors identified. Some commentators have suggested that this could be because some of these issuers are seeking to avoid compensation recovery under their clawback policies." (footnote omitted)).

[4] Our Acting Chief Accountant recently warned companies to conduct objective materiality analyses and invited them to come in and talk to the Office of Chief Accountant. Paul Munter, Assessing Materiality: Focusing on the Reasonable Investor When Evaluating Errors, SEC (Mar. 9, 2022), https://www.sec.gov/news/statement/munter-statement-assessing-materiality-030922.

[5] See Comment Letter from American Bar Association Committee on Federal Regulation of Securities of the Section of Business Law at 17, Feb. 11, 2016, https://www.sec.gov/comments/s7-12-15/s71215-67.pdf (hereinafter "ABA 2016").

[6] See Adopting Release at 7 n.9 (quoting S. Rep. No. 111-176 at 136 (2010)).

[7] See 17 CFR § 240.10D-1(d); Adopting Release at 50-55.

[8] Jesse M. Fried, Rationalizing the Dodd-Frank Clawback, 13 (Eur. Corp. Governance Inst., Working Paper No. 314, 2016) (hereinafter "Fried").

[9] See, e.g., id. at 62 n.144. In addition to easing the rule's burdens, such an approach might better achieve the objective of improving corporate behavior, since these five people are most able to affect what the company does. As Fried explains, "there is a vast difference in power between the most powerful executives in the top-5 and the most powerful executives in the below-5." Id. at 48.

[10] See Comment Letter from Society for Corporate Governance at 2-3, Nov. 29, 2021, https://www.sec.gov/comments/s7-12-15/s71215-9411438-263053.pdf (hereinafter "SCG 2021").

[11] Adopting Release at 178.

[12] See, e.g., Comment Letter from ABA 2016 at 74-75 (listing specific ways in which the Commission could tailor regulations for EGCs and SRCs).

[13] See Pay Versus Performance, Rel. No. 34-95607, 87 FR 55134, 55162, Oct. 11, 2022 (Allowing SRCs "to provide the required Inline XBRL data beginning in the third filing in which it provides pay versus-performance disclosure, instead of the first.").

[14] See, e.g., Comment Letter from Sullivan and Cromwell at 2, Sep. 22, 2015, https://www.sec.gov/comments/s7-12-15/s71215-63.pdf ("Because employment law is often governed by the location of the employee, a limited conflicts of law exception for a foreign private issuer's home country law will not adequately address the issues faced by multinational corporations (including US issuers) with executive officers resident in and performing services in numerous jurisdictions. For this reason, the Proposed Rule would potentially put an issuer in the position of failing to comply with the applicable listing standard or governing local law.").

[15] Comment Letter from ABA 2016 at 28.

[16] Adopting Release at 63 ("Although the phrase 'financial information required to be reported under the securities laws' might be interpreted as applying only to accounting-based metrics, in consideration of the statutory purpose described above, we have determined that it is appropriate to interpret the term to include performance measures including stock price and TSR that are affected by accounting-related information and that are subject to our disclosure requirements.") (emphasis added); see also Comment Letter from McGuireWoods, LLP and Brownstein Hyatt Farber Schreck LLP at 18, Nov. 22, 2021, https://www.sec.gov/comments/s7-12-15/s71215-9385310-262666.pdf ("[N]either stock price nor TSR is a financial reporting measure used in preparing financial statements.) (hereinafter "McGuireWoods"). The Commission implausibly argues that Congress' intent to include a broad set of metrics is evident in the phrase "based on financial information." Adopting Release at 63-64 (emphasis added). If Congress intended "based on" to encompass compensation that was only "in part" based on financial metrics, it would have said as much. Dodd-Frank uses the phrases "based in whole or in part" and "based, in whole or in part" elsewhere.

[17] See, e.g., Comment Letters from the U.S. Chamber of Commerce Center for Capital Markets Competitiveness at 7-8, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-29.pdf ("In many ways, the Proposal seems premised on the faulty, cynical notion that notwithstanding their well-established fiduciary duties under state law, independent directors are not to be trusted to do the right thing when it comes to matters of executive compensation or legal compliance."); Center On Executive Compensation at 2, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-38.pdf ("The Commission's approach to the implementation of the Dodd-Frank clawback requirement should be considered in concert with the fiduciary duties of a registrant's Board of Directors. Pursuant to these duties, which extend to all areas of board oversight, a board must act in good faith and with reasonable care to make decisions which are in the best interest of the corporation and its shareholders. These fiduciary duties weigh in favor of granting the Board discretion in key areas of the final rule to ensure the clawback requirement is implemented in a manner which both fulfills congressional intent and protects shareholder interests."); FedEx Corporation at 2, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-31.pdf ("A company's board of directors should have discretion whether to seek recovery of incentive-based compensation if there is a triggering financial restatement. The board of directors has a fiduciary duty to act in the best of interests of stockholders."); ABA 2016 at 60 ("We firmly believe that Boards of Directors will be sufficiently motivated both by their fiduciary obligations, as well as the implicit pressure that is likely to result from the required disclosure [of clawback policies under Section 954], to take appropriate action to recover excess incentive-based compensation in an expeditious and pragmatic manner. Additional detailed requirements that will either govern or impact the manner of recovery would simply make an already overly-prescriptive rule even more formalistic and difficult to enforce").

[18] See CFR § 240.10D-1(b)(1)(iv).

[19] See Adopting Release at 92 ("The final rules also require the issuer to make a reasonable attempt to recover incentive-based compensation before concluding that it would be impracticable to do so. The issuer must document its attempts to recover and provide that documentation to the exchange.").

[20] Comment Letter from Society for Corporate Governance (formerly Society of Corporate Secretaries & Governance Professionals) at 8, Sept. 18, 2015, https://www.sec.gov/comments/s7-12-15/s71215-60.pdf (hereinafter "SCG 2015"); see also Comment Letter from ABA 2016 at 48 n.91.

[21] See, e.g., Jesse M. Fried & Nitzan Shilon, Excess-Pay Clawbacks, 36 Iowa J. Corp. L. 721, 749 n.120 ("[T]here could of course be a carveout for 'de minimis' amounts of excess pay. We see no real cost to such a carveout. Refraining from clawing back small amounts of excess pay will not substantially affect shareholders' returns nor meaningfully reduce the deterrent effect of the clawback. At the same time, such a carveout will confer a benefit on shareholders by avoiding the transaction costs associated with effecting a clawback.").

[22] See 17 CFR § 229.601(b)(97) and 17 CFR § 229.402(w)(4).

[23] 17 CFR § 229.402(w)(1)(i)(B).

[24] Id.

