SEC adopts changes to regulatory framework of fund of funds arrangements
On October 7, 2020, the Securities and Exchange Commission (SEC) voted to adopt Rule 12d1-4 under the Investment Company Act of 1940 (1940 Act) and related amendments to the regulatory framework governing funds that invest in other funds (fund of funds arrangements). In addition, the SEC is rescinding Rule 12d1-2 and most exemptive orders granting relief from Sections 12(d)(1)(A), (B), (C) and (G) of the 1940 Act, as well as making related amendments to Rule 12d1-1 and Form N-CEN.
Rule 12d1-4 will allow a registered investment company or a business development company (acquiring fund) to acquire shares of any other registered investment company or business development company (acquired fund) in excess of the limitations currently imposed by the 1940 Act without obtaining individual exemptive relief from the SEC, subject to certain conditions.
Rule 12d1-4 will be effective 60 days after publication in the Federal Register and the compliance date for the amendments to Form N-CEN will be 425 days after publication in the Federal Register. The rescission of Rule 12d1-2 and the existing exemptive orders will be effective one year after the effective date of Rule 12d1-4.
As background, Section 12(d)(1) of the 1940 Act places limits on the investments that funds may make in other funds. However, over the years, the SEC has adopted rules and issued many exemptive orders permitting fund of funds arrangements in excess of these limits. The various statutory exemptions, exemptive rules and exemptive orders have resulted in a regulatory regime whereby similarly managed funds of funds operate subject to differing conditions. In adopting Rule 12d1-4, the SEC is seeking to harmonize the conditions under which funds of funds operate.
Rule 12d1-4 will permit an acquiring fund to acquire the shares of any acquired funds in excess of the limits described above, subject to certain conditions, which include:
- Control and Voting. Rule 12d1-4 will prohibit an acquiring fund (and its “advisory group,” individually or in the aggregate) from controlling an acquired fund.
- Evaluations and Findings Requirement. Rule 12d1-4 will require that the investment adviser to an acquiring fund or an acquired fund undertake certain evaluations and make certain findings prior to the initial acquisition.
- Complex Structure Limits. Rule 12d1-4 will restrict the ability to establish three-tier fund of funds structures, by limiting: (i) the ability of other funds to acquire shares of an acquiring fund that relies on Rule 12d1-4; and (ii) the ability of an acquired fund to itself invest in other funds, except in certain circumstances (e.g., investments in money market funds in reliance on Rule 12d1-1, certain inter-fund lending or borrowing transactions, or investments in funds that are wholly owned and controlled subsidiaries).
The SEC also is rescinding Rule 12dl-2, which permits funds that primarily invest in other funds within the same group of investment companies in reliance on Section 12(d)(1)(G) to invest in: (i) unaffiliated funds (up to certain limits); and (ii) non-fund assets. Further, the SEC is rescinding the exemptive relief under Section 12(d)(1) it has granted with respect to fund of funds arrangements (other than exemptive relief related to interfund lending arrangements and certain other limited exceptions).
SEC adopts new rules and amendments to update approach to regulation of registered funds’ and business development companies’ use of derivatives
On October 28, 2020, the SEC approved by a 3-2 vote a new rule and rule amendments (collectively, Final Rule) related to the use of derivatives, reverse repurchase agreements and certain other transactions by registered investment companies (i.e., open-end funds other than money market funds (with a limited exception); exchange-traded funds; and closed-end funds) and business development companies (collectively, funds).
The Final Rule includes: (1) new Rule 18f-4 under the 1940 Act; (2) a related rule amendment under the 1940 Act pertaining to leveraged/inverse exchange-traded funds; (3) related fund reporting requirements and form amendments; and (4) a conforming amendment to the liquidity risk management program rule. The Final Rule was proposed in November 2019 (Proposed Rule) and was a re-proposal of a 2015 SEC rulemaking effort, which itself was the first significant SEC or staff action relating to funds’ use of derivatives and certain other transactions that create leverage since the SEC’s issuance of a Concept Release in 2011. Rule 18f-4 and the related items represent the most significant change to the way the SEC regulates funds’ use of derivatives and the obligations of fund boards since the seminal Release 10666 was published.
The Final Rule requires that funds trading derivatives or engaging in other transactions that create future payment or delivery obligations (except reverse repurchase agreements and similar financing transactions): are subject to a value-at-risk (VaR) leverage limit; must maintain a derivatives risk management program; and have board oversight and reporting responsibilities. Generally, these requirements apply unless a fund satisfies a “limited derivatives users” exception. The Final Rule requires a fund to aggregate the amount of indebtedness associated with reverse repurchase agreements or similar financing transactions (including certain tender option bonds) with the aggregate amount of any other senior securities representing indebtedness when calculating the fund’s asset coverage ratio. Alternatively, a fund could treat all such transactions as derivatives transactions. The SEC also provided guidance regarding the use of securities lending collateral.
The Final Rule includes a number of significant changes to the Proposed Rule. Many of these changes were made in response to industry comments, and certain changes take into account commenters’ experiences in managing funds’ derivatives risk through the period of market volatility following the 2020 outbreak of the COVID-19 pandemic. Notably, these changes include allowing investments by funds (including money market funds) in certain forward-settling securities not to be deemed senior securities, thus increasing the VaR limits and providing the option to treat reverse repurchase agreements and similar financing transactions as derivatives transactions.
