Curated for compliance officers of mutual funds and investment advisers, please find summaries and links to headlining compliance and regulatory topics from the third quarter of 2022.

While advisers have been trying to catch their breath following the implementation of two major new rules for investment companies (valuation and derivatives), and preparing for the new marketing rule, a technological snafu at the SEC has caused the Commission to pump the brakes on new rulemakings. Having discovered that some public comments submitted online were not received, the SEC decided to reopen a bevy of rulemakings to additional comments. The SEC’s enforcement and examination programs, however, did not get the message to slow down. Enforcement seems to have focused on regulatory blocking and tackling, bringing cases centered on fairly banal topics like recordkeeping and safeguarding client data, but packing some punch with massive penalties. If that message were not clear enough, examiners also have been acting as possible canaries in the enforcement coal mine. Based on our experience, we have seen exams focused on topics as far ranging as board 15(c) practices, ESG disclosures, and the use of e-signatures. And the staff has issued an alert to be prepared for examinations for marketing rule compliance, and we are hearing rumblings about exams focused on the implementation of policies to comply with new valuation and derivatives rules. No rest for the weary.

Below are highlights of the recent activity and related commentary addressing how these matters may impact advisers and funds.

Amendments to Rules Governing Proxy Voting Advice

In an about-face from proxy changes that had been adopted recently under Chairman Clayton, the SEC adopted amendments to its rules governing proxy voting advice and proxy advisory firms (as proposed in November 2021). As amended, proxy voting advice would continue to be treated as a “solicitation” subject to the proxy rules, and proxy advisory firms still would be subject to conflicts of interest disclosure requirements adopted in 2020. But the amendments rescind two rules that the Commission adopted in 2020. First, the amendments rescind conditions to the availability of exemptions from the proxy rules’ information and filing requirements. Those conditions required proxy voting advice firms to (1) make their advice available to the companies that are the subject of their advice at or before the time that they make the advice available to their proxy advisory clients, and (2) provide their clients with a mechanism by which they would be made aware of any written statements by the companies who are the subject of the advice regarding the proxy advisory firms’ proxy voting advice. Chairman Gensler believes these conditions imposed unnecessary compliance costs on proxy voting advice firms and could impair the independence and timeliness of their proxy advisory. The amendments also delete the 2020 changes made to the proxy rules’ liability provision, affirming that proxy voting advice generally is subject to liability under the proxy rules, but rescinding the guidance that stated that the failure to disclose material information regarding proxy voting advice could be misleading. Finally, the adopting release rescinds guidance that the Commission issued in 2020 to investment advisers regarding their proxy voting obligations.

This quick reversal of a 2020 amendment, without any data demonstrating that the 2020 rule was burdensome or costly to implement, faced withering criticism from Commissioner Peirce and many industry participants. In one sense, the amendment merely reflects an ongoing battle over the proper balance of power between corporate management and shareholder advocates, as corporations want protection from activists that they feel may not fairly present the corporation’s stance in proxy battles. In a broader sense, the amendments reflect a deepening political divide and erosion of the regulator’s independence: If this is precedent for revisiting rulemakings every time the Commission’s composition changes, industry and the investing public may wonder if regulation is designed to serve the Commission’s stated three-part mission (protect investors; maintain fair, orderly and efficient markets; facilitate capital formation) or some other political agenda.

For more information on the final rule as well as Commissioner Peirce’s statement, please visit the SEC’s website at the links below:

Final Rule: Proxy Voting Advice

Commissioner Peirce: U-Turn: Comments on Proxy Voting Advice

Resubmission of Comments and Reopening of Comment Periods for Certain Rulemaking Releases

In welcome news, the SEC recently decided to reopen the comment periods on numerous recent rulemakings, effectively delaying consideration of the rule proposals. Due to a technological error, public comments submitted through the SEC’s internet comment form were received by the Commission. Most of the affected comments were submitted in August 2022, but the error may have impacted comments from as early as June 2021. Accordingly, the SEC has reopened the comment periods until November 1, 2022. The relief appears to apply to anyone, not just commenters who previously submitted comments that were not received. The affected rulemakings include numerous items, including several prnot all ominent proposed rules such as money market reform, investment company names (Rule 35d-1), the cybersecurity rule, and ESG rules.

