SEC Request for Comment on "Information Providers"
On June 15, 2022, the Securities and Exchange Commission (the "SEC") issued a request for comment to "help determine which 'information providers,' such as index providers, model portfolio providers, and pricing services, might come under the SEC's definition of an investment adviser."1 The request for comment (the "RFC") discusses the roles played by these entities in, for example, the construction and calculation of indices, and analyzes the factors used to determine whether an entity is providing investment advice within the meaning of the Investment Advisers Act of 1940 (the "Advisers Act"). Among other things, the SEC is concerned about what it terms "significant discretion" in index methodologies.2
The RFC is an Advisers Act and Investment Company Act of 1940 (the "1940 Act") release, and is mainly concerned with Advisers Act issues. However, the potential effect of any rulemaking in response to this RFC will reach beyond Advisers Act issues and, in the context of index providers, affect other securities linked to indices, such as structured notes, as well as derivatives that reference indices. Consequently, this article discusses these potential effects on the broader market and not just in the context of, for example, registered funds or variable annuities.
Who are the Information Providers?
The RFC focuses on three industry players, which together comprise the information providers:
- "Index providers," which "compile, create the methodology for, sponsor, administer and/or license market indices."3 This group is broad enough to run the gamut from large, well known index providers like S&P Dow Jones Indices LLC, Bloomberg, and FTSE Russell, and also include an arm of an investment bank creating custom, proprietary indices. The term index is not defined, either in the RFC or elsewhere in the federal securities laws. Given the discussion elsewhere in the RFC, it is likely that the SEC may mean "index" in a broader sense than it is sometimes used in practice – potentially including, for example, embedded strategies or stock baskets.
- "Model portfolio providers," which design custom portfolios of assets (mutual funds and exchange traded funds ("ETFs") are used in the RFC as an example) "designed to achieve a particular return, with corresponding risks." These model portfolios may be rebalanced or have constituent changes over time, and offer various degrees of customization.4
- "Pricing services," which provide "prices, valuations, and additional data about a particular investment (e.g., a security, derivative, or another investment), to assist users with determining an appropriate value of the instrument." Pricing services may provide prices when they are not available through a normal, arm's-length third-party transaction, such as when relevant markets are closed.
What is the SEC's Concern?
The SEC is concerned that the activities of the various information providers may cause them to fall within the definition of an "investment adviser" under Section 202(a)(11) of the Advisers Act. Information providers whose activities are determined to cause them to fall within that definition would, absent an exemption, be required to register as an investment adviser with the SEC.
As summarized in the RFC:
The Advisers Act generally defines an "investment adviser" as any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or any person who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. The definition generally includes three elements for determining whether a person is an investment adviser: (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. Each element must be met in order for a person to be deemed an investment adviser.5
The SEC analyzed the three elements of the definition, noting that (i) a person generally is an investment adviser even if its advice, reports, or analyses about securities do not relate to specific securities, provided the services are performed as part of a business and for compensation, (ii) giving advice does not need to constitute the principal business activity or any particular portion of the business activities of a person in order for the person to be considered "in the business" of acting as an investment adviser; the giving of advice need only be done on a basis such that it constitutes a business activity occurring with some regularity and (iii) the source of an "economic benefit" that would satisfy this element of the definition is not limited to fees and commissions.6 The SEC also noted that the Staff has considered whether data, in the context of "databases and various computer software services offering calculation and pricing models," might constitute "analyses or reports concerning securities" within the meaning of Section 202(a)(11) of the Advisers Act.7
Last, the SEC discussed and questioned the applicability of the "publisher's exclusion" in Section 202(a)(11)(D) of the Advisers Act, which excludes from the definition of "investment adviser" any "publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation." As discussed in the RFC, the Supreme Court has held that "publishers are excluded from the definition under the Advisers Act as long as their publication: (i) provides only impersonal advice; (ii) is 'bona fide,' meaning that it provides genuine and disinterested commentary; and (iii) is of general and regular circulation rather than issued from time to time in response to episodic market activity."8
The SEC stated its interpretation of how the publisher's exclusion is used, and its concerns:
Certain providers have relied on the publisher's exclusion. We believe that index providers have historically concluded, for example, that, even if they meet the definition of investment adviser, they may rely on the exclusion and thus need not register with the Commission or be subject to any section of the Advisers Act, including section 206. Similarly, other providers, such as pricing services, may be relying on the publisher's exclusion. Given the length of time since Lowe was decided, and understanding that new business models have developed in the interim, we are considering the extent to which providers' activities, in whole or in part, may raise investment adviser status issues.9
The SEC's Assumptions About Information Providers
There are a number of statements and assumptions in the RFC that do not reflect actual industry practice.
For example, this is the RFC's summary of how an index provider operates:
Index providers compile, create the methodology for, sponsor, administer, and/or license market indexes. They typically determine the particular "market" (which may be a sector or other group of securities) that the index measures, the index constituents that measure that market, and the weightings that each constituent receives. Once the index is designed and its methodology is created, index providers determine the index's level (or measurement) pursuant to that methodology. These activities leave room for significant discretion—for example, an index provider typically has the ability to make changes to the index by adding or dropping particular constituents (i.e., index reconstitution) or modifying their weighting within the index (i.e., index rebalancing), in some cases without publicly disclosing their index methodologies or rules. 10
The footnote citation for the last sentence above is to a law review article, which states that "'[C]ompiling an index ... is an inherently discretionary exercise.'"11
Why and How Index Providers Avoid Discretion
The SEC is concerned about the abuse of unregulated advice and discretion. Advice and discretion are assiduously avoided by index providers.
Index providers avoid discretion by using precise, replicable, rules-based methodologies. Index providers design their indices and methodologies so that if an index is transferred from one sponsor to another, the new sponsor will be able to continue to operate the index without interruption. Vague methodologies, or those with significant discretionary elements, will not transition smoothly to a successor index sponsor.
Ministerial discretion in an index methodology is acceptable. For example, the index methodology of an equities or commodities index will set forth certain market disruption events, which may cause the index sponsor not to publish the index level for the disrupted day, or provisions for substitutions or replacements of components under certain circumstances. Often there will be limited discretion involved under these circumstances. Valuing a distribution of property to equity index component owners in a merger, spin-off or other distribution event may require an exercise of judgment by the index calculation agent. Substituting an index component for another after a merger or bankruptcy of the original component may require some discretion. However, none of this constitutes an "inherently discretionary exercise."
EXISTING GUIDELINES FOR INDEX PROVIDERS
Although there are no U.S. regulations governing indices, the NYSE Arca, Nasdaq and Cboe BZX exchanges have similar generic listing rules for securities, such as structured notes, exchange-traded notes or ETFs linked to an underlying index. The generic listing rules, which are reviewed and approved by the SEC, are designed to ensure that an index is "broad" and not "narrow." A narrow-based index may raise questions about whether the index is a bona fide index, or whether the so-called index is actually designed for some other purpose. For example, a model portfolio would not satisfy the generic listing rules of the exchanges. Index providers and their counsel assess any new index against the generic listing rules since the generic listing rules have been approved by the SEC.12 As part of an exchange's review of an application for a listed security linked to an index, such as an exchange-traded note, the exchange will review the index methodology. Any discretion in an index methodology will be questioned by the exchange and be cause for rejection.
1 See SEC Chair Gary Gensler's statement available at: https://www.sec.gov/news/statement/gensler-statement-comment-certain-information-providers. The request for comment (Rel. Nos. IA-6050; IC-34618 (June 15, 2022)) is available at: https://www.sec.gov/rules/other/2022/ia-6050.pdf.
2 See the RFC at note 4 and surrounding language.
3 See the RFC at pp. 4-6.
4 See the RFC at pp. 7-9. This article does not discuss model portfolios because this market appears to be limited to institutional accounts or sophisticated investors, not retail clients.
5 RFC at 11 (footnote omitted).
6 See the RFC at pp. 11-13.
7 See the RFC at 13.
8 RFC at 14 (citing Lowe v. SEC, 472 U.S. 181, 208-210 (1985)).
9 RFC at 15.
10 RFC at pp. 4-5 (footnote omitted) (emphasis added).
11 See RFC at note 4.
12 See, e.g., NYSE Arca Equity Rule 5.2-E(j)(6). The Nasdaq and Cboe BZX Exchange have substantially similar generic listing rules. See Nasdaq Rule 5710 and Cboe BZX Exchange Rule 14.11(d).
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