August-December 2021 Report on Financial Services Regulatory Developments

Happy New Year! Going forward, I will aim to issue this report on a quarterly basis. Below is a summary of select August-to-December 2021 regulatory developments for investment advisers, broker-dealers and other securities market participants. Topics include SEC staffing, an SEC request on digital engagement practices and technology usage, SEC Risk Alerts, and SEC rulemaking and enforcement activity.

Send any comments or questions to mscanlon@mpslgl.com or call me at 410.624.5744.

SEC Staffing

Commissioner Elad Roisman Resigns and SEC Announces More Senior Staff Appointments, Including New General Counsel and New Directors of Division of Investment Management and Division of Trading and Markets.

Commissioner Roisman Resigns. On December 20, SEC Commissioner Elad Roisman, the senior Republican Commissioner, sent a letter to President Biden announcing his intention to resign by the end of January 2022 (his last day was January 21, 2022). Commissioner Roisman was appointed an SEC Commissioner in 2018.

New Director of Investment Management. On December 21, the SEC announced the appointment of William Birdthistle as Director of the SEC’s Division of Investment Management. He previously was a professor at Chicago-Kent College of Law and wrote “Empire of the Fund”, a book on mutual funds and retirement saving.

New Director of Trading and Markets. On November 19, the SEC announced the appointment of Haoxiang Zhu as Director of the SEC’s Division of Trading and Markets, effective December 10. Mr. Zhu previously served as an expert for the CFTC and most recently was a professor at MIT.

New General Counsel. On September 28, the SEC announced that CFTC Commissioner Dan Berkovitz had been named SEC General Counsel, effective November 1. Mr. Berkovitz, a former partner at the WilmerHale law firm, was General Counsel of the CFTC from 2009 to 2013, when current SEC Chair Gensler was CFTC Chair.

New Senior Advisor to the Chair. On August 25, the SEC announced the appointment of Barbara Roper as Senior Advisor to Chair Gensler. Ms. Roper, a well-known investor advocate, previously was the Director of Investor Protection at the Consumer Federation of American, where she worked for 35 years.

Additional Appointments. The SEC also announced the following appointments:

• PCAOB. Chairperson Erica Y. Williams; Board Members Christina Ho, Kara M. Stein, and Anthony (Tony) C. Thompson; also, Duane M. DesParte continues as a Board Member.
• SEC. Sanjay Wadwha, Deputy Director, Enforcement; Erik Gerding, CorpFin Deputy Director, Legal and Regulatory Policy; Nicole Creola Kelly, Chief, Whistleblower Office; Ahmed Abonamah, Director, Credit Ratings Office; Daniel R. Gregus, Director, Chicago Regional Office; James E. Grimes, Chief Administrative Law Judge; Ernesto A. Lanza, Acting Director, Municipal Securities Office.
• SEC Chair’s Staff: Corey Frayer, Crypto Assets; Philipp Havenstein, Operations Counsel; Jennifer Songer, Investment Management Counsel; Jorge G. Tenreiro, Enforcement Counsel.

SEC Request – Digital Engagement Practices (DEPs) and Use of Technology to Develop and Provide Investment Advice

Introduction. On August 27, the SEC issued a release requesting information on broker-dealer and investment adviser use of digital engagement practices (“DEPs”) and investment adviser use of technology to develop and provide investment advice.[1] The release also sought comment on whether additional regulations are needed to protect investors and ensure fair, orderly and efficient markets in light of recent technology-related advances and concerns about DEPs being used to “gamify” online investing.

The release asked for feedback by October 1, giving financial services firms and other members of the public barely 30 days to submit responses to more than 91 questions. Many commenters objected to this timeline, but Chair Gensler’s SEC is in a hurry to address a wide variety of regulatory issues and compressed public comment periods appear to be part of its strategy for doing so [2].

DEPs. The SEC release broadly described DEPs as design elements or features designed to engage with retail investors on digital platforms such as websites, portals and apps. The release gave 9 examples of DEPs, including social networking tools, notifications and chat bots.

The release acknowledged DEPs can benefit retail investors by making investment platforms more accessible, serving as educational tools, and encouraging wealth-building. It also said DEPs can harm retail investors by prompting them to engage in investment activity inconsistent with their goals and risk tolerance, such as frequent trading and risky trading strategies – for example, options, margin, complex securities.

The release raised the possibility that broker-dealers are using DEPs based on predictive data analytics and artificial intelligence/machine learning (“AI/ML”) with the intent to encourage or nudge investors to engage in these harmful behaviors and thereby increase broker-dealer revenue – e.g., from payment for order flow.

The release then listed regulatory requirements DEPs may implicate, including Reg. BI where a DEP used by a broker-dealer involves a “recommendation” to a retail investor, and asked for feedback on related issues.

Use of Technology to Develop and Provide Investment Advice. In addition to focusing on DEPs, the SEC release requested information and comment on the analytical tools and other technology investment advisers increasingly are using to formulate and deliver investment advice, including how advisers oversee this technology and the benefits and potential risks of using technology for these purposes.