For more information, including a full list of affected rulemakings, please visit the release found at the link below:

Resubmission of Comments and Reopening of Comment Periods for Several Rulemaking Releases Due to a Technological Error in Receiving Certain Comments

Proposal to Enhance Private Fund Reporting

The SEC has proposed amendments to Form PF, which is used by certain SEC-registered investment advisers to private funds, including those that also are registered with the CFTC as a commodity pool operator (“CPO”) or commodity trading adviser (“CTA”). The amendments, which the CFTC is jointly considering, are designed to enhance the Financial Stability Oversight Council’s (“FSOC’s”) ability to monitor systemic risk and improve the SEC’s oversight of private fund advisers. The proposal would advisers to provide more information about their AUM, withdrawal and redemption rights, flows, base currency, borrowings, fair value hierarchy, beneficial ownership, and fund performance. It also would require large hedge fund advisers (with hedge funds with greater than $500 million) to provide more granular information on investment exposures, borrowing and counterparty exposure, market factor effects, currency exposure reporting, turnover, country and industry exposure, central clearing counterparty reporting, risk metrics, investment performance by strategy, portfolio correlation, portfolio liquidity, and financing liquidity. At the same time, large hedge fund advisers no longer would be required to report aggregated information about the hedge funds they advise.

Comments on the proposal were due by October 11, 2022. For more information about this proposal, please visit the SEC’s website at the link below:

Form PF: Reporting Requirements for All Filers and Large Hedge Fund Advisers

Examinations Focused on the New Investment Adviser Marketing Rule

With the impending November 4 compliance deadline for the amended marketing rule ((206(4)-1), the SEC’s Division of Examinations has issued an alert informing investment advisers to private funds about likely areas of focus for upcoming examinations. Not surprisingly, the staff will review policies and procedures to ensure they are calibrated to the amended rule and have “objective and testable” means reasonably designed to ensure compliance. This may include pre-review and approval of advertisements, risk-based sampling of advertisements, and pre-approving templates. The staff also will look to determine if advisers have evidence to substantiate material statements of fact. For performance advertising, the staff will verify whether advisers are complying with express prohibitions in the rule, such as providing net performance along with any gross performance data, presenting specific time periods for performance results, and complying with restrictions on extracted, hypothetical, and predecessor performance. The staff also reminded advisers that they must report certain marketing information in their Form ADV and keep records of all advertisements they disseminate, including certain working papers, performance-related information, and documentation of testimonials and endorsements.

For more information, please visit the SEC’s website at the following link:

Risk Alert: Examinations Focused on the New Investment Adviser Marketing Rule

SEC Charges Wall Street Firms with Recordkeeping Failures

The SEC announced charges against fifteen broker-dealers and one investment adviser for recordkeeping violations involving the use of “off-channel” communications (e.g., WhatsApp) without properly preserving the electronic communications. According to the settled orders, the firms’ employees (including senior personnel) routinely communicated about business matters using text messaging applications on personal devices. From the Commission’s perspective, by not preserving required electronic records, the firms deprived the Commission of valuable information needed in support of the examination and enforcement mission. Each of the firms was charged with violating the Exchange Act recordkeeping provisions requiring the firms to supervise and prevent and detect violations. The Exchange Act essentially requires preserving all communications relating to the firm’s business. One firm was charged with violating an analogous provision under the Advisers Act. That provision is a bit more targeted, requiring preservation of communications relating to recommendations made or proposed to be made and any advice given or proposed to be given. Each firm agreed to pay a substantial penalty (including eight firms and their affiliates each agreeing to $125 million penalties, two agreeing to $50 million penalties, and one agreeing to a $10 million penalty), and each also agreed to hire a compliance consultant to review their policies and procedures. In a related action, the CFTC announced settlements with the same firms (with penalties ranging from $6 million to $100 million), for violating recordkeeping regulations that generally require preserving records of all transactions relating to the firm’s business of dealing in commodity interests. One firm, Bank of America, paid a larger penalty for, among other things, a supervisor that instructed his team to delete text messages and move their communications to unapproved applications. The final tally of penalties for all firms was approximately $1.8 billion.