[25] 17 CFR § 229.402(w)(1)(i)(C).

[26] See Instruction 5 to 17 § CFR 229.402(c), and Instruction 5 to 17 § CFR 229.402(n).

[27] 17 CFR § 229.402(w)(1)(i)(D).

[28] 17 CFR § 229.402(w)(1)(ii).

[29] Many commenters raised concerns about the disclosures and suggested alternate approaches. See, e.g., Comment Letters from ABA 2016 at 5-6, 62 (recommending website disclosure); Davis Polk 2021 at 5 (suggesting that disclosure of the methodology for calculating the recoverable amounts would be burdensome, lack comparability, and involve litigation risk); SCG 2021 at 4 (suggesting that the disclosure could be confusing and would add legal, audit, compensation consulting, and other expenses); Business Roundtable at 3, Sept. 15, 2015, https://www.sec.gov/comments/s7-12-15/s71215-42.pdf (raising safety concerns associated with disclosing names); Compensation Advisory Partners LLC at 2, Sept. 10, 2015, https://www.sec.gov/comments/s7-12-15/s71215.htm (expressing reputational concerns); Mercer at 11, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-10.pdf (suggesting that, instead of public disclosure, exchanges could require individualized information as needed) (hereinafter "Mercer"); Sullivan & Cromwell LLP at 7, Sept. 22, 2015, https://www.sec.gov/comments/s7-12-15/s71215-63.pdf (suggesting that the specific identity of an executive will in most cases not be material to the evaluation of the boards' determination not to pursue recovery); UBS Group AG at 5, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-51.pdf (suggesting that naming individuals from whom the issuer determines not to recover is irrelevant and provides no benefit to shareholders); McGuireWoods at 12 (recommending generalizing compensation recovery disclosure); Exxon Mobil Corporation at 4, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-22.pdf (expressing concern that disclosure of individuals' names could conflict with local data privacy laws); Japanese Bankers Association at 8, Sept. 14, 2015, https://www.sec.gov/comments/s7-12-15/s71215-17.pdf (expressing concern that proposed disclosures could conflict with Japanese data privacy laws).

[30] Comment Letter from SCG 2021 at 6.

[31] The process of revising existing clawback policies and renegotiating contracts with executive officers is likely to be expensive. See, e.g., Comment Letters from Keith Paul Bishop at 6, Sept. 13, 2015, https://www.sec.gov/comments/s7-12-15/s71215-24.pdf (indicating that issuers will face significant costs and litigation risk as policies are re-written); SCG 2015 at 16 (indicating that current recovery plans prevent or restrict amendments unless approved by the participant affected by the amendment, and that it is unlikely that someone no longer working for the issuer will agree to an amendment that results in costs to herself).

[32] Comment Letter from McGuireWoods at 22; see also Comment Letter from SCG 2015 at 9 ("[W]e do not believe it will always be necessary for a reasonable attempt to be made in order for the compensation committee to determine that recovery is 'impracticable.' For example, consider when the amount to be recovered is de minimis in amount. Because there is no de minimis exception or threshold to the recovery amount, issuers are expected to recover any amount of excess compensation in connection with every accounting restatement, no matter how small. In such cases, we believe the compensation committee may very well determine that the recovery is 'impracticable' and not in the best interests of the issuer or its stockholders without first having to seek recovery to make that determination.").

[33] 17 CFR § 240.10D-1(d).

[34] Fried at 49.

[35] One study of restatements from 2003 through 2012 found that "restatements at over 4,000 companies caused only an average 1.5% decline in stock price and a median decline of 0.01%." Comment Letter from Mercer at 6 (citing a study of restatements by the Center for Audit Quality - Financial Restatement Trends in the United States: 2003-2012). According to one commenter, conducting an event study to determine what TSR would have been absent a restatement could cost an estimated $100,000 to $200,000. Comment Letter from Davis Polk & Wardwell LLP at 2, Sept. 11, 2015, https://www.sec.gov/comments/s7-12-15/s71215-14.pdf. Litigation risk may lead companies to conduct these studies despite the rule's allowance for a "reasonable estimate" of TSR. See, e.g., Comment Letter from Pearl Meyer at 3, Sept. 15, 2015, https://www.sec.gov/comments/s7-12-15/s71215-47.pdf ("Arriving at this reasonable estimate will necessitate extensive research, testing, and expense to understand how stock price and TSR would have been impacted by a restatement, and there are countless assumptions that go into the 'but for' price of the stock. . . . If adopted as is, the Proposal will be a windfall for the plaintiffs' bar as any "reasonable estimate" will be fair game for challenge, and executive officers will also likely dispute these estimates if subject to a clawback.); see also Comment Letter from McGuireWoods at 17-18 (Under a "reasonable estimate" standard, "an issuer will still be faced with the complexity of doing an event study if selected as the methodology utilized, or will be faced with the complexity of selecting and developing another method. In our view, the subjectivity, difficulty, and costs associated with the development of reasonable estimates on which to determine the impact of a restatement on stock price or TSR to calculate excess executive compensation subjects issuers to an undue burden . . . .").

[36] 17 CFR § 240.10D-1(b)(1)(ii)(A).

[37] Adopting Release at 45.

[38] 17 CFR § 240.10D-1(b)(1).

[39] See, e.g., Exxon at 2 ("Money is fungible. As a practical matter . . . it is easier to cancel or retain amounts that remain within the control of the company than to recover amounts already paid out to an executive. In the absence of recovery via set-off, if the executive resists recovery, litigation to recover compensation already paid can be costly and time consuming. If the Commission is concerned about the time value of money for certain recovery practices, the Commission could have required that interest costs must be taken into account for any recovery.").

Today, the Commission is voting on a recommendation to adopt rules implementing Section 954 of the Dodd-Frank Act ("Section 954") by directing the exchanges to establish listing standards for the recovery of compensation erroneously awarded to management, generally referred to as "clawbacks."[1] I have several objections to how the Commission is implementing Section 954.

Outsourcing the Commission's Economic Analysis Responsibilities

It has been well established that the Commission undertakes an economic analysis of its proposed rules and subjects that analysis to public comment. Yet, the Commission did not do so for this proposal. Instead, the Commission conducted an economic analysis of the proposal and the factual data as it existed in 2015, not 2022.

Rather than re-proposing the 2015 rules with updated data and analysis,[2] the Commission took a procedural shortcut and simply re-opened the comment period.[3] The reopening notice recognized that "important developments" related to clawbacks had occurred since 2015.[4] But rather than providing a new economic analysis, the Commission raised questions as to whether there "[a]re . . . any other developments . . . that should affect our consideration of the Proposed Rules or their potential economic effects [and] are there any changes we should consider in the methodologies and estimates used to analyze the economic effects. . ."[5] In effect, the Commission outsourced its responsibility to conduct an appropriate economic analysis to commenters - and then it only gave them 30 days to do so.