The release noted an increase in the number of robo-advisers and acknowledged technology’s potential benefits to investment advisers and clients, including lower costs, ease of access to advisory services, and (interestingly) less susceptibility to behavioral biases, mistakes and illegal behavior. The release also described potential risks, including risks of limited client access to investment adviser personnel, website access problems, data security and cybersecurity risks, and faulty or inadequately overseen/understood algorithms.

Provocatively, the release suggested that using technology to interact with clients and formulate investment advice may result in flawed advice because of factors such as too much importance being placed on client responses to questionnaires and limited or no human interaction between clients and personnel of the adviser. The release also expressed concern over the potential limited ability of investment adviser personnel to override or challenge technology-based investment advice.

The release asked for information and comment on technology-related compliance issues, including how investment advisers assess whether technology they use enables them to satisfy their fiduciary duties and what types of policies and procedures they maintain with respect to such technology. The release also asked if the SEC should make specific technology-related rule changes, including to Form ADV and Rule 3a-4.

What’s Next? I expect the SEC, after reviewing the submitted comments, will conclude that existing laws and regulations, including the new marketing rule and the principles-based fiduciary duty for investment advisers, are adequate to regulate most aspects of DEP and technology usage. In particular, I do not expect the SEC to amend Rule 3a-4 or take other action to disadvantage technology-based means of communicating with clients.

One area where rulemaking seems possible is online broker-dealer trading prompts or nudges that are based on predictive analytics or AI and seek to spur retail investors to engage in frequent trading or other behavior seen as harmful. To the extent such features are not recommendations subject to Reg. BI, the SEC may propose prohibiting or somehow restricting them, instead of just requiring cautionary disclosures.

New disclosure requirements also seem likely to be proposed, including changes to Form ADV to require disclosure of the types of technologies investment advisers use to develop and provide investment advice. Proposed requirements for robo-advisers and online broker-dealers to provide clients with human contacts and alternative functionality (e.g., to place trades), particularly during technology outages, are possible as well.

I expect the SEC will issue written guidance on how existing laws and regulations apply to certain key DEP- and technology-related compliance issues, focusing on (i) what broker dealer DEP-related communications rise to the level of recommendations subject to Reg. BI, (ii) oversight of technology used to develop and provide investment advice (from fiduciary duty and business continuity perspectives), and (iii) disclosure of limitations, risks and conflicts of interest associated with technology-based investment advice.

SEC Risk Alerts

The SEC’s Division of Examinations issued Risk Alerts describing compliance weaknesses and positive practices for investment advisers to investment companies and for investment advisers that provide electronic advice, as well as with respect to investment advisory fees.

During the last 5 months of 2021, the SEC’s Division of Examinations issued guidance to investment advisers in the form of 3 Risk Alerts. Investment advisers should review their compliance policies, procedures and practices against the compliance deficiencies and weaknesses, as well as the positive compliance practices, described in these documents to ensure they are living up to the Division’s expectations in the covered subject matter areas. The Division’s intent is to have the Risk Alerts help investment advisers assess relevant compliance risks and meet their compliance program and other obligations under the Advisers Act.

Risk Alert on Mutual Funds and ETFs. On October 26, the Division issued a Risk Alert describing the most frequent compliance deficiencies and weaknesses its examiners observed in a series of recent examinations focused on mutual funds and ETFs in 6 different categories [3, 4]. These were related to fund and investment adviser compliance programs and to inaccurate, incomplete and omitted fund-related disclosures.

For compliance programs, deficiencies and weaknesses included inadequate policies and procedures relating to, and inadequate oversight of, portfolio management (e.g., compliance with restrictions, asset-specific risk oversight, fund names rule compliance, liquidity risk management, vendor oversight), valuation, trading practices, conflicts of interest, fees and expenses, advertisements and sales literature, and Board oversight.

The Division described effective practices it observed in both the compliance program and disclosure areas, including reviewing compliance policies and procedures for consistency with actual practice (always a good idea), conducting testing and reviews of compliance with disclosures (e.g., investment strategies, fees and expenses), and updating fund website disclosures concurrently with new or amended prospectus, SAI, shareholder report, and investor letter disclosures.

Risk Alert on Electronic Investment Advice. On November 9, the Division issued a Risk Alert to raise awareness of compliance deficiencies its examiners found while examining investment advisers that provide automated digital investment advisory services [5]. The Division examined many of these firms, which it calls “robo-advisers”, as part of its recent Electronic Investment Advice Initiative, focusing on how they met their fiduciary duty to provide clear and adequate disclosures regarding their services and to act in clients’ best interests. The Division also focused on these firms’ compliance programs and marketing and data protection practices.

The Risk Alert says the Division found most examined robo-advisers had inadequate compliance programs, typically as a result of a lack of written policies and procedures or having ones that were insufficient for their operations, unimplemented or untested. Examiners identified deficiencies in the areas of portfolio management (e.g., oversight, disclosure and conflict of interest failures), performance advertising and marketing, cybersecurity and protection of client information, and Rule 3a-4 compliance (with respect to discretionary advisory programs).

The Risk Alert closed by identifying certain effective compliance practices for robo-advisers, including (i) adopting and implementing written policies and procedures tailored to the actual firm practices (one size generally does not fit all), (ii) periodic testing of advice-formulation algorithms by a multidisciplinary group (not just the algo’s designer and/or software developers) to ensure they are operating as expected/intended, and (iii) safeguarding of such algos, to prevent unauthorized changes and to give compliance staff advance notice of substantive changes or overrides.

Follow-Up Risk Alert on Advisory Fees. On November 10, the Division issued a follow-up Risk Alert on the topic of investment advisory fees, which was the subject of a recently-concluded national examination initiative that focused on retail client fees [6]. The follow-up Risk Alert provides detail on fee-related compliance issues examiners observed in examinations they conducted as part of this initiative.

As part of the initiative, examiners typically reviewed (i) the accuracy of fees charged, (ii) the accuracy and adequacy of fee-related disclosures, (iii) the effectiveness of investment advisers’ compliance programs (e.g., written policies and procedures) with respect to fees, and (iv) the accuracy of fee-related books and records. They found many advisers calculated and charged inaccurate fees due to a range of errors, including using fee rates that differed from contractually agreed-upon rates, errors in fee rates manually entered into billing systems, breakpoint- and house holding-related calculation failures, and use of incorrect account valuations. Examiners also found failures to make pro rata refunds of pre-paid fees after termination.

Examiners found fee-related disclosure failures, and that many investment advisers did not have adequate (or any) written policies and procedures relating to calculation, billing and oversight (e.g., compliance testing) of fees. The Risk Alert closed by identifying observed fee-related practices that may help firms meet compliance obligations, including (i) adopting and implementing written policies and procedures addressing fee billing processes and validating fee calculations (as consistent with contracts and disclosures), (ii) centralizing the fee billing process, and (iii) properly recording advisory fees charged and received.

Given the centrality of fees to advisory relationships and the compliance failures highlighted in this latest fee-related Risk Alert, it is likely that SEC examiners will continue to prioritize advisory fee practices in 2022.

SEC Rulemaking

SEC rulemaking under Chair Gensler has begun in earnest, with the SEC recently finalizing rules requiring universal proxies for contested director elections and rules implementing the China-focused Holding Foreign Companies Accountable Act (HFCAA).

The SEC also recently issued rule proposals on proxy voting, Rule 10b5-1 plans, securities lending, security-based swaps, electronic recordkeeping, share repurchases, and money market funds.

Finalized Rules – Universal Proxy Requirement. On November 17, the SEC adopted amendments to the 1934 Act’s proxy rules that require parties that solicit shareholder proxies for contested public company director elections to use universal proxy cards – i.e., proxy cards that include all director nominees, not just those supported by management or a dissident [7].

The changes, which take effect for shareholder meetings after August 2022, will enable shareholders to split votes among candidates from competing management and dissident slates, just as they would be able to do if they attended a shareholder meeting in person.

The universal proxy requirement, which the current SEC views positively as facilitating shareholder democracy, does not apply to elections of investment company and BDC directors.

Finalized Rules – HFCAA. On December 2, the SEC finalized rules implementing the recently enacted Holding Foreign Companies Accountable Act (HFCAA), which seeks to pressure China to permit the PCAOB to fully inspect and investigate China-based accounting firms that are registered with the PCAOB and audit financial statements of Chinese companies with U.S.-traded securities [8].

To simplify, if after about 3 years China has not permitted this, then securities of covered issuers (i.e., Chinese companies required to file 1934 Act Section 13 or 15 reports) audited by these firms will no longer be permitted to trade in U.S. markets. The finalized rules establish the SEC’s process for identifying these issuers and impose special disclosure and other requirements on them.

Proposed Rules – Proxy Voting Advice. On November 17, the SEC proposed deleting certain proxy rule provisions the SEC had just adopted in 2020, citing “strong” concerns from many market participants and recent improvements to the practices of proxy voting advice businesses (“PVABs”) [9]. The provisions the SEC proposes to delete would require a PVAB to adopt and disclose policies and procedures designed to ensure (i) its voting advice is made available to the companies that are the subject of the advice no later than when the advice is given to the PVAB’s clients, and (ii) it provides a mechanism through which its clients would become aware of a company statement regarding the advice before the relevant shareholder meeting [10].

Proponents of the provisions, including public company advocates, viewed them as likely to help ensure that PVAB clients, many of which are investment advisers, receive more accurate and complete information on which to base their proxy voting decisions. But PVABs, investment advisers and others objected to these provisions’ requirements as unjustified company-favoring intrusions into the advisory process that would make timely independent proxy voting advice less likely and also more costly.

Proposed Rules – Fund and Manager Reporting of Proxy Votes. On September 29, the SEC proposed (i) amendments to Form N-PX to increase, and provide for more usable presentation of, the information mutual funds, ETFs and certain other investment companies annually report about their proxy votes, and (ii) rule and form amendments that would require institutional investment managers required to file Form 13F to also report, on Form N-PX, how they vote on certain executive compensation matters [11,12].

The proposed amendments would require reporting of any securities on loan a fund or manager was able to, but did not, recall in order to vote on a matter. They also would require each reported vote to be assigned to one of 89 subcategories of 17 different vote categories, including the following ESG-related categories: environment or climate, DEI, human rights or human capital/workforce, and “other social”.

The ICI and the IAA objected to the proposed treatment of securities lending (preferring instead narrative disclosure of policies for recalling loaned securities) and urged the SEC to simplify the proposed changes and more carefully consider their costs. They also asked the SEC to give funds and managers ample time to make the significant operational adjustments that will be needed to comply with new requirements in this area.

Proposed Rules – 10b5-1 Plans and Executive Compensation. On December 15, the SEC proposed to amend Rule 10b5-1 under the 1934 Act to limit the availability of Rule 10b5-1 plans that public companies and their officers and directors may use to trade company securities without subjecting themselves to Section 10(b) and Rule 10b-5 insider trading exposure [13]. The SEC is concerned that Rule 10b5-1, which was adopted in 2000 and provides an affirmative defense for trades made pursuant to pre-set plans, gives companies and their insiders too much latitude to trade while in possession of material non-public information (“MNPI”).

The proposed amendments would add conditions to the affirmative defense’s availability, including a 120-day post-plan-adoption/modification cooling off period during which an insider could not make a trade pursuant to the plan, and limit the defense’s availability for single-trade plans to one such plan every 12 months [14]. Also, the defense would be available to a company or insider for only one plan at a time [15].

The SEC also proposed new public company disclosure requirements for Rule 10b5-1 plans, and for stock option grants to directors and named executive officers made within 14 days of the company’s release of MNPI [16]. Stock option grants in these circumstances may involve “spring-loading” or “bullet-dodging”, MNPI-linked compensation practices designed to enrich and financially protect insiders [17]. The SEC wants greater disclosure in these areas, to help it enforce compliance with laws prohibiting trading based on MNPI and to enable investors to better understand and monitor insider trading and executive compensation practices.

Proposed Rules – Securities Lending. On November 18, the SEC proposed new Rule 10c-1 under the 1934 Act to provide for lender (and lending agent) reporting of securities lending transaction data to FINRA, which in turn would publicly report certain transaction- and security-specific data, and also certain aggregate data [18]. The proposed rule is intended to fulfill a Dodd-Frank Act mandate to provide for greater transparency in the securities lending market, a nearly $1.5 trillion market in which mutual funds and ETFs are major lenders.

The ICI submitted comments disagreeing with many of the proposed rule’s provisions, asking for an extension of the 30-day comment period, and calling for more dialogue and analysis before a rule is adopted in this area. The Managed Funds Association, which represents hedge fund managers, objected to the proposed security-specific disclosure requirements, believing they would harm fund managers’ ability to successfully implement constructive short-selling strategies, for example by making short squeezes more likely and leading to more scenarios resembling the January 2021 volatility in Games top and other meme stocks.

Proposed Rules – Security-Based Swaps. On December 15, the SEC proposed 3 new rules under the 1934 Act relating to security-based swaps, which themselves are securities: (i) an antifraud and anti-manipulation rule tailored to swaps’ unique structures, payment and delivery processes, and fraud/manipulation opportunities, (ii) a CCO-protection rule, and (iii) a rule requiring reporting of large security-based swap positions (as opposed to swap transactions, which will be publicly reported beginning February 14, 2022) [19].

These proposed rules complement various operational swap rules the SEC recently adopted and are intended to implement parts of the Dodd-Frank Act, goals of which included providing for SEC and CFTC regulation, and greater transparency, of the OTC swaps market.

The CCO protection rule (Rule 15Fh-4(c)) would make it unlawful for any officer, director, supervised person, or employee of a security-based swap dealer (“SBSD”) or major security-based swap participant (“MSBSP”), or any person acting under their direction, to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence such firm’s CCO in the performance of their duties under federal securities laws [20].

Proposed Rules – Electronic Broker-Dealer and Swap Market Records. On November 18, the SEC proposed amendments to 1934 Act Rule 17a-4, the rule establishing the conditions under which a broker-dealer may keep records electronically [21]. The amendments are intended to modernize the rule, which was adopted in 1997, and make it more technology neutral by providing an “audit-trail alternative” under which electronic records must be preserved in a manner that permits recreation of an original record if it is altered, overwritten or erased (this would be an alternative to current rule’s non-erasable WORM requirement).

The amendments would also require broker-dealers to produce electronic records to regulators in a reasonably usable electronic format that allows them to search and sort information contained in the records. Also, as part of the proposal, the SEC proposed similar recordkeeping changes for SBSDs and MSBSPs.

Proposed Rules – Share Repurchase Disclosure Modernization. On December 15, the SEC proposed a new rule and form (Form SR) and other changes that would require public companies, including certain closed-end funds, to provide more timely and detailed disclosure about share repurchases [22]. The SEC noted the public interest in and concerns about share repurchases and also that they amounted to nearly $700 billion in 2020.

Since 2003, public companies have only been required to report aggregate monthly repurchases each quarter, which often results in disclosure being made weeks or even months after the actual repurchase transactions. Under the proposal, companies would be required to disclose repurchases one business day after the day they are executed – i.e., T + 1. Thus, depending on a company’s repurchase activity, it might need to complete and publicly report multiple Form SRs during a quarter – i.e., one for every day it repurchases shares [23].

