Midterms shake up Washington while regulators eye new rules

With the midterm elections in the rearview mirror, Congress returned to Washington for a busy lame-duck session to resolve some key issues. Meanwhile, regulators continued their breakneck pace, unveiling a daunting set of rule proposals that would create additional compliance burdens for advisor firms. Here's a roundup of what advisors need to know.

Change is coming to Capitol Hill after midterms

The midterm elections surprised many observers who had expected a major win for Republicans. Instead, Democrats retained their narrow majority in the Senate and netted two new governor's seats. Republicans narrowly won the majority in the House of Representatives but by a much smaller margin than was anticipated. The single-digit majority is likely to be politically complicated, as Rep. Kevin McCarthy (R-CA), the frontrunner to be the next Speaker of the House, may have a difficult time uniting an unruly caucus to push Republican priorities through the House.

House Democrats will also be dealing with a significant leadership change, after outgoing Speaker Nancy Pelosi (D-CA) announced that she will step down from party leadership. The second- and third-ranking leaders, Rep. Steny Hoyer (D-MD) and Rep. James Clyburn (D-SC), will also relinquish their positions. The new leadership trio is expected to be Rep. Hakeem Jeffries (D-NY) as minority leader, Rep. Katherine Clark (D-MA) as minority whip, and Rep. Pete Aguilar (D-CA) as caucus chair. This group represents a dramatic generational change for Democrats. The average age of the top three Democrats in the House will drop from 82 to 51.

In the Senate, Democrats will retain a razor-thin 51-49 margin. The resulting split Congress likely means gridlock on Capitol Hill over the next couple of years, as bitter partisan divisions will make it very difficult to find common ground. Creating a better regulatory structure for cryptocurrency is one possible area for bipartisan compromise in 2023, particularly in the wake of the November implosion of FTX, one of the largest crypto exchanges. But expectations are low that any significant tax or other major legislation can pass the divided Congress in the year ahead.

One issue the markets will be watching carefully next year is the looming battle over the debt ceiling. Congress will need to increase the debt limit sometime in mid-2023 or risk a catastrophic default. While the issue is always politically fraught, analysts see parallels to the debt ceiling fight of 2011. That summer saw the U.S. come within days of an unprecedented default as a divided Congress struggled to reach a compromise on increasing the debt ceiling. Market volatility soared, and Standard & Poor's downgraded the U.S. credit rating for the first time in history. Lawmakers eventually found a last-minute deal to avert default. Markets historically do not like uncertainty about when and whether Congress will act on the debt ceiling, but uncertainty may be what we get as we head into next year.

Hopes remain high for a SECURE Act 2.0 deal this month

As December began, Congress was back in Washington for what is known as a lame-duck session. The key deadline is December 16, when the current agreement to provide funding for government operations expires (though a one-week extension to December 23 appears likely). Lawmakers are focused on either passing a gigantic appropriations bill that funds every government agency and federal program or, more likely, passing another short-term extension to avoid a government shutdown. A short-term solution would put the issue in the hands of the new Congress that convenes in January.

The key issue for advisors continues to be the fate of the retirement savings legislation, known as SECURE Act 2.0. The package would increase the required minimum distribution age, increase catch-up contributions for individuals approaching retirement, and make a number of enhancements to employer-sponsored 401(k) plans. It continues to have strong bipartisan support in both chambers of Congress. Lawmakers are optimistic that it can be attached to the must-pass government funding bill, but final details are still being worked out.

Busy regulatory agenda for RIAs

The SEC has continued to keep the focus on advisors with a series of regulatory initiatives this year. The new Marketing Rule for advisors is officially in effect, as the compliance date of November 4 has come and gone. In September, the SEC issued a Risk Alert indicating that compliance with the new rule will be an exam priority. The agency said that examiners will focus on four areas: a firm's policies and procedures with regard to the new rule, the substantiation requirement, performance advertising requirements, and books and records. Registered Investment Advisors (RIAs) should review the brief Risk Alert to get the details.

Earlier this year, the SEC proposed two new rules, one regarding cybersecurity risk management and the other governing environmental, social, and corporate governance (ESG) disclosure. Comment periods are closed for both proposals, but each received notable pushback from the industry. Small and medium-size firms were concerned about the cost of complying with the cybersecurity rule, and firms of all sizes questioned whether the requirement to notify the SEC within 48 hours of a cybersecurity incident makes sense, given that firms are likely to still be involved in understanding and responding to the situation.

One issue that many commenters raised was whether the ESG proposal, which requires new disclosures to investors about how an advisor incorporates ESG factors into investment advice, overemphasizes the role of those factors. Both the cybersecurity proposal and the ESG proposal are expected to be finalized by the SEC next year. How much they may be modified based on comments received remains unknown.

Most recently, the agency proposed a rule outlining new requirements for advisors who outsource certain services or functions to third parties. The proposal requires advisors to conduct due diligence before outsourcing and to periodically monitor the performance of service providers, including regular reassessments of whether to retain them.

The SEC provided several examples of the kinds of services that would be covered, including portfolio account, portfolio management and trading services or software, investment risk software or services, and investment modeling or custom portfolios. Employing language it has used in a variety of recent RIA-related guidance and rules, the SEC said that firms cannot just “set it and forget it” when it comes to outsourcing critical business functions. Republican Commissioner Hester Peirce voted against the proposal, arguing that the SEC was effectively “repackaging existing fiduciary obligations into a new set of prescriptions for investment advisors.” The comment period for the proposal closes December 27, and we can expect a robust response from advisors articulating a variety of concerns about the proposal.

Another SEC focus area that advisors need to be aware of is the use of personal mobile devices for business-related communications. In recent months, the SEC and the Commodity Futures Trading Commission have taken a series of high-profile enforcement actions against major financial institutions, with the two agencies levying a staggering $1.8 billion in fines for violations.

While most enforcement actions to date have targeted large financial institutions, at least one action has been taken against an RIA firm. At a National Compliance Outreach Seminar in mid-November, SEC officials indicated that this is a priority area for advisor examinations. The SEC has found that a variety of firms do not have adequate policies and procedures governing the use of personal devices and that the ability to monitor and archive business-related communications on personal devices is inadequate. It is critically important that RIA firms develop policies and procedures tailored to the organization's size and structure. Any devices used for business communications need to be approved by the firm. It's clear this will continue to be a focus area for regulators.

The SEC, of course, has been busy in other areas as well, with major rules awaiting final approval to increase transparency around private funds, reform money market funds, and require public companies to disclose more about their climate risk. The agency is also expected to propose a series of rules before year end to overhaul equity market structure. There's little sign that the SEC will slow its staggering pace of regulatory activity in 2023, so advisors will need to be vigilant in keeping up with the latest developments.

About the author

Michael Townsend

Managing Director, Legislative and Regulatory Affairs, Charles Schwab & Co., Inc.