A Deep Dive Into 14 Nixed Gensler-Era SEC Rule Proposals

Originally published on Law360

Under former Chair Gary Gensler's leadership, the U.S. Securities and Exchange Commission proposed a record number of new rules and rule amendments, frequently with shorter comment, review and implementation periods than had traditionally been provided.

Industry groups such as the Investment Adviser Association, the Alternative Investment Management Association and others had provided extensive comments on several of the proposed rules, which had been viewed by many industry participants as being overly burdensome and unnecessary.

In a move that reflects a strategic shift for the SEC, on June 12, the commission formally withdrew 14 notices of proposed rulemaking, including several significant and widely criticized proposals that had been issued under Gensler's leadership.¹ A number of these proposed rules would have had a major impact on investment advisers, investment companies, broker-dealers and public markets.

The withdrawals are generally viewed as welcome news by participants in the industry, as certain of the proposed rules would have introduced considerable implementation challenges. Notably, the SEC does not always withdraw rule proposals that do not end up being finalized. Accordingly, the withdrawals appear intended to signal a clear and definitive shift away from the Gensler era.

Key Withdrawn Proposed Rules for Asset Managers

Certain of the withdrawn rule proposals would have had a significant impact on investment advisers, investment companies and broker-dealers.

Although the SEC offered no formal rationale for withdrawing any of the rule proposals, several of them had been the subject of widespread scrutiny and intense criticism. Industry groups objected to these proposals on a variety of grounds, but particularly because they were viewed as not being sufficiently tailored, and introducing a variety of uncertainties and practical challenges.

As a result, critics broadly believed they would have imposed undue compliance burdens, while providing limited practical benefit to end investors.

1. Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers: The Artificial Intelligence Rule

This September 2024 proposed rule would have required broker-dealers and investment advisers to eliminate or neutralize conflicts of interest from using predictive data analytics and similar technologies in investor interactions.² Firms would have been required to adopt detailed policies and procedures to evaluate the use of such technologies and comply with certain prescriptive rules when using covered technologies in investor interactions.

The proposal was widely criticized for several reasons, including the significant compliance burden that it would have imposed on firms, along with the rule's potential to stifle the development of beneficial technologies and innovation. The rule also caused concern because its expansive definition of "covered technology" could have included even simple tools like Excel spreadsheets, not just advanced AI technologies.³

In a significant departure from long-standing SEC practice, the proposed rule would have required such conflicts to be eliminated, rather than allowing for mitigation of the potential conflict combined with disclosure and informed investor consent, and many viewed this requirement as being unrealistic and impractical.

Notably, this proposal had been so poorly received that in 2024, then-Chair Gensler stated that he had directed the staff to modify the proposal and seek further comment.⁴ With the proposal having been withdrawn, such a reproposal is unlikely during this administration.

2. Safeguarding Advisory Client Assets: The Safeguarding Rule

This significant August 2023 proposal, which would have been a substantial change to the manner in which advisory client assets are held, would have redesignated the current Rule 206(4)-2 — the custody rule — under the Investment Advisers Act, as amended, as new Advisers Act Rule 223-1, also known as the safeguarding rule.⁵

A primary goal of the proposed safeguarding rule was to enhance the SEC's ability to regulate the crypto industry. Unlike the existing custody rule, which applies only to funds and securities, the new safeguarding rule would have covered all client assets, including cash, digital and real assets, requiring such assets to be segregated and protected in case of bankruptcy. The rule also would have expanded the types of activities that would cause an investment adviser to have custody of assets.

Among other requirements, the safeguarding rule would have:

• Required investment advisers to enter into written agreements with qualified custodians and obtain assurances, including concerning the segregation and protection of assets in the event of custodian bankruptcy or insolvency;
• Expanded the custody rule's current exception from maintaining client assets with a qualified custodian for certain privately offered securities to include certain physical assets;
• Retained the requirement for advisers to undergo a surprise examination by an independent public accountant to verify client assets, while expanding the availability of the audit provision as an alternate means of satisfying this requirement; and
• Required more detailed records of trade and transaction activity and position information, as well as an amended Form ADV, to cover custody-related data.

The proposed rule received an overwhelming number of comments and drew widespread criticism from industry groups because it would have imposed significant operational and compliance challenges, and had the potential to disrupt established custodial practices. As with the artificial intelligence rule, the comments on the safeguarding rule were so overwhelmingly negative that Gensler suggested that the rule would be modified and reproposed.⁶

The safeguarding rule was also viewed as uniquely hostile to the use of crypto-assets in advisory accounts, and the proposing release contained requirements that many suggested would make it impractical for advisers to custody crypto-assets on behalf of clients.

While the safeguarding rule proposal has now been withdrawn, custody of crypto-asset securities continues to be an area of uncertainty for the industry. Accordingly, we expect that the SEC or the staff may adopt rules or issue guidance relating to the custody of crypto-asset securities by investment advisers and/or investment companies.