The SEC believes daily disclosure will reduce current information asymmetries and enable investors to better evaluate the motivations behind repurchase decisions. The proposing release notes concerns that some repurchases have been driven by managerial self-interest, to the detriment of shareholders – e.g., to inflate executive compensation or to bring about more favorable conditions for stock sales by company insiders.

Proposed Rules – Money Market Funds (“MMFs”). On December 15, the SEC proposed yet another set of amendments to the rules that govern MMFs under the 1940 Act – primarily Rule 2a-7 [24]. The amendments seek to address the heightened susceptibility to heavy redemptions of institutional prime and tax-exempt MMFs, which was highlighted in March 2020 when short-term funding markets were negatively affected (until emergency Federal Reserve actions helped restore stability). The amendments would increase MMF reporting, specify how to calculate weighted average maturity and weighted average life, and:

1. increase Rule 2a-7’s daily and weekly minimum liquid asset requirements from 10% and 30% to 25% and 50%, respectively, giving MMFs larger buffers to help manage redemption activity;
2. remove Rule 2a-7 provisions permitting liquidity fees and redemption gates for prime and tax-exempt MMFs, in the belief that the possibility of these can motivate destabilizing redemption activity (i.e., runs on MMFs) in times of market stress; and
3. require an institutional prime or institutional tax-exempt MMF to adopt swing pricing in the event of net redemptions – swing pricing adjusts NAV so a redeeming shareholder’s redemption price reflects an estimate of the market costs associated with the redemption.

Enforcement Wrap-Up

SEC enforcement activity during the last 5 months of 2021 targeted a wide range of conduct, including fee- and valuation-related conduct and alleged failures to maintain adequate MNPI policies and procedures and to keep required records.

Rather than describing all enforcement activity during the last 5 months of 2021, I summarize below only some of what I consider the more interesting matters.

• Private Fund Fees. On December 20, the SEC settled proceedings against an investment adviser for overcharging its private fund management fee as a result of (i) failing to offset portfolio company fees the adviser received against the management fee, as required by fund offering and governing documents, and (ii) incorrectly calculating other fee offsets [25]. The SEC also found the fund offering and governing documents inconsistently described how the management fee would be calculated.
• As a result, the SEC found the investment adviser violated Advisers Act antifraud provisions and rules, as well as the Advisers Act compliance program rule for failing to have appropriate policies and procedures regarding fee calculation and communication of fee information to investors. The SEC imposed a $4.5 million penalty and the adviser paid fund investors approximately $5.5 million.
• Recordkeeping. On December 17, the SEC settled proceedings against a broker-dealer for widespread and longstanding failures to maintain and preserve required records as a result of employee (including supervisor) use of text messaging, WhatsApp, and personal email accounts to communicate about firm business [26]. The failures hindered multiple SEC investigations, and the firm was ordered to pay a $125 million penalty. In a companion proceeding, the CFTC imposed a $75 million penalty on the firm and certain of its affiliates for related conduct that violated CEA recordkeeping and supervision requirements [27].
• MNPI Policies and Procedures. On November 19, the SEC settled proceedings against an investment adviser for violating Advisers Act Section 204A by failing to establish, maintain and enforce written policies and procedures reasonably designed, considering the nature of the adviser’s business, to prevent misuse of MNPI [28].
• The investment adviser’s board, which oversaw and sometimes ratified the adviser’s investment activity, was made up primarily of personnel of its parent company (a global management consulting firm) who routinely possessed (i) MNPI about the parent company’s clients, some of which the adviser invested in, and (ii) MNPI about the adviser’s investments, which had the potential to improperly influence the parent company’s consulting services.
• The SEC found the investment adviser’s written policies and procedures did not address these facts, despite the significant MNPI misuse risks involved. In particular, the SEC found they did not seek to identify MNPI possessed by board members or provide for recusal procedures to guard against MNPI misuse. The SEC imposed a penalty of $18 million.
• Mozambican Bond Offerings. In connection with a colossal emerging markets bribery and corruption scandal, the SEC on October 19 settled proceedings against Credit Suisse and VTB Capital, imposing penalties and requiring disgorgement totaling nearly $100 million on the former and more than $6 million on the latter for misleading investors in Mozambican bond offerings [29].
• The SEC found Credit Suisse created and distributed misleading and false offering materials, maintained deficient internal accounting controls in violation of the FCPA, and repeatedly failed to respond to corruption risks. The SEC found VTB Capital violated negligence-based securities law antifraud provisions as a result of its failures in connection with one of the offerings.

