Compliance Matters Q2 2022

Jul 28, 2022

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 2022.
The SEC is back to its full complement with the Senate having confirmed Jaime Lizarraga and Mark Uyeda as new Commissioners (filling the seats vacated by Allison Herren Lee and Elad Roisman). And the new Commissioners were thrown into the deep end as SEC Chairman Gensler has been pressing ahead with an aggressive regulatory agenda. Several big rulemakings have already been released and there is no rest for the weary. What’s in a name? Evidently, ESG is the name of the game, and the Commission is concerned that some fund names are merely “greenwashing” ESG Trojan Horses, and true ESG funds will have a lot of disclosure explaining to do, if the Chairman gets his way. Index and model providers, and possibly pricing services, may fall prey to new regulation. A spate of court challenges, including a Supreme Court case involving the Environmental Protection Agency, point to an overheated regulatory agenda and more challenges to come. But don’t count the SEC out just yet. The Enforcement Division is flexing its muscle and is here to remind everyone there are cops on the beat and they sometimes carry a big stick.
Below are highlights of the recent activity and related commentary addressing how these matters may impact advisers and funds.

SEC Proposed Rules

Rule 35d-1 Amendments: Investment Company Names
Following a 2020 request for comment, the SEC has proposed amendments to Rule 35d-1, colloquially called the “Names Rule,” which generally requires registered funds and BDCs to invest at least 80% of their assets consistent with the investment focus that the fund’s name suggests. The SEC portrays the proposal as a modest effort to prevent misleading fund names, which can have a significant impact on investors’ decisions when selecting investments. Without much pretense, it is plainly focused on “greenwashing,” and thus should be understood in the broader context of ESG regulation (also subject to rulemaking). But it also would extend rule 35d-1’s reach to more conventional naming conventions like “growth” and “value” that until now have avoided Rule 35d-1’s reach. The proposal does allow that some terms still imply only “characteristics” of the portfolio as a whole that do not trigger a requirement for an 80% policy. Thus, for example, a fund with stated duration, target date, or described as “balanced” need not adopt an 80% policy. (While somewhat helpful, it is hardly obvious why “balanced” is excepted but “value” is not. We suspect this will either get re-worked or the disclosure review staff will be making ad hoc determinations about who needs 80% policies.)
Much of the proposal is sensibly focused on ensuring adequate disclosure; it does not, for example, prescribe ESG standards. To that end, funds will have to disclose how they define the terms used in their names, including the criteria the fund uses to select the investments that the term describes. All the commissioners agree with that, in principle. Of course, the devil is in the details, and critics (including Commissioner Peirce) are concerned that there is too much subjectivity in identifying fund names that imply “particular characteristics,” which can lead to uneven (or unfair) enforcement. And the likely upshot is that fund sponsors will simply make names more generic and less informative to avoid the rule’s clutches.
The proposal would bar funds from using ESG terminology (e.g., green, sustainable, etc.) in a name if such factors carry equal weight in the manager’s investment decisions as other non-ESG factors. For these so-called “integration funds,” the ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors are not dispositive in deciding to include or exclude any particular investment in the portfolio. Commenters likely will urge better calibration on this issue because, as a practical matter, many funds would say that ESG is a “significant” factor but would not be willing to say that it is predominant or at least equal to all other non-ESG factors. Moreover, it would put ESG-focused funds in a bit of a pickle when considering the companion ESG rule (discussed below): integration of ESG factors requires more disclosure, but the funds could not name the fund to signal that integration. Thus, sponsors may choose to simply go all in or all out on ESG, which could limit the manufacture of choices in the middle.
The amendment also would impose significant new restrictions on “defensive” positioning as a means to deviate from the fund’s 80% policy. Funds will be permitted to deviate only under particular circumstances, including market fluctuations, to address large inflows or redemptions, or moving to cash to avoid losses from adverse market conditions. It also specifies that funds have 30 days (or 180 days for fund launches) to return to compliance with the 80% threshold. While advisers will balk at that change – it may force transactions that could harm shareholders – the Commission believes it will prevent funds from drifting away from their mandates and taking perpetually defensive positions. We suspect this feature of the proposal will generate a lot of discussion about shareholder protection on both sides, and perhaps actively managed funds will be given more leeway than passive funds.
The amendments also try to grapple with the increased use of derivatives. Current Rule 35d-1 does not address how to incorporate derivatives, which can magnify exposure, into the 80% calculation. The amendment thus seeks to ensure that a fund’s name accurately reflects the economic reality of the fund’s sources of returns and risk by specifying that notional exposure, rather than market value, is used for the 80% calculation. Furthermore, the rule would specify the derivatives instruments that a fund may include in its 80% basket.
For unlisted closed-end funds and BDCs, the proposal would prohibit changing the 80% policy without a shareholder vote (ie, the 80% policy must be a fundamental policy). This is designed to protect shareholders who are limited in their ability to exit the investment if they do not like the changes made.
Finally, the amendments would require recordkeeping that shows how the funds comply with the rule, and it would require new disclosure on Form N-PORT to designate whether an investment is included in the 80% bucket. Commenters will surely observe that this extra reporting operational complexity and expense without much corresponding benefit to shareholders.
In many respects, the amendments are merely refreshing a benign disclosure rule that says nothing more than a fund should make investments consistent with the strategy implied by its name. Critics will observe that we should not overstate the significance of a name because a name is hardly the sole source of information for investors to understand a fund’s strategy and risks, though the SEC recognizes that a lot of advertising punch is packed into a name. Most of the debate surely will concern the use of ESG terminology; ironically, the amendments may accomplish what many conservative commentators had hoped: discouraging the use of ESG terminology. And it is unclear what else lies inside pandora’s box. ESG is the flavor of the day, but will the SEC wade into the thicket of faith-based funds? What about thematic names? Obviously, these matters can be addressed in detailed prospectus disclosures. Indeed, that is the very point critics are making.
Comments on the proposal are due within 60 days of publication in the Federal Register, or by August 16, 2022. For more information about this proposal, please visit the SEC’s website at the link below:
ESG Disclosures
The SEC also proposes various amendments to disclosure and reporting forms to promote consistent, comparable information concerning funds’ and advisers’ incorporation of ESG criteria into investing decisions. The proposed changes apply to advisers (including private fund advisers), registered funds, and BDCs. If adopted, the amendments would impose ESG categorization and require funds and advisers to provide specific disclosures in prospectuses, annual reports, and Form ADV. Funds that focus on environmental factors would have to disclose greenhouse gas (GHG) emissions associated with their portfolio investments. “Impact” funds would have to describe the specific impact(s) they seek to achieve and summarize their progress on achieving those goals. There also would be certain proxy voting disclosure requirements. Managers also would need to craft policies and procedures to ensure compliance with their own ESG investment guidelines.
The level of disclosure required would depend on the degree to which ESG factors are part of the fund’s strategy. The proposal identifies three types of ESG funds:
  • Integration Funds – These funds include ESG factors among other non-ESG factors in investment decisions and would be required to describe how ESG factors are incorporated into their investment process. This could potentially affect many advisers that consider ESG factors, but where ESG is not dispositive when selecting or excluding investments.
  • ESG-Focused Funds (EFFs) – ESG is a significant or principal consideration in selecting investments or in engaging with portfolio companies, which may include ESG screens or engaging via proxy voting or direct engagement. These funds would be required to provide detailed disclosures, including data in a standardized strategy overview table.
  • Impact Funds – A subset of EFFs, these seek to achieve a particular ESG impact and thus would be required to disclose how they measures progress on the particular objective both quantitatively and qualitatively with respect to a related time horizon.
Integration Funds would have streamlined disclosure requirements, requiring brief summaries of how the fund incorporates ESG factors into its selection process.” A fund that considers GHG emissions also would have to provide more detailed disclosure concerning its methodology for considering this factor. EFFs, which also include funds with a name implying ESG focus (thus coupling with the Names Rule), would face steeper disclosure burdens. Primarily, EFFs would have to complete an ESG Strategy Overview table in the fund’s prospectus, providing summary information about the strategy and how the fund incorporates ESG factors into investment decisions. The proposal is agnostic about which standards or frameworks may be used, acknowledging that two similar-sounding fund names could result is opposing views about particular investment decisions. (For instance, one company may exclude oil companies as environmentally harmful, while another approach may approve such companies for having good governance practices.) Additional disclosures around proxy voting or engagement with company management also may be required.
The proposal includes a more rigid reporting structure for environmentally-focused EFFs to report GHG emissions. This surely will be among the most controversial aspects of the proposal. The SEC proposes that such funds disclose the “carbon footprint” and “weighted average carbon intensity” of its portfolio, as well as scope 3 emissions (other indirect emissions) consistent with the widely-used “GHG Protocol.” Suffice to say this is a complicated calculation and it would spawn a whole industry of consultants. Funds that do not consider GHG emissions as part of their strategy would be excepted from this requirement. The SEC appears to be aligning itself with European regulators on this score.
Significantly, the ESG proposal is replete with nearly 200 questions for which it seeks public comment. Thus, the proposal reads more like a broad concept release than a hardened view on what the final rule will include. The SEC’s approach seems to contemplate a fair amount of leeway for advisers to choose their own methodology without prescribing any particular scoring or rating system (save for the GHG disclosures). Nevertheless, we anticipate fierce challenges to many features of the proposal, particularly with respect to GHG reporting.
As with the Names Rule, comments on this rule are due by August 16, 2022. For more information about this proposal, please visit the SEC’s website at the link below:
Request for Comment on Requiring Registration for Index Providers, Model Portfolio Providers, and Pricing Services
The SEC issued a request for comment on whether certain “information providers,” specifically index providers, model portfolio providers, and pricing services, should be subject to registration as investment advisers. The SEC posed numerous questions exploring whether these information providers satisfy the definition of “investment adviser” and the implications of requiring registration under both the Advisers Act and the Investment Company Act.
These services have grown in size and influence, and the SEC seeks to ensure oversight and investor protection. To that end, the SEC seeks to better understand when these entities are providing particularized investment advice rather than merely broad-based information. While index and model providers may perform functions that, in some respects, resemble portfolio management, some may wonder why the SEC to chose to include pricing services in the discussion. One theory is that registration would give the SEC a foothold for conducting examinations because, as a practical matter, it is becoming increasingly challenging for advisers to conduct meaningful oversight (as is required, for example, by Rule 2a-5) of the large pricing services that have become so essential to every fund’s pricing. Any new rule will require proper calibration; while aspects of their services would seem to meet the technical definition of an investment adviser, subjecting them to the gauntlet of section 15(c) approvals would be cumbersome and limit the ability to change service providers. Thus, advisers and fund managers may welcome some SEC supervision, but only if it were to lessen the burdens on managers and retain their flexibility.
As with the other new proposals, the SEC imposed a short comment period with comments due by August 16, 2022. For more information about this request for comment, please visit the SEC’s website at the following link:

SEC Guidance and Alerts

SEC Regulatory Flex Agenda
The SEC has released the Spring 2022 Regulatory Agenda, which charts the SEC Chairman’s current regulatory priorities and approximate timeline for rulemakings. One person’s “ambitious” agenda is another person’s “aggressive,” or, as Commissioner Peirce dubbed it, a “rip current” of rulemakings. The agenda is broken down into short- and long-term agendas, which separates those items expected to be considered in the next 12 months from those that will take longer.
The short-term list is sprawling and includes some familiar items for the fund industry, including impending final rules governing cybersecurity, reporting of proxy votes on Form N-PX, new fund shareholder reports, money market reforms, securities lending disclosures, and a shortened (T+1) settlement cycle. The list also includes possible amendments to the Names Rule (recently proposed), ESG rules for investment companies and advisers (recently proposed), new rules for third-party service providers (presumably the request for comment on registration of index providers and pricing services), and reforming the listing and trading of exchange-traded products (concept release published in 2015). The Commission also is considering updates to fund fee disclosures as well as open-end fund liquidity and dilution management (probably expanding, rather than restricting, rule 22e-4). Investment advisers likely will see amendments to the compliance rule to require documentation of compliance reviews (already proposed), Form PF (already proposed), the custody rule and new rules for digital engagement practices (including robo advisers). The Commission seeks to address broad-based rules such as data security for the Consolidated Audit Trail, mandatory electronic filing, and modernizing Reg ATS. The Commission also seems poised to revisit proxy advice rules and reopen rules on shareholder proposals, whistleblowers, and resource extraction, each of which was adopted in 2020 under the last chairman. And it aims to regulate SPACs, require climate change disclosures, update Reg D, revise insider trading rules, and introduce rules to address a variety of conflicts in the securities markets. And the list goes on.
The long-term list is far more modest. It includes the long-standing item to reform regulation of transfer agents. It also includes potential enhancement to proxy processes, or the proxy “plumbing.” Other actions do not generally relate to the fund industry but may have some indirect impact including disclosure rules related to so-called conflict minerals, incentive-based compensation, and credit ratings agencies’ conflicts of interest, each of which should be viewed through the lens of the Chairman’s view on ESG-type considerations. The Commission also is delaying consideration of rules to harmonize SEC and CFTC rules concerning margining of uncleared swaps.
Much of the agenda ostensibly is focused on disclosure and protection of retail investors, though critics observe that the agenda may impose substantial costs that may be passed on to investors or retard capital formation, and the agenda actually dispenses with priorities that may have been more impactful or had more immediate benefits (like addressing custody, cryptocurrencies, and proxy plumbing). And the torrid pace of rulemaking leaves scant opportunity for the public to study the proposals and provide important feedback that could help better calibrate the rules. As Commissioner Peirce laments, issuing numerous complex rule proposals with short comment periods may leave only large entities with deep resources able to fully participate in the notice-and-comment process.
Cynics will view this agenda as a rush to complete controversial rulemakings before a change of administration. That is, unfortunately, a feature rather than a bug in the rulemaking process. Bear in mind that events often overtake priorities, and comments from interested parties often cause the SEC to rethink rule proposals or scrap them altogether. For more information, please visit the Office of Management and Budget’s website at the following link:
SEC Risk Alert: Adviser Codes of Ethics
The SEC’s Division of Examinations (DOE) has issued a risk alert discussing deficiencies in codes of ethics under Adviser Act Rule 204A, which requires that advisers adopt a code of ethics designed to prevent the misuse of material non-public information (“MNPI”) by the adviser or any person associated with the adviser. To that end, the rule requires that certain supervised persons, access persons, report their personal securities transactions to the firm. Deficiencies observed include insufficient policies or implementation of policies concerning:
  • the use of “alternative data” (e.g., satellite imagery or internet search data used to inform investment decisions);
  • “value-add” investors, ie., key persons or entities who are more likely to possess MNPI (e.g., officers at a public company); and
  • expert networks, such as tracking and logging of calls, reviewing notes from calls, and reviewing trading of supervised persons in securities of publicly traded companies that are in similar industries as those discussed during the calls.
The staff also noted various compliance issues, such as:
  • failing to identify access persons (or not defining clearly who is an access person);
  • failing to seek pre-clearance of IPOs and private placements;
  • lacking evidence that there was any review of personal securities transactions and transaction reports;
  • not having the CCO report transactions to some other person for review;
  • late or failing to submit transaction reports, or not including the information required by the code; and
  • not having written acknowledgement of supervised person’s receipt of the code.
The staff made two specific recommendations. First, they suggested that firms should consider developing a restricted list (and of course monitor compliance with it). Second, they commended a policy that requires investment opportunities first be offered to clients before the adviser or employees may act on them (essentially to avoid front running).
Advisers should review their compliance with Rule 204A. Because fund compliance officers must oversee the compliance programs of their principal service providers, they also should be mindful of advisers’ compliance as well as reviewing their own compliance under the analogous Investment Company Act Rule 17j-1. For more information, we encourage you to consult DOE’s publication available on the SEC’s website:

Enforcement Actions

SEC Charges Allianz Global Investors and Portfolio Managers with Securities Fraud
The SEC charged Allianz Global Investors U.S. LLC and three former senior portfolio managers with fraud for concealing the downside risks of a complex options trading strategy that lost billions of dollars. Allianz admitted that it defrauded investors over several years, concealed losses, and failed to implement key risk controls. The portfolio managers allegedly manipulated financial reports and other information provided to investors to conceal the risks and actual performance; they also allegedly provided false testimony to the SEC. The essential issue – taking on a far riskier derivatives strategy than disclosed – has occurred elsewhere and was an animating factor for the derivatives rule. The brazen cover-up and fraud (falsifying reports and manipulating data), however, is unprecedented and led the SEC to seek steep penalties. Allianz has agreed to pay $5 billion in restitution and a $1 billion penalty to settle the charges. The parties agreed to plead guilty to parallel criminal charges. As a consequence of the guilty plea, Allianz is disqualified from providing advisory services to US registered investment funds for the next ten years. Consequently, it has sold its fund business to Voya Funds.
For more information about these proceedings, please view materials on the SEC’s website at the following links:
Ernst & Young Sanctioned for Employees Cheating on CPA Ethics Exams
Imposing the largest penalty ever against an audit firm, the SEC charged Ernst & Young (EY) for cheating by approximately 200 of its audit professionals on CPA exams and then hiding that fact from the SEC. The cheating mostly involved the ethics portion of the exam and with respect to continuing education courses, including ones addressing compliance with GAAP. EY also failed to correct a submission to the SEC even after its own internal investigation confirmed there had been cheating. EY admitted the misconduct and agreed to a $100 million penalty and to undertake remedial actions, including notifying audit clients of the misconduct. It is doubtless unflattering that an audit firm would employ professionals who cheated on ethics exams. The misconduct also could impair audits because the professionals in question did not act with required integrity, and the firm did not have adequate controls in place to ensure integrity. If EY has performed audits or other attest work, audit committees are well advised to discuss this matter with their audit engagement team to determine if there has been any impact on their services.
For more information about this matter, please follow the link on the SEC website:
SEC Enforcement for ESG Disclosures
A possible shot across the bow just before a new ESG rule was proposed (as discussed above), the SEC brought an enforcement action against BNY Mellon Investment Adviser for disclosure violations related to its ESG practices in six mutual funds. The SEC alleged that BNY misrepresented its ESG review process for portfolio holdings as numerous investments evidently were not screened for ESG. According to the SEC, BNY failed to state that the “subadvisor could and did select portfolio investments that were not necessarily subject to that aspect of the research process.” Although these funds were not part of BNY’s suite of sustainable funds (for which ESG is a principal investment strategy), BNY made misleading representations about its investment process in RFP responses, prospectus disclosures, and board minutes. Thus, in material respect, this is simply a case about following one’s own procedures and making accurate disclosures. But it should not be lost on anyone that the thrust of this case is a concern over greenwashing, which is a central focus of the newly proposed ESG Rule and proposed amendments to the Names Rule. Managers thus should place even greater emphasis than usual on the quality and accuracy of disclosures around their ESG practices.
For more information, please visit the SEC’s website at the link below:
SEC Charges CCO for Compliance Failures
Any time the SEC brings an enforcement action against a CCO, it will raise regulatory eyebrows. The recent action against Jeffrey Kirkpatrick, CCO of Hamilton Investment Counsel LLC, elicited a public statement from SEC Commissioner Hester Peirce, who supported the action and explained why this case is a rare example of the SEC charging the CCO. The case involved weaknesses in the firm’s compliance program regarding conflicts of interest and outside business activities for the firm’s investment adviser representatives. The broker-dealer with which the IAR was associated flagged transactions involving transfers of client assets to the IAR’s outside business activity. Despite repeated red flags and several opportunities to take corrective action, Kirkpatrick, who also was a principal of the firm, did not take action for more than a year. He thus demonstrated a “wholesale failure” to carry out his compliance responsibilities.
As Commissioner Peirce observed, the “decision to charge a CCO who is complicit in a fraud is easy.” (Indeed, the SEC charged James McArthur for securities fraud, but not a compliance violation, in another recent case.) This case requires closer attention to those features that make a case “debatably inappropriate” from those that constitute a “wholesale failure” to discharge compliance duties. Among the factors weighing in favor of enforcement were:
  • Kirkpatrick was a principal of the firm with authority to address the compliance issues;
  • The matter concerned a key area of the compliance program and the concepts are well understood; this is not a mere technical violation;
  • The lapses persisted for more than a year and the CCO had multiple opportunities to take corrective action; and
  • The fact that the broker-dealer flagged transactions that involved transfers of client assets to the IAR’s outside business activity was an aggravating factor.
Although not a case involving the CCO’s participation in a fraudulent scheme (or obstruction of an SEC investigation), Kirkpatrick’s failures were sufficiently extreme to warrant enforcement. CCOs therefore should take comfort that their care and attention is the best shield against liability.
For more information, please visit the links at the SEC’s website:
Fifth Circuit: SEC Administrative Proceedings Unconstitutional
Hedge fund manager George Jarkesy prevailed in his challenge to the SEC’s authority to bring securities fraud charges in an administrative proceeding. In a 2-1 decision, the U.S. Court of Appeals for the Fifth Circuit held that proceedings before an administrative law judge are unconstitutional because (1) they deprive the accused of the Seventh Amendment right to a jury trial, (2) they constitute an improper delegation of legislative power, and (3) ALJs are inferior officers improperly shielded from executive removal under the Constitution’s “Take Care” clause. The decision is technically binding only in Texas, Louisiana, and Mississippi, but it could have far broader implications. This decision continues a trend of decisions chiseling away at the SEC’s administrative powers, following the Supreme Court’s 2018 decision in Lucia v. SEC, holding that ALJs are subject to the Constitution’s Appointments Clause and therefore must be appointed by the President. A more recent Supreme Court case, West Virginia v. EPA, could spell more trouble for the SEC (and other executive agencies). Ostensibly a case about environmental regulation, the Supreme Court determined that the EPA exceeded its authority absent a clear delegation of power from Congress. The same logic easily could be applied to trim the sails of the SEC. With defendants emboldened by recent victories, we expect to see more challenges to SEC authority, and at least the agency likely will be more judicious in using administrative tribunals.
For more information about the Jarkesy decision, please review the decision at the following link:

15382230 7/27/2022

Sign up for Blogs

Interested in receiving the latest blogs information?

Want to Know More?

Interested in learning more about our solutions? We want to hear from you.

Institutional Strength | Boutique Service

The Ultimus Group, LLC is an Equal Opportunity Employer. All rights reserved.

DISCLOSURE: Information contained on this website is based on public data, historical agreements and dialogue with intermediaries. Such information represents our current understanding of the described platforms and the costs associated with them. In many cases, such costs may be negotiable. All pricing and fee information is subject to change without notice.

Ultimus Fund Solution

8778 UFS 2/18/2022

Ultimus Fund Solution