In view of the Final Rule, and consistent with the approach identified under the Proposed Rule, the SEC is rescinding Release 10666 and the related “asset segregation” requirements articulated in that release, after an 18-month transition period for funds to prepare to come into compliance with Rule 18f-4 following the effective date of the Final Rule, which will be 60 days after publication of the Final Rule in the Federal Register. The SEC staff also will withdraw related no-action letters and other guidance or portions thereof to the extent moot, superseded or otherwise inconsistent with the Final Rule.
President Trump bans investments in publicly traded securities of “Chinese Military Companies”
On November 12, 2020, President Trump issued an Executive Order (Order) that will prohibit U.S. persons from investing in publicly traded securities of certain companies determined to be affiliated with China’s military. The Order is currently in effect, having so far not been rescinded by the new administration of President Biden.
Citing a threat to U.S. national security posed by China’s military-industrial complex, President Trump issued the Order to prevent China from exploiting U.S. investors to finance the development and modernization of its military. The key elements of the Order are summarized below:
- As of January 11, 2021, U.S. persons generally are prohibited from transacting in “publicly traded securities” (or related derivatives) of any “Communist Chinese military company” (CCMC). However, U.S. persons can engage in transactions until November 11, 2021 to divest any publicly traded securities of CCMCs that they held as of January 11, 2021. As a practical matter, this means that U.S. persons:
- can purchase publicly traded securities of CCMCs until January 11, 2021, after which time such purchases generally are prohibited;
- can - but are not required to - divest any such holdings any time until November 21, 2021, provided that such divestments are to a non-U.S. person; and
- can continue to hold, but cannot divest or otherwise increase positions in, any CCMC securities held as of November 21, 2021.
- The Order initially affects publicly traded securities of 31 companies identified as CCMCs on lists issued by the Department of Defense (DOD) in June and August of this year. Many, but not all, of these currently have securities that are publicly traded on U.S., Chinese or other exchanges.
- Additional companies could be targeted under the Order if: (i) the DOD expands its CCMC lists; (ii) the Treasury Department publicly lists a company as meeting the definition of a CCMC (even if it is not identified on the DOD lists); or (iii) the Treasury Department publicly lists a subsidiary of an already-listed CCMC.
- Prohibitions would take effect 60 days after a company has been added to the list of covered CCMCs. U.S. persons would be prohibited from purchasing publicly traded securities (or derivatives) of such companies after that time, but could divest any captured holdings up to one year after the company was added to the CCMC list.
- The Order only prohibits actions of “U.S. persons,” defined to include companies organized under U.S. law or any individual who is a U.S. citizen, U.S. legal permanent resident, or otherwise located in the United States.
- Unlike certain other sanctions programs (e.g., Iran and Cuba), the Order does not expressly apply to non-U.S. entities that are owned or controlled by U.S. persons.
- The Order does not restrict U.S. persons from engaging in activities with CCMCs or their property or subsidiaries, other than with respect to publicly traded securities. Restrictions may apply under other authorities, however, as some of the CCMCs are subject to export restrictions under the Commerce Department’s Entity List or certain prohibitions related to involvement in U.S. Government federal contracts.
DOL releases final regulation on social investing
On October 30, 2020, the Department of Labor (DOL) released a final regulation (Final Regulation) relating to the consideration of non-pecuniary factors by fiduciaries of employee benefit plans (Plans) that are subject to Employee Retirement Income Security Act of 1974 (ERISA). The Final Regulation is expected to have a pointed impact on the use of environmental, social and governance (ESG) factors in the context of investment decisions.
As background, following the enactment of ERISA, the DOL under successive presidential administrations had put forth its own gloss on basic ERISA principles governing social investing. With the Final Regulation, the DOL now uses actual regulatory language to address the current administration’s view on taking into consideration non-pecuniary goals when investing on behalf of Plans, with the hopes of enshrining those views with greater permanence.
The Final Regulation works within this existing framework to emphasize the need to focus on pecuniary factors. However, whereas in the past ERISA fiduciaries may have felt comfortable selecting strategies that included ESG factors so long as those factors would not be harmful to economic returns, the Final Regulation likely places more emphasis on requiring fiduciaries to justify the positive economic benefits of such strategies. One key high-level effect of this regulatory initiative arguably will be to increase the focus of Plan fiduciaries and investment managers on affirmatively identifying the positive economic benefit of ESG-type thinking, as opposed to proceeding on the basis that considering ESG may not be harmful to economic returns.
The Final Regulation emphasizes the need for fiduciaries to look to pecuniary factors when selecting Plan investments, and continues to require that consideration of non-pecuniary factors be empirical and supported by appropriate processes (including documentation in certain instances). It expressly states that Plan fiduciaries are not permitted to sacrifice investment returns or take on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals, and that a fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the Plan to other objectives. While references to ESG have been removed from the text of the Final Regulation, it does not specify when ESG-type considerations would be considered pecuniary. In addition, the DOL indicated in the preamble to the Final Regulation that the term “pecuniary factor” should be judged by generally accepted investment theories that a fiduciary could consider in making a prudent judgment. In so doing, the DOL specifically stated that it did not intend to foreclose ERISA fiduciaries from considering emerging theories regarding investment practices.
