Compliance Matters Q4 2019

Jan 31, 2020

Curated for compliance officers of mutual funds and investment advisers, please find summaries and links to headlining compliance and regulatory topics from the fourth quarter of 2019.

SEC Proposed Rules


Derivatives Rule 18f-4

The SEC proposed new Investment Company Act Rule 18f-4, which would set limits on leverage and require certain funds to have a derivatives risk management program. Leverage limits would be based on a “value-at-risk” test, which compares the fund’s risk level to a “designated reference index.” Funds would be required to report to the SEC if they exceed the Rule’s limits. The proposal also would impose sales practice rules that would require broker-dealers and investment advisers to exercise due diligence in approving a retail customer’s or client’s account to buy or sell shares of certain “leveraged/inverse investment vehicles.” As a reprisal of, and modification to, a 2015 proposal, we expect significant industry scrutiny during the Rule’s comment period. The SEC also must be mindful of the industry’s experience with another recent risk management rule – Liquidity Rule 22e-4 – as it shapes the final rule. For more information, please follow this link to the SEC’s website:

SEC Proposed Rule 18f-4

Advertising and Cash Solicitation Rule 18f-4

The SEC proposed amendments to both the advertising (206(4)-1) and cash solicitation (206(4)-3) rules under the Investment Adviser Act. First, the proposal would modernize advertising to address social media and would, if adopted, permit the use of testimonials (as long as the adviser discloses when the endorser is a client and whether they are being paid). It also would permit the use of third-party ratings, subject to certain contextual disclosures. Notably, however, the rule does not cover advertisements or sales materials about a registered investment company, which are subject to other advertising rules (e.g. Securities Act Rules 156 and 482, Company Act Rule 34b-1). Second, the proposal would apply to both cash and non-cash compensation (e.g., directed brokerage). It would require, subject to limited exceptions, that advisers and solicitors have a written agreement that describes the activities and compensation arrangement and describe the solicitor’s conflicts of interest. The rule also would dispense with the requirement that investors provide acknowledgments of receipt of the disclosures. The industry likely will applaud the SEC’s principles-based approach, and fine tuning during the comment process likely will result in welcome changes. For more information, please follow this link to the SEC’s website:

SEC Proposed Rule: Investment Adviser Advertisements; Compensation for Solicitations

Accredited Investor Definition

The SEC proposed amendments to the definition of “accredited investor,” under Rule 501(a) of Regulation D of the Securities Act, which is a key element of the exemptions from registration for private placements. The proposal would expand the group eligible to participate in private offerings to include persons with certain professional credentials, a private fund’s “knowledgeable employees,” certain entities meeting specified conditions, and family offices with at least $5 million in assets under management. The proposal also would revise the definition of “qualified institutional buyers” under Rule 144A. Taken together, these amendments are intended to better identify those individuals and institutions that have the knowledge and expertise to participate in the private capital markets, which is part of a broader effort to make the markets accessible and effective for both issuers and investors. For more information, please follow this link to the SEC’s website:

SEC Proposed Rule: Amending the “Accredited Investor” Definition

Auditor Independence

The SEC proposed amendments to Rule 2-01 of Reg. S-X that would, among other things, revise the definition of “affiliates,” which would allow a broader selection of potential auditors for funds. This would loosen restrictions where the auditor’s foreign affiliate performs work for small international companies held by the funds and where the auditor provides services to affiliates, including to advisers under common control and the funds advised by those advisers. The proposed rule would focus more on the materiality of those affiliate relationships so that independence is deemed impaired only if the affiliate relationships threaten auditor objectivity and impartiality. As part of a larger trend, the proposal reflects a move toward a more principles-based approach to making independence determinations. For more information, please follow this link to the SEC’s website:

SEC Proposed Rule: Amendments to Rule 2-01, Qualifications of Accountants

SEC Risk Alerts


OCIE Risk Alert Regarding Examinations of Investment Companies

The SEC’s Office of Compliance Inspections and Examinations issued an alert identifying compliance deficiencies observed during examinations of registered investment companies. The alert discusses familiar issues such as Rule 38a-1 oversight, disclosure to investors, the 15(c) process, and implementation of the Code of Ethics. OCIE also discussed money market funds and, among other things, the staff cited funds’ failure to perform proper credit risk determinations or to confirm proper collateral. With respect to target date funds, the staff noted that disclosures did not always accurately track asset allocation or disclose conflicts of interest. The alert’s common theme is failing to tailor the compliance program to the fund’s business, or simply not following one’s own policies and procedures. Funds should be vigilant to ensure their compliance house is in order. For more information, please follow this link to the SEC’s website:

OCIE Risk Alert: Top Compliance Topics Observed in Examinations of Investment Companies and Observations from Money Market Fund and Target Date Fund Initiatives

SEC Guidance


Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation

The Commission’s Division of Investment Management issued responses to frequently asked questions concerning the disclosure of financial conflicts of interest. The FAQs discuss the staff’s expectations for disclosing revenue sharing and other financial conflicts (e.g., 12b-1 and share class selection or asset-based incentives from custodians). It sets forth the well-worn principles that conflicts must be disclosed and/or eliminated and discusses the specific requirements for Form ADV. It repeats the admonition that “may” is not sufficient for disclosing when a conflict actually exists. It also discusses various facts that advisers should consider in making disclosures concerning the effect of different incentives, the nature of the conflicts, and how the adviser addresses conflicts. This guidance should be viewed in the context of recent enforcement cases that have addressed financial conflicts, serving as a reminder that advisers should take a fresh look at their disclosures. For more information, please follow this link to the SEC’s website:

Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation

Client Relationship Summaries on Form CRS

The Commission’s Division of Investment Management and Division of Trading and Markets issued responses to frequently asked questions concerning required disclosures on Form CRS, which was implemented recently in connection with Regulation Best Interest. The FAQs discuss formatting and delivery requirements for the new Form, which requires broker-dealers and investment advisers to provide retail customers and clients with certain information. Compliance is required by June 2020. The SEC expects to update the FAQs periodically to address additional questions. For more information, please follow this link to the SEC’s website:

Frequently Asked Questions on Form CRS

Performance and Fee Disclosures

The SEC’s Division of Investment Management’s Disclosure Review and Accounting Office issued an Accounting and Disclosure Information addressing various disclosure issues they have observed related to performance and fees in fund disclosure filings. The key issues are miscalculating net expenses when there is recoupment after an expense limitation/ fee waiver, failing to incorporate acquired fees, arithmetic errors, and mis-tagging in XBRL. This bulletin emphasizes the importance of verifying the accuracy of disclosures prior to filing them with the Commission and providing them to investors. For more information, please follow the link below to the SEC’s website:

ADI 2019-09: Performance and Fee Issues

Extension of Temporary Measure to Facilitate Cross-Border Implementation of the European Union’s MiFID II’s Research Provisions

The SEC’s Division of Investment Management issued an extension of a 2017 no-action letter designed to assist firms in complying with the provisions relating to research in the European Union’s Markets in Financial Instruments Directive II (MiFID II). MiFID II generally requires broker-dealers to separate the cost of the research they are selling from the cost for their advisory services; correspondingly, asset managers are required to pay for research directly rather than through commission revenues. Absent relief, U.S. broker-dealers receiving research payments from EU-based asset managers risked losing an exemption from registration as an investment adviser under the Advisers Act. The SEC’s extension, good until July 3, 2023, effectively allows broker-dealers to continue receiving payments in hard dollars or through research payment accounts from clients subject to MiFID II. The SEC will continue to examine this issue during the interim and hopefully will find a permanent fix. For more information, please follow the link below to the SEC’s website:

Staff Letter to SIFMA Concerning MiFID II Implementation

FINRA Items


FINRA Exam Filings Report

FINRA released a summary of key findings from its examinations of member firms over the past year. FINRA made a deliberate attempt to distinguish between findings – a determination that a firm or person violated the law – and observations – recommended best practices. Both should help firms improve their control environment and develop a robust compliance program. Among other things, the report addresses sales practices, supervision, suitability, AML, cybersecurity and business continuity, best execution, and financial management issues. For more information, please follow this link to the FINRA website:

FINRA 2019 Report on Examination Findings and Observations

CFTC Items


CFTC Guidance on CPO and CTA Exemptions

The CFTC issued guidance on preparing the annual affirmation required for entities currently operating under an exemption from CPO or CTA registration. The CFTC requires that firms annually affirm the applicable notice of exemption within 60 days of the calendar year end (February 29, 2020). The notice also includes responses to frequently asked questions. For more information, please follow this link to the CFTC website:

CFTC Notice I-19-29: Guidance on the annual affirmation requirement for entities currently operating under an exemption from CPO or CTA registration

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