SEC’s Investment Management Division Director, Dalia Blass, anticipates that
the Division will soon recommend changes to the adviser marketing and solicitation
rules. In her annual speech to the Investment
Company Institute membership, Ms. Blass also announced initiatives for a
summary shareholder report, updates to the valuation guidance, modernization of
the offering rules for business development companies and closed-end funds, and
changes to the rules for funds’ use of derivatives. Additionally, Ms. Blass wants the Division to
finalize the proposed ETF and fund-of-funds rules. She has also asked the staff to begin an
outreach to small and mid-sized fund sponsors about regulatory barriers. She announced that the Division is
considering the formation of an asset management advisory committee to solicit diverse
viewpoints on critical issues.
We applaud the reinvigorated Investment Management Division for tackling some of the thornier problems that have faced the industry for many years. For instance, the marketing rules haven’t changed for decades despite revolutionary change in the financial services industry.
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.
“We’ve always done it this way” is not a legitimate excuse for failing to comply with regulatory requirements. The firm engaged in the undisclosed revenue sharing for nearly 20 years before the SEC uncovered the conflict of interest. Perhaps, the firm never considered that its longstanding practice violated the securities laws. This is why we recommend retaining a fully-dedicated and experienced chief compliance officer either as a full-time employee or through a compliance services firm.
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.