The Final Regulation begins by requiring Plan fiduciaries to consider the risk of loss and the opportunity for gain (or other return) associated with an investment or investment courses of action “compared to the opportunity for gain (or other return) associated with reasonably available alternatives with similar risks.” In response to comments received regarding the regulation as proposed, however, the Final Regulation requires a fiduciary to compare alternatives that are reasonably available under the circumstances, but not to “scour the market” or to consider every possible alternative. The Final Regulation provides that, if a fiduciary is unable to determine which investment is in the best interest of the Plan on the basis of pecuniary factors alone, the fiduciary, with appropriate documentation, may base the investment decision on non- pecuniary factors.
The Final Regulation generally makes clear that a fiduciary is not automatically prohibited from considering or including an investment alternative merely because it pursues ESG-type goals, if the applicable rules are satisfied. That said, alternatives may be added only if they can be justified solely on the basis of pecuniary factors. Under no circumstances may any investment alternative be included in any qualified default investment alternative if its investment objectives or goals or its principal investment strategies include, consider or indicate the use of non-pecuniary factors.
The Final Regulation will generally become effective 60 days after it is published in the Federal Register. Plan fiduciaries will not be required to divest or cease any existing investment, investment course of action or designated investment alternative, even if originally selected using non-pecuniary factors in a manner prohibited by the Final Regulation.
SEC adopts amendments to shareholder proposal rules
On September 23, 2020, the SEC announced the adoption of amendments to its shareholder proposal rule, Rule 14a-8, aimed at modernizing the requirements for submitting (and resubmitting) shareholder proposals.
The amendments were adopted substantially as originally proposed by the SEC in November 2019, except that the so-called “Momentum Requirement,” which would have allowed registrants to exclude any shareholder proposal dealing with the same subject matter as another previously submitted proposal that failed to win significant support multiple times in recent years, and the requirement that co-filers designate a lead filer with authority to withdraw the proposal on their behalf, have not been adopted.
As revised, Rule 14a-8(b) will increase the current share-ownership and holding-period requirements, which previously provided that in order to have a shareholder proposal included in a registrant’s proxy statement, the proponent must have owned at least $2,000 worth of, or 1% of, the registrant’s securities for at least one year, in favour of a tiered system: the proponent must now have owned $25,000 worth for at least one year, $15,000 worth for at least two years, or $2,000 worth for at least three years. Further, the 1% of outstanding securities alternative method of meeting the requirement has been removed, and groups of shareholders can no longer aggregate their holdings for purposes of meeting the share ownership and holding period requirements.
SEC IM Division Director Blass provides insight as to remaining division actions during 2020
On September 24, 2020, Dalia Blass, SEC Director of the Division of Investment Management (Division), delivered remarks to the Investment Company Institute’s 2020 Virtual Securities Law Developments Conference. Director Blass’ remarks centred on the SEC’s philosophy of “seek[ing] forward-looking solutions” in rulemaking, as well as assessing the ways in which that philosophy has been tested by market disruptions caused by the COVID-19 pandemic earlier in the year. As examples, the Director cited the 2010 and 2014 amendments to Rule 2a-7, which governs money market funds, and the recently adopted Rule 6c 11, which established a regulatory framework for exchange-traded funds. She noted the importance of evaluating the extent to which the amendments to Rule 2a-7 “may have either alleviated or contributed to” the challenges that money market funds have experienced, and she emphasized the importance of continuing to support “healthy innovation” in the exchange traded fund (ETF) industry. While Director Blass acknowledged that analysis of past events is critical, she underscored the importance of data-driven regulatory tools, risk management and international engagement as “pathways” to developing regulations that have “enough flexibility to permit healthy innovations while also providing appropriate protections and oversight.”
Director Blass reiterated that the Division’s plans “to make recommendations for next steps to the Commission on all of the outstanding proposals in our area, including fund of funds arrangements, funds’ use of derivatives, fund valuation practices, and investment adviser advertising and solicitation.” Director Blass also stated that the Division is “exploring ideas for updating the Commission’s guidance on e-delivery [of shareholder communications] and to permit virtual board meetings under circumstances beyond those in the recent temporary relief related to COVID-19.”
FTC and DOJ propose HSR rule changes, increasing burdens for asset managers and private equity
On September 21, 2020, the Federal Trade Commission (FTC) and the Antitrust Division of the DOJ announced proposed changes to the rules implementing the Hart-Scott-Rodino Act (HSR Act). The HSR Act is a procedural statute that requires parties to notify the FTC and the DOJ of proposed acquisitions that exceed certain thresholds. After submitting an HSR filing, the parties must observe a mandatory waiting period before completing the acquisition, giving the FTC and DOJ an opportunity to review the filing and determine whether the acquisition presents any substantive antitrust concerns.
The proposed changes would require an acquiring fund to aggregate its holdings with those of its broader fund family. This will substantially increase the number of transactions subject to HSR reporting and waiting period requirements, especially for asset managers and private equity funds. The preparation of HSR filings also would be more complex and time-consuming, potentially making it more costly to close transactions.
A new “de minimis” exemption for acquisitions that do not exceed 10% of an issuer’s equity would allow minority investors to participate in active corporate governance of the issuer, unlike the current “Investment Only” and “Institutional Investor” exemptions. However, the de minimis exemption would not be available if the acquiring firm or any of its associates is a competitor of the issuer or holds more than one percent of any competitor of the issuer. The term “competitor” is vaguely defined and likely will create uncertainty about filing obligations for some acquirers. These and other complex criteria for the exemption may limit its applicability.
