Compliance Matters Q1 2021

Apr 28, 2021

Curated for compliance officers of mutual funds and investment advisers, please find summaries and links to headlining compliance and regulatory topics from the first quarter of 2021.

The first quarter started off relatively quietly, with no new pertinent rules (save for updates to the EDGAR filing manual), as the new year was marked by transition with a change in Administration. That may change now that the Senate has confirmed Gary Gensler, who formerly chaired the CFTC, as the new chairman of the SEC. It remains to be seen whether the fall regulatory flex agenda, just published in the Federal Register, will prove to be a relic of the past or a roadmap for the new chairman’s priorities. Below are highlights of regulatory activity from the past quarter, with some predictions for the future sprinkled into the mix.

SEC Final Rules

Adoption of Updated EDGAR Filer Manual, Form ID Amendments

The SEC has adopted updates to the Filer Manual and related rules and a form for the Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system. The amendments update the EDGAR access process, particularly for those seeking EDGAR access codes that already have CIK codes but have not previously filed electronically on EDGAR. The updated process will require those applicants to submit a Form ID and an authenticating document to gain access to EDGAR.

The new rule will be effective upon publication in the Federal Register. For more information, including specific detailed requirements, registrants should review the SEC’s adopting release at the following link on the SEC’s website:

Other SEC Guidance and Alerts

Update on the Commission’s Targeted Regulatory Relief to Assist Market Participants Affected by COVID-19

The SEC issued a statement concerning the various temporary relief it has issued in the wake of the COVID-19 pandemic. This statement provides an update across all Divisions concerning their view on the continued need for such relief. Most significant for the fund industry, relief from the in-person board meeting requirements will remain in effect until terminated upon at least two weeks’ public notice. The Division recognizes that restrictions and concerns relating to travel are likely to continue for some time, and because directors and meeting participants will need significant lead time to make appropriate travel plans, the Division anticipates providing sufficient advance notice before setting any termination date for this relief. Other temporary relief (discussed in prior editions of this quarterly update) also will continue until terminated after public notice at least two weeks in advance, with the exception that several elements of relief have expired and will not be extended. The expired relief includes delayed prospectus deliveries and transmittals of shareholder reports; extended filing deadlines for Forms N-CEN, ADV, PF, and N-23C-2; and delayed mailing of certain shareholder communications to persons in foreign jurisdictions. A detailed summary of the status of the various temporary orders and relief can be found on the SEC’s website:

Division of Examinations Priorities for 2021

SEC’s Division of Examinations (DOE, formerly OCIE) has issued its exam priorities for 2021, a bit later than in the years past. There are no substantial surprises, with predictable topics ranging from protecting retail and retirement investors to AML compliance, and emerging topics like information security, digital assets, and the LIBOR transition. There also is distinct focus on ESG and climate risk, which will be largely integrated into broader regulatory topics (and likely surfacing in the new chairman’s regulatory agenda). For example, the staff will consider whether proxy voting aligns with investors’ expectations and whether business continuity plans consider the physical risks associated with climate change. Focusing on those issues most relevant to our adviser clients and registered funds, key exam priorities include

  • Compliance programs;
  • Mutual fund disclosures, valuation, and fund governance;
  • Retail investors;
  • Information security and business continuity;
  • FinTech and digital assets; and
  • LIBOR transition

The exam priorities cover many other topics, ranging from market structure to FINRA oversight, and there are brief discussions about other registrants including transfer agents and broker-dealers (including AML compliance and cybersecurity). We encourage you to review the detailed summary we prepared in March for further information and welcome your additional questions. In the meantime, you may wish to consult DOE’s publication available on the SEC’s website:

Division of Investment Management Statement on Investment Company Cross Trading

The Division of Investment Management issued a non-binding statement concerning its interpretation of Rule 17a-7 as it pertains to cross trading of fixed income securities. The staff recognizes that new Rule 2a-5s’ definition of “readily available market quotations” will apply to both valuation and cross trading under Rule 17a-7, effectively barring cross trading of fixed income securities. (Because fixed income securities generally are not exchange-traded, they would not have “readily available market quotations,” which is a prerequisite to invoking the cross-trading exemption under Rule 17a-7.) In conjunction with a FAQ on the topic, the staff has confirmed that a fund may continue to rely on Rule 17a-7 without regard to the new definition of “readily available market quotation,” even if the fund is an early adopter of the new valuation rule, until Rule 2a-5’s compliance deadline of September 8, 2022.

The staff is considering a rewrite of Rule 17a-7 to address this concerns about the impending restriction on cross trades. Hence, the staff issued a series of question concerning current practices and concerns and would like feedback industry feedback. Rulemaking is a notoriously slow process, however, so, absent further temporary relief, funds should be prepared to comply with a more restrictive cross-trading rule come September 2022. In the meantime, funds should proceed with caution given that the staff evidently believes the prevailing interpretation of current Rule 17a-7 has been too liberal. For more information, you may wish to consult the staff statement and FAQs available on the SEC’s website:

Division of Investment Management Statement Regarding Withdrawal and Modification of No-Action Letters Concerning Use of Derivatives

In conjunction with the adoption of a new derivatives rule (18f-4), which permits registered investment companies and business development companies to enter into derivatives and certain other transactions provided they comply with certain conditions, the Commission stated that it would withdraw or modify historical guidance on the use of derivatives. At the time of adopting rule 18f-4, the Commission already stated that it would be rescinding the 1979 General Statement of Policy (Release 10666) that provided Commission guidance on how funds may engage in certain derivatives transactions in light of section 18’s restrictions. The Division of Investment Management has now reviewed its no-action letters and other guidance addressing funds’ use of derivatives and other transactions covered by rule 18f-4 and identified additional prior guidance that will be rescinded or modified, effective as of August 19, 2022 (when compliance with 18f-4 is required). For a list of prior guidance subject to rescission or modification, please see the staff statement on the SEC’s website:

Risk Alert: Compliance Issues Related to Suspicious Activity Monitoring and Reporting at Broker-Dealers

Based on recent examinations of mutual funds and broker-dealers, the Division of Examinations staff reminded market participants of the importance of anti-money laundering (AML) compliance, particularly with respect to suspicious activity reporting (SARs) under the Bank Secrecy Act. The staff expressed concern that broker-dealers have not always filed SARs when they had reason to suspect unlawful activity. (Indeed, as discussed below, FinCEN recently filed an enforcement action against a bank for failing to file SARs.) The alert identified deficiencies in policies and procedures, such as imposing reporting thresholds above the mandatory $5,000 level or failing to include red flags. The staff noted that red flags in policies should be tailored to the type of activity in which customers engage. The staff also criticized firms for filing incomplete SARs, submitting only boilerplate, non-specific information, or leaving it to another entity to identify suspicious activity and report it. The staff also observed that some firms lacked automated systems for monitoring and reporting suspicious activity when there are large trade volumes. For example, automation could be used to help identify trends or suspicious patterns across multiple accounts. Finally, the staff observed that some firms have good policies and procedures but failed to implement or follow their own procedures.

Although ostensibly directed at mutual funds, the alert never identifies any issues particular to funds. In fact, many of the staff’s observations concern trading not directly relevant to mutual funds (e.g., penny stocks or trading issues subject to trading suspensions), and there was no discussion of transfer agents, which typically take on principal responsibility for funds’ AML compliance. But the core message – if you see something say something (file a SAR) – pertains to any financial institution. Moreover, this alert is part of a succession of recent alerts and enforcement actions in the past few years, so this should be viewed as a potential shot across the bow. For more information, please follow this link to the SEC’s website:

Risk Alert: Focus on Digital Asset Securities

The Division of Examinations issued an alert that concerns responsibilities when investing in digital assets like Bitcoin. Along with a new SEC chairman who seems interested in addressing cryptocurrencies, and a flurry of new applications to launch open-end funds holding such assets, this alert seems a nod to the evolving – and maturing – digital assets industry. The alert addresses advisers, exchanges, custodians, broker-dealers, and transfer agents. Focusing on advisers, DOE expects to see policies and procedures that address risks, including with regard to trading and execution, performing due diligence, and maintaining books and records. Due diligence includes understanding how digital “wallets” work and understanding the liquidity and volatility of the particular assets. Risk management requires, among other things, mitigating risks of security breaches, fraud or market manipulation, insolvency, KYC/AML procedures, and the quality of market surveillance on the trading platforms. Recordkeeping should consider, among other things, the reliability and consistency of with respect to trade execution and settlement, as well as post-trade recordation and notification. Advisers also must be mindful of custody requirements. The staff will be examining controls around safekeeping of assets, business continuity risks around access to private “keys,” software reliability, and security procedures. Valuation and pricing will be major issues, particularly considering market fragmentation and volatility. Advisers will be expected to have robust disclosures that address these unique risks. Finally, advisers must consider how digital assets affect registration, including for purposes of calculating RAUM and characterizing the assets as securities (which could require registration as an investment company).

