Compliance Matters Q4 2020

Feb 01, 2021

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 2020.

What a holiday season it has been! Following in the wake of the new fund-of-funds rule 12d1-4 (discussed in last quarter’s update), the SEC showed off its holiday giving spirit with final approval of two more major rule packages (derivatives (18f-4), and valuation (2a-5)). Rounding out the naughty or nice list, the SEC brought an enforcement action against a major pricing service, and to spice things up the outgoing President issued an Executive Order prohibiting transactions in a bevy of Chinese companies. The SEC’s semi-annual regulatory flex agenda offers some clues of what the next chairman may try to tackle in the new year. Below are highlights from the evolving regulatory landscape.

SEC Final Rules

Use of Derivatives by Registered Investment Companies and Business Development Companies

The SEC has approved new Rule 18f-4 under the Investment Company Act to permit funds to use derivatives subject to certain conditions, serving as an exemption to Section 18’s restriction on funds’ use of senior securities. Rule 18f-4 replaces a patchwork of prior guidance concerning asset segregation in favor of new “value at risk” (VaR) limits coupled with derivatives risk management requirements. The Rule applies to mutual funds (but not money market funds), ETFs, closed-end funds, and BDCs. Fundamentally, the rule limits leverage by confining a fund’s use of derivative (swaps, futures, forwards, options, short sales, borrowings, and similar transactions) to a prescribed VaR limit and requiring funds using derivatives to adopt a derivatives risk management program (DRMP), administered by a derivatives risk manager (DRM), overseen by the board. Funds that make only limited use of derivatives (no more than 10% of net assets derivatives exposure) will not be required to have a DRMP or DRM, but such funds still will have to adopt and implement policies and procedures reasonably designed to manage the fund’s derivatives risks. The Rule also amends certain forms and requires additional reporting about funds’ use of derivatives, and it imposes recordkeeping requirements.

For derivatives users, the rule’s default VaR test requires that a fund’s VaR be measured relative to the VaR of the fund’s “designated reference portfolio,” which is either a reference index selected by the DRM or the fund’s own portfolio excluding derivatives transactions. Under this relative VaR test, the fund’s VaR is not permitted to exceed 200% (250% for certain closed-end funds) of the VaR of the designated reference portfolio. Alternatively, if the DRM reasonably determines that no designated reference portfolio can be identified (less common), the fund instead would calculate an absolute VaR and may not exceed 20% (25% for certain closed-end funds) of the fund’s net assets. A fund must measure its compliance with the applicable VaR test at least once each business day. Derivatives users will be required to adopt a formal DRMP that includes policies and procedures to manage derivatives risk. While there is some flexibility to tailor the program to the particular portfolio, every fund’s program must provide for risk identification and assessment, risk guidelines, weekly stress testing, weekly back-testing, internal reporting and escalation, and periodic reviews of the DRMP.

In a welcome change from the proposal, the final rule scrapped a proposal that would have required certain sales practices requirements for distributing leveraged or inverse funds that seek a return greater than 200% of the return (or its inverse) of a reference index. Such funds instead will be subject to the derivates rule (effectively limiting new leveraged funds to 2x), and likely a separate future rulemaking. Existing 3x funds (i.e., those in operation by October 28, 2020) can continue to operate, but new funds will not be permitted to exceed 200% VaR (except for de minimis deviations). The SEC also amended Rule 6c-11 to permit leveraged or inverse ETFs to operate without exemptive relief provided they satisfy Rule 6c-11. Notably, in a separate statement, the SEC reiterated concerns that retail investors may not understand how leveraged and inverse funds operate and perform. Recent enforcement actions in this area reflect that concern and, hence, we anticipate there will be rulemaking in this area.

The new rule will be effective February 19, 2021, and compliance will be required by August 19, 2022. For more information, including specific detailed requirements, registrants should review the SEC’s adopting release at the following link on the SEC’s website:

Good Faith Determination of Fair Value

The SEC approved new Rule 2a-5 under the Investment Company Act to clarify a fund board’s valuation duties, consolidate and eliminate a constellation of prior guidance, and explicitly permit a board to assign day-to-day valuation duties to the investment adviser (but not a subadviser). The new rule tracks closely to the rule proposal, which was designed to hew closely to well-established valuation practices and existing guidance. The final rule requires the board or its designee to periodically assess and manage risks, select valuation methodologies and monitor for circumstances that require fair valuation, test fair valuation methodologies, and provide oversight of third-party pricing services. If the board assigns valuation to the adviser, the rule requires some segregation between the portfolio manager and the valuation process, but advisers can continue to seek assistance from third parties (e.g., the administrator, pricing services). The final rule provides a bit more flexibility to board reporting than had been proposed. For example, the valuation designee now will have five (rather than three) business days to report “material” valuation matters, which includes significant deficiencies or material weaknesses in the fair value determination process or material errors in the NAV calculation. The final rule also eliminates the mandatory quarterly reporting to fund boards. The Commission simultaneously approved a new rule 31a-4 (splitting it out of proposed Rule 2a-5), which imposes new recordkeeping requirements with respect to fair valuations. Shifting this provision to a separate rule ensures that boards are not targeted for valuation enforcement actions just because record-keeping was deficient.

Importantly, Rule 2a-5’s definition of “readily available market quotations” (which is used to distinguish securities that will require fair valuation) will be applied to Rule 17a-7. Many in the industry have interpreted Rule 17a-7 to allow cross trading fixed-income securities. Under the new definition, however, securities that are not exchange-traded (e.g., most fixed income) would not qualify for Rule 17a-7’s exemption that otherwise permits cross trading in certain circumstances. SEC staff have confirmed that compliance with the new definition for Rule 17a-7 purposes is not required until compliance with Rule 2a-5 is required, but in the meantime, advisers would be well advised to proceed with caution given that the Commission evidently disfavors employing Rule 17a-7 to cross-trade fixed-income securities.

The new rule will be effective March 8, 2021, and compliance will be required by September 8, 2022. For more information, including specific detailed requirements, registrants should review the SEC’s adopting release at the following link on the SEC’s website:

Electronic Signatures in Regulation S-T Rule 302

The SEC amended (without notice or comment) Rule 302 of Reg. S-T to allow electronic signatures instead of “wet” signatures on filings as long as certain procedures are followed. Specifically, the rule allows electronic signatures on authentication documents required for EDGAR filings that are required to be signed. The current rule requires filers to manually sign a signature page or other document (“authentication document”) before or at the time of the electronic filing to “authenticate, acknowledge, or otherwise adopt the signature that appears in typed form within the electronic filing.” In order to use an electronic signature, you must satisfy the following conditions:

  • Require the signatory to present a physical, logical, or digital credential that authenticates the signatory’s individual identity;
  • Reasonably provide for non-repudiation of the signature;
  • Provide that the signature be attached, affixed, or otherwise logically associated with the signature page or document being signed; and
  • Include a timestamp to record the date and time of the signature.

Beware that you still must have a manual signature on file. Before using an electronic signature, the signatory must manually sign a document agreeing that the electronic constitutes the legal equivalent of that person’s manual signature. The electronic filer then must retain this manually signed document for as long as the electronic signature will be used, and a minimum of seven years after the date of the most recent electronically signed authentication document. The authentication document itself also must be maintained for five years, as currently required. The new rule was effective as of December 4, 2020. For more information, please review the SEC’s adopting release at the following link on the SEC’s website:

Other SEC Guidance and Alerts

OCIE Observations: Investment Adviser Compliance Programs

The SEC’s Office of Compliance Inspections and Examinations (OCIE, now known as the Division of Examinations) issued an alert that identifies common compliance deficiencies with investment advisers, most notably observing that CCOs often have insufficient resources or lack sufficient authority, and CCOs failing to document their annual review. OCIE also observed advisers failing to implement written procedures, having weak written policies or failing to tailor the policies to the adviser’s business, and failing to maintain accurate and complete information about the adviser. For more information, please follow this link to the SEC’s website:

SEC Regulator Flex Agenda

The SEC has released its Agency Rule List for Fall 2020 pursuant to the Regulatory Flexibility Act. The list, published in the Unified Agenda of Federal Regulatory and Deregulatory Actions in the Federal Register, provides the status of pending rulemakings and identifies rules for which the agency has indicated that preparation of an analysis is required. The list is divided into short-term and long-term priorities, depending on whether the agency expects regulatory action within or after 12 months from publication of the agenda. Among other things, the current long-term agenda includes possible rulemakings affecting proxy voting, custody, cross trading, fund names, and transfer agency. Importantly, however, the items on the list reflect only the priorities of the then-Chairman of the SEC and are subject to modification each reporting cycle. For more information, please follow this link to the Office of Information and Regulatory Affairs website:

Other Orders and Guidance

Executive Order 13959: Addressing The Threat From Securities Investments That Finance Communist Chinese Military Companies

On November 12, 2020, President Trump issued an executive order 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 Department of the Treasury’s Office of Foreign Assets Control has identified more than 40 CCMCs and their subsidiaries subject to the Executive Order, and it has issued FAQ guidance and general licenses that concern the Order’s application. The Department of Defense also has identified additional CCMCs under the Department’s authority under the National Defense Authorization Act. U.S. persons have until November 11, 2021, to divest of CCMCs first identified on the list, and they will have 365 days subsequent to the addition of new names. There have been frequent changes to the CCMC list and related guidance as the Order is being newly implemented, so advisers should consult the website below for the most recent pronouncements.

LIBOR Extension

The Federal Reserve Board and UK Financial Conduct Authority (FCA) have agreed to consult on extending certain USD LIBOR rates until June 30, 2023, which should allow most legacy contracts to expire before any LIBOR disruptions occur. New contracts, however, should not reference LIBOR (with the expectation that LIBOR is being phased out at end of 2021). ICE Benchmark Administration (ICE), which is appointed by the FCA as the administrator of LIBOR, will make separate announcements following the outcome of the consultation. Additional information may be found on ICE’s website:

Enforcement Actions

Guidance on Factors Used in Evaluating Corporate Compliance Programs in Connection with Enforcement Matters

The SEC charged ICE Data Pricing & Reference Data, LLC (ICE) with compliance failures related to its delivery of evaluated prices of more than 40,000 fixed-income securities based on a single broker quote. The SEC also cited deficiencies in ICE’s review of market information submitted by clients that sought to challenge those ICE prices. ICE’s system would automatically affirm the single broker-quoted prices without any further review of material submitted by clients. In cases when data was reviewed, the evaluator merely contacted the quote provider to confirm that the quote received was what was intended, but there was no further analysis to determine if the quote was reasonable. ICE also evidently did not assess the reliability of particular quote providers, for instance when a particular provider’s quotes were subject to frequent challenges due to deviation from trade data. ICE agreed to an $8 million civil penalty to settle the SEC charges. Notably, the settlement appears related to ICE’s recent decision to drop liquidity classifications (or to deem them illiquid) for broker-quoted securities, which is relevant to liquidity risk management programs under Rule 22e-4. The settlement also should be viewed in the context of the adoption of Rule 2a-5, which will place substantial responsibility on advisers (to whom 2a-5 allows boards to assign fair value duties) to police pricing vendors like ICE. In connection with the settlement, ICE has confirmed that it has updated its policies and procedures.

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

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