A lot has changed since 2015 - arguably, a full business cycle has passed since that time.[6] As such, the Commission should have undertaken new economic analysis of costs and benefits. The publication in June 2022 of a supplemental memo providing some economic data falls short of the breadth of the analysis contained in the 2015 proposal.[7]

"It's Déjà Vu all Over Again."[8]

Like other recent rulemakings, the comment period for 2021 and 2022 reopening notices was 30 days. I have expressed my objections to these shortened comment periods elsewhere.[9] These shortened comment periods significantly weaken a cornerstone of effective rulemaking: feedback from investors, issuers, and intermediaries to provide us with their expertise. This process improves our ability to make informed decisions.

Compliance Burdens Have Been Updated

I am pleased, however, that today's recommendation is using an updated cost burden calculation.[10] Prior estimates likely dramatically understated the compliance burdens when the Commission estimated that legal professionals would have an average cost of $400 per hour.[11] Today, the Commission has revised that number to $600 per hour-a 50% increase, to reflect an inflation adjustment. It is important that our estimates are up-to-date so that costs are properly evaluated, both on an individual and cumulative basis. The prior $400 estimate was used for about 16 years.[12] I hope that moving forward, these estimates will be revised regularly to reflect current compliance costs.

The Commission's Final Rules Are Overly Broad

Today's recommendation also includes a new interpretation that Section 954, which covers "an accounting restatement due to the material noncompliance . . .with any financial reporting requirement," should include "little r" restatements.[13] The inclusion of "little r" restatements represents a dramatic shift in the Commission's interpretation of Section 954.[14] The 2015 proposal contained not a single reference to the term "little r" and minimal discussion of related terms.[15] The Commission's first signal that the rules would capture "little r" restatements came nearly eleven years after the passage of the Dodd-Frank Act, and six years after the 2015 proposal.[16] The adopting release we are voting on today, contains 65 references to "little r" restatements.

Today's release cites an Audit Analytics restatement study.[17] An accompanying release for the study provides background on "little r" restatements, noting that: " 'little r' restatements, deal with immaterial misstatements, or adjustments made in the normal course of business . . . [b]ecause revision restatements are less severe, they are not generally viewed as a sign of poor reporting."[18] By broadening the scope of the 2015 proposal to include "little r" restatements, the final rules appear to conflict with the statutory directive and even some of the underlying data.

Moreover, brand new checkbox disclosure on Form 10-K has been included with respect to "little r restatements," irrespective of whether it is connected to a clawback or executive compensation payment issue.[19] While concerns about the use of "little r" restatements may be a topic worthy of addressing, including this checkbox disclosure extends far beyond the scope of the Section 954 rulemaking.

In addition, the final definition of the term "executive officer" appears overly broad. Congress indicated that the clawbacks should apply to "executive officers, a very limited number of employees."[20] Yet the rules adopted today may capture persons beyond the narrow scope contemplated by Congress. Commenters have raised related concerns regarding the scope of this definition, but the final rules appear to brush these concerns aside.[21]

Unintended Regulatory Consequences

Ultimately, the final rules may increase misalignments between the interests of shareholders and corporate executives. My predecessors raised concerns related to the Dodd-Frank Act's executive compensation provisions,[22] and noted that under Section 954, "compensation arrangements [might] be restructured so that executives end up receiving less incentive pay that could be clawed back but larger discretionary bonuses ..."[23] This may result in salary increases, rather than compensation mechanisms tied to financial reporting measures. The broad approach the Commission takes may ultimately weaken alignment of interests between shareholders and management.[24] According to some media reports, parallel trends may already be occurring as corporations remove performance goals and replace options with shares.[25]

Therefore, I am unable to support the recommendation today. I thank, however, the staff in the Divisions of Corporation Finance, Economic and Risk Analysis, Trading and Markets, and the Offices of the General Counsel and the Chief Accountant, for their work and for their willingness to engage, particularly Steve Hearne, Jessica Barberich, Luna Bloom, Chyhe Becker, and Al Sheen. I also want to acknowledge the comprehensive summary of the public comments received, including a 117-page summary for the original 2015 proposal and a 26-page summary on the 2021 re-opening of the comment period.

[1] Pub. L. No. 111-203, Sec. 953(a), 124 Stat. 1841 (2010).

[2] Listing Standards for Recovery of Erroneously Awarded Compensation, Release No. 34-75342 (Jul. 1, 2015) [80 FR 41144 (Jul. 14, 2015)] (the "2015 Proposal") available at https://www.sec.gov/rules/proposed/2015/33-9861.pdf.

[3] Reopening of Comment Period for Listing Standards for Recovery of Erroneously Awarded Compensation, Release No. 34-93311 (Oct. 14, 2021) (the "2021 Reopening Notice") available at https://www.sec.gov/rules/proposed/2021/33-10998.pdf; Reopening of Comment Period for Listing Standards for Recovery of Erroneously Awarded Compensation, Release No. 34-95057 (June 8, 2022)(the "2022 Reopening Notice") available at https://www.sec.gov/rules/proposed/2022/33-11071.pdf.

[4] 2021 Reopening Notice at 6.

[5] Id. at 19.

[6] Approximately six and a half years passed between the time of the 2015 Proposal and the 2022 Reopening Notice, which represents under many measures a full business cycle. Refer to the business cycle troughs and peaks for the period between June 1857 and February 2022, available at https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions.

[7] For context, the Economic Analysis and Paperwork Reduction Act analysis in the 2015 Proposing release represented nearly 60 pages of impact analysis, whereas the memorandum from the Division of Economic and Risk Analysis (DERA) was 9 pages long. Memorandum supplemental data and analysis on the voluntary adoption of compensation recovery provisions by issuers and the impact of including "little r" restatements as triggers for a compensation recovery analysis (June 8, 2022) available at https://www.sec.gov/comments/s7-12-15/s71215-20130560-298718.pdf.

[8] For a selection of quotes from Yogi Berra in the context of a discussion on clawbacks, see Dissenting Statement at an Open Meeting on Dodd-Frank Act "Clawback" Provision, Commissioner Michael S. Piwowar (July 1, 2015) available at https://www.sec.gov/news/statement/dissenting-statement-open-meeting-clawbacks-erroneously.

[9] Remarks at the APABA-DC Awards and Installation Reception, Commissioner Mark T. Uyeda (Oct. 19, 2022) available at https://www.sec.gov/news/speech/uyeda-apaba-dc-20221019.

[10] Listing Standards for Recovery of Erroneously Awarded Compensation, Release No. 33-11126 (Oct. 26, 2022), available at https://www.sec.gov/rules/final/2022/33-11126.pdf.

[11] See e.g., Reopening of Comment Period for Pay Versus Performance, Release No. 34-94074 (Jan. 27, 2022) [87 FR 5751 (Feb. 2, 2022)], available at https://www.sec.gov/rules/proposed/2022/34-94074.pdf.

[12] See Executive Compensation and Related Person Disclosure, Release No. 33-8732A (Aug. 29, 2006) [71 FR 53158, 53214 n. 574)] ("We recently have increased this hourly rate estimate to $400.00 per hour after consulting with several private law firms").

[13] Listing Standards for Recovery of Erroneously Awarded Compensation at 34.

[14] See 2015 Proposal. See also generally, Highlights of the Dialogue with the Director of the SEC's Division of Corporation Finance, Meeting of the Federal Regulation of Securities Committee of the ABA Business Law Section, as part of that Section's Annual Meeting in Chicago, Illinois (Sept. 18, 2015), written summary available at https://www.weil.com/~/media/files/pdfs/highlights-of-the-dialogue-with-the-director-of-the-sec.pdf, noting that The Division of Corporation Finance Director Keith F. Higgins "confirmed that the [2015] proposal extends only to so-called "Big R" restatements, meaning restatements to correct material errors in the financial statements. There is no intention here to create new restatement definitions that deviate from GAAP concepts associated with restatement under ASC 250."

[15] 2015 Proposal at note 262, referencing a study discussing "non-4.02 restatements."

[16] See 2021 Reopening Notice; 2022 Reopening Notice.

[17] Audit Analytics, 2020 Financial Restatements (A Twenty Year Review), (Nov. 2021) available at https://www.auditanalytics.com/doc/2020_Financial_Restatements_A_Twenty-Year_Review.pdf.

[18] Audit Analytics 2020 Financial Restatements Review, (Dec. 7, 2021) available at https://blog.auditanalytics.com/2020-financial-restatements-review/.

[19] Listing Standards for Recovery of Erroneously Awarded Compensation at 117.

[20] Report of the Senate Committee on Banking, Housing, and Urban Affairs, S.3217, Report No. 111-176 at 136 (Apr. 30, 2010).

[21] See e.g., Letter from David Lynn, Chair, American Bar Association Committee on Federal Regulation of Securities of the Section of Business Law (Feb. 11, 2016) available at https://www.sec.gov/comments/s7-12-15/s71215-67.pdf.

[22] Remarks at the 26th Annual Corporate Law Institute, Tulane University Law School: Federal Preemption of State Corporate Governance, Commissioner Daniel M. Gallagher, (Mar. 27, 2014) available at https://www.sec.gov/news/speech/2014-spch032714dmg.html.

[23] Remarks at Society of Corporate Secretaries & Governance Professionals, 66th National Conference on "The Shape of Things to Come." Commissioner Troy A. Paredes, (July 13, 2012), available at https://www.sec.gov/news/speech/2012-spch071312taphtm.

[24] See remarks from The Division of Economic and Risk Analysis Director Mark J. Flannery at the Open Commission Meeting of July 1, 2015, available at https://www.youtube.com/watch?v=oMCsrByH6t0 at 16:00, noting that under the 2015 Proposal "[. . .] the interest of the executives could therefore diverge from those of the shareholders."

[25] See Patrick Temple-West, US Companies Rework Bonus Plans to Protect Executive Pay, Financial Times (Oct. 22, 2022), available at https://www.ft.com/content/6aa4ab2d-fc4d-454f-b365-e8c07f8ba0ef.

The Securities and Exchange Commission today proposed a new rule and rule amendments under the Investment Advisers Act of 1940 to prohibit registered investment advisers from outsourcing certain services and functions without conducting due diligence and monitoring of the service providers.

"Registered investment advisers - more than 15,000 of them in total - play a critical role in our economy, advising more than 60 million accounts with combined assets under management of over $100 trillion," said SEC Chair Gary Gensler. "Though investment advisers have used third-party service providers for decades, their increasing use has led staff to make several recommendations to ensure advisers that use them continue to meet their obligations to the investing public. When an investment adviser outsources work to third parties, it may lower the adviser's costs, but it does not change an adviser's core obligations to its clients. Thus, today's proposal specifies requirements for investment advisers designed to ensure that advisers' outsourcing is consistent with their obligations to clients."

As demand for the asset management industry has grown and clients' needs have become more complex, many advisers have engaged third-party service providers to perform certain functions or services, many of which are necessary for an adviser to provide its advisory services in compliance with the Federal securities laws. These functions can include providing investment guidelines, portfolio management, models related to investment advice, indexes, or trading services or software. Outsourcing can benefit advisers and their clients, but clients could be significantly harmed when an adviser outsources a function or service without appropriate adviser oversight.

The proposal would require advisers to satisfy specific due diligence elements before retaining a service provider that will perform certain advisory services or functions, and to subsequently carry out periodic monitoring of the service provider's performance. The rule would apply to advisers that outsource certain "covered functions," which include those services or functions that are necessary for providing advisory services in compliance with the Federal securities laws and that if not performed or performed negligently would result in material negative impact to clients.

Additionally, the proposal would require advisers to conduct due diligence and monitoring for all third-party recordkeepers and obtain reasonable assurances that the recordkeepers will meet certain standards. Finally, the proposal would require advisers to maintain books and records related to the new rule's oversight obligations and to report census-type information about the service providers covered under the rule.

The proposal was published today on SEC.gov and will be published in the Federal Register. The public comment period will remain open for 60 days after the date of issuance and publication on SEC.gov or 30 days after the date of publication in the Federal Register, whichever period is longer.

I am happy to support today's proposed rule, which would establish certain minimum standards to which an adviser must adhere when they outsource core advisory duties to third parties. Outsourcing, a trend which appears to cross a variety of services and functions in the asset management space,[1] can introduce efficiencies in an adviser's ability to carry out its functions. For example, service providers may give the adviser or its clients access to certain specializations that the adviser otherwise does not have in-house. Outsourcing may also have associated cost savings that can be passed along to investors.

But, when an adviser outsources certain functions, it can also open investors up to key vulnerabilities - vulnerabilities about which an investor may not even be aware.