While no firm was accused of fraud or other nefarious conduct, the regulators are sending an unmistakable message that recordkeeping is important. This is not the first time they have aired that grievance. At least as far back as 2006, Morgan Stanley (which is among the settling parties this go around) paid a $15 million penalty for failing to properly maintain back-up tapes of certain emails, and in 2021 J.P. Morgan paid a $125 million penalty for conduct that presaged the latest actions. To be sure, it is challenging to manage the flow of communications on so many different platforms, and the informal nature of many ephemeral communications – the modern-day version of chats around the water cooler – is perhaps incongruent with regulations dating to the 1930s when regulators probably did not contemplate recording for posterity every casual conversation. (In a possible case of “do as I say, not as I do,” SEC officials reportedly may use off-channel communications to circumvent their own analogous federal recordkeeping obligations.) And the fact that the failures are so widespread suggests that firms have (wrongly) considered informal chats akin to face-to-face communications that the SEC has not (yet) deigned to require be captured and recorded. Nevertheless, as regulated entities, firms must follow the rules. This means implementing technology to capture and record all relevant communications, and making clear to employees that they must follow the rules or face discipline.

For more information about these proceedings, please view materials on the SEC’s and CFTC’s websites at the following links:

SEC Charges 16 Wall Street Firms with Widespread Recordkeeping Failures

CFTC Charges 11 Firms for Recordkeeping and Supervision Failures for Widespread Use of Unapproved Communication Methods

Failure to Safeguard PII in Violation of Reg S-P

Morgan Stanley Smith Barney LLC settled charges with the SEC for the firm’s failure to scrub millions of customers’ personal identifiable information (PII) from computer hardware before decommissioning the hardware. Morgan Stanley hired a moving and storage company with no expertise in data destruction services to decommission thousands of hard drives and servicers. Morgan Stanley, however, did not monitor the moving and storage company’s handling of the equipment. The equipment ended up sold around the world via an internet auction site to third parties; Morgan Stanley recovered a fraction of the devices, which contained unencrypted customer data. During a records reconciliation process, Morgan Stanley discovered that some devices had been equipped with encryption capability, but the firm failed to activate that software for several years.

The SEC order found that Morgan Stanley failed to safeguard customer PII, and Morgan Stanley agreed to pay $35 million to settle charges for violating the Safeguards and Disposal Rules of Reg. S-P.

Clients should be mindful that improper handling of client or shareholder information not only violates various regulations, but it also exposes firms to private litigation and reputational harm. Thus, firms must be vigilant to ensure proper handling, storage, and ultimately destruction of sensitive data. We recommend reviewing relevant policies and procedures and working with experienced IT consultants, and firms should consider using encryption technology to ensure that data that falls into wrong hands will be unusable.

In short, advisers should not expect a honeymoon period; the staff is gearing up for examinations as soon as the compliance deadline passes. For more information about these proceedings, please view materials on the SEC’s website at the following link:

In the Matter of Morgan Stanley Smith Barney LLC

Reg S-ID Violations

The SEC has settled enforcement actions against JP Morgan Securities, LLC; UBS Financial Services, Inc.; and TradeStation Securities, Inc. for deficiencies in their programs to prevent identity theft, in violation of Reg S-ID. Generally, all three failed to have policies and procedures reasonably designed to identify red flags, incorporate the red flags into their programs, and to update the programs periodically. The SEC also faulted JP Morgan for insufficient oversight of service provider arrangements, in particular for failing to ensure their service provider contracts had language requiring the service providers to detect identity theft red flags and either report red flags to JP Morgan or respond to the red flags themselves. The SEC also faulted UBS for not periodically reviewing new or existing account types to determine how to apply the program to them, and both UBS and TradeStation for failing to adequately involve the board of directors, an appropriate committee thereof, or a designated senior management employee in the oversight, development, and implementation of the program. The orders suggested that the entities should have periodically reviewed their respective programs and conducted risk assessments to understand the types of covered accounts and applicable red flags. The firms also were faulted for not providing the board “sufficient information addressing the effectiveness” of the program. The SEC criticized TradeStation for not specifying what steps staff should take for additional due diligence when they detected problems. All respondents were faulted for failing to adequately train their staff as well.

The SEC has been more aggressive in recent years for anti-money laundering, cybersecurity, and identity theft enforcement, so registrants should take heed. Each investment company is a financial institution subject to Reg S-ID, and funds in turn typically rely on their transfer agent to oversee the identity theft programs. Thus, we recommend reviewing contracts to ensure responsibilities are clear, reexamining identity theft procedures, and documenting the review and training.

For more information about these proceedings, please view materials on the SEC’s website at the following links:

In the Matter of J.P. Morgan Securities LLC

In the Matter of UBS Financial Services Inc.

In the Matter of TradeStation Securities, Inc.

Proxy Voting by Mutual Funds

In a recent enforcement action, the SEC challenged the practice of an investment adviser employing a standing instruction to its proxy voting service to vote all the funds’ securities in favor of proposals put forth by the issuer’s management and against shareholder proposals. The SEC criticized the adviser for failing to review each proxy to evaluate whether each management proposal was in fact consistent with the adviser’s clients’ best interests. The SEC also found that the adviser’s policies and procedures were not adequately designed to ensure the firm voted in its clients’ best interests.

There was no hint from the SEC that the adviser’s clients were harmed or that any votes should have been different. Nor does the SEC grapple with the question whether advisers and clients might agree that a standing instruction is in fact in the clients’ best interest because the expense of reviewing individual proxies may outweigh any perceived benefit. (Indeed, the adopting release to Rule 206(4)-6 expressly contemplates that there may be instances that an adviser may refrain from voting proxies if the adviser “determines that the cost of voting a proxy exceeds the expected benefit to the client.”) The message should be clear, however, that advisers must have policies consistent with exercising some judgment, rather than just reflexively voting all proxies one way or refraining from voting altogether.

For more information about this matter, please visit the SEC’s website at the following link:

In the Matter of Toews Corp.

Delaware Statutory Trusts: Anti-Takeover Defenses

The state of Delaware has amended the Delaware Statutory Trust Act to include a so-called control share statute, which acts as an anti-takeover defense. The Delaware statute is similar to those already in place in Maryland and Massachusetts (which, together with Delaware, account for almost all closed-end fund organizations), though Delaware’s statute is designed to address the particular structure of ’40 Act funds. The control share statute restricts the voting power of activist shareholders (and affiliates or others that act in concert with the acquiring person) in registered closed-end funds and BDCs, organized as Delaware statutory trusts with shares listed on a national exchange, negating their ability to exercise control using minority positions absent approval from other shareholders or the board. The statute restricts those acquiring “control beneficial interests,” defined via a series of voting power thresholds, from voting their shares that exceed such threshold unless they have received approval of two-thirds of all the votes cast by the other beneficial owners or an exemption from the board. Control thresholds are set at 10, 15, 20, 25, and 30%, as well as at a majority of voting interests. An acquirer must repeat the approval or exemption process at each threshold level. (For example, an acquirer with 14% of voting shares cannot vote more than 10% without approval from shareholders/exemption from the board; if that acquirer then exceeds 15% ownership, the acquirer would need another approval/exemption to vote shares in excess of 15%.) Shareholders must disclose to the covered Fund its acquisition of control shares within 10 days of such acquisition; the Fund reciprocally has the right to demand shareholders to disclose the number of shares owned or over which the shareholder can directly or indirectly exercise voting power.

There are several features in the Delaware statute that seem designed to address the unique aspects of ’40 Act governance. The low control thresholds appear to be a nod to the fact that registered funds often have low overall rates of shareholder participation, thus allowing relatively small positions to have an outsize influence on voting matters. Furthermore, for those funds that have preferred share classes permitting election of two preferred directors (under section 18(a)(2)(C) of the Investment Company Act), the control share restrictions apply separately to the preferred class. Finally, the definition of “associates” with whom an acquiring shareholder may coordinate seems to close the gap in the ’40 Act that otherwise does not prohibit affiliated funds with the same adviser from acting in concert to acquire a controlling interest in a closed-end fund.

The control share statute applies automatically to Delaware trusts; there is no opt-in requirement. The provision only applies prospectively, however; shares acquired before August 1, 2022, are not impacted.

For more information, please review the statutory amendments (sections 3881-3888) found on the State of Delaware’s website at the following link:

Delaware Statutory Trust Act, Subchapter III: Control Beneficial Interest Acquisitions

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