Compliance Matters Q2 2021

Jul 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 second quarter of 2021.

The second quarter was relatively quiet on the regulatory front, but the new SEC chairman, Gary Gensler, has set out an ambitious regulatory agenda that suggests the rulemaking workshop is abuzz behind the scenes. While it remains to be seen which issues will percolate to the top, recent staff statements and risk alerts seem to be paving the way for regulation in the ESG and cryptocurrency spaces. President Biden also issued a new Executive Order revisiting the prohibitions on investing in certain Chinese companies, and there have been a few enforcement actions of note. Below are highlights of the regulatory activity along with some commentary and predictions for what is to come.

SEC Guidance and Alerts

Division of Investment Management Staff Statement Regarding Termination Notice for Exemptive Relief and Withdrawal of Staff Letters Related to COVID-19 Response

The SEC’s Division of Investment Management issued an update concerning temporary relief it has issued in the wake of the COVID-19 pandemic. As previously committed, the staff provided two weeks’ advance notice that it would be terminating temporary relief concerning interfund lending and affiliated purchases of debt. First, the staff terminated a conditional exemptive order that had provided temporary flexibility to obtain short-term funding for mutual funds (except money market funds) and insurance company separate accounts registered as UITs. The staff also terminated two no-action letters that allowed certain affiliates to purchase securities from a money market fund or debt securities from a mutual fund under specified conditions. Both sets of relief were terminated effective April 30, 2021. The Division’s staff statement can be found at the link below.

There still has not been any word on discontinuing relief from the in-person board meeting requirements, though it seems unlikely the staff would require in-person meetings any time soon given continued uncertainty surrounding new COVID-19 variants coupled with the fact that the SEC staff itself is not returning to its offices this fall.

Risk Alert: The Division of Examinations’ Review of ESG Investing*

Recognizing the state of regulatory flux around ESG standards, the Division of Exams has issued a risk alert regarding ESG investing. ESG is somewhat of a wild west because there are few standards or precise definitions that govern ESG marketing, and the agency is concerned that asset managers will “green wash” their products to increase distribution to ESG-minded consumers. This alert picks up on that theme, reporting the staff’s observations about misleading disclosures, inconsistencies between disclosures and practices, and proxy practices that fail to adhere to supposed ESG restrictions. This alert should be read in conjunction with the 2021 exam priorities, which also focused on ESG investing (among other topics), as well as a push among some commissioners to impose regulation in the space either via Rule 35d-1 or general disclosure or proxy rules.

Of particular interest for our clients, the alert noted that written policies and procedures often were not reasonably designed, or not implemented, to provide for compliance oversight of ESG investing practices and disclosures. The staff observed that policies and procedures did not address ESG investing analyses, decision-making processes, or compliance review and oversight, and written policies were sometimes weak or vague, and controls were not being followed. Compliance was particularly weak where compliance personnel had limited knowledge of ESG issues. Disclosures also often reflected unsubstantiated claims or failed to disclose all material facts. The staff credited firms that made clear that ESG factors would be considered alongside many other factors, thus allowing a firm to hedge when they seemingly followed somewhat inconsistent (non-ESG) investments. They also noted approvingly where firms utilized documentation at various stages of the investment process and had compliance personnel integrated into the ESG-related processes. For more information, please follow this link to the SEC’s website:

Staff Statement: Registered Funds Investing in Bitcoin Futures

The Division of Investment Management has issued a statement concerning investments by registered funds in the Bitcoin futures market, sanctioning investing in cash-settled Bitcoin futures so long as the fund has suitable policies and procedures in place and it discloses the risks. Conspicuously, the staff does not mention other cryptocurrencies. The staff emphasized that funds must consider valuation, liquidity, custody, arbitrage for ETFs, and manipulation risk with cryptocurrencies; the staff evidently believes the Bitcoin futures market is sufficiently mature to address those risks, but they suggest funds should proceed with caution, and only those funds with “appropriate strategies” and “full disclosure of material risks” should be investing. Consequently, funds investing in such digital assets should expect scrutiny from the Division of Examinations, which will be looking closely at policies and procedures, risk management (including derivatives risk management under 18f-4), and disclosures.

The staff suggest that open-end mutual funds can invest up to 15% of their assets in Bitcoin futures, effectively treating the investment like an illiquid investment (which one might argue conflates volatility and liquidity). The staff telegraphed that it is not yet ready to approve ETFs investing in Bitcoin because they are concerned that ETFs cannot control subscription and redemption flows on exchanges. (More recently, the SEC has again extended the review period for a bitcoin ETF, signaling that its concerns have not abated.) The staff also suggested that closed-end funds may have more leeway because they do not have to meet daily redemptions, but such funds should consult the staff before filing a registration statement. There was no mention of investing directly in grantor trusts (e.g., Grayscale Bitcoin Trust), which are exchange-traded and provide only indirect exposure to the Bitcoin market. The staff previously has expressed support for funds investing as such, again subject to 15% limits, and many funds in fact already invest in Grayscale and similar products. Advisers should be mindful, however, that grantor trusts produce “bad income” for purposes of the Internal Revenue Code 90% gross income test. For more information about the staff statement, please follow this link to the SEC’s website:

SEC Regulatory Flex Agenda

The SEC has published its Agency Rule List for Spring 2021 pursuant to the Regulatory Flexibility Act. While much of the agenda has been coopted from the prior chairman’s agenda, there are several changes reflecting the priorities of the new chairman. Some notable items on the short-term agenda (i.e., items expected to have some regulatory action in the next 12 months) that may impact the fund industry include possible amendments to the rules for the proxy voting advice rule, custody for investment advisers, ESG disclosures, and shareholder reporting. The agency also is considering amendments to the requirements for open-end fund “liquidity and dilution management” – a tantalizing prospect for ratcheting back requirements for most funds for which the risk management rules seem more onerous than useful, or perhaps increasing requirements for those funds that faced particular stresses during pandemic-induced market volatility. The agency also is considering disclosure rules for reporting companies that could find their way into fund requirements. This includes disclosures around board diversity, climate change, human capital management, and cybersecurity governance. The agency is also evaluating possibly shortening the settlement cycle (to T+1 or T+0?). On the long-term agenda (where regulatory action is expected more than 12 months from now), the SEC is considering amending the custody rule for investment companies (a likely companion to updates to the adviser custody rule), proxy governance (a possible roll-back of the Chairman Clayton-era constraints on proxy advice firms?), updates to the names rule (Rule 35d-1, a likely vehicle for some ESG guardrails), and securities lending.

This agenda is no doubt equal to the ambition of the prior SEC chairman but takes a different tact. It remains to be seen, however, whether Chairman Gensler pushes a muscular regulatory approach or instead merely aims to modernize existing regulations and fine-tune rules to be more responsive to current policy debates. For more information, please follow the links to the Office of Information and Regulatory Affairs website.

Other Orders and Guidance

Executive Order 14032: Addressing The Threat From Securities Investments That Finance Certain Companies of the People’s Republic of China

Revisiting Executive Order 13959, which was issued in November 2020, President Biden issued a June 3, 2021, Executive Order 14032 that both widens and narrows aspects of the prior restrictions on investing in Chinese-military related companies. Under the new Executive Order, the President has expanded the prohibitions to apply to a broader set of companies, not just military-related companies. Accordingly, the prohibited entities are now referred to as CMICs (Chinese Military-Industrial Complex Companies) rather than CCMCs (Communist Chinese Military Companies) . The new order narrows the prior order, however, because it applies investment restrictions only to entities explicitly named in the Order (or later added to the list). Thus, industry participants no longer have to grapple with identifying entities that “closely match” a name on the list. Superseding the prior order, Executive Order 14032 restricts investment in the securities of 59 “Chinese Military-Industrial Complex Companies (CMICs), which overlaps with and expands the prior “CCMC” list. (Technically, sanctions against entities identified on the old list have been lifted, but then nearly identical sanctions have been imposed – albeit with new deadlines – to all the entities on the new, longer list.) Key features of the new EO are:

  • Only companies explicitly listed are restricted; there is no longer a “close match” standard.
  • The Prohibition takes effect on August 2, 2021, at 12:01 am for any CMIC entity listed in the order. (For entities later added, the prohibition takes effect 60 days after being added.)
  • The new order prohibits trading the securities, but it does not prohibit possession of the securities. Divestment, however, is one form of trading that is permitted until June 3, 2022 at 12:01 am (or 365 days after being named for those entities later added).

In short, advisers may trade freely in those securities identified on the CMIC list until August 1. After that, they can continue to hold those securities, but they will not be permitted to trade except for purposes of divestment, which is permitted until June 3, 2022. For more information about this sanctions program, or to view the Annex identifying the 59 prohibited companies, please consult the Executive Order at the link below.

LIBOR Transition

Market participants and services providers continue to grapple with the impending transition away from LIBOR to an alternative reference rate. The CFTC’s Market Risk Advisory Committee has recommended a market best practice for switching interdealer trading conventions from LIBOR to SOFR (Secured Overnight Financing Rate) for U.S. dollar linear interest rate swaps by July 26, 2021. The committee recommended keeping LIBOR data for informational purposes, but not trading activity, for an additional three months. The Alternative Reference Rates Committee (a committee established by the Federal Reserve and the NY Fed) announced its selection of CME Group as the administrator for a forward-looking SOFR rate for use in contract fallback language once market indicators for the term rate are met. There remains the possibility that there will be federal legislation to facilitate the transition from legacy LIBOR-based contracts to an alternative reference rate for those contracts that do not have clear fallback provisions. (This may be similar to New York State LIBOR legislation recently signed into law that would apply ARCC-recommended fallback language to those contracts governed by NY law that do not have an effective fallback provision.)

The UK Financial Stability Board (FSB) has published several statements to support a smooth transition away from LIBOR by the end of 2021, and the Financial Services Bill is now law and provides the Financial Conduct Authority the powers needed to oversee the orderly wind down of LIBOR. The FSB has emphasized that the tools necessary to complete the transition are currently available, and market participants should not await further development of additional tools.

There are many different financial products linked to LIBOR, with different contractual provisions, based on different currencies and maturities. Consequently, there is no one-size-fits-all alternative reference rate, and the discussion above is but a sampling of efforts to harmonize the transition. If you have legacy LIBOR-based investments, we strongly advise you to review your contracts to determine if there is an operative fallback provision governing the transition to an alternative rate. For more information about the matters discussed above, please consult the statements published at the links below.

Enforcement Actions

SEC Enforcement Action for Disclosure Controls and Procedures Violations

The SEC brought an enforcement action against a public company (First American Financial Corporation) for having inadequate disclosure controls and procedures (DCAPs). The company allegedly failed to have sufficient controls to ensure that cybersecurity vulnerabilities were properly communicated to senior management. This case does not involve a mutual fund or even an investment adviser, but it nevertheless should serve as a warning to funds to have their own DCAP policies in order. For registered funds, the DCAP rule (Rule 30a-3, which implements Sarbanes Oxley requirements) requires controls over filing Form N-CSR and internal controls over financial reporting. Essentially, the rule requires the principal executive and principal financial officers (i.e., the president and treasurer of a trust) to certify that financial statements fairly present the transactions and disposition of the investment company’s assets. The rule also requires the company to have controls and procedures designed to ensure that information required to be disclosed on Form N-CSR is properly communicated to company management (including the principal officers) as appropriate to permit timely decisions regarding the required disclosure. Furthermore, the DCAP rule (30a-3) also requires that the fund’s management, including the principal executive and financial officers, must evaluate the company’s DCAPs within 90 days prior to filing each report on Form N-CSR. While Form N-CSR does not require cybersecurity reporting, this enforcement action may reflect a new front in enforcement actions for evaluating registrants with the compliance rules.

For more information about this enforcement action, please follow this link to SEC’s website:

SEC Enforcement Action Against Adviser for Undisclosed Conflicts of Interest

The SEC settled an enforcement action against the principal of an investment adviser for undisclosed conflicts of interest impacting its mutual fund client. The adviser caused the mutual fund to invest more than $8 million (15% of net assets) into a private fund but failed to disclose to the board that (a) the adviser served as a subadviser to an affiliate of the private fund, (b) the adviser had a referral agreement with the platform through which the mutual fund invested in the private fund, and (c) the principal had sought investments from the chairman of the private fund. The referral agreement provided the adviser would pay a portion of its management fee for AUM referred to the mutual fund (the mutual fund received approximately $15mm in AUM), and the adviser earned a portion of the advisory fee on assets referred to the private fund. This fact pattern presents a fairly straightforward case of undisclosed conflicts of interest because the adviser had a financial incentive to direct mutual fund assets to the private fund or to maintain relationships that were driven by the adviser’s, as opposed to the fund’s, interests. The principal and the adviser failed to disclose these conflicts to the board, either via Form ADV or otherwise. To be clear, financial services can entail all sorts of conflicts of interest and misaligned financial incentives. Conflicts of interest are not necessarily prohibited, but the failure to disclose those conflicts violates the law. It is up to the client, or the board in the case of a mutual fund, to decide whether particular conflicts should be avoided (except in those cases, like certain affiliated transactions, that are per se prohibited). And the board cannot judge those conflicts if the adviser does not disclose them.

For more information about this enforcement action, please follow this link to SEC’s website:

The SEC announced fraud charges against Princeton Alternative Funding LLC, an investment adviser to a private fund, and its senior officers, including the adviser’s chief compliance officer, for misrepresenting its management of consumer loan portfolios. What makes this case interesting is that the SEC charged the CCO for helping conceal from investors the criminal history of the investment adviser’s principal, disseminating misleading investor presentations, and misleading other investors when the largest shareholder sought to redeem from the fund. Although CCO liability can be an enforcement third rail, this action fits comfortably within the SEC’s well-established rubric for charging a CCO. Generally, the SEC charges CCOs only in three circumstances: (1) the CCO participates in the fraud, (2) the CCO obstructed a Commission investigation, or (3) the CCO exhibited a wholesale failure to carry out her compliance responsibilities. In this case, the CCO allegedly helped perpetuate the fraud; thus, enforcement should be no surprise. Nevertheless, industry professionals would welcome a formal framework from the Commission – as has been suggested by the New York City Bar and many others – to guide charging decisions and provide compliance professionals the peace of mind that mere negligence will not result in their finding themselves on the receiving end of the next enforcement action.

For more information about this enforcement action, please follow this link to SEC’s website:

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