• Valuation Fraud. On September 30, the SEC settled proceedings against former executives (CEO and Chief Portfolio Manager) of an investment adviser for their roles in fraudulently inflating the monthly NAVs and performance of offshore funds the adviser managed, including by (i) improperly treating certain non-binding term sheets and portfolio company fee agreements as fund assets in calculating monthly fund NAVs, and (ii) selectively waiving the adviser’s management and performance fees in order to manipulate reported fund performance [30].
• The SEC found the treatment of the term sheets and fee agreements resulted in the investment adviser and an affiliated general partner overcharging their fees by approximately $10.5 million. The SEC barred the CEO, whom it found primarily responsible for the antifraud violations involved, from the securities industry and required him to pay disgorgement and interest of over $5.1 million, as well as a $292,570 penalty. The SEC barred the Chief Portfolio Manager for at least 3 years and ordered her to pay a $50,000 penalty, finding she had aided and abetted the violations.
• Reg. S-P and Email Account Takeovers; Misleading Breach Notifications to Clients. On August 30, the SEC settled proceedings against affiliated investment advisers and broker-dealers for violating Reg. S-P and, in the case of the advisers, the Advisers Act compliance program rule [31]. The SEC found the firms, which operate largely through independent contractors, failed to adequately protect contractors’ cloud-based email accounts, some of which then were taken over by unauthorized third parties that accessed, or may have accessed, client PII stored in the accounts.
• Specifically, notwithstanding an internal policy to use multi-factor authentication (“MFA”) wherever possible to protect such email accounts, the firms did not use MFA for many accounts, including those that were taken over. The firms compounded this failure by sending misleading breach notifications to certain affected clients, indicating that the unauthorized access to client PII had taken place more recently than was actually the case. The SEC imposed a penalty of $300,000.

Also, on November 18, the SEC announced enforcement results for the 2021 fiscal year ended September 30, 2021 [32]. During the period, the SEC filed 434 new enforcement actions, representing a 7 percent increase over the prior year, and a total of 697 enforcement actions, representing a 3% decrease from the prior year.

Notably, 70 percent of the new enforcement actions involved at least one individual defendant or respondent. The SEC said filed enforcement actions during the period “spanned the entire securities waterfront”, covering areas such as crypto and SPACs (as well as many others), and resulted in nearly $2.4 billion in disgorgement and more than $1.4 billion in penalties. Finally, the SEC noted that its whistleblower program had a record year, with a total of $564 million awarded to 108 whistleblowers.

---

[1] SEC Requests Information and Comment on Broker-Dealer and Investment Adviser Digital Engagement Practices, Related Tools and Methods, and Regulatory Considerations and Potential Approaches; Information and Comments on Investment Adviser Use of Technology (Aug. 27, 2021), www.sec.gov/news/press-release/2021-167.

[2] Investment industry associations and the SEC’s Republican commissioners have expressed concern over time periods the SEC sets for public comment being too short to allow for adequate public review and comment. See, e.g., SIFMA, The SIFMA Asset Management Group, The Risk Management Association, The Managed Funds Association, The ICI, The IAA and The Security Traders Association (Nov. 23, 2021), www.sec.gov/comments/s7-18-21-9402961-262828.pdf; Statement on the Proposed Rules Regarding 10b5-1 Plans (Dec. 15, 2021), www.sec.gov/statement/roisman10b5-1-20211215; Rat Farms and Rule Comments – Statement on Comment Period Lengths (Dec. 10, 2021), www.sec.gov/statement/peirce-rat-farms-and-rule-comments-121021.

[3] Observations from Examinations in the Registered Investment Company Initiatives (Oct. 26, 2021), www.sec.gov/files/exams-registered-investment-company-risk-alert.pdf.

[4] One category consisted of investment advisers to mutual funds that also manage similar-strategy private funds, or that have a portfolio manager managing both a mutual fund and a private fund – each situation likely involves allocation conflicts that compliance policies and procedures need to address. The other 5 categories were: (1) index funds that track custom-built indexes, (2) smaller ETFs and ETFs with little secondary market trading volume, (3) mutual funds with higher allocations to certain securitized investments, (4) mutual funds with aberrational underperformance relative to peers, and (5) mutual funds managed by investment advisers that are relatively new to managing such funds.

[5] Observations from Examinations of Advisers that Provide Electronic Investment Advice (Nov. 9, 2021), www.sec.gov/files/exams-eia-risk-alert.pdf.

[6] Division of Examinations Observations: Investment Advisers’ Fee Calculations (Nov. 10, 2021), www.sec.gov/files/exams-risk-alert-fee-calculations.pdf.

[7] SEC Adopts New Rules for Universal Proxy Cards in Contested Director Elections (Nov. 17, 2021), www.sec.gov/news/press-release/2021-235.

[8] SEC Adopts Amendments to Finalize Rules Relating to the Holding Foreign Companies Accountable Act (Dec. 2, 2021), www.sec.gov/news/press-release/2021-250.

[9] SEC Proposes Rule Amendments to Proxy Rules Governing Proxy Voting Advice (Nov. 17, 2021), www.sec.gov/news/press-release/2021-236.

[10] The proposing release describes this latest SEC proxy voting advice proposal as not a “wholesale reversal” of the 2020 rule changes. In this regard, the SEC is not seeking to undo (i) its 2020 codification, in 1934 Act Rule 14a-1(l), of the view that proxy voting advice is a solicitation subject to the proxy rules’ private right of action for material misstatements or omissions of fact, or (ii) the PVAB conflict-of-interest disclosure requirements it adopted in 2020.

[11] The SEC also proposed that (i) these funds and managers be required file Form N-PX in XML format (i.e., data tagged) to make the reported information easier to use and sort, and (ii) these funds, in addition to filing Form N-PX, be required to disclose proxy voting records on or through their websites. Small business investment companies registered on Form N-5 and UITs are not covered by the proposals. Also, note that under Advisers Act Rule 206(4)-6, which the SEC adopted in 2003, an SEC-registered investment adviser is required to disclose proxy votes it casts for a client to the client on request.

[12] The second proposal is aimed at completing implementation of Section 951 of the Dodd-Frank Act (i.e., Section 14A of the 1934 Act) and was first proposed, with some differences, in 2010. Shareholder votes covered by the proposal are executive compensation-related votes required by paragraphs (a) and (b) of Section 14A.

[13] SEC Proposes Amendments Regarding Rule 10b5-1 Insider Trading Plans and Related Disclosures (Dec. 15, 2021), www.sec.gov/news/press-release/2021-256.

[14] Under the proposed amendments, such a cooling off period, which would be 30 days for an issuer trading plan (120 days for a director or officer trading plan), would start when the plan was adopted and would restart any time the plan was modified.

[15] An additional proposed new condition is that, at the time of adopting or modifying a Rule 10b5-1 trading plan, a director or officer would need to submit to the company (and retain a copy for 10 years) a written certification that they were unaware of any company-related MNPI and were adopting the plan in good faith and not as part of a plan or scheme to evade prohibitions relating to trading on based on MNPI. Also, the proposed amendments would require such a plan to be “operated” in good faith, which the proposing release says would prohibit an insider from (i) cancelling or modifying a plan to evade the rule’s prohibitions, or (ii) exerting influence to affect the timing of a company disclosure to make a plan trade more profitable or to avoid or reduce a loss associated with a plan trade.

[16] The proposed amendments would require public company disclosure, on Forms 10-Q and 10-K, of securities trading plans the company or any of its officers or directors had adopted or terminated. Also, Form 10-K and proxy statement disclosure of company insider trading policies and procedures would be required, and securities trades made pursuant to 10b5-1 or other plans would need to be identified as such on Forms 4 and 5 (for officer and director trades) and Forms 10-K, 10-Q and 20-F (for issuer trades). Finally, all insider gifts of company securities would need to be reported on Form 4.

[17] Spring-loading occurs when a company grants stock options to an insider right before the company discloses MNPI that causes the price of the company’s stock to increase and thereby increases the value of the options. Bullet-dodging, in contrast, occurs when a company grants stock options to an insider soon after the company has disclosed MNPI that caused the price of the company’s stock to decline and thereby gives the insider a lower option exercise price (exercise prices are usually the market value of the stock on the date of the option grant). The SEC recently released guidance for companies on how to properly recognize and disclose compensation cost for spring-loaded compensation awards made to executives. SEC Staff Issues Accounting Guidance on “Spring-Loaded” Compensation Awards to Executives (Nov. 29, 2021), www.sec.gov/news/press-release/2021-246.

[18] SEC Proposes Rule to Provide Transparency in the Securities Lending Market (Nov. 18, 2021), www.sec.gov/news/press-release/2021-239.

[19] The proposed antifraud/anti-manipulation rule, Rule 9j-1(a), would prohibit both scienter-based and non-scienter-based misconduct. In addition, unlike other antifraud prohibitions, Rule 9j-1(a) would prohibit attempted misconduct. Antifraud provisions of the 1934 Act (and Rule 10b-5) and 1933 Act would also apply to security-based swap transactions, but unlike Rule 9j-1(a) they might not reach swap-related conduct not directly connected to entry into a transaction, such as conduct related to performance of swap obligations.

[20] As of January 3, 2022, 41 firms were registered with the SEC as SBSDs and no firms were registered as MSBSPs. keep records electronically.

[21] SEC Proposes Updates to Electronic Recordkeeping Requirements (Nov. 18, 2021), www.sec.gov/news/press-release/2021-240.

[22] SEC Proposes New Share Repurchase Disclosure Rules (Dec. 15, 2021), www.sec.gov/news/press-release/2021-257. Share repurchases for this purpose are purchases of an issuer’s equity securities registered under Section 12 of the 1934 by or on behalf of the issuer or any affiliated purchaser, as defined in Rule 10b-18(a)(3) under the 1934 Act.

[23] Under the proposal, companies also would be required to make the following quarterly or annual narrative disclosures that are not currently required: (i) repurchase objectives or rationales, (ii) processes or criteria used to determine repurchase amounts, and (iii) any company policies and procedures for officer and director stock purchases during a repurchase program. Also, companies would be deemed to have “furnished” rather than “filed” Form SR (on EDGAR), which means Form SR disclosures would not be subject to liability under 1934 Act Section 18 or 1933 Act Section 11 – the SEC believes this is appropriate in light of the compressed T+1 reporting time frame under the proposal.

[24] The SEC most recently amended Rule 2a-7 in 2010 and 2014, in the aftermath of the Great Recession (during which one MMF “broke the buck” and others received financial support from sponsors to prevent this), tightening the requirements for MMFs and adding (i) the liquidity fee and redemption gate provisions now proposed to be removed, and the (ii) daily and weekly liquid asset minimums now proposed to be increased.

[25] Global Infrastructure Management, LLC (Dec. 20, 2021), www.sec.gov/litigation/admin/2021/ia-5930.pdf. Private fund fee calculation and disclosure (and fee billing practices in general) has also featured in recent SEC Risk Alerts for investment advisers. See Observations from Examinations of Private Fund Advisers (Jan. 27, 2022), www.sec.gov/files/private-fund-risk-alert-pt-2.pdf; Division of Examinations Observations: Investment Advisers’ Fee Calculations (Nov. 10, 2021), www.sec.gov/files/exams-risk-alert-fee-calculations.pdf; Observations from Examinations of Investment Advisers Managing Private Funds (Jun. 23, 2020), www.sec.gov/files/Private%20Fund%20Risk%20Alert_0.pdf.

[26] J.P. Morgan Securities LLC (Dec. 17, 2021), www.sec.gov/litigation/admini/2021/34-93807.pdf. J.P. Morgan admitted to violating (i) 1934 Act recordkeeping requirements (under which all communications received and sent relating to a broker-dealer’s business are required records), and (ii) the 1934 Act Section 15(b)(4)(E) requirement to supervise employees with a view to preventing or detecting certain violations. Also, in an accompanying press release, the SEC said it had begun additional investigations of record preservation practices at other financial firms as a result of this matter. In a companion proceeding, the CFTC imposed a $75 million penalty on the firm and certain of its affiliates for related conduct that violated CEA recordkeeping and supervision requirements. JPMorgan Admits to Widespread Recordkeeping Failures and Agrees to Pay $125 Million Penalty to Resolve SEC Charges (Dec. 17, 2021), www.sec.gov/news/press-release/2021-262.

[27] CFTC Orders JPMorgan to Pay $75 Million for Widespread Use by Employees of Unapproved Communication Methods and Related Recordkeeping and Supervision Failures (Dec. 17, 2021), www.cftc.gov/PressRoom/PressReleases/8470-21.

[28] MIO Partners, Inc. (Nov. 19,2021), www.sec.gov/litigation/admin/2021/ia-5912.pdf. In addition to finding a violation of Advisers Act Section 204A, which relates specifically to MNPI policies and procedures, the SEC found the investment adviser violated Advisers Act Section 206(4) and Rule 206(4)-7, the Compliance Program Rule. In a separate matter, a now former partner of the adviser’s parent company recently pled guilty to illegal insider trading based on MNPI he obtained from a consulting engagement. See Former Management Consulting Firm Partner Pleads Guilty To Insider Trading (Dec. 15, 2021), www.justice.gov/usao-sdny/pr/former-management-consulting-firm-partner-pleads-guilty-insider-trading.

[29] Credit Suisse Group AG (Oct. 19, 2021), www.sec.gov/litigation/admin/2021/33-11001.pdf; VTB Capital plc (Oct. 19, 2021), www.sec.gov/litigation/admin/2021/33-11000.pdf.

[30] Robert D. Press (Sept. 30, 2021), www.sec.gov/litigation/admin/2021/33-10991.pdf; Donna D. Silverman (Sept. 30, 2021), www.sec.gov/litigation/admin/2021/33-10990.pdf.

[31] Cetera Advisor Networks LLC, Cetera Investment Services LLC, Cetera Financial Specialists LLC, Cetera Advisors LLC, and Cetera Investment Advisers LLC (Aug. 30, 2021), www.sec.gov/litigation/admin/2021/34-92800.pdf.

[32] SEC Announces Enforcement Results for FY 2021 (Nov. 18, 2021), www.sec.gov/news/press-release/2021-238.

© MPS Legal 2022.

NOTE: This report is dated January 31, 2022 (FS Spotlight #5), is for informational purposes only, and is or may be attorney advertising. It is not intended as legal advice and should not be relied on as such. The author believes statements of fact are correct as of the report date, but this is not guaranteed and the author has no obligation to update or correct any statement. To save space and enhance readability, the report uses, or may use, the following abbreviations: “1933 Act” is the Securities Act of 1933, as amended; “1934 Act” is the Securities Exchange Act of 1934, as amended; “1940 Act” is the Investment Company Act of 1940, as amended; “Advisers Act” is the Investment Advisers Act of 1940, as amended; “BDC” is business development company; “BSA” is the Bank Secrecy Act, as amended; “CCO” is Chief Compliance Officer; “CEA” is the Commodity Exchange Act of 1954, as amended; “CEO” is Chief Executive Officer; “CFO” is Chief Financial Officer; “CFTC” is the Commodity Futures Trading Commission; “CME” is the Chicago Mercantile Exchange; “ERISA” is the Employee Retirement Income Security Act of 1974, as amended; “ETF” is exchange-traded fund; “FCPA” is the Foreign Corrupt Practices Act of 1977, as amended; “FINRA” is the Financial Industry Regulatory Authority; “IAA” is the Investment Adviser Association; “ICI” is the Investment Company Institute; “NFA” is the National Futures Association; “OCC” is the Office of the Comptroller of the Currency; “OFAC” is the Office of Foreign Assets Control; “PCAOB” is the Public Company Accounting Oversight Board; “Reg. 9” is OCC Regulation 9; “SEC” is the Securities and Exchange Commission; and “SPAC” is special purpose acquisition company.