Our Take: financial services regulatory update – June 14, 2024

• What happened? On June 5th, the Fifth Circuit Court of Appeals vacated an August 2023 SEC rule aimed at enhancing private fund investor protection. The court agreed with the industry groups challenging the rule that the SEC did not have statutory authority to promulgate the rule, stating that its authority is limited to protecting investors that are “retail customers” and preventing fraudulent, deceptive or manipulative acts by investment advisers.
• What did the rules require? After originally proposing one rule, the SEC split the provisions into five final rules, including:
  • Private fund adviser audits. Registered private fund advisers would have been required to obtain audits annually as well as upon liquidation for each private fund they advise.
  • Private fund quarterly statements. Registered private fund advisers would have been required to prepare and provide investors with statements on fund performance over the past 10 years, costs of investing in the fund, fees and expenses paid by the fund, and certain compensation and other amounts paid to the adviser.
  • Adviser-led secondaries. Registered private fund advisers would have been required to obtain and distribute to investors an independent fairness or valuation opinion on interests offered to the private fund along with a written summary of any material business relationships between the adviser and the opinion provider.
  • Private fund adviser restricted activities. Advisers would have been prohibited from certain activities, including charging certain fees without disclosures.
  • Preferential treatment. The final rules also prohibited advisers from providing preferential treatment unless certain terms are disclosed in advance as well as at least annually to all investors.
• What’s next? The rules were set to take effect in September 2024 but as they have been vacated, private fund advisers will not need to comply unless the decision is overturned. The SEC has said it is reviewing the decision and determining next steps.

Our Take

Another legal win for the industry that will empower further challenges to the SEC’s authority. This decision was not only a victory for the private fund advisors that will no longer have to undertake the significant effort needed to comply with the rules, it is an encouraging sign for all the various industry groups challenging SEC rulemaking. While the SEC’s decision to split the single proposed rule into five final rules may have been intended to preserve some provisions in the event of some being vacated, this decision showed that such a strategy would not get around challenges to the authority to promulgate the rules in the first place. The court’s opinion that the SEC’s authority in this space is effectively limited to protecting retail investors against fraud jeopardizes SEC Chair Gary Gensler’s mission to comprehensively increase transparency of private fund fees, expenses and performance. Although the SEC could appeal the decision, it would face an uphill battle to get the rule reinstated by a conservative majority Supreme Court that has been skeptical of agency authority claims.

• What happened? CFPB Director Rohit Chopra testified this week before the Senate Banking Committee and House Financial Services Committee to present the agency’s submission of its Semiannual Report to Congress. His testimony followed several actions from the CFPB, including:
  • On June 3rd, the establishment of a “repeat offender” registry
  • On June 4th, the publication of a circular warning against deceptive contractual terms in fine print
  • On June 5th, the issuance of a final rule on standards setting for open banking
  • On June 11th, the issuance of a proposal to ban medical bills from credit reports
• What was discussed at the hearings? Much of the discussion focused on the recent Supreme Court decision to uphold the CFPB’s funding structure as constitutional (see Our Take here) as well as the agency’s proposed medical debt rule. Other notable areas included:
  • Data rights and privacy. Chopra heavily emphasized the need to protect consumers’ rights over their data, specifically urging Congress to act in response to large financial firms that intend to use consumer financial data for “surveillance-based targeting.” He also noted that he intends to finalize the open banking rule in the fall and that the CFPB will soon propose a rule under the Fair Credit Reporting Act to restrict data brokers’ use of consumer data.
  • Credit cards. Chopra also highlighted several issues in the credit card industry, including the growing number and volume of delinquencies, increase in interest rates and “bait-and-switch” tactics with rewards programs.
  • ”Junk fees.” Many Democrats applauded the CFPB’s focus on junk fees while Republicans criticized the initiative as interfering with financial institutions’ ability to do business and limiting consumers’ access to financial services.
  • Generative AI. Chopra and several Democrats expressed concern over the use of generative AI to commit fraud, including through faking consumers’ voices. They also discussed the potential for AI-fueled market manipulation.
  • Nonbanks including fintechs. Chopra asserted the CFPB’s jurisdiction over nonbanks that provide financial services, noting that the 2008 financial crisis exposed gaps in regulation over nonbank companies.

Our Take

The CFPB is continuing to go full steam ahead. Following the recent Supreme Court decision upholding the CFPB’s funding structure as constitutional, the agency has wasted no time in vigorously pursuing rulemaking, guidance and enforcement actions. Considering that the CFPB is actively recruiting enforcement attorneys, this momentum is set to only pick up, with a final open banking rule and proposals around data brokers’ and large firms’ use of customer data likely to come before the election. Firms should also anticipate continued high scrutiny of areas that have become key priorities under Chopra’s tenure such as junk fees, contract clauses that the agency considers unfair, deceptive or abusive as well as issues related to fair lending, anti-competitive practices and big tech companies offering financial services.