Affected companies have an opportunity to influence how the FTC finalizes these rules during the public comment period, and the FTC also is seeking comments on certain additional changes flagged for the near future.
Legislation introduced in House of Representatives regarding Section 36(b) lawsuits against investment advisers
On September 8, 2020, Republican Congressman Tom Emmer introduced a bill in the House of Representatives that would amend Section 36(b) of the 1940 Act. Section 36(b) provides mutual fund shareholders with a private right of action for breach of fiduciary duty against mutual fund advisers that charge excessive fees. The proposed amendment (named the Mutual Fund Litigation Reform Act), would raise the evidentiary burden placed on a plaintiff and require the relevant complaint to “...state with particularity all facts establishing a breach of fiduciary duty...and such security holder shall have the burden of proving a breach of fiduciary duty by clear and convincing evidence.” As noted in a statement issued on September 9, 2020 by ICI President and Chief Executive Officer Paul Schott Stevens, “this is the [evidentiary] standard required for lawsuits under [ERISA], various federal whistleblower statutes (e.g., the Sarbanes-Oxley Act), patent law, and several other federal statutes.”
The Congressman’s office stated that the proposed legislation would help to “reduce frivolous lawsuits against firms who are already heavily regulated to ensure investor protection.” The proposed legislation has not been well-received by certain plaintiffs’ attorneys and investor protection groups. However, ICI President Stevens expressed his view that the proposed amendment would “help federal courts to terminate before trial abusive lawsuits against mutual fund advisers, while preserving the right of shareholders to bring meritorious actions.”
The bill was referred to the House Committee on Financial Services and to the House Committee on the Judiciary. The period of time in which the bill will be considered in such committees has yet to be determined.
CFTC issues guidance on factors used in evaluating corporate compliance programs in connection with enforcement matters
On September 10, 2020, the Commodity Futures Trading Commission (CFTC) announced new guidance to be issued by the staff of the CFTC’s Division of Enforcement and that will be published in the CFTC’s Enforcement Manual. The guidance “provides a framework for [Enforcement] Division staff’ conducting a review and assessment of the compliance programs of CFTC registrants and other market participants. The Chairman of the CFTC described the new guidance as an example of the agency’s commitment to transparency and the Director of the Division of Enforcement described it as a tool that “...will help both Division staff in evaluating a corporate compliance program and companies seeking to cultivate a culture of compliance for their businesses.”
With regard to the evaluation of the design and implementation of a compliance program, the guidance states that the staff will consider whether a compliance program “...(i) prevent[s] the underlying misconduct at issue; (ii) detect[s] the misconduct; and (iii) remediate[s] the misconduct.” The CFTC’s press release notes that the Division of Enforcement will perform risk-based analyses of compliance programs and will consider various factors, including “the specific entity involved, its role in the market, and the potential market or customer impact of the underlying misconduct.” The guidance also sets forth staff considerations with respect to evaluation of “a compliance program’s ability to prevent” and detect misconduct and remediation efforts by a company to correct the misconduct and compliance program deficiencies and prevent future misconduct.
FinCEN seeks comments on enhancing the effectiveness of anti-money laundering
On September 16, 2020, the Financial Crimes Enforcement Network (FinCEN), a bureau of the Department of the Treasury, issued an advance notice of proposed rulemaking (Notice) seeking comments regarding proposed regulatory amendments under the Bank Secrecy Act. The Notice incorporates various recommendations made by an Anti-Money Laundering Effectiveness Working Group, which aim to enhance the national anti-money laundering framework. The Notice states that “all covered financial institutions subject to an anti-money laundering program requirement must maintain an ‘effective and reasonably designed’ anti-money laundering program.” Covered financial institutions include (among other entities) banks, brokers and dealers, mutual funds, insurance companies, futures commission merchants and introducing brokers in commodities.
FinCEN noted that the regulatory amendments discussed in the Notice are “intended to modernize the regulatory regime to address the evolving threats of illicit finance, and provide financial institutions with greater flexibility in the allocation of resources, resulting in the enhanced effectiveness and efficiency of anti-money laundering programs.” Further, the Notice states that the proposed regulatory amendments would define an “effective and reasonably designed” anti-money laundering program as one that “assesses and manages risk as informed by a financial institution’s risk assessment, including consideration of anti-money laundering priorities to be issued by FinCEN consistent with the proposed amendments; provides for compliance with Bank Secrecy Act requirements; and provides for the reporting of information with a high degree of usefulness to government authorities.”
SEC adopts fund fair valuation rule
On December 3, 2020, the SEC adopted a long-anticipated rule for the fair valuation of fund investments. Rule 2a-5 under the 1940 Act establishes requirements for good faith determinations of fair value, and addresses both the board’s and the “valuation designee’s” role and responsibilities relating to fair valuation. The SEC declined to reframe Rule 2a-5 as a safe harbour, as some commenters had suggested. Instead, Rule 2a-5 “establishes the requirements the board must meet to fulfill its continuing statutory obligations.” The SEC did, however, make several changes to the rule as proposed, in response to industry comments on the prescriptiveness of the proposal. The following provides a brief overview of Rule 2a-5 and certain of these changes.