There is, of course, risk of investor harm. Outsourcing to third party providers - who may not be subject to the duties imposed by the Advisers Act or U.S. securities laws (or any U.S. laws in the case of certain off-shore providers) - carries concomitant risk that sensitive investor information could be misused or lost; compliance gaps might enable fraudulent advisory activities; or, vendors could front-run investor opportunities, just to name a few. Along with state securities regulators, we have brought some key enforcement actions where inadequate oversight of third party providers has led to investor harm.[2]

In addition to the potentially heightened risk of investor harm, the use of a service provider can more generally reduce an adviser's control of, or visibility into, the performance of core advisory functions.[3] It can lead to conflicts of interest, where the adviser's goals in outsourcing certain functions and of reaping cost-savings may not be aligned with investor expectations about the advisory services being performed or the oversight of those services, among other potential conflicts of interest.[4] The potential misalignment between the expectations of clients and advisers, coupled with the lack of transparency, can lead to further moral hazard problems.[5]

Further, if an adviser is dependent on a service provider for a number of services, any disruption in the relationship could have widespread effects on the advisory services provided.[6] Or, if a third party provider is servicing wide swaths of the asset management industry, disruption could have systemic effects.[7]

These are just to name a few of the risks that may accompany outsourcing of key advisory functions. And, all of these risks may be exacerbated when the services being rendered are fundamental to the advice being provided, as is more and more often the case today - for example where an adviser subcontracts out portfolio management services to a sub-adviser, or where an index provider creates a bespoke index for a portfolio of assets.[8]

When an adviser outsources a core function, that adviser does not check its fiduciary duties at the door. In no uncertain terms, the onus is on the investment adviser to ensure that its obligations under the securities laws are fulfilled, even for those functions that it may outsource.

Further, it is a fair expectation of the reasonable investor that, where an investment adviser outsources functions necessary to the performance of its advisory services, there will be effective oversight over those services. As we say in the release, a lack of effective oversight under such circumstances "would be misleading, deceptive, and contrary to the public interest."[9]

These are the issues that we address today. Where an adviser outsources certain covered functions necessary for its provision of investment advisory services in compliance with the securities laws, it must: perform crucial due diligence to reach the conclusion that outsourcing this function, to this service provider, is appropriate; engage in ongoing monitoring and oversight of the service provider's performance; ensure that books and records attendant to the services are adequately maintained and available for inspection; and, disclose certain information on its Form ADV related to these service providers.

These requirements would go a long way to protecting investors and mitigating the risks attendant to these core outsourced relationships. I am looking forward to reviewing comment letters on this subject - and here are some things that I would ask commenters to consider:

Today we are not requiring that advisers who outsource core functions have agreements in writing with their service providers. Is that in line with investor expectations?

Additionally, should there be further disclosures relating to outsourcing, beyond the census-type data we propose to be listed in the Form ADV? For example, should we require additional, more specific disclosure of fees or expenses? And, do investors currently have adequate insight into the conflicts of interest that may be presented by the service provider relationships and services? What are investors' expectations in these regards?

As always, I want to thank the staff. You have been busy and it has not gone unnoticed. And, although you have been immersed in a number of rulemaking efforts, there has been no sacrifice in the quality of your work product or the insightful nature of your advice and comments. Many thanks to the teams from the Division of Investment Management, the Division of Economic and Risk Analysis, the Office of the General Counsel, and the staff in the Chair's Office.

[1] See Outsourcing by Investment Advisers, Release No. IA-6176 ("Proposing Release") at Section III.B.2 ("Reasons for use of Service Providers"), 105-106.

[2] See, e.g., Morgan Stanley Smith Barney LLC, Investment Advisers Act Release No. 6138 (Sept. 20, 2022). See generally In the Matter of Aegon USA Investment Management, LLC, et al, IA Release No. 4996 (Aug. 27, 2018); Maria Armental, BNY Mellon to Pay $3 Million to Resolve Massachusetts Probe Over Glitch, The Wall Street Journal (Mar. 21, 2016); In the Matter of Aegis Capital, LLC, Investment Advisers Release No. 4054 (Mar. 30, 2015).

[3] Proposing Release at 107; see generally id. at Section III.B.2 ("Risks Associated with use of Service Providers").

[4] Id. at 9, 107-109.

[5] Id. at 110-111 and nn. 116-117 ( "When an agent's actions cannot be observed or directly contracted for by the principal, it is difficult to induce agents to supply the proper amounts of productive inputs or appropriately share risk with the principal.")

[6] Id. at 109.

[7] Id. at 10-11, 109-110; see also The Monolith and the Markets, The Economist (Dec. 7, 2013), available at https://www.economist.com/briefing/2013/12/07/the-monolith-and-the-markets

[8] Proposing Release at 7.

[9] Id. at 14.

Today, the Commission is proposing a set of key reforms that would bring accountability and enhanced investor protections when an investment adviser outsources its activities. I am pleased to support today's proposal.

As of this month, there are over 15,000 advisers registered with the Commission. By one estimate, over the last twenty years we've seen more than a six fold increase in the amount of assets managed by SEC-registered advisers.

The growth in numbers and assets under management has been accompanied by a changing technological landscape. Certain firms are providing investment advice solely through digital platforms. Firms are increasingly communicating and connecting with their clients through social media. Other firms are using analytical tools to develop their investment advice. Technological advancements have also been fueled by the need for increased efficiencies to meet investor demand, whether organically or through exigent and long-lasting events, such as the COVID-19 pandemic. 

As advisers adapt and change the way they operate, and as a result outsource more and more of the functions necessary for their advisory services, there can be significant implications for investor protection.

Heightened risks for investors can arise when many advisers use the same service provider for multiple services, when there's mismanagement of outsourced functions, or when there are gaps in outsourced compliance functions.

Poor oversight over outsourced functions also can be harmful to investors - many of whom entrust their life savings with their advisers and may be unaware that certain functions are outsourced.

Regardless of whether an adviser outsources certain of its functions, it must act in the best interests of its client at all times. An adviser's legal obligations under the Federal securities laws do not change when the adviser outsources. Effective, continuous oversight over outsourced functions is critical to ensuring an adviser's legal obligations continue to be met.

Outsourcing could also pose significant systemic risks, particularly if a widely-used provider of a specialized function fails to perform. It's important that advisers evaluate how dependent they are on a particular service provider and the impacts on the adviser and clients in the case of service disruptions. Today's proposal would provide minimum requirements for ongoing due diligence and monitoring of those providers.

The proposal also provides for the collection of census-like data on advisers' service providers, including the location of the office principally responsible for the covered functions. In reviewing this proposal, it became clear to me that there's a significant lack of visibility in this area, which could limit our ability to assess systemic risks or potential threats to financial stability.

The data-gathering component of the proposal would improve our ability to identify concentration of service providers in specific regions for certain functions, domestically and abroad. As regulators, we need to remain vigilant when we observe significant and widespread use of one or a small number of service providers for critical and specialized services and to have a clear picture of where these activities are occurring.

