Risk Alert: Registered Investment Companies
The Division of Examinations issued a new risk alert that directly addresses the fund industry and follows previously announced exam priorities. It particularly focused on funds that track custom indexes, small ETFs, funds with high allocations to securitized investments, those with aberrational or poor performance, those with new advisers, and those with advisers managing private funds with similar strategies. The broad subject areas cover policies and procedures, disclosures, and fund governance – familiar topics – but it is a fairly far-ranging alert that arguably says so much as to say almost nothing. Areas of interest and observations include:
- Compliance programs – policies and procedures not tailored to address various business practices, including:
- portfolio compliance, trade aggregation, allocation, best execution, and senior securities;
- monitoring for investment restrictions and names rule;
- monitoring for specific risks, such as asset classes or other operational risks;
- liquidity risk management and oversight of related vendors;
- oversight of thinly-traded ETFs and “oversight of their liquidation, as applicable, including communications with their shareholders”;
- Valuation – policies and procedures should address
- valuation processes and controls, including oversight of pricing vendors and process for reviewing stale prices and making price challenges;
- potential conflicts of interest, especially when the adviser has input on a fair value committee;
- Trading Practices
- allocation practices, including ensuring there is oversight for potential conflicts;
- preventing prohibited principal transactions (which would include cross trading with private funds where the adviser is a general partner);
- cross trading monitoring and controls (which will be severely restricted upon compliance with Rule 2a-5);
- soft dollars and whether clients are being disadvantaged;
- Conflicts with affiliated index providers, which includes possible revenue sharing or misuse of MNPI;
- Fees and expenses – ensuring the allocation of fees between advisers and funds, and waivers or expense limitations are properly calculated;
- advertising should be fair and balanced and disclosures accurate;
- affiliated index provider websites should be evaluated as to whether they constitute fund advertising;
- Board oversight
- policies and procedures for monitoring and board reporting of fees paid to intermediaries and shareholder servicing, pricing exceptions, adviser recommendations for fund liquidations, and compliance with senior securities and asset coverage requirements;
- 15(c) review should address adviser financial condition and ability to meet contractual obligations;
- completing an annual review, including ensuring the adviser has policies and procedures to address specific risk areas and to address matters that have been delegated to advisers;
- omitted disclosures regarding strategies, risks, conflicts, and change of indexes;
- inaccurate net assets and expenses (including limitation agreements), standing committees, number of accounts, etc.;
- inaccurate sales information. The staff recommended testing for consistency with stated investment objectives and conflicts. The staff also commended policies that provide for ensuring websites get updated at the same time as prospectus updates and testing of fees and expenses for accuracy and completeness; and
- Vendor oversight, including pricing vendors.
Compliance officers are well-advised to conduct a gap analysis to ensure that the compliance house is in order as these topics likely will sever as an informal checklist for upcoming examinations. For more information, please visit the SEC’s website:
Risk Alert: Advisory Fee Calculations
The Division of Examinations cannot throw a risk-alert party for investment companies without inviting advisers. This alert, by contrast, is laser focused, essentially supplementing a 2018 risk alert that addressed advisory fees and expenses, this time providing more details on observations from recent exams. The new alert addresses failures to follow procedures, or in some cases not having procedures, governing billing and fee calculations. Many of the observations seemed to reflect simple errors or sloppiness. The staff cited miscalculated fees, double billing, rebates that were not provided, and inaccurate disclosures. Some mistakes found their way into adviser financial statements. In addition to the usual entreaty for good policies and procedures, the staff seemed to recommend having a centralized billing process to reduce errors. The staff also suggested there should be a process for reviewing fee calculations and ensuring all fees assessed and received are accurately recorded. Advisers definitely should review their ADVs to make sure they are accurate (including accurately stating whether fees are negotiable).
For more information, please visit the SEC’s website:
Staff Statement on LIBOR Transition
LIBOR is dead (or perhaps reports of its demise are greatly exaggerated!). Hence, the SEC staff has issued a statement concerning obligations tied to the LIBOR transition. Significant LIBOR reference rates (the one-week and two-month USD LIBOR maturities and non-USD LIBOR maturities) no longer will be published after December 31, 2021; all other maturities will cease after June 30, 2023. The SEC has issued several statements about this transition, and by now market participants should have made arrangements for using alternative rates, such as SOFR. This latest statement is yet another reminder and spells out some specific considerations for different market segments. As it pertains to advisers and funds, the staff observes the following:
- Advisers must continue to assess their investment recommendations to ensure they have considered risks and benefits, volatility, likely performance, time horizon, and cost of exit for LIBOR-linked investments.
- Advisers should consider whether LIBOR-linked investments have fallback language (to trigger an alternative reference rate) and how that impacts the investment profile.
- Registered funds should consider disclosures. If there are significant LIBOR-linked investments in the fund, there should be risk disclosures concerning the cessation of LIBOR.
- Valuation, to the extent tied to LIBOR, may need to be reassessed.
- Advisers may need disclosure around performance fees if, for example, they tie fees to exceeding a LIBOR-linked hurdle
All market participants and service providers also should be mindful of operational or IT changes that may be required to handle the LIBOR transition. Please visit the SEC’s website to view the Staff Statement:
Staff Statement Regarding Form CRS
The SEC staff issued a statement discussing observations (good and bad) about firms’ Form CRSs (ADV part 3). The form is a client relationship summary designed to help retail investors make informed choices about the type of relationship (brokerage, advisory, or both) that best suit’s the investor’s objectives. Although Form CRS is not required for mutual funds, advisers who also serve retail clients must file the form with the Commission, deliver a copy to retail investors, and post it on the firm’s website. The staff reminds registrants that the relationship summary should be written in plain English, avoiding technical jargon and disclaimers. Firms are permitted to summarize information while pointing investors to more detailed disclosures (e.g., by using hyperlinks or other means to access detailed summaries in the Form ADV). The Form CRS also requires certain disclosures while prohibiting extraneous information. Advisers are encouraged to review the staff’s statement as well as other resources for further guidance, which are available on the SEC’s website: