On 15 June 2022, the SEC issued a request for comment to help determine whether “information providers”, defined as index providers, model portfolio providers, and pricing services might come under the Commission’s definition of an investment adviser.
In this blog, we will explore some of the Commission’s concerns raised in their request for comment, how the industry may look to address these concerns and some of the wider implications for firms if they are defined as an investment adviser.
Areas of interest from the SEC
Across index providers, model portfolio providers and pricing services, the SEC raised a number of concerns which could potentially apply to all such parties.
Firstly, they raised potential conflicts of interest in respect of these providers where they see a potential for front-running as “providers and their personnel will have advance knowledge” (for example, upon an index rebalancing, which equities will be removed from the index) of potential changes or the level at which the index, model or price will be set to prior to dissemination. We recommend that Information providers should review and look at their policies and controls around the handling of material non-public information and personal investments to ensure any conflict is managed.
The Commission raised in numerous points of the paper on the use of discretion by providers, across indices, models, and pricing services. The use of “significant discretion” by Information Providers was referenced in a number of occasions by the Commission. There is a concern on the lack of transparency on the use of discretion, for example where a pricing service may have multiple “inputs, methods, models, and assumptions” .Without a clear methodology with a hierarchy of inputs it could be confusing for users to understand whether the provider prioritises certain sources and whether it can be compared to other pricing providers
In addition, the SEC highlighted their concerns around the transparency and communications to market participants and users around changes to the index, model or price. A particular example highlighted is how do users understand whether price challenges are raised by other users and whether changes are made to previous or subsequent prices following the change.
For index providers, the IOSCO Principles for Financial Benchmarks and Oil Price Reporting Agencies sets a framework for providers to adhere and can be used to potentially address some of the concerns raised by the SEC. Several index providers currently attest to the IOSCO Principles and obtain third party assurance reports to demonstrate their compliance. Our view is that this framework could be applied to model portfolio and pricing service providers to address areas such as governance, conflicts of interest and use of discretion where the principles require more disclosure and transparency to users.
Implications of being an investment adviser
The request for comment from the SEC provides three elements where a party must meet all three to be deemed an “investment adviser” under the Advisers Act; (i) the person provides advice, or issues analyses or reports, concerning securities; (ii) the person is in the business of providing such services; and (iii) the person provides such services for compensation.
If providers are considered as an “investment adviser”, providers will be regulated and under the supervision of the SEC, regardless of jurisdiction. There is a question on whether these regulatory requirements are suitable for providers and adequately address the concerns raised by the SEC or does regulation need to evolve to meet the changing market environment we are currently in. The request for comment does highlight UK and EU regulation on index providers, where regulation implemented following the LIBOR scandal looked to provide transparency across the key areas highlighted by the SEC with differing levels of regulation and supervision for indices deemed significant and critical. In the EU and UK, all index providers are regulated regardless of type or criticality of the indices they administer, which helps to ensure administrators are subject to regulatory supervisory mechanisms.
The SEC have highlighted several concerns that are being met partially by principles-based framework and regulation outside the US. The paper and recent press articles around indices, such as with the rebalancing of an ESG index, highlights the need for the SEC to address whether current rules and regulation suitably protect investors and markets as these products are persuasively used and could materially impact markets.
We encourage market participants across from provider to users of these products to comment on the SEC’s request for comment.