Any such rules or guidance, however, would likely be designed to provide greater certainty for investment advisers and investment companies to enable them to comply with their custody obligations with respect to crypto-assets.

3. Cybersecurity Risk Management for Investment Advisers, Registered Investment Companies and Business Development Companies: The Cybersecurity Rule⁸

This February 2022 proposed rule would have required investment advisers, investment companies and business development companies to maintain policies to identify cybersecurity risks, improve cybersecurity preparedness, and report significant cybersecurity incidents to the SEC and the public.⁷ Advisers would have had to report any significant adviser or fund cybersecurity incident to the SEC within 48 hours.

The proposed rule raised concerns because it was seen as imposing significant compliance costs, particularly for smaller firms that may lack dedicated cybersecurity personnel or resources. The 48-hour reporting requirement for "significant" incidents, in particular, would have introduced practical challenges and particular concerns regarding the impact on smaller firms.

4. Enhanced Disclosures by Certain Investment Advisers and Investment Companies About Environmental, Social and Governance Investment Practices: The ESG Rule

This May 2022 proposal would have required new prescriptive disclosures by investment advisers, investment companies and business development companies regarding the role of environmental, social and governance factors in their investment decisions.⁹

Investment companies that incorporated ESG factors into their investment strategies would have been categorized into one of three buckets — integration funds, ESG-focused funds and impact funds — and would have been required to provide detailed strategy disclosures, with the amount of disclosure depending upon the fund's categorization.

Advisers would have had to make similar categorization decisions and disclosures in their Form ADV brochures. For example, environmentally focused funds would have been required to disclose greenhouse gas emissions related to their portfolio investments, and funds considering ESG factors would have had to disclose additional strategy information based on how central ESG factors were to their strategy.

Critics of the ESG rule argued that the rule exceeded the SEC's statutory authority by requiring disclosures beyond what is financially material and instead seeking to resolve significant social or political issues through agency rulemaking, a principle known as the major questions doctrine.

5. Outsourcing by Investment Advisers

This October 2022 proposal, which would have imposed specific requirements on oversight of outsourcing by investment advisers, would have required investment advisers to conduct enhanced due diligence and establish an oversight framework prior to outsourcing a "covered function."¹⁰

The proposal included specific factors that an adviser would be required to consider in performing service provider due diligence. The rule would also have required ongoing monitoring and oversight of service providers, maintenance of records, and related reporting to the SEC.

The proposed rule received substantial negative feedback from the industry commenters. A major criticism was that the rule would have imposed significant compliance burdens, particularly on smaller advisers, when the SEC had not presented enough evidence to justify the need for the rule. The rule's definition of "covered functions" was viewed as overly broad, meaning that it could potentially encompass nearly any outsourced service, leading to extensive compliance obligations.

Commenters were also concerned that the rule could lead to a decrease in the availability of certain services for smaller advisers, unintentionally resulting in fewer specialized services being available to investment advisers. Many also believed that the rule's requirements would overlap with existing fiduciary duties and due diligence obligations under the Advisers Act, making it redundant and potentially creating unnecessary compliance burdens.

6. Regulation Best Execution

Although the Financial Industry Regulatory Authority has had a best execution rule in place since 1968, generally requiring broker-dealers to secure the most favorable trade terms for customers, the SEC proposed its own best execution framework in December 2022 that would have, among other things, allowed the SEC, in addition to FINRA, to pursue enforcement for failure to seek best execution by broker-dealers.¹¹

Critics of the new rule observed that it would have created confusion and compliance challenges by introducing a parallel framework that largely reflected the existing requirements under the FINRA rules, without providing any significant additional benefit for investors.

Other Withdrawn Proposed Rules

Although less of a concern for investment advisers and investment companies specifically, the SEC also withdrew the following rule proposals that would have had an impact on a variety of participants in the U.S. public markets.

7. Order Competition Rule

This December 2022 proposed rule would have required "restricted competition trading centers" — such as off-exchange dealers, known as wholesalers — to seek competition when executing marketable orders from smaller investors by requiring certain orders to be exposed to a qualified auction meeting certain requirements before they could be executed internally by the trading center.¹²

The proposed rule would have covered orders for U.S.-listed stocks made for accounts of natural persons or accounts with fewer than 40 daily trades over the past six months.

8. Volume-Based Exchange Transaction Pricing for National Market System Stocks

This October 2023 proposed rule was intended to address concerns around exchanges offering broker-dealer members lower fees based on volume, thus reducing competition and creating conflicts of interest.¹³

Proposed Rule 6b-1 under the Securities Exchange Act sought to level the playing field for smaller and mid-sized broker-dealers that currently pay higher fees by prohibiting exchanges from offering volume-based pricing for agency or riskless principal orders in NMS stocks and requiring exchanges to submit monthly reports to the SEC, which would have been publicly accessible via the SEC's EDGAR system.

9. Substantial Implementation, Duplication and Resubmission of Shareholder Proposals Under Exchange Act Rule 14a-8

This July 2022 proposed amendment to Exchange Act Rule 14a-8 sought to change the shareholder proposal process by amending the substantial implementation, duplication and resubmission exclusion bases.¹⁴

The proposed changes would have made it more difficult for public companies to exclude shareholder proposals from their proxy statements.

10. Proposed Amendments to the National Market System Plan Governing the Consolidated Audit Trail To Enhance Data Security

In 2012, the SEC adopted Rule 613, which created a consolidated audit trail system that allows the SEC and other regulators to access comprehensive trading data quickly, helping them reconstruct market events, monitor behavior and investigate misconduct.

Despite existing stringent security measures, the SEC in August 2020 proposed certain data security-related amendments because it believed further steps were needed to enhance the system infrastructure and protect the security of consolidated audit trail data.¹⁵

11. Regulation ATS for ATSs That Trade U.S. Government Securities, NMS Stock, and Other Securities; Regulation SCI for ATSs That Trade U.S. Treasury Securities and Agency Securities; and Electronic Corporate Bond and Municipal Securities Markets

The SEC proposed amendments in September 2020 to extend the existing Regulation ATS and Regulation SCI under the Exchange Act to cover U.S. treasuries and other government securities markets.¹⁶

The proposal was designed to enhance operational transparency, system integrity and regulatory oversight for alternative trading systems that trade government securities and repurchase and reverse repurchase agreements on government securities.

12. Regulation Systems Compliance and Integrity

The SEC had proposed amendments to Regulation Systems Compliance and Integrity, or Regulation SCI, under the Exchange Act to enhance the SEC's regulatory oversight of the core technology infrastructure underlying the U.S. securities markets.¹⁷

The March 2023 proposal would have expanded the scope of entities subject to Regulation SCI and significantly expanded its requirements to address certain technological and trading advancements since the rule was initially adopted in 2014, with the aim of ensuring the capacity, integrity, resiliency, availability and security of the U.S. securities markets' technology infrastructure.

13. Amendments Regarding the Definition of "Exchange" and ATSs That Trade U.S. Treasury and Agency Securities, NMS Stocks, and Other Securities

The SEC had proposed amendments to Exchange Act Rule 3b-16 that would have broadened the definition of an "exchange" to bring decentralized finance platforms under the regulation of national securities exchanges.¹⁸

The April 2023 proposal had drawn widespread criticism, particularly from the crypto community, because the proposed rules would have affected trading systems for crypto-asset securities and those using distributed ledger or blockchain technology, including decentralized finance systems.

14. Position Reporting of Large Security-Based Swap Positions

In June 2023, the SEC had proposed Exchange Act Rule 10B-1, a large trader position reporting rule for security-based swaps, which would have required the public reporting of large positions in security-based swaps, as well as positions in any security or loan underlying the swap and related instruments.¹⁹

Among other requirements, the proposed rule would have required any person or entity that owns or sells a security-based swap position exceeding the reporting threshold to file an initial Schedule 10B with the SEC by the end of the next business day.

Conclusion

Although it was not expected that the SEC would continue with the rule proposals from the previous administration, the withdrawals represent a significant shift in the SEC's regulatory approach and signal a move away from the more aggressive rulemaking agenda pursued under Gensler's leadership.

It should also be noted, however, that although the SEC is expected to engage in less aggressive rulemaking during Chairman Paul Atkins' tenure, certain of the general concerns that had been highlighted by the SEC in the withdrawn proposals may continue to be pursued under the new administration, particularly through the agency's ongoing examination and enforcement activities.

Under Atkins, the SEC is expected to focus on developing a clear regulatory framework for digital assets, fostering innovation while maintaining investor protection. Industry observers also anticipate a reduced pace of rulemaking and potentially a shift away from regulation through enforcement actions.

Under Executive Order No. 14215,²⁰ signed by President Donald Trump on Feb. 18, the SEC is also now required to submit draft proposed and final rulemakings to the Office of Information and Regulatory Affairs within the Office of Management and Budget for review. We anticipate that this additional step will add significant time to the process for proposing and adopting new rules.

From a substantive perspective, the commission has already been active in addressing the regulation of crypto, including through the creation of a crypto task force that coordinates across SEC offices and divisions, as well as the issuance of multiple guidance pieces concerning the application of the existing federal securities laws to cryptocurrencies. We anticipate these efforts will continue, including through the adoption of new rules governing the issuance, custody and trading of crypto-assets that are securities.

The SEC will also likely focus on enhancing retail access to private markets, including private equity and private credit strategies; reviews of the information the SEC currently collects from market participants to determine whether such collection continues to be appropriate; and an updated e-delivery framework. In addition, the joint May 2024 U.S. Department of the Treasury and SEC proposal on customer identification programs for investment advisers remains outstanding.²¹