Again, I am pleased to support this proposal and appreciate the work of the Commission staff, and particularly staff in the Division of Investment Management, in crafting it.

Thank you.

Thank you Chair Gensler. Investment advisers are fiduciaries to their clients, so why are we giving them step-by-step instructions on how to do their jobs? If we think Congress got it wrong-that investment advisers cannot, absent regulatory handholding, serve their clients faithfully-then we should tell Congress. The approach we are taking-incrementally displacing their judgment with our own-is neither statutorily grounded nor protective of investors. I could have supported Commission guidance highlighting the importance of an adviser's ongoing obligations to its clients when it has engaged a service provider. I cannot support repackaging existing fiduciary obligations into a new set of prescriptions for investment advisers.

Proposed rule 206(4)-11, among other things, would establish due diligence and monitoring obligations for advisers that outsource "covered functions" to a service provider. What precisely is the problem this proposal is trying to correct? The release tells us that some advisers are operating under the misimpression that outsourcing certain functions somehow absolves them of their responsibilities as fiduciaries with respect to those functions.

Why this sudden urgency to propose a rulemaking reconfirming the incontrovertible fact that outsourcing does not terminate an adviser's fiduciary duty? Has there been a surge of enforcement actions against advisers for service provider-related failures or infractions? Are our examiners seeing advisers running from their fiduciary obligations with respect to outsourced functions? Are we aware of widespread investor harm due to advisers not overseeing their service providers? If the answer to any of these questions is yes, the release does not tell us so.

The actual number of advisers who think that they are off the hook when it comes to outsourced services likely is negligible and, even if it is not, we do not need new rules to hold them to account. As the Commission states quite clearly in this release, "[a]n adviser remains liable for its obligations, including under the Advisers Act, the other Federal securities laws and any contract entered into with the client, even if the adviser outsources functions."[1] SEC compliance staff has made many similar public pronouncements. In 2009 for instance, exams staff reminded industry that "when a service provider is utilized, the adviser still retains its fiduciary responsibilities for the delegated services."[2] The fiduciary duty that attaches to an adviser is intrinsic to the role. While the scope of that duty will be interpreted within the context of the agreed-upon relationship with the client, the adviser cannot wish it away by deciding to contract out services to a third party.

Reducing the fiduciary duty to a set of prescriptions could undermine investor protection. Standing alone, the fiduciary duty requires one to act in the client's best interest at all times. If the rule intends to define what constitutes the client's best interest, the definition quite naturally will lead to exclusion of other alternatives. The rule thus may end up abrogating fiduciary duty and replacing it with our predefined approach to best interest-one not responsive to unique facts and circumstances.

Even were I in favor of specific requirements regarding outsourcing, I would have concerns about promulgating them under section 206(4) of the Investment Adviser Act, which makes it unlawful "to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative." Section 206(4) authorizes the Commission to "define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative." While the release states that it is being adopted as a "means reasonably designed to prevent fraudulent, deceptive, or manipulative acts, practices, or courses of business," the release also seems to suggest that departing from the proposed requirements would itself be deceptive.[3] An adviser need not engage in a fraudulent, deceptive, or manipulative act, practice, or course of business to fall afoul of the rule, but any resulting enforcement charges likely will include section 206(4), which could lead people to believe that the adviser has engaged in much more nefarious conduct. This proposal is not the first to take such an approach, but I hope commenters nevertheless think about the collateral consequences advisers will face if their due diligence or monitoring is deemed inadequate and thus unlawful under section 206(4). Would adopting this type of rule under section 206(4) serve to confuse investors given that more serious conduct also could be charged under that section?

Another concern that gets only passing mention is the likely effect these changes would have on smaller advisers.[4] Small advisers are already stretched, and their compliance resources are limited. Adding another regulatory checklist to the compliance officer's clipboard will only make it harder for small firms to hire high-quality compliance personnel. Costs charged by service providers who will indirectly be subject to the rule's requirements will inevitably go up. Small advisers will have little leverage in negotiating contracts with service providers.

Some advisers may determine that they can no longer afford to engage service providers and will be forced to bring contracted services back in-house. Advisers contract out services for a variety of reasons, including to benefit from cost efficiencies and to secure for investors superior service. Forcing strapped smaller advisers to DIY functions perhaps better performed by third parties is a recipe for investor harm, not investor protection. Other small advisers may consolidate in pursuit of economies of scale. With each new regulatory burden, we make it harder for small advisers to compete. If we insist on pursuing this regulatory initiative, we should carve out smaller advisers.

Because prescriptive regulations like this one inevitably favor big firms and incumbents, small service providers will face disproportionate competitive challenges. Larger service providers-especially those that offer multiple services-will have a distinct advantage over their smaller competitors who may not be able to provide "one stop shopping." Advisers will face less risk of second-guessing by the Commission if they pick service providers that everybody else is using. Tilting the regulatory field in favor of large providers raises barriers to entry and limits the opportunities for enterprising new firms trying to break into the business.

Although I cannot support today's proposal, I am no less grateful for the work, unflagging professionalism, and dedication of the Commission staff, including especially in the Divisions of Investment Management and Economic and Risk Analysis and Office of General Counsel. Even when, as here, I am not enthusiastic about the substance, I enjoy the process of engaging with you. I look forward to hearing what the commenting public has to say about this proposal, if they can find the time, in between commenting on the multitude of other Commission proposals, to share their wisdom.

[1] Proposing Release at 13.

[2] See The Evolving Compliance Environment: Examination Focus Areas, 2009 CCOutreach Regional Seminars (Apr. 2009), at 9, http://www.sec.gov/info/iaiccco/iaiccco-focusareas.pdf. See also SEC Division of Examinations 2022 Examination Priorities ("EXAMS will review [adviser] compliance programs to examine whether they address that . . . oversight of service providers is adequate. . . .") at 17, https://www.sec.gov/files/2022-exam-priorities.pdf.

[3] Compare the following passages from the proposing release:

We also believe it is a deceptive sales practice and contrary to the public interest and investor protection for an investment adviser to hold itself out as an investment adviser, but then outsource its functions that are necessary to its provision of advisory services to its clients without taking appropriate steps to ensure that the clients will be provided with the same protections that the adviser must provide under its fiduciary duty and other obligations under the Federal securities laws. We believe a reasonable investor hiring an adviser to provide investment advisory services would expect the adviser to provide those services and, if significant aspects of those services are outsourced to a provider, to oversee those outsourced functions effectively. To do otherwise would be misleading, deceptive, and contrary to the public interest.