Legal and political challenges remain. While the CFPB cleared a major legal challenge, individual rulemakings are likely to continue to face challenges under claims that the agency (a) issued the rules arbitrarily and capriciously and (b) failed to perform an adequate cost benefit analysis. The upcoming Supreme Court decision around agencies’ abilities to interpret statutes that Congress directs them to administer could open the door for even more legal challenges around the CFPB’s interpretation of terms such as “unfair, deceptive, or abusive acts or practices” as well as its ability to oversee nonbanks and areas such as AI and digital assets.¹ To the extent the CFPB needs additional authority from Congress - as Chopra hinted while discussing use of consumer data for targeted advertising - it is unlikely to find support considering the stark Republican opposition displayed at the hearings. Further, Republicans’ continued attacks on efforts related to junk fees and enforcement against nonbanks is a reminder of the potential effect of a change in Administration following the upcoming election.

¹ See Loper Bright Enterprises v. Raimondo, which challenges the longstanding “Chevron deference” precedent of deferring to agency’s statutory interpretations.

• What happened? On June 12th, Treasury issued sanctions on over 300 entities and individuals connected with Russia’s war in Ukraine or sanctions evasion efforts, including the Moscow Stock Exchange. It also expanded the potential for secondary sanctions, which impose penalties on non-U.S. financial institutions that provide services to sanctioned parties, to include a broader spectrum of entities including Russian banks’ entities outside of Russia.
• The action follows Treasury’s expansion of its secondary sanctions authority last December by imposing strict liability - rather than the previous standard that held entities liable for “knowingly” violating sanctions - for transactions related to specific Russian military-industrial entities.
• Which entities are impacted? Expanded sanctions now apply to:
  • Foreign locations of Russian financial institutions;
  • Russian financial infrastructure, including exchanges and clearinghouses;
  • International entities and individuals involved with complex money laundering schemes;
  • Entities connected to Russia’s defense or related industries (which has been significantly broadened to include the IT sector); and
  • Any person designated under Executive Order 14024.

Our Take

This new round of sanctions significantly expands the legal risk faced by all companies, particularly non-US financial institutions. These firms have long relied on the fact that “secondary sanctions” - which block firms that conduct business with sanctioned parties from the US financial system - required that they “knowingly” engage in such activity. Following Treasury’s expansion of secondary sanctions in December, which opened the possibility that firms could be cut off from the US financial system even if they do not know they are transacting with sanctioned parties, some firms have been challenged by the increased due diligence expectations regarding customers, counterparties and transactions. The further expansion of this authority to include all persons designated under EO 14024 will significantly expand these obligations.

In response, non-US financial institutions - especially those with higher risk of inadvertently conducting business with Russia-affiliated entities - should conduct additional diligence on their current customer base across the enterprise. They should also consider using existing technology and tools to detect difficult-to-identify beneficial owners and other obfuscated parties.

These notable developments hit our radar recently:

• ISDA and SIFMA host Treasury Forum. On June 5th, the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) jointly hosted the Treasury Forum where senior market participants, regulators, and industry professionals gathered to discuss the SEC’s rule to expand the scope of U.S. Treasury products required to be centrally cleared through a covered clearing agency. For more on the impacts and questions raised during the forum, see our discussion.
• Several speeches and actions on AI. On June 6th, the Treasury Department issued a request for information on uses, opportunities, and risk of artificial intelligence (AI). Members of the public are encouraged to submit comments within 60 days. On the same day, Acting Comptroller of the Currency Michael Hsu spoke on the systemic risk implications of AI. Similarly on June 6th Secretary of the Treasury Janet Yellen spoke on AI and financial stability.
• SEC issues risk alert. On June 5th, the SEC issued a Risk Alert to provide additional information on its broker-dealer examination selection process. The alert also includes an Appendix describing the types of documents and information that staff may request during an examination.
• Biden nominates insurance member of FSOC and renominates SEC Commissioner. On June 13th, in addition to the two nominations discussed above, President Biden nominated Gordon Ito to be the independent insurance representative member of the Financial Stability Oversight Council (FSOC). He also nominated Caroline Crenshaw to serve another term as Commissioner for the SEC.
• Letters on Basel III endgame. The past two weeks featured further industry engagement on the Basel III endgame proposal:
  • On June 4th, the CFTC's Global Markets Advisory Committee (GMAC) issued two recommendations to examine the impacts of the proposal and to improve collateral and liquidity management for non-centrally cleared derivatives.
  • On June 10th, ISDA and SIFMA announced that they sent a letter to the Fed, FDIC and OCC on amendments to the Basel III endgame notice of proposed rulemaking applicable to large banking organizations and banking organizations with significant trading activity.
  • Also on June 10th, ISDA, the Global Financial Markets Association (GFMA) and the Institute of International Finance (IIF) issued a joint response to the Basel Committee on Banking Supervision’s consultation on the revised assessment framework for global systemically important banks.
• Fed stress test results coming June 26th. The Fed announced that the results from its annual Comprehensive Capital Analysis and Review (CCAR) stress tests will be released on June 26th at 4:30 p.m. EDT.
• Gensler and Behnam testify. On June 13th, SEC Chair Gary Gensler and CFTC Chair Rostin Behnam testified before the Subcommittee on Financial Services and General Government on FY25 budget requests for their respective agencies.
• OCC issues handbook update. On June 11th, The OCC issued a new version of the Retail Nondeposit Investment Products booklet of the Comptroller's Handbook.