The staff recognizes this is a new area with regulatory obligations that are not easily applied in the context of digital assets. Thus, they invite industry participants to engage with the staff to address questions. There is staff dedicated to this area in a group known as the Strategic Hub for Innovation Technology (FinHub), which can be reached through their website:

For more information, please follow this link to the SEC’s website:

Risk Alert: Prohibited Securities Investments That Finance Communist Chinese Military Companies

As discussed last quarter, on November 12, 2020, then-President Trump issued Executive Order 13959 that restricts investment by U.S. persons in designated Communist Chinese Military Companies (“CCMCs”). The Order generally restricts any transactions in the publicly traded securities of designated CCMCs and their subsidiaries, subject to a period for divestiture. The SEC’s Division of Examinations issued a risk alert in January to notify investment advisers, broker-dealers, and other market participants that they must follow the Order.

Both the Department of the Treasury’s Office of Foreign Assets Control (OFAC) and the Department of Defense have identified dozens of CCMCs and their subsidiaries subject to the Executive Order, and OFAC continues to issue FAQ guidance and general licenses that concern the Order’s application. While broker-dealers are familiar with the restrictions and generally will prohibit advisers from transacting in prohibited securities, advisers must be vigilant to ensure that their trading activity does not violate the restrictions or divestiture requirements. Advisers investing in Chinese companies, or funds with exposure to Chinese securities, should consult the OFAC website below for an updated list of restricted entities and the most recent guidance.

SEC Regulator Flex Agenda

The SEC’s Agency Rule List for Fall 2020 pursuant to the Regulatory Flexibility Act has been published in the Federal Register. As noted last quarter, the list reflects only the priorities of the then-Chairman of the SEC (reflecting priorities as of October 2020) and is subject to modification each reporting cycle. With a new chairman (Gary Gensler) at the helm of the SEC, we would expect some shift in the agency’s priorities, particularly with respect to disclosures (ESG reporting) and possibly the regulation of cryptocurrencies. The period for public comment closes on April 30, 2021. For more information, please follow this link to the Federal Register’s website:

Other Orders and Guidance

LIBOR Extension

Following discussions with the UK Financial Conduct Authority (FCA) and other official bodies, ICE Benchmark Administration (IBA), which is appointed by the FCA as the administrator of LIBOR, has expressed its intention to cease publication of most LIBOR rates after December 31, 2021, or, June 30, 2023, in the case of USD LIBOR overnight and 1-, 3-, 6-, and 12-month rates. A majority of panel banks advised IBA that they would not be willing to contribute relevant LIBOR data after such dates, which means that IBA could not continue publishing LIBOR except on a “synthetic” basis, if required by the FCA. The FCA has advised IBA that it has no intention to require such publication for lesser-used LIBOR rates, but it may require publication on a synthetic basis for some rates, including the more widely used 1-, 3-, and 6-month USD LIBOR settings. Additional information may be found on ICE’s website:

Enforcement Actions

FinCEN Enforcement Action Against Capital One for Anti-Money Laundering (AML) Violations

The Financial Crimes Enforcement Network (FinCEN) brought a settled enforcement action against Capital One, National Association (Capital One) for violations of the Bank Secrecy Act. Along with paying a $390 million civil money penalty, Capital One admitted to willfully failing to implement and maintain an effective AML, including failing to file thousands of suspicious activity reports (SARs) and currency transaction reports (CTRs) with respect to a particular business unit known as the Check Cashing Group. The failure allowed millions of dollars in suspicious transactions, including proceeds connected to organized crime, tax evasion, fraud, and other financial crimes, to go unreported in a timely and accurate manner and be laundered through the bank into the U.S. financial system. Despite warnings from regulators, criminal charges against some customers, and internal assessments flagging substantial risks, the bank failed to detect and report the suspicious activity. While this action does not involve registered funds or investment advisers, it is a sign of aggressive enforcement in the AML space. This action should be read in conjunction with recent SEC enforcement actions and risk alerts (including one discussed above) that have emphasized the importance of AML compliance.

For more information, please follow this link to FinCen’s website:

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