Compliance Matters Q4 2022

Mar 06, 2023

A compendium of regulatory matters for Q4 2022

SEC Final Rules

Enhanced Reporting of Proxy Votes

The U.S. Securities and Exchange Commission (the “SEC”) recently adopted amendments to Form N-PX that, in theory, should enhance disclosures to the benefit of shareholders. The amendments will require funds to categorize each matter by type consistent with a selection of standardized, but non-exclusive, categories prescribed by rule. Where a form of proxy or “proxy card” is available (which seems to exclude foreign issuers), funds also must use the same language and present the issues in the same order as they appear in the proxy card. The amendments also prescribe how funds must organize their reports and require them to use XML structured data language. The amendments will require funds to disclose the number of shares loaned and not recalled to vote. The SEC also adopted new Rule 14Ad-1 under the Exchange Act, which would require for the first time that institutional investment managers disclose how they voted on so-called “say-on-pay” (executive compensation) matters.

The new rule is effective for votes occurring on or after July 1, 2023, with the first reports on the amended Form N-PX required by August 31, 2024.

Tailored Shareholder Reports for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements

The SEC has adopted rule and form amendments that require open-end management investment companies to transmit concise and visually engaging annual and semi-annual reports to shareholders that highlight key information that is particularly important for retail investors to assess and monitor their fund investments. Certain information that may be more relevant to financial professionals and investors who desire more in-depth information will no longer appear in funds’ shareholder reports but will be available online, delivered free of charge upon request, and filed on a semi-annual basis on Form N-CSR. The amendments exclude open-end management investment companies from the scope of the current rule that generally permits registered investment companies to satisfy shareholder report transmission requirements by making these reports and other materials available online and providing a notice of that availability. The amendments also require that funds tag their reports to shareholders using the Inline eXtensible Business Reporting Language (“Inline XBRL”) structured data language to provide machine-readable data that retail investors and other market participants may use to access and evaluate investments more efficiently. Finally, the SEC adopted two amendments to the advertising rules for registered investment companies and business development companies to promote more transparent and balanced statements about investment costs.

Generally, all shareholder reports must comply with the new rules no later than July 24, 2024.

SEC Proposed Rules

Outsourcing by Investment Advisers

On October 26, 2022, the SEC proposed a new rule under the Investment Advisers Act to prohibit registered investment advisers from outsourcing certain services or functions without first meeting minimum requirements. The proposed rule would require advisers to conduct due diligence prior to engaging a service provider to perform certain services or functions. Additionally, the proposed rule would further require advisers to periodically monitor the performance and reassess the retention of the service provider in accordance with due diligence requirements to reasonably determine that it is appropriate to continue to outsource those services or functions to that service provider. The SEC also proposed corresponding amendments to Form ADV to collect census-type information about the service providers defined in the proposed rule, as well as amendments to the Investment Advisers Act books and records rule, including a new provision requiring advisers that rely on a third party to make and/or keep books and records to conduct due diligence and monitoring of that third party and obtain certain reasonable assurances that the third party will meet certain standards.

Comments on the proposal were due by December 27, 2022. For more information about the proposed rule, please visit the SEC’s website at the link below:

To view comments received on the proposed rule, please visit the SEC’s website at the link below:

Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT Reporting

The SEC has proposed updates to Rules 22e-4 and 22c-1 that would require open-end funds (but not money market funds) to upgrade their liquidity risk management programs, and to require mutual funds (but not money market funds and ETFs) to implement swing pricing. The proposal would amplify stress testing in liquidity classifications, replace reasonably anticipated trading sizes with 10% of each investment, and require funds to maintain a minimum 10% of net assets in highly liquid assets. As for classifications, the rule would eliminate the “less liquid” category (investments that may take greater than 7 days to settle) and simply treat those as illiquid, but it also may require daily liquidity classifications.

The headline here, however, is the proposal’s swing pricing feature. The theory is that swing pricing will retard the pace of redemptions as exiting shareholders are required to bear the expense of transaction costs associated with meeting redemption requests, which otherwise could dilute value for remaining shareholders. The swing pricing rule would require mutual funds (not MMFs or ETFs) to implement swing pricing so that transaction costs from inflows or outflows are passed on to the buying/selling shareholder rather than non-transacting shareholders. Funds would have to implement a “swing factor” – reflecting bid-ask spreads and transaction costs, but also market impact costs – whenever there are net redemptions (aggregated across share classes, excluding in-kind transactions), or when net purchases exceed 2% of net asset value (“NAV”). (Because net trading activity cannot be known until end of day, shareholders won’t know whether their trades are subject to swing pricing until after the fact.)

If net redemptions exceed the “market impact threshold” (1% of NAV unless the swing pricing administrator elects a lower threshold), then the swing pricing factor must include a good faith estimate of the market price impact from selling securities.

In order to facilitate calculating the flows, the proposed rule also would require a “hard close,” which generally means orders must be received before the 4 pm close, which prevents any late trading and would complicate the quite common practice of intermediaries aggregating trades for delivery in omnibus format after 4 pm. The rule also would require monthly Form N-PORT filings (currently, they must be prepared but only have to be filed quarterly).

Implementing this rule, if adopted, would impose significant operational and compliance challenges. At a minimum, it will require new policies and procedures. The board also will have to appoint a new “swing pricing administrator” who will prepare periodic board reports to inform the boards’ oversight function. Prospectuses will have to be updated with new disclosures, and Forms N-PORT and N-CEN will include another category of data.

Comments on the proposal were due to the SEC by February 14, 2023.

SEC News

SEC Division of Examinations Announces 2023 Priorities

On February 7, 2023, the SEC’s Division of Examinations announced its 2023 examination priorities. The Division publishes its examination priorities annually to provide insights into its risk-based approach, including the areas it believes present potential risks to investors and the integrity of the U.S. capital markets. The following is a selection of the Division’s 2023 priorities:

New Investment Adviser and Investment Company Rules

  • The Division will focus on the new Marketing Rule (Investment Advisers Act Rule 206(4)-1) and whether registered investment advisers (RIAs) have adopted and implemented written policies and procedures regarding the Marketing Rule.
  • The Division will also focus on new rules applicable to investment companies, including the Derivatives Rule (Investment Company Act Rule 18f-4) and Fair Valuation Rule (Investment Company Act Rule 2a-5).

RIAs to Private Funds

  • Examinations will review issues regarding an adviser’s fiduciary duty, and will assess risks, including a focus on compliance programs, fees and expenses, custody, the new Marketing Rule, conflicts of interest, and the use of alternative data.
  • The Division will also review private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations, focusing on conflicts and disclosures around these areas.
  • The Division will focus on RIAs to private funds with specific risk characteristics, including highly leveraged private funds and private funds managed side-by-side with business development companies.

Retail Investors and Working Families

  • The Division will continue to address standards of conduct issues for broker-dealers and RIAs to ensure that retail investors and working families are receiving recommendations and advice in their best interests.

Environmental, Social, and Governance (ESG)

  • The Division will continue its focus on ESG-related advisory services and fund offerings, including whether funds are operating in the manner set forth in their disclosures.
  • The Division will assess whether ESG products are appropriately labeled and whether recommendations of such products for retail investors are made in the investors’ best interests.

Information Security and Operational Resiliency

  • The Division will review broker-dealers,’ RIAs,’ and other registrants’ practices to prevent interruptions to mission-critical services and to protect investor information, records, and assets.
  • Reviews of broker-dealers and RIAs will include a focus on the cybersecurity issues associated with the use of third-party vendors.

Emerging Technologies and Crypto-Assets

  • The Division will conduct examinations of broker-dealers and RIAs that are using emerging financial technologies or employing new practices, including technological and on-line solutions to meet the demands of compliance and marketing and to service investor accounts.
  • Examinations of registrants will focus on the offer, sale, recommendation of, or advice regarding trading in crypto or crypto-related assets and include whether the firm (1) met and followed their respective standards of care when making recommendations, referrals, or providing investment advice; and (2) routinely reviewed, updated, and enhanced their compliance, disclosure, and risk management practices.

The published priorities are not exhaustive of the focus areas of the Division in its examinations, risk alerts, and outreach. The scope of any examination includes analysis of an entity’s history, operations, services, products offered, and other risk factors.

SEC Receives Special Master to Oversee Return of Remaining Funds to harmed Investors of the Infinity Q Mutual Fund

On November 10, 2022, the SEC filed a settled action against the Infinity Q Diversified Alpha Mutual Fund for mispricing its NAV and is seeking an appointment of a Special Master over the mutual fund to oversee the return of remaining funds to harmed investors. The SEC’s complaint charges the mutual fund with violating the pricing provisions of Rule 22c-1 under the Investment Company Act and that the mutual fund’s reported NAV was materially and falsely inflated from at least February 2017 through February 2021. On February 22, 2021, Infinity Q and the mutual fund’s board filed an application for an order pursuant to Section 22(e)(3) of the Investment Company Act to suspend redemptions in the mutual fund and the mutual fund was subsequently liquidated. To date, the mutual fund has distributed approximately $670 million to current shareholders. Approximately $570 million remains to be distributed to harmed investors.

On January 10, 2023, a court appointed Andrew M. Calamari as the Special Master to oversee the return of remaining funds.


2023 Report on FINRA’s Examination and Risk Monitoring Program

The Financial Industry Regulatory Authority (“FINRA”) published its 2023 Report on FINRA’s Examination and Risk Monitoring Program (the Report) which provided member firms with insight into findings from the recent oversight activities of FINRA’s Member Supervision, Market Regulation and Enforcement programs (collectively, regulatory operations programs). The Report reflects FINRA’s commitment to providing greater transparency to member firms and the public about its regulatory activities as well as the increasing integration among its regulatory operations programs.

The Report highlights FINRA’s regulatory operations programs’ expanded focus on ongoing key areas of risk to investors and the markets:

  • Reg BI and Form CRS. FINRA’s reviews of member firms’ adherence to their obligations pursuant to Reg BI and Form CRS address a number of areas, such as making recommendations that adhere to Reg BI’s Care Obligation; identifying and addressing conflicts of interest; disclosing to retail customers all material facts related to conflicts of interest; establishing and enforcing adequate written supervisory procedures (WSPs), including the provision of effective staff training; and filing, delivering and tracking accurate Forms CRS. Member firms should regularly review and update their approach to compliance with Reg BI and Form CRS, taking into consideration new interpretive guidance the SEC continues to issue.
  • Mobile Apps. As noted in last year’s Report, mobile apps can benefit investors in several ways, including increasing their market participation, expanding the types of products available to them, and educating them on financial concepts. However, these apps also raise novel questions and potential concerns, such as whether they encourage retail investors to engage in trading activities and strategies that may not be consistent with their investment goals or risk tolerance, and how the apps’ interface designs and functionality could influence investor behavior.
  • Cybersecurity. Cybersecurity threats continue to be one of the most significant risks many customers and member firms face. The frequency, sophistication and variety of attacks continue to increase; in 2022, for example, the attacks FINRA witnessed included customer account intrusions, ransomware attacks and cyber-enabled fraud. In August 2022, FINRA established the Cyber and Analytics Unit (CAU) to enhance their ability to proactively address the evolving sophisticated cyber threat landscape and growth of the crypto-asset market. CAU has a team that examines member firms’ cybersecurity risk management through reviews of their controls, a team responsible for conducting investigations of cyber-related fraud and a team that investigates and examines crypto-asset activity. FINRA has also increased its outreach to member firms this year to make them aware of cybersecurity threats. These efforts include email alerts to member firms’ Chief Information Security Officers (CISOs) and Chief Compliance Officers (CCOs) and notifying member firms when it identifies website(s) or social media profiles that may be attempting to impersonate that member firm, one or more of its current or previous registered representatives, or individuals purporting to be associated with a member firm. In December 2022, FINRA issued Regulatory Notice 22-29 (FINRA Alerts Firms to Increased Ransomware Risks) to provide firms with questions they can use to evaluate their cybersecurity programs, information about possible additional ransomware controls and relevant resources.

No-Action Letters and Alerts

Differential Advisory Fee Waivers

On February 2, 2023, the SEC issued an Alert regarding differential advisory fee waivers. In the Alert, the SEC reminded mutual funds, their boards, and their legal counsel of implications under Section 18 of the Investment Company Act and Rule 18f-3 thereunder of fee waiver and expense reimbursement arrangements that result in different advisory fees being charged to different share classes of the same fund (“differential advisory fee waivers”).

In order for mutual funds to operate as multi-class funds, those funds must rely on, and meet certain conditions contained in, Rule 18f-3 under the Investment Company Act. Rule 18f-3(b) expressly allows expenses to be waived or reimbursed by a fund’s adviser, underwriter, or any other provider of services to the fund. In Rule 18f-3’s adopting release, the SEC stated that, although permitted under the rule, waivers and reimbursements were not intended to become “de facto modifications of the fees provided for in advisory or other contracts so as to provide a means for cross-subsidization between classes.” The SEC further noted in the adopting release that fund boards “must monitor the use of waivers or reimbursements to guard against cross-subsidization between classes” consistent with its “oversight of the class system and its independent fiduciary obligations to each class.”

In the Alert, the SEC reminds mutual funds that one of the principles underlying Rule 18f-3 is that advisory fees charged to shareholders of all classes of a fund should generally be the same percentage amount, as shareholders receive the same advisory services no matter which class of shares they are invested in. In the Staff’s view, differential advisory fee waivers that are long-term or permanent, or effectively long-term or permanent, and are not substantiated with a clearly defined temporal purpose, could present a means for cross-subsidization between classes of shares in contravention of Rule 18f-3.

As noted in the Alert, in the Staff’s view, whether a differential advisory fee waiver presents a prohibited means of cross-subsidization between classes is a facts-and-circumstances determination that the mutual fund’s board, in consultation with the investment adviser and legal counsel, should consider making and documenting after considering all relevant factors. The Staff provides an example of a fund’s board being able to conclude that a long-term waiver of an advisory fee for one class of shares, but not other classes of shares, does not provide a means for cross subsidization in contravention of Rule 18f-3 if the board finds that (i) shareholders in the waived class pay fees to the adviser at the investing fund level in a fund-of-funds structure for advisory services and (ii) such fees, when added to the advisory fees that are paid by the waived class, after giving effect to the waiver, are at least equal to the amount of advisory fees paid by the other classes, such that the waiver for the waived class is demonstrably not being subsidized by other classes. The Staff further noted that one fact that should not be used to justify a differential advisory fee waiver is the existence of any Staff No-Action Letter that does not explicitly address any such waiver under Section 18 of the Investment Company Act and Rule 18f-3 thereunder.

In the Alert, the Staff notes that, for a fund that already has such differential advisory fee waivers in place, the board may wish to consider specifically within the context of Rule 18f-3 whether such waivers present a means for cross-subsidization, whether the steps they are taking to monitor such waivers guard against cross-subsidization are (and continue to be) effective, and/or whether alternative fee arrangements may be appropriate. Additionally, the Staff notes that a fund should consider the extent to which the board’s consideration of these issues under Rule 18f-3 should be disclosed to fund shareholders.

To view the Alert, please visit the SEC’s website at the link below:

Enforcement Actions

Inadequate Code of Ethics Policies and Procedures

The SEC’s Division of Enforcement recently brought an enforcement case against an investment adviser’s CCO as the adviser did not have an adequate Code of Ethics as required by Rule 204A-1 under the Advisers Act. The adviser adopted compliance policies and procedures in 2012 and never updated them. The Code of Ethics was particularly inadequate as the firm merely adopted an unnamed professional organization’s handbook on standards of practice that was designed to provide “ethics-based guidance” to help candidates prepare for a professional examination; the handbook did not purport to set out policies and procedures, much less did it address requirements under the Advisers Act. The SEC found that the firm never conducted an annual review, and consequently, the CCO never addressed the need to craft a policy that addresses the specific requirements under Rule 204A-1, including transaction reporting.

The firm ultimately replaced the CCO, and the SEC charged the CCO with causing the firm’s compliance violations and assessed a $25,000 penalty. (The firm also was charged with direct violations.) Although the SEC does not articulate the precise basis for charging the CCO, it appears that there was a wholesale failure of the CCO to perform his duties.

US Congress Legislation

SECURE 2.0 Act of 2022 Enacted

On December 29, 2022, President Biden signed a $1.7 trillion budget bill, which includes the Securing a Strong Retirement Act of 2022, or SECURE Act 2.0, which builds on the changes made to the retirement system by 2019’s Setting Every Community Up for Retirement Enhancement (SECURE) Act. The bill’s retirement savings package aims to reshape the structure of most Americans’ 401(k), 403(b), and IRA plans by making the process of contributing to and withdrawing from retirement savings plans easier.

SECURE 2.0 Act Highlights:

  • Automatic enrollment increased. Beginning in 2025, with some exceptions for small businesses, the bill requires 401(k) and 403(b) plans to automatically enroll eligible participants, starting at a minimum 3 percent contribution and increasing annually to at least 10 percent but no more than 15 percent. Employees who do not wish to enroll will be required to opt out.
  • Withdrawals allowed for emergency expenses.Beginning in 2024, qualified plan participants will be able to take a penalty‐free distribution of up to $1,000 once per year, which will not be subject to the usual additional 10 percent tax that applies to early distributions. However, if you do not repay the distribution within a certain time frame, you will have to wait three years before being allowed to take another emergency distribution.
  • Matching Contributions for Student Loan Payments.Beginning in 2024, employers will be permitted to make qualified retirement plan contributions to employees who are not contributing to the plan if that employee is making qualified student loan payments.
  • Required minimum distribution age raised. The age to start taking required minimum distributions (RMDs) increases to age 73 in 2023 and to 75 in 2033.
  • Reduced Penalties for RMDs. Starting in 2023, the penalty for failing to take an RMD will decrease to 25% of the RMD amount, from 50% currently, and 10% if corrected in a timely manner for IRAs.
  • Catch-up contribution limits boosted. Catch-up contributions will increase in 2025 for 401(k), 403(b), governmental plans, and IRA account holders.
  • Penalty-free rollovers from 529 plans. Also in 2024, a new provision will allow tax‐and penalty‐free rollovers from 529 accounts to the 529 plan beneficiary’s Roth IRA (capped at $35,000 over the beneficiary’s lifetime and subject to annual Roth contribution limits). The 529 plan must have been open for at least 15 years.

State Matters

State Attorneys General Sue to Stop ESG Rule

Attorneys General in 25 states have sued for a preliminary and permanent injunction of the U.S. Department of Labor’s (“DOL”) new rule that would allow retirement plan fiduciaries to consider environmental, social, and governance (“ESG”) factors in making investment decisions on behalf of the retirement plans.


  • Basis for the Lawsuit. There are two primary bases for the lawsuit that was filed. First, the new DOL rule violates the Employment Retirement Income Security Act (“ERISA”) because ERISA restricts retirement plan investing decisions to only financial gain considerations. Second, the new DOL rule violates the Administrative Procedure Act (“APA”) by being arbitrary and capricious.
  • ERISA Violation Claim. The lawsuit claims the new DOL rule violates ERISA by violating the requirement that retirement plan fiduciaries act with the financial interests of plan participants and their beneficiaries as the only factor in making investment decisions.
  • APA Violation Claim. The lawsuit claims the new DOL rule violates the APA as being arbitrary and capricious because the DOL failed to assess either: (1) the harm the rule poses to plan participants and beneficiaries or (2) the advantage of superseding the previous effective ban on ESG considerations in making retirement plan investment decisions.
  • Harms Claimed by the States. Attorneys General of plaintiff states claim that the harms posed by the DOL’s new rule would include: (1) diminished tax revenue and (2) reduced employment resulting from decreased investment in the fossil fuel industry.
  • Harms Claimed by Others. Other plaintiffs, which include two energy companies, an energy trade group, and an individual participant, claim additional harms, including (1) burdensome monitoring of retirement plan fiduciaries’ investment decisions, (2) legal resources for inevitable proxy battles with parties that have no pecuniary interest, and (3) new and additional resources to evaluate and select investments based on new, non-financial standards.
  • Magnitude of Effect. The magnitude of this rule would affect all retirement plan investments, which is estimated to be the size of half the annual GDP of the United States.
  • Plaintiff States Included. Alabama, Alaska, Arkansas, Florida, Georgia, Indiana, Idaho, Iowa, Kansas, Kentucky, Louisiana, Mississippi, Missouri, Montana, Nebraska, New Hampshire, North Dakota, Ohio, South Carolina, Tennessee, Texas, Utah, Virginia, West Virginia, and Wyoming.

16538013 3/6/2023

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