As background, Section 2(a)(41) of the 1940 Act and Rule 2a-4 thereunder require valuation of a portfolio security for which market quotations are not readily available at fair value as determined in good faith by the board of directors.
Rule 2a-5 provides that a market quotation is readily available only when that quotation is a quoted price (unadjusted) in active markets for identical investments that the fund can access at the measurement date, provided that a quotation will not be readily available if it is not reliable. The SEC explained that this is consistent with the definition of Level 1 inputs in the fair value hierarchy under U.S. GAAP and that securities valued with Level 2 inputs are not consistent with this definition. The SEC stated further that the “definition of readily available market quotations that we are adopting will apply in all contexts under the 1940 Act and the rules thereunder, including [R]ule 17a-7,” and that “certain securities that had been previously viewed as having readily available market quotations and being available to cross trade under [R]ule 17a-7 may not meet our new definition and thus would not be available for such trades.” The SEC acknowledged that many cross trades are undertaken in reliance on certain SEC staff no-action letters and noted that the “staff is reviewing these letters to determine whether these letters, or portions thereof, should be withdrawn.” In addition, the SEC noted that its current rulemaking agenda includes consideration of potential updates to Rule 17a-7. These developments could have far-reaching implications for investment companies and the debt markets.
Under Rule 2a-5, determining fair value in good faith requires each of the following:
- Periodically assessing material risks associated with determining fair value of fund investments (valuation risks), including material conflicts of interest, and managing valuation risks.
- Establishing and applying fair valuation methodologies, taking into account the fund’s valuation risks, which involves:
- Selecting and applying in a consistent manner appropriate methodologies for determining and calculating fair value, provided that a selected methodology may be changed if a different methodology is equally or more representative of the fair value of fund investments, including specifying key inputs and assumptions specific to each asset class or portfolio holding;
- Periodically reviewing the appropriateness and accuracy of the methodologies selected and making necessary adjustments; and
- Monitoring for circumstances necessitating the use of fair value.
- Testing the appropriateness and accuracy of fair valuation methodologies selected, including identifying testing methods and minimum frequency for their use.
- Overseeing pricing services, if used, including establishing the processes for:
- Approving, monitoring and evaluating each pricing service; and
- Initiating price challenges, as appropriate.
The SEC reiterated its position expressed in the rule proposal that, in order to be an appropriate fan valuation methodology under Rule 2a-5, the methodology must be “consistent with the principles of the valuation approaches laid out in ASC Topic 820.”
Rather than requiring the maintenance of specific records as part of Rule 2a-5, the SEC opted instead to adopt a separate rule - Rule 31a-4 - to contain recordkeeping requirements associated with Rule 2a-5.
In response to concerns raised by commenters that a technical failure could result in a statutory violation, the SEC “underscore[d] that the objective of the final rule is to ensure that a fund’s assets are properly valued” and stated that “[a] violation of the final rule does not necessarily mean that the actual values ascribed to particular fund investments were in fact inappropriate, or, for example, that the fund has violated [R]ule 22c-1.”
Rule 2a-5 expressly places fair valuation responsibilities on a fund’s board, but permits the board to designate a “valuation designee,” which the board would continue to oversee, to perform fair valuation determinations relating to any or all fund investments. Under Rule 2a-5, the valuation designee may be the fund’s investment adviser (other than a sub-adviser) or an officer of an internally managed fund. However, the adopting release provides guidance as to how a valuation designee may engage other third parties (e.g., pricing services, fund administrators, sub-advisers, accountants or counsel) to assist with certain functions of the fair value determination process, other than making such determinations.
A valuation designee must carry out its responsibilities in accordance with the above fair valuation determination requirements, subject to additional conditions pertaining to: (i) quarterly, annual and prompt reporting; (ii) segregation of fair value determination responsibilities from portfolio management; and (iii) recordkeeping requirements. Specifically, as these requirements relate to board reporting:
- At least quarterly, the valuation designee is required to provide, in writing: (i) any reports or materials requested by the board related to the fair value of designated investments or the valuation designee’s process for fair valuing fund investments; and (ii) a summary or description of material fair value matters that occurred during the prior quarter.
- At least annually, the valuation designee is required to provide a written assessment of the adequacy and effectiveness of its process for determining the fair value of the designated portfolio investments.
- The valuation designee is required to promptly (within a time period determined by the board and, in any case, no later than five business days after the valuation designee becomes aware of the “material matter”) report to the board in writing on the occurrence of matters that materially affect the fair value of the designated portfolio of investments.
The SEC is rescinding in their entirety two Accounting Series Releases that provided accounting guidance on fund valuation matters, as well as certain other SEC and SEC staff guidance that is superseded by the rule requirements. Rule 2a-5 will be effective 60 days after publication in the Federal Register. The SEC adopted an 18-month transition period beginning from the March 8, 2021 effective date for both Rule 2a-5 and the associated new recordkeeping requirements.
Congress passes National Defense Authorization Act, restoring and codifying expansive SEC disgorgement authority
On January 1, 2021, Congress overrode a presidential veto and enacted the William M. (Mac) Thornberry National Defense Authorization Act (NDAA) for Fiscal Year 2021. In part, the NDAA restored significant enforcement powers to the SEC that had been limited through two landmark Supreme Court decisions in 2017 and 2020. The passage of this legislation, which inter alia codifies the SEC’s ability to seek disgorgement in federal court actions, is a bold statement by Congress in support of the SEC’s enforcement program.
As background, the SEC has a long tradition of seeking “disgorgement” (the return of any “ill-gotten gains”) through its civil enforcement actions in federal district court for violations of U.S. securities laws. In recent years, the SEC has obtained billions of dollars in disgorgement awards from respondents, including a record-setting $3.59 billion in 2020. However, the Supreme Court limited the SEC’s power to seek disgorgement in two recent decisions. First, in its 2017 decision, Kokesh v. SEC, the Court limited the length of time during which the SEC could seek disgorgement, holding that disgorgement in the securities context is a “penalty,” and therefore is subject to a five-year statute of limitations. Three years later, in Liu v. SEC, the Court affirmed the SEC’s power to seek disgorgement as equitable relief, but only if the award: (1) is for the benefit of victims harmed by the relevant misconduct; (2) is not based on joint-and-several liability; and (3) excludes any “legitimate expenses,” so that only net profits are recoverable. The recency of the Supreme Court decisions, particularly the Liu decision, has meant that all practical impacts of those decisions have not yet been fully manifested.
The NDAA codifies the SEC’s ability to seek disgorgement in federal court proceedings and establishes separate statutes of limitations for different claims the SEC may bring. For scienter-based fraud claims (including among others, Section 17(a)(1) of the Securities Act of 1933 (Securities Act) and Section 206(1) of the 1940 Act), the SEC must bring a claim for disgorgement within “10 years after the latest date of the violation that gives rise to the action or proceeding.” The SEC must bring all other types of claims for disgorgement within five years after the last date of the violation that gives rise to the action or proceeding. The statute therefore repudiates the more limited five-year period prescribed under Kokesh, at least for cases involving scienter-based fraud.
The NDAA also makes clear that disgorgement can only be sought from “the person who received such unjust enrichment as a result of such violation.” Under Liu, as an equitable remedy, the SEC was required to deduct “legitimate expenses” from any disgorgement amount and, therefore, could only seek disgorgement amounting to “net profits.” Whether there is a distinction between “unjust enrichment” as specified in the NDAA, and “net profits” subject to the equitable limitations proscribed in Liu, likely will be addressed in the courts. But Liu’s “net profits” limit arguably is still operative. Moreover, while the Liu court left open, but seriously questioned, whether the SEC could pursue disgorgement based on joint-and-several liability, the NDAA expressly provides that the SEC may only seek disgorgement from “the person who received such unjust enrichment,” likely ruling out efforts by the SEC to seek joint-and-several liability where unjust enrichment cannot be proven.
In addition, the NDAA further imposes a statute of limitations for “any equitable remedy,” including injunctions, bars, suspensions, or cease-and-desist orders, thus providing the SEC up to 10 years after the latest date on which a violation giving rise to the claim occurs to bring such a claim. Previously, the SEC arguably was not constrained by a statute of limitations for equitable remedies.
The NDAA also provides that the new disgorgement provisions “apply with respect to any action or proceeding that is pending on, or commenced on or after, the date of [the NDAA’s] enactment,” meaning Congress intends for the new disgorgement statute of limitations to be applied retroactively. It is unclear whether courts will permit any attempts by the SEC to apply the law retroactively.
SEC adopts modernized investment adviser marketing rule governing advertisements and solicitation
On December 22, 2020, the SEC adopted rule amendments to Rule 206(4)-1 to modernize the regulatory framework governing investment adviser advertising and payments to solicitors, together with related Form ADV amendments. The rulemaking creates a single rule (Marketing Rule) governing investment adviser marketing by replacing the existing investment adviser advertising and cash solicitation rules. The Marketing Rule will apply to an adviser’s marketing of “investment advisory services with regard to securities,” including marketing to advisory clients and private fund investors, but does not include marketing of registered investment companies or business development companies.
The Marketing Rule prohibits investment advisers registered or required to be registered with the SEC from directly or indirectly disseminating any “advertisement” that violates any of its provisions. The Marketing Rule contains: (i) general prohibitions concerning advertisements; (ii) requirements for “testimonials” and “endorsements”; (iii) provisions regarding inclusion of “third-party ratings” in advertisements; and (iv) requirements pertaining to performance advertising.
Under the Marketing Rule, the term “advertisement” is defined to include two broad categories of communications - the first concerning communications by an investment adviser offering advisory services, and the second concerning endorsements and testimonials for which the adviser provides compensation. The Marketing Rule generally prohibits advertisements from:
- Including any untrue statement of a material fact, or making a material omission.
- Including a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the SEC.
- Including information that would reasonably be likely to cause an untrue or misleading implication or inference to be drawn concerning a material fact relating to the adviser.
- Discussing any potential benefits to clients or investors connected with or resulting from the adviser’s services or methods of operation, without providing fair and balanced treatment of any associated material risks or material limitations.
- Including a reference to specific investment advice provided by the adviser where such investment advice is not presented in a fair and balanced manner.
- Including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced.
- Otherwise being materially misleading.
The Marketing Rule permits advertisements to include “testimonials” and “endorsements,” each as defined in the Marketing Rule, and permits advisers to provide direct or indirect compensation for testimonials or endorsements, subject to several conditions. The Marketing Rule contains certain related disqualification provisions and exemptions. Prior to the Marketing Rule, “testimonials” by sports stars and famous people were strictly prohibited.
The Marketing Rule also permits an advertisement to include a “third-party rating,” as defined in the Marketing Rule, subject to several conditions.
The Marketing Rule addresses several perennial topics in performance advertising: the use of gross and net performance; the time periods for performance results presented; statements regarding SEC approval; related performance; extracted performance; hypothetical performance; and predecessor performance.
In connection with adopting the Marketing Rule, Form ADV amendments will require certain disclosures concerning the adviser’s marketing practices. The Investment Advisers Act of 1940 (Advisers Act) record keeping rule also was updated in light of the adoption of the Marketing Rule. Further, the SEC is withdrawing certain no-action letters and other guidance that either are incorporated into the Marketing Rule or no longer will apply. A list of SEC staff no-action letters being withdrawn will be available on the SEC’s website.
The Marketing Rule and related amendments provide for an 18-month transition period following effectiveness. The Marketing Rule and related amendments will be effective 60 days after publication in the Federal Register. Compliance will be required following the 18-month transition period from the effective date.
Last pending 36(b) suit is dismissed
On December 30, 2020, the plaintiffs voluntarily dismissed with prejudice their Section 36(b) case against T. Rowe Price. Initially filed in 2016, the T. Rowe Price case was the only one remaining of the more than 20 Section 36(b) cases that had been filed following the Supreme Court’s 2009 Jones v. Harris Associates decision. In the T. Rowe Price case, the plaintiffs had alleged that the fees that T. Rowe Price charged to seven of its proprietary mutual funds were excessive because T. Rowe Price charged lower prices to sub-advise certain third-party funds that followed similar strategies. The case had an extended schedule, with fact discovery completed in October 2020 and expert discovery due to be completed in April 2021.
The stipulation filed by the plaintiffs indicates that the dismissal was not the result of a settlement and was without the payment of compensation. Accordingly, the plaintiffs were not paid anything by T. Rowe Price to dismiss the case, a sign that the plaintiffs did not want to devote further resources to a case with a slim chance of victory. The stipulation is similar to those that have been filed in several other cases, with the first such stipulation filed in February 2017 in a Section 36(b) case against Prudential. Given that the case against T. Rowe Price was the only remaining Section 36(b) case currently pending, it appears that the most recent wave of mutual fund litigation may be over.
Securities pricing service settles charges relating to compliance failures
On December 9, 2020, the SEC issued a cease-and-desist settlement order (Order) against ICE Data Pricing & Reference Data, LLC, a securities pricing service and a SEC-registered investment adviser (ICE), for compliance deficiencies under the 1940 Act, relating to ICE’s provision of quotes from a single market participant (referred to as “single broker quotes”) to its clients. According to the Order, from at least 2015 until
September 2020, ICE failed to adopt and implement policies and procedures reasonably designed to prevent violations of the Advisers Act and rules thereunder and, in doing so, failed to address the risk that single broker quotes ICE provided clients did not reasonably reflect the value of the securities.
The Order notes that ICE provided its clients with single broker quotes for approximately 46,000 securities out of the roughly 2.8 million securities for which it provided pricing information, in cases where ICE did not have enough information to provide a price based on its analysis of a variety of market information (referred to as an “evaluated price”). The Order alleges that ICE did not clearly identify which of the prices it provided to clients were single broker quotes rather than evaluated prices.
Further, according to the Order, ICE’s controls’ procedures for single broker quotes, including its quality controls to monitor single broker quotes for unchanged values and daily tolerance and process for administering price challenges submitted by clients, were inadequate or not executed effectively or consistent with its own procedures. The Order indicates the following:
- Unchanged prices controls deficiencies - For quotes that were supplied infrequently (e.g., weekly or monthly) by quote providers or quotes in which the same price for a security was provided by the quote provider over a period of time, ICE did not have, or did not follow, policies to verify that the unchanged values still reasonably reflected the security’s value. For example, ICE represented to its clients that steps would be taken to verify the accuracy of unchanged quotes after 20 business days. However, ICE employees were trained to wait 30 business days or longer before taking steps to verify the accuracy of the quote. Also, ICE’s verification steps at times merely required the ICE employee to contact the quote provider to confirm that the quote was intended to remain unchanged, and if confirmed, the quote would then be accepted by ICE without any further scrutiny.
- Daily tolerance controls deficiencies - ICE maintained controls that flagged broker quotes that were more than 5% higher or lower than the previously provided price for further review. However, ICE did not have sufficient policies in place to appropriately assess the reliability of such quotes. For example, certain employees were trained to only take steps to verify a flagged quote when the quote moved more than 10% or 20% from the previous price. Additionally, this verification process consisted only of confirming with the quote provider that the quote ICE received reflected what the quote provider intended to provide. No steps were taken to independently verify the reasonableness of the quote.
- Challenge process deficiencies - ICE offered its clients the ability to challenge its prices for securities. However, in most cases for single broker quoted securities, ICE’s system automatically rejected challenges from clients without considering any underlying market information that the client may have provided, such as trades. Moreover, when an ICE evaluator did review a challenge for a single broker quoted security, the evaluator would simply ask the quote provider to confirm that the quote it provided was what the provider intended to send, and no consideration was given by ICE to the information submitted with the challenge.
As a result of these deficiencies, the Order alleges that ICE provided clients with prices for certain securities that did not properly reflect the securities’ value and nature. Without admitting or denying the SEC’s findings, ICE agreed to pay $8 million in civil penalties, as well as to cease and desist from causing future violations of applicable provisions of the Advisers Act and rules thereunder.
New York adopts new rules requiring registration and exams for investment adviser representatives, principals and solicitors
The New York State Department of Law (the Department) recently adopted new regulations, effective February 1, 2021, imposing registration and exam requirements on investment adviser representatives, principals and supervisors of investment advisers, solicitors, and principals and representatives of solicitors. The regulations provide an implementation period for certain persons who are currently permissibly engaged in the investment advisory business, so long as such persons submit an application for registration by August 31, 2021. The newly adopted regulations also impose a new recordkeeping requirement for investment advisers; and require state-registered investment advisers to verify the “accredited investor” and “qualified client” status for their clients, effective February 1, 2021. The new regulations do not impact the requirement to register as an investment adviser in New York.
This update summarizes certain notable aspects of the new regulations. The new regulations:
- Exclude federally-registered investment advisers from the definition of the term “investment adviser.”
- Define the term “investment adviser representative” to include certain natural persons, who:
- work for an investment adviser that has more than five (5) New York clients who are not financial institutions or institutional buyers;
- work for a federally-registered investment adviser that has more than five (5) New York clients who are not financial institutions or institutional buyers; work from a place of business located in New York; and satisfy the federal definition of “investment adviser representative,” as that term is defined under the 1940 Act;
- register through the Central Registration Depository/Investment Adviser Registration Depository; and
- comply with exam requirements.
- Impose investment adviser registration obligations on certain solicitors.
- Require certain single-person solicitor firms to comply with exam requirements and register as both an investment adviser and an investment adviser representative.
- Provide a new exam waiver category for persons currently serving as investment adviser representatives and having two (2) years of experience in that capacity prior to February 1, 2021.
- Include an implementation period allowing persons who permissibly operated under the rules in existence prior to February 1, 2021 to continue to do so until December 2, 2021, so long as they submit an application for registration by August 31, 2021.
- Require investment advisers to file any records required to be maintained upon the Department’s request.
- Require state-registered investment advisers to make and maintain documents evidencing reasonable steps to verify any “accredited investor” or “qualified client” designation of its clients
Certain principals of state-registered investment advisers, as well as their investment adviser representatives and solicitors, are now required to register and comply with exam requirements in New York. With respect to persons associated with federally registered investment advisers, the registration and exam requirements will be imposed only on certain persons who: (1) fall under the federal definition of “investment adviser representative,” as that term is defined under the 1940 Act; and (2) have a place of business in New York.
Persons who were permissibly engaged in the investment advisory business prior to February 1, 2021 must submit their application for registration to New York by August 31, 2021 in order to be eligible under the implementation period, which ends on December 2, 2021. Eligible persons may continue to provide investment advisory services during the implementation period without an approved registration.
The proposed Exemptive Order for finders who raise capital
On October 7, 2020, the SEC proposed an Exemptive Order (Release No. 34-90112) granting a conditional exemption from broker registration for two types of finders who raise capital for companies. The proposal allows two kinds of activities involving the referral of investors for certain types of issuers, which would not require broker-dealer registration. With respect to either type of activity:
- only accredited investors as defined in Rule 501(a) under the Securities Act may be solicited; only natural persons - not entities - may rely on the exemption; and
- the finder must enter into a written agreement with the issuer.
The following is a general description of the two types of exemptions under the Exemptive Order. Certain other conditions enumerated in the proposal must also be satisfied.
Under the “Tier I” exemption, a person may receive compensation for referring investors to an issuer, if the person:
- engages in only one capital-raising transaction for a single issuer in any 12 month period;
- provides only contact information about prospective investors to the issuer; and
- does not discuss the issuer or the investment with the prospective investor.
Under the “Tier II” exemption, a person may:
- receive compensation for referring an unlimited number of investors to the issuer;
- distribute offering materials to prospective investors;
- discuss the issuer with prospective investors; and
- participate in meetings between the investors and the issuer.
Under the Tier II exemption, however, the finder is not permitted to give advice on the value or advisability of the investment. The Tier II exemption also requires the referring person to make certain written disclosures to investors and to obtain the investors’ acknowledgement of the receipt of those disclosures.
It is expected that the Exemptive Order will be finalized later this year. However, there are certain statutes and regulations that would continue to apply to the solicitation of investors, apart from the broker-dealer registration requirement. For example, the anti-fraud provisions under the Securities Exchange Act of 1934 and the Advisers Act prohibit making misrepresentations or omitting material facts in connection with soliciting investors.
The Exemptive Order will offer much more clarity on the activities that are permitted for individuals who raise funds from investors but are not registered as broker-dealers or associated with broker-dealers.
More importantly, the Exemptive Order creates two new and clearly defined categories of persons who may be enlisted by investment funds, in particular, to identify potential investors. Because those persons are not required to be employed by a registered broker-dealer or have licenses issued by FINRA, the Exemptive Order opens investment funds to a much larger pool of potential “finders,” including financial advisers, family offices, high net worth individuals, lawyers, accountants, and consultants as well as persons who are already investors in such fund, to identify and refer potential investors to the funds.