FSI calls on SEC to end 'regulation by enforcement' as agency reopens

As the SEC moves closer to fully reopening along with other parts of the federal government, wealth management groups are calling for policies to end what they deem "regulation by enforcement."

The Financial Services Institute, a lobbying and advocacy group for independent financial firms, sent a letter to Securities and Exchange Commission Chair Paul Atkins late last month calling on him and other policymakers to adopt procedures meant to prevent what they perceive as the sometimes capricious enforcement of industry rules in recent years. The letter, written by FSI CEO Dale Brown, said subjects of SEC investigations often lack money and other resources needed to fight the agency's allegations. 

Firms in those circumstances seldom have much of a choice but to accept a settlement and the resulting fines, which can sometimes be heavy.

"Based on recent events, FSI believes it is appropriate for the commission to review past tactics engaged in by the enforcement staff in pressuring unfair settlements, as such tactics have been part and parcel of the method used by the staff to engage in regulation by enforcement," Brown wrote in the letter.

FSI's proposed framework for reform

FSI's letter calls on the SEC to adopt several policies first put forward in a "white paper" released in the Biden Administration's last full year. FSI calls on regulators to weigh "the specific factual context" of a contemplated enforcement action before filing formal allegations.

Among other things, according to FSI, the SEC should consider whether it or other watchdogs have issued a public notice warning the industry about the practices coming under regulatory scrutiny. The SEC should also look into whether its staff had been presented with a similar alleged violation in the past and declined, for whatever reason, to take action. And before going the enforcement route, FSI says, regulators should see if there are alternative ways of dealing with questionable conduct. 

"This evaluation should be documented in internal memoranda and explicitly referenced in public communications related to the enforcement action," according to FSI.

Benefits of codified policies

FSI's letter says the SEC should consider codifying these procedures in its enforcement manual, perhaps making them harder to change under future administrations. FSI also says the SEC should call on the federal Office of the Inspector General, which produces reports on government agencies, to conduct periodic audits of its enforcement practices. 

Brian Rubin, co-head of the law firm Eversheds Sutherland's securities enforcement and regulatory investigations practice, said he sees at least one benefit to having written policies on regulation by enforcement. Codification, he said, should help prevent wild swings in regulatory interpretations from one presidential administration to the next. 

"I think the prior administration would say it wasn't rulemaking or regulation by enforcement for X, Y and Z reasons," Rubin said. "So having it in writing, I think, would help the staff and the industry understand the contours of the issue better." 

Off-channel communications and the $93M Commonwealth penalty

Of particular concern to FSI is the series of hefty fines the SEC and Commodity Futures Trading Commission have imposed on firms for failing to record business-related messages advisors sent using WhatsApp and other types of "off-channel" communications. Those cases yielded the two regulatory agencies more than $3 billion in fines under former President Joe Biden but have largely disappeared amid the deregulatory policies of President Donald Trump. 

The American Securities Association sued the SEC in 2024 in an attempt to learn how penalties in the off-channel communications cases were being set.

"Were they based on the content of the off-channel communications that were sent?"  Daniel Shapiro, a lawyer at Arlington, Virginia-based Consovay McCarthy, then wrote on behalf of the securities association. "The volume of communications collected? The controls that the firm had in place? The seniority of the employees who violated the regulations? Or were the fines entirely arbitrary? It's anyone's guess."

Also stoking FSI's ire is a $93.2 million penalty that a federal judge in Boston handed down against Commonwealth Financial Network in 2024 after agreeing with SEC allegations that the firm had failed to properly disclose to investors how it made money from sales of certain mutual fund products. That ruling was overturned in April after the First Circuit Court of Appeals found that the lower court judge had made "fundamental legal errors."

The SEC returning to full operation with government reopening

Rubin, formerly a senior enforcement counsel at the SEC, said regulation by enforcement is likely to be just one of the SEC's priorities as the agency prepares to return to full operations along with other parts of the federal government that have been at least partially shut down since Oct. 1. 

An operations plan the SEC circulated in August called for only 393 of its 4,289 employees, or about 9% of the total, to continue working. Industry experts have said the remaining skeleton staff would concentrate on protecting investors from fraud and other imminent threats while putting on hold tasks like registering new advisory firms.

Rubin the SEC will soon resume its periodic examinations of registered advisory firms, as well as restart any lower-priority enforcement actions that may have gone by the wayside over the past month and a half. Regulators often have a five-year window to bring securities-related cases and may have to extend those deadlines because of shutdown-related disruptions.

Rubin said there's a good chance the SEC will send a form letter to firms that are under examination or regulatory scrutiny, essentially saying, "Hey, we're still here, and we'll reach out to you in two weeks or a month to discuss the status of your situation."

"And if, for example, they had documents or information due to the staff, either in exams or investigations, and they haven't produced them and they haven't requested an extension, and they haven't sent out an email to the SEC either, they should be prepared to either request an extension and negotiate with staff or produce whatever documents and information was due," he said.