. . .

Under proposed rule 206(4)-11, as a means reasonably designed to prevent fraudulent, deceptive, or manipulative acts, practices, or courses of business within the meaning of section 206(4) of the Act, it would be unlawful for an investment adviser registered or required to be registered with the Commission to retain a service provider to perform a covered function unless the investment adviser conducts certain due diligence and monitoring of the service provider.

Proposing Release at 14 and 19 (footnote omitted).

[4] See Proposing Release at 164 ("As an initial matter, the proposed rule would create new costs of providing advisory services, which could disproportionately impact small or newly emerging advisers who may be less able to absorb or pass on these new costs. New costs, especially fixed costs, could also disproportionately impact small or newly emerging advisers.").

Thank you, Chair Gensler. Under the Investment Advisers Act of 1940 ("Advisers Act"), an investment adviser owes a fiduciary duty to its clients.[1] The proposing release indicates that, because an adviser cannot waive its fiduciary duty, the "adviser should be overseeing outsourced functions to ensure the adviser's legal obligations are continuing to be met despite the adviser not performing those functions itself."[2] Thus, today's proposal introduces a brand new regulatory regime that prescribes the specific manner in which an investment adviser must oversee its service providers.

Less clear, however, is whether: (1) there is widespread misunderstanding among investment advisers regarding the application of their fiduciary duties to outsourced functions, and (2) there is any observable problem related to investment advisers' oversight of service providers that necessitates the blanket imposition of specified oversight requirements.

The proposed rule imposes oversight requirements with respect to the outsourcing of "a function or service that is necessary for the investment adviser to provide its investment advisory services in compliance with the Federal securities laws."[3] According to the proposal, this formulation is "designed to apply in the context of outsourcing core advisory functions."[4] Tellingly, the observations cited in the proposing release as a basis for proposing this rule do not appear to describe service provider failures that would have been prevented had the rule been in effect.

For example, the release cites an article describing problems encountered by a mutual fund service provider when it temporarily was unable to calculate net asset values ("NAVs") on approximately 1,200 mutual funds in 2016.[5] However, there is no discussion of whether and to what extent the mutual funds' investment advisers conducted oversight of the service provider in accordance with their existing obligations, and whether the specified oversight requirements contemplated by the proposed rule would have prevented or mitigated the problem.[6]

The proposing release also cites an enforcement action against investment advisers that used models and volatility guidelines from a third-party subadviser without first confirming that they worked as intended.[7] The settlement order details numerous violations, including failure to verify the proper functioning of the model, misleading disclosure to clients, and misrepresentations to the mutual fund boards that were tasked with overseeing certain of the investment products.[8] In this case, the adviser ignored several existing legal obligations and there is no explanation as to how the overlay of a prescriptive service provider rule would have altered the adviser's conduct.

The release then discusses two service provider matters that do not appear to involve core advisory functions, including one matter that involves a breach of customer data that resulted from an investment adviser's hiring of a moving and storage company.[9] However, the matters appear to be included because the proposal would extend the requirement to conduct service provider oversight to third parties that make and/or keep any books and records required to be kept by Rule 204-2 under the Advisers Act.[10] Again, the proposing release is silent as to whether these service provider issues resulted from a failure of proper oversight and how the proposed rule would prevent or mitigate the perceived problems.

Substantively, the proposed rule text is problematic because it creates significant interpretive challenges. The proposing release states that the rule is intended to relate only to core advisory functions, but the definition of a "Covered Function" is a function or service that "is necessary for the investment adviser to provide its investment advisory services in compliance with the Federal securities laws." Many functions or services that do not relate to an adviser's investment advisory function nonetheless are necessary for the adviser to provide its investment advisory services in compliance with the federal securities laws.[11] Therefore, under a technical reading of the proposed definition of "Covered Function," almost any function outsourced by an investment adviser could trigger the numerous oversight functions set forth in the proposed rule.[12] What is a chief compliance officer to do? An already burdensome regulatory regime is made ever more burdensome when the functions that trigger the rule's requirements are not clearly spelled out.

To add to the confusion, although the Commission has stated that an adviser's fiduciary duty extends to voting proxies on behalf of its clients,[13] there is not one mention in the proposing release of the use of proxy voting advisory firms by investment advisers. The outsourcing of proxy voting advice presumably would be a "Covered Function" under the rule. However, when the release requests comment on whether various types of specified services or services providers should be identified in the final rule text, proxy voting advisory businesses are noticeably absent.[14] Coupled with the implication that seemingly non-advisory functions - such as moving and storage - may be subject to the requirements of the rule, the glaring absence of any reference to a commonly outsourced advisory function in the proposing release raises additional questions about how the rule would be applied.

Finally, the economic analysis fails to account for the substantial burden that would likely be placed on smaller advisers. While the release discusses potential differences in costs that complying with the rule would impose on larger advisers as compared to smaller advisers, the release fails to consider other outcomes that might further disproportionately impact smaller advisers. One possibility is that the burdensome nature of the service provider oversight requirements could cause certain service providers to cease doing business with smaller advisers altogether.

The lack of attention to the impact of this rule on smaller advisers is further evidenced by the absence of a staggered compliance date. At a minimum, any new rule imposing significant new compliance burdens on investment advisers should afford smaller advisers a longer time period to come into compliance with the rule. I had similar concerns with respect to the lack of a staggered compliance date in the recently-adopted broker-dealer recordkeeping rule.[15] I strongly encourage commenters to consider whether smaller advisers will be disproportionately affected by this proposed rule and - if so - include in comment letters ideas as to what the dividing line should be between smaller advisers and larger advisers for purposes of implementing a staggered compliance date in any future final rule.

There may be a role for enhanced procedures for oversight of specified functions performed by third parties for investment advisers, but the breadth of this proposal goes too far. It also seems premature when the Commission has yet to identify a path forward on index providers.[16] Perhaps the best role of this proposal is to serve somewhat akin to a concept release on what constitutes "core advisory functions." Although I am unable to support this proposal, I thank the staff in the Divisions of Investment Management and Economic and Risk Analysis, as well as the Office of the General Counsel, for their efforts. I will look forward to the public comments.

[1] See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963). See also Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Release No. 5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)].

[2] See Outsourcing by Investment Advisers, Investment Advisers Act Release No. 6176 (Oct. 26, 2022), available at https://www.sec.gov/rules/proposed/2022/ia-6176.pdf.

[3] Id.

[4] Id.

[5] See Armental, Maria, BNY Mellon to Pay $3 Million to Resolve Massachusetts Probe Over Glitch, The Wall Street Journal (Mar. 21, 2016), available at https://www.wsj.com/articles/bny-mellon-to-pay-3-million-to-resolve-massachusetts-probe-over-glitch-1458581998.

