March 2021 Investment Adviser Regulatory Developments
Below are summaries of March 2021 regulatory developments, including enforcement activity, that may be of interest to SEC-registered investment advisers and other securities market participants.
ESG at the SEC
The SEC’s ESG focus has implications for enforcement, examinations, and public company disclosures. SEC Commissioners Peirce and Roisman and Senator Toomey express concerns.
ESG Website Page. Reflecting the SEC’s enhanced focus on ESG, the SEC on March 22 launched a new website page showcasing its “all-agency” approach to climate and other ESG issues, and serving as a central location for information on related SEC actions (www.sec.gov/sec–response–climate–and–esgrisks–and–opportunities).
ESG Enforcement & Examinations. On March 4, the SEC announced a new 22-member Division of Enforcement Climate and ESG Task Force that will develop initiatives to proactively identify ESG-related misconduct.1 The Task Force will focus on climate risk disclosures by public companies, and on disclosure and compliance issues related to investment advisers’ and funds’ ESG investment strategies.
ESG also featured in the SEC’s 2021 Examination Priorities (see pages 2 & 3 below), which noted the following ESG-related focus areas: (i) BCPs and DR plans, in light of the increased frequency and intensity of climate-related events, and (ii) disclosures about ESG-related investment products and strategies, which had large inflows in 2020.
Regarding disclosures, the SEC wants investment advisers that provide ESG investment products and strategies to be clear and honest with investors about how they are incorporating ESG factors into their investment processes. The SEC is likely on the lookout for any firms that are adopting ESG-related labels and/or making ESG-related claims, and then not following through in terms of their security selection and proxy voting processes – a misleading practice known as “greenwashing”.
Climate Change Disclosure. The ESG issue receiving the most publicity is public company disclosure of climate change risk. A key question is whether current, largely principles-based disclosure requirements, outlined in a 2010 SEC interpretive release, are adequate or whether more specific requirements are needed to ensure disclosure of reliable, comparable and consistent climate change risk information.2
On March 15, Acting SEC Chair Lee issued a request for public comments on potential regulatory approaches to public company climate disclosures.3 Investment advisers, particularly those engaged in ESG investing, may wish to submit comments before the comment period closes in mid-June.
Concerns. On March 4, SEC Commissioners Peirce and Roisman issued a statement questioning the appropriateness of the new Climate and ESG Enforcement Task Force and emphasizing the need for the SEC to enforce securities laws as they currently exist.4 On March 24, U.S. Senate Banking Committee
Ranking Member Pat Toomey (R-PA) sent a letter to Acting SEC Chair Lee expressing similar concerns.5
ESG at the DOL
The DOL adopted a no-enforcement position for two recently adopted rules that could have increased ERISA fiduciary reluctance to consider ESG factors in making investment and proxy voting decisions.
No-Enforcement Position. On March 10, the DOL said it would not enforce two rules it adopted in the last months of the Trump Administration.6 These rules could have increased the reluctance of investment advisers to consider ESG factors when making investment and proxy voting decisions for ERISA plan assets. The DOL said it intends to conduct more stakeholder outreach and craft revised rules that better recognize the role ESG can play in the management of plan assets, consistent with fiduciary obligations.
Duty of Prudence. Investment advisers should be aware that management of, and proxy voting for, ERISA plan assets still must comply with ERISA’s statutory duty of prudence, one requirement of which is that investment and proxy voting decisions be made for the exclusive purpose of providing financial benefits to plan participants and beneficiaries.
2021 SEC Examination Priorities
The 2021 examination priorities include many compliance items prioritized in 2020 and a few new items, such as RegTech and TAMPs.
The SEC Division of Examinations released its 2021 Examination Priorities on March 3, saying it would continue to emphasize protection of retail investors and prioritize examining practices, products and services that present heightened risk.7 The Division emphasized the importance of compliance, firm culture and tone at the top, and noted a potentially increased risk of fraudulent conduct due to recent market volatility and industry pressures.
Investment adviser-related areas the Division of Examinations said it will prioritize include:
- BCPs, DR Plans, and Information Security. Whether BCPs and DR plans, particularly those of systemically important firms, account for climate change risks, and whether information security practices and controls (including in relation to cybersecurity, operations resilience, recordkeeping, and vendor management) are adequate in the current environment.
- Compliance Programs. Sufficiency of resources, implementation risks of using technology to facilitate compliance (aka, RegTech), and whether a firm’s compliance program is appropriately adapted to its current business model.
- ESG. Disclosures about ESG investment products and strategies, including whether they match the firm’s actual processes and practices and are not false or misleading. The Division also will assess proxy votes and voting policies for alignment with ESG strategies.
- Fees. Fee disclosures and errors, including (if applicable based on client agreement terms) failures to (i) aggregate related accounts for breakpoint discount purposes, (ii) exclude certain holdings in calculating fees, and (iii) make refunds of prepaid fees for terminated accounts.
- Fiduciary Duty. Compliance with fiduciary duties of care and loyalty outlined in the SEC’s 2018 Fiduciary Interpretive Release, including with respect to best execution, complex products, conflicts of interest, and undisclosed or inadequately disclosed compensation arrangements.
- Fintech and Digital Assets. Use of technology to provide investment advice and accuracy of related disclosures and, for firms engaged with digital assets, assessment of the following with respect to such assets: (i) whether investments are in client best interests, (ii) valuation and safety, (iii) portfolio management and trading, (iv) compliance program effectiveness, and (v) supervision of outside business activities.
- Private Funds. Liquidity-related conflicts, such as those associated with restructurings, and whether certain investors have received preferential liquidity. The Division will also review valuations and their impact on fees, cross trades, principal investments, and risk disclosures for funds with sizable structured product (e.g., CLO, MBS) holdings.
- TