Investment management regulation: Navigating the present, and preparing for the future

The level of intensity of the regulatory environment can change based on how regulators are focusing on new and existing rules. For example, the SEC finalized 16 new rules in 2023 that added requirements, whereas, in 2020, it had finalized 17 rules, such as those related to securities offering reforms for closed-end companies and private markets, which either removed requirements or expanded certain exemptions for the industry.³ The DREG index levels of 98 in 2020 and 113 in 2023 are due, in large part, to the two different focuses of the SEC in these two years (figure 2). The type of approach also contributes to the index level. The chairperson or administration in charge may choose to encourage compliance in the manner they deem fit—for instance, by adjusting the number of enforcement actions or changing the penalty fine amount. The difference in approach can be instructive when two index levels are similar, such as those in years 2016 and 2022. Enforcement actions reached a high of 868 in 2016, yet fines and penalties totaled a below average US$4.1 billion.⁴ In 2022, enforcement actions totaled 760, about average, but the fines and penalties totaled a record aggregate amount of US$6.4 billion.⁵ The direct cost of noncompliance increased in 2022 when some investment management firms were hit with a record dollar amount of fines.⁶ This is in contrast to 2016, when the average dollar amount fined by the SEC decreased from the prior year for the first time since 2011.⁷ Similarly, a regulatory agency may determine an increase in the potential capacity for examinations as the preferred route to encourage compliance. The agency may increase its capacity in 2024 with a larger budget—possibly over US$2.4 billion—representing a 12% increase from fiscal year 2023, and about 5% additional headcount.⁸ Therefore, a packed rulemaking agenda and the additional expected capacity at the SEC are drivers of the rise in the DREG index level to 125 in 2024.

In 2024, the SEC plans to finalize as many as 21 new regulations with fresh industry requirements, an increase from 16 in 2023.¹⁰ For a more detailed review of these rules, refer to the 2024 Investment Management Regulatory Outlook. This flurry of activity has led some industry participants to believe that the number of new rules has been too much too fast for the industry.¹¹ However, this pace is not likely to ebb. The SEC is planning to continue its record rule-setting pace in 2024. If the SEC finalizes just 75% of its proposed agenda for 2024, it will surpass the previous highwater mark set in 2023.¹²

Moreover, regulators have returned to using fines and penalties as a method to encourage compliance.¹³ The SEC issued a record dollar amount of enforcement penalties in 2022, followed by the second-highest dollar amount ever in 2023.¹⁴ Client communications continues to be an active area for SEC investigations. In February 2024, the SEC announced penalties totaling over US$81 million against 16 investment management firms for failures to properly preserve electronic communications.¹⁵ Regulators in the United States may continue using penalties as a tool to correct behavior, rather than encouraging compliance through other means. This means that noncompliance could become costlier than ever before, and this trend may continue for the foreseeable future.

The heightened focus on new rules marks a shift for the agency after several years in which it was more likely to reexamine the utility, and in some cases redundancy, of existing rules. For example, in 2018 and 2019, several final rules from the SEC were aimed at streamlining the overlaps between US generally accepted accounting principles and required disclosures by certain issuers, expanding the exemptions available under Regulation A to more issuers, and easing some restrictions on proprietary trading that had been in place under the Volcker Rule.¹⁶ This focus on existing rules was the main driver of the relatively lower intensity index values seen from 2017 to 2020. Two additional elements that contributed to the lower intensity values were the relatively less frequent use of enforcement actions, and lower fines and penalties. During this period, regulators seemed to mainly turn their attention toward rules and regulations already on the books to deliver on their mission to help facilitate financial markets stability.¹⁷

Leading investment management firms tend to manage their regulatory-ready posture through proactive planning

Regardless of the strategies regulators employ, investment management firms will likely benefit from having a formal action plan in place to strengthen compliance and mitigate the risk of enforcement actions. By implementing a standardized compliance plan across the firm, investment management leaders may enhance their monitoring capabilities of new rules or amendments and identify instances of “interlocking impacts.”¹⁸ With so many new rules under consideration, it could be exceedingly difficult for regulators and investment management firms to fully understand their impact and any potential unintended consequences. One way to standardize a compliance plan is to establish a Regulatory Assessment and Response Execution (RARE) team with specific capabilities (refer to figure 3 for an illustrative example) that can facilitate coordination and communication across the organization.¹⁹ RARE team members are cross-functional within the organization, helping to ensure a consistent view of how regulatory changes might affect the firm. This cross-functionality also can aid the firm in developing a more comprehensive interpretation of rule changes and prioritizing them on an enterprise-wide basis, while considering any potential “interlocking impacts.” Through scenario planning and risk assessments, the RARE team can assist in formulating an effective response based on the potential impact of regulatory changes on the firm. The team can then relay these insights to leadership, who can implement them throughout the firm, fostering a coordinated response and developing suitable regulatory change solutions.²⁰

Another potential advantage of having a RARE team is that it can facilitate a centralized evaluation of compliance systems, instead of a scattered approach that may cause inefficiencies. Feedback from the RARE team can assist leaders in understanding how changing regulatory demands could affect existing roles and responsibilities, thereby helping them in creating a target operating model for their investment compliance monitoring systems.²¹ This method allows leaders to identify and prioritize compliance areas specific to their organization’s needs, which can lead to a more efficient response.

Moreover, ensuring effective coordination and communication throughout the organization can help people better understand the impact of the new rules and seamlessly incorporate any necessary process alterations. Leaders who communicate the desired outcomes of their compliance programs internally are more likely to successfully achieve their business strategy goals.²² Communicating these outcomes also tends to facilitate consistent compliance monitoring across the organization.

Investment management firms with greater technological maturity may benefit from more effective compliance capabilities

Recent rule-making actions from the SEC show that enhanced technical capabilities may be needed at investment management firms. For example, the SEC voted in October 2023 to adopt a rule amendment dating from the Dodd-Frank Act to require additional data collection around short-selling practices for the purpose of making it publicly available in aggregate.²³ In light of the new amendments, some hedge fund groups have sought clarification in courts concerning whether aggregate or individual short position disclosure reports are required.²⁴ While the final outcome of this litigation is still undecided, the quest for increased transparency is unlikely to dissipate. Another final rule concurrently adopted by the SEC and the Commodity Futures Trading Commission makes significant changes to the Form PF filling requirements for private fund investment advisers.²⁵ The final rule mandates the collection of numerous additional data sets to enhance data quality and requires disclosure to investors to improve comparability across funds. Given the scope of these new requirements, investment management leaders may benefit from conducting an in-depth review of their firms’ reporting and disclosure technological capabilities across all their funds.

Investment management firms can potentially enhance their operating models’ agility and effectiveness in responding to regulatory changes by either insourcing or outsourcing technical compliance capabilities. A higher level of in-house technological maturity could enhance a firm’s ability to effectively adapt to regulatory changes. Leaders who indicated in 2020 that their organizations were already “seasoned” in integrating AI technologies into their business will likely have a better understanding of the potential impacts of the proposed rules on their operating models in 2024.²⁶ Regardless of their stage in the AI adoption curve, investment management firms could benefit from developing a compliance strategy that optimally uses both talent and AI capabilities to limit regulatory scrutiny.²⁷

Some organizations may consider outsourcing certain compliance activities as a more appropriate approach to satisfy new regulatory mandates. As expectations for heightened attention to compliance with record-keeping and surveillance of employees at regulated firms grow, some investment management firms have taken steps to have video calls in addition to text messaging proactively monitored with the implementation of third-party communication surveillance platforms.²⁸ Leading investment management firms seem to be focusing on assessing their regulation-ready capabilities to better mitigate their regulatory compliance risks. Given the complexities of effectively and efficiently increasing monitoring capabilities, some have engaged with not only compliance specialists, but also outside counsel and risk professionals.²⁹ These steps may be necessary for some organizations to build and maintain a healthy compliance posture in a more cost-effective way.

A vigorous compliance posture for 2024 and beyond

With a tight regulatory environment likely to stick around for some time, investment management companies will likely prioritize taking action to review procedures and identifying gaps in 2024. A robust regulatory readiness framework that employs sensing and influencing, planning and prioritizing, and implementing a compliance change management program could position investment management firms for compliance success, allowing leaders to manage regulatory readiness even as they continue to develop core businesses. Building and maintaining a collaborative team environment as well as flexible processes that can effectively respond to emerging regulatory demands will likely be instrumental over the coming year, since change seems to be the only constant in regulatory intensity.