[6] The release also does not address that - unlike other types of advisory clients - mutual funds are required by the Investment Company Act of 1940 ("Investment Company Act") to have independent boards of directors that oversee the funds' operations. See, e.g., 15 U.S. Code § 80a-10. In addition, Rule 38a-1 under the Investment Company Act requires mutual fund boards to approve the compliance policies and procedures of a fund's investment adviser and certain enumerated service providers. See 17 CFR § 270.38a-1.

[7] See In the Matter of Aegon USA Investment Management, LLC, et al, Investment Advisers Act Release No. 4996 (Aug. 27, 2018) (settled order), available at https://www.sec.gov/litigation/admin/2018/33-10539.pdf.

[8] Id. According to the settled order, the primary adviser's employees recognized that "we run the risk of the [the subadviser's analyst] making an error, which is easy to do." Id.

[9] See Morgan Stanley Smith Barney LLC, Investment Advisers Act Release No. 6138 (Sept. 20, 2022) (settled order), available at https://www.sec.gov/litigation/admin/2022/34-95832.pdf. The other matter is the failure of certain investment advisers to produce records to evidence the delivery of firm brochures due to the use of third-party client relationship managers to perform that function.

[10] See 17 CFR § 275.204-2.

[11] For example, Rule 204-3 under the Advisers Act requires an adviser to deliver a firm brochure to clients or prospective clients. See 17 CFR § 275.204-3. While the delivery of firm brochures is not a core advisory function, it is nevertheless a function that is necessary for an adviser to provide its investment advisory services in compliance with the federal securities laws.

[12] The proposing release exacerbates these interpretive problems by citing to an enforcement action involving moving and storage functions as an example of service provider oversight failures that justify the rule.

[13] See Proxy Voting by Investment Advisers, Release No. IA-2106 (Jan. 31, 2003) [68 FR 6585, 6586 (Feb. 7, 2003)], available at https://www.sec.gov/rules/final/ia-2106.htm.

[14] See Outsourcing by Investment Advisers, supra note 2.

[15] See Electronic Recordkeeping Requirements for Broker-Dealers, Security-Based Swap Dealers, and Major Security-Based Swap Participants, Release No. 34-96034 (Oct. 12, 2022), available at https://www.sec.gov/rules/final/2022/34-96034.pdf.

[16] See Request for Comment on Certain Information Providers Acting as Investment Advisers, Investment Advisers Release No. 6050 (Jun. 15, 2022) [87 FR 37254 (Jun. 22, 2022)], available at https://www.sec.gov/rules/other/2022/ia-6050.pdf. The proposing release indicates that "we are continuing to consider all of the comments received." See Outsourcing by Investment Advisers, supra note 2.

James engaged in excessive and unsuitable trading in the accounts of Customers A, B, C, and D, as described below. 

Customer A is a 71-year-old owner of an architecture design firm from Texas. Between January 2015 and December 2018, James recommended that Customer A place 69 trades in his account, and Customer A accepted James's recommendations. Collectively, the trades that James recommended caused Customer A to pay $17,080.99 in commissions and fees and resulted in an annual cost-to-equity ratio of more than 37 percent-meaning the customer's investments had to grow by more than 37 percent just to break even. Although Customer A's account had an average month-end equity of $12,621.22, James recommended purchases with a total principal value of $433,852.48, which resulted in an annual turnover rate in the account of more than eight. 

Customer B is a 51-year-old owner of a lumber business from Pennsylvania. Between January 2015 and August 2017, James recommended that Customer B place 44 trades in his account, and Customer B accepted James's recommendations. Collectively, the trades that James recommended caused Customer B to pay $9,635.89 in commissions and fees and resulted in an annual cost-to-equity ratio of more than 45 percent-meaning the customer's investments had to grow by more than 45 percent just to break even. Although Customer B's account had an average month-end equity of $8,566.55, James recommended purchases with a total principal value of $334,451.46, which resulted in an annual turnover rate in the account of more than 14. 

Customer C is a 79-year-old farmer from South Carolina. Between November 2015 and March 2020, James recommended that Customer C place 118 trades in his account, and Customer C accepted James's recommendations. Collectively, the trades that James recommended caused Customer C to pay $39,935.17 in commissions and fees and resulted in an annual cost-to-equity ratio of more than 21 percent-meaning the customer's investments had to grow by more than 21 percent just to break even. Although Customer C's account had an average month-end equity of $53,054.76, James recommended purchases with a total principal value of $1,391,752.23, which resulted in an annual turnover rate in the account of nearly six. 

Customer D is a 75-year-old retired grocery store manager from Missouri. Between January 2017 and August 2019, James recommended that Customer D place 70 trades in his account, and Customer D accepted James's recommendations. Collectively, the trades that James recommended caused Customer D to pay $11,281.19 in commissions and fees and resulted in an annual cost-to-equity ratio of nearly 25 percent-meaning the customer's investments had to grow by nearly 25 percent just to break even. Although Customer D's account had an average month-end equity of $18,489.92, James recommended purchases with a total principal value of $383,413.05, which resulted in an annual turnover rate in the account of more than seven. 

The customers described above collectively had losses in their accounts of approximately $52,000 and paid $77,933.24 in commissions and fees based on the trades James recommended during the relevant period. James's recommended securities transactions in the accounts of Customers A, B, C, and D were excessive and unsuitable in light of their investment profiles. Therefore, James violated FINRA Rules 2111 and 2010.

Douberly was the designated principal responsible for supervising the registered representatives assigned to Aegis's Boca Raton, Florida branch office, where Representatives A and B worked. From July 2017 through December 2018, Representatives A and B recommended that 11 customers with low or moderate risk tolerances, or investment objectives other than aggressive or speculation, purchase VRSPs, including steepeners. Douberly, who was responsible for reviewing Aegis's trade blotter, was aware that Representatives A and B recommended VRSPs, including steepeners, to the 11 customers. Nonetheless, Douberly did not take any steps to confirm whether the recommendations were suitable, such as reviewing the customers' investment objectives and risk tolerances or speaking with the customers to confirm they understood the risks of the VRSPs. Nor did Douberly complete an attestation form certifying that she reviewed the recommendations and confirmed they were suitable in light of the customers' risk tolerances and investment objectives. ln fact, the recommendations were not suitable for the 11 customers given their investment objectives and risk tolerances. The customers suffered significant realized losses as a result of their VRSP positions, even after accounting for the income they earned from the investments. 

Douberly therefore violated FINRA Rules 3110 and 2010. 

• Securities Industry Commentator
• Bill Singer