The SEC’s Office of Compliance Inspections and Examinations has announced a sweep of certain mutual funds and ETFs. The OCIE staff will target smaller ETFs and funds/ETFs that use custom indexes, allocate to securitized assets, exhibit aberrational underperformance, or employ inexperienced managers or private fund sponsors that manage a similar mutual fund. The SEC will assess compliance policies and procedures and fund oversight of risks and conflicts, disclosures to shareholders and the Board, and oversight processes. Among some of the issues of concern to the OCIE staff include bid/ask spreads for secondary market trading of smaller ETFs, portfolio management for underperforming funds, the effect of unexpected market stresses on securitized assets, and side-by-side allocations for private and public funds. OCIE is encouraging fund sponsors and boards “to consider improvements in their supervisory, oversight, and compliance programs.”
Compli-pros and fund lawyers should mobilize to review policies and procedures for affected advisers and boards, consult about changes, and implement enhanced oversight and processes. We recommend taking action before the OCIE staff arrives for its examination.
The SEC’s Director of the Division of Investment Management, Dalia Blass, questioned whether ETF index providers should continue to claim a blanket exemption from investment adviser registration. Ms. Blass, acknowledging an exemption for publishers of broad-based indexes, asked whether providers of more narrow indexes should register as investment advisers especially where such providers create indexes for a single fund or take significant input from the fund sponsor. Ms. Blass cautioned “against assuming that the status of a provider can be determined based simply on its characterization as an index provider” and encouraged fund sponsors and index providers to “refresh your analysis if you are looking at a bespoke or narrowly focused index.” Ms. Blass also advised funds to consider disclosure implications of narrow indexes.
OUR TAKE: As a result of Ms. Blass’s speech, index providers should expect some hard questions from fund counsel and independent directors’ counsel as the lines blur between index creation and investment recommendations.
A large ETF adviser agreed to pay a $1.5 Million fine for operating a fund without obtaining the required exemptive relief. According to the SEC, from 2010 to 2015, the adviser relied on exemptive relief for a separate ETF trust even though the SEC staff had opined that the relief did not apply to the fund at issue. The SEC asserts that both internal and outside counsel advised (incorrectly, according to the SEC) that the firm could rely on the pre-existing exemptive relief. The SEC did acknowledge that the fund complied with exemptive order requirements even though it did not obtain its own, specific relief. The offending fund was merged out of existence in 2015. An exemptive order is required to operate an ETF because it would otherwise violate various pricing provisions of the Investment Company Act.