Political Divide Hits The Fund Industry


Author(s): NICSA TA Committee

The political divide within the US has impacted various aspects of our lives including our social activities, how we interact with others, as well as how we spend and invest money. Moreover, the impact has filtered into the funds industry with some unintended consequences.

Federal rules are the driver for the regulatory and compliance activities performed by funds and their service providers, along with a limited amount of State-issued mandates. This arrangement has allowed fund compliance and regulatory teams to focus on identifying and complying with rules and requirements issued by a limited number of entities.

A recent trend with legislative initiatives is making compliance and regulatory oversight more complex and costly. In some cases, rules on how and when to best address fund industry challenges are being put forth because of differences between the political parties in control at State and Federal levels. The result is the issuance of new State laws in areas where Federal laws are not currently in place, are pending, or overlap with Federal edicts—some with variances in requirements. These activities are occurring in spite of restrictions imposed by the National Markets Improvement Act of 1996 (NSMIA) that limit states’ authority for mutual funds, investment advisers and broker-dealers.

This confluence of rules includes requirements related to adviser fiduciary standards, lost shareholders, cyber-security, and elder protection and are occurring at a time when the industry is focused on providing high quality products with cost efficient expense ratios. The burden of monitoring and adapting to an increasing number of rules runs counter to that objective. The challenge is further amplified by an increasingly mobile and connected society. Consider an advisor having an online meeting with an investor from their work office located in a different state, although their residence is located in a third state.

Much Ado About Federal Preemption

While a hierarchy of authority would appear to be straight-forward (Federal law trumps conflicting State law), it is not quite that easy. The concept of Federal preemption is a tremendously nuanced matter. Indeed, courts and legal scholars spend a lot of time discussing and arguing about preemption, and the doctrine is deeply ingrained in viewpoints regarding the appropriate roles of Federal and State governments.

Fortunately, the Supreme Court of the United States has developed a useful preemption analysis through decades of case law. Pursuant to the Supreme Court’s analysis, preemption may be either “express” or “implied”. Express preemption occurs when Congress expressly states in a Federal law that it intends for the law to supersede related State laws. The only question in such cases is whether a particular State law is of the type that Congress intended to preempt. Where the Federal law is ambiguous regarding Congress’ intent, the Supreme Court has historically invoked a presumption against preemption.

Preemption may be implied where a Federal law does not expressly state that it preempts State law. There are two types of implied preemption: (1) “field” preemption, and (2) “conflict” preemption. Field preemption occurs when Congress legislates in a way that is so comprehensive as to occupy the entire field of an issue, although without expressly stating in the Federal law that it intends to supersede related State laws. Conflict preemption occurs either (1) when it is impossible for someone to comply with both Federal and State law, or (2) when the purposes and objectives of Federal law would be thwarted by State law. These two sub-types of conflict preemption are known as “impossibility” preemption and “purposes and objectives” preemption, respectively. Given the wide range of Federal laws that could have applicability to the asset management/asset servicing industry, and the similarly wide range of potentially applicable preemption standards, caution should be exercised whenever trying to predict the outcome of a given preemption question absent judicial clarity.

The Fundamental Question

Preemption raises fundamental questions about the balance between Federal and State power and highlights the difficulties that the balance of power creates for the fund industry. As Federal and State laws increasingly conflict, this causes uncertainty and difficulty for our industry and many others. If this trend continues, the requirement for compliance within the funds industry will become much more challenging and potential benefits to shareholders will come at some cost.

Note: Although the observations, thoughts, and conclusions contained in this work represent the best thoughts of the individuals comprising the NICSA Committee that authored the work, they do not necessarily reflect the views of NICSA or any of its member organizations. Similarly, although the matters addressed in this work may touch upon legal or regulatory matters, nothing herein is intended to be or should be construed as legal advice. You should contact your own counsel in order to obtain legal advice regarding these or any other matters.

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