The SEC has once again proposed new derivatives rules for registered funds including mutual funds, ETFs, closed-end funds, and BDCs. Funds that employ derivatives would be required to limit leverage to 150% of the value-at-risk of a designated referenced index. The fund would also have to create a derivatives management program that would include a designated derivatives risk manager in addition to stress testing, backtesting, reporting and escalation procedures, and reviews. Different rules would apply to levered or inverse funds, although any adviser or broker-dealer recommending or selling such funds would have to implement due diligence procedures for retail accounts. A 60-day comment period will follow publication.
Here we go again. The SEC tried derivatives reform back in 2015 but never adopted the rule in the face of industry objections. The new proposal puts a lot of burden on the designated derivatives risk manager which, we expect, means more work for the Chief Compliance Officer.
The SEC Division of Investment Management’s Disclosure Review and Accounting Office has warned the fund industry to improve its fee and performance disclosure. In its most recent release, the DRAO highlighted “several issues” including failures to verify the accuracy of performance and fee information. In particular, the DRAO cites multiple funds that have failed to reflect the effect of sales loads in their average annual returns table, showing negative performance as positive performance, and transposing the performance of different fund classes and benchmarks. The DRAO also faults fund-of-funds for failing to show the expenses of underlying acquired funds. Funds also routinely make arithmetic errors and fail to properly use XBRL tags. The DRAO “encourage[s] funds to closely review their performance and fee disclosures prior to providing them to investors.”
Over the years, many fund firms have delegated the preparation of registration statements to low-cost service providers that may not have the necessary knowledge, staffing and/or systems to prepare correct filings. When hiring a vendor (administrator, lawyer, auditor), make sure that the firm has the experience and the resources to do your job right. The cheapest is never the best and could cost you in the long run with a rescission or enforcement order.
A fund sponsor agreed to pay over $32.5 Million in disgorgement and penalties because its tax planning strategy harmed the funds it managed. In 2005, the fund manager caused the underlying funds to convert to partnerships in order to benefit from certain deductions. However, the deductions required the unwinding of securities lending transactions that benefited the funds. The SEC asserts that the fund sponsor did not disclose this conflict of interest to the Board or the shareholders. The firm failed to resolve the internal dispute between the tax department and the securities lending group, until (10 years later) the securities lending group informed the Chief Compliance Officer, who prompted an internal investigation. The SEC also faults the firm for not reimbursing the funds for certain foreign taxes paid as a result of the conversion to a partnership. The SEC gave credit, which resulted in a lower fine, to the CCO and the firm for initiating the internal investigation and the self-reporting.
It’s never a good idea to keep Compliance in the dark about internal conflicts of interest. The Chief Compliance Officer is in the best position to protect the long-term interests of the firm and clients.
The in-person meeting requirement is so archaic that it feels like it was adopted in 1940, although it was actually adopted in 1970. As a statutory requirement, the SEC cannot completely strike the in-person requirement without an act of Congress (which is not a bad idea). The SEC deserves some credit for adapting the rules to modern realities, and we would urge them to further liberalize the rules to the extent legally permissible.
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.
OUR TAKE: If you didn’t work in the fund industry, you might think it inconceivable that fund firms have been required to mail hard copies of voluminous shareholder reports. Finally, the SEC has stood down the paper lobby to adopt this long overdue modernization. Our only question is why wait until 2021?
The SEC has voted to delay the classification requirement of the open-end fund liquidity risk management rule until June 1, 2019 for large funds (over $1 Billion) and December 1, 2019 for smaller funds. The other requirements of the rule – implementing a risk management program, limiting illiquid investments to 15% of the portfolio – will still go into effect on December 1, 2018 for large funds and June 1, 2019 for smaller funds. The SEC also released a series of FAQs that provide additional guidance about how to effect the classification requirements.
OUR TAKE: The bad news is that the Clayton SEC will not rescind the liquidity risk management rule. The good news is that the SEC will provide more time and flexibility to implement its more complicated requirements.
The staff of the SEC’s Division of Investment Management has released FAQs for the new Liquidity Risk Management Rule for open-end funds and ETFs (Rule 22e-4). Most significantly, the staff will allow funds to delegate liquidity program responsibilities to a sub-adviser either in whole or in part “subject to appropriate oversight” including relevant policies and procedures. The staff also clarifies that the same investment may carry different liquidity classifications by different advisers or funds, provided the liquidity program properly supports the classification. The FAQs address several technical issues for in-kind ETFs.
OUR TAKE: Many industry participants acknowledged the broad policy goals of the liquidity rule but questioned the rule’s practical implementation. The FAQs help that process by addressing some of the outstanding questions.
OUR TAKE: A compliance program is not a static exercise that you can set and forget. As the markets and the business changes, firms must continuously review policies and procedures to determine if they still make sense given new realities. In this case, the wider availability of institutional share classes necessitated changes to the firm’s compliance practices.
An RIA was censured and agreed to pay disgorgement for failing to offer the lowest-fee mutual fund share classes available and failing to adequately disclose compensation paid to its affiliated broker-dealer. The RIA recommended third party mutual funds to 403(b) and IRA clients, who directed the investments. The SEC faults the respondent for recommending Class A shares that paid 12b-1 fess to its affiliated broker and failing to make available lower-fee institutional shares. The SEC also cites the insufficiency of various disclosures that generally discussed payment of 12b-1 fees but failed to specifically explain that an affiliate would receive the trailers. The SEC charges the RIA with violations of the compliance rule (206(4)-7) for failing to adopt and implement adequate policies and procedures around conflicts of interest, disclosure, and mutual fund share class selection.
OUR TAKE: We believe that the SEC wants advisers to offer the lowest share class available and refrain from accepting any form of revenue sharing compensation. We think that the SEC will find inadequate even the most robust disclosures and procedures because of the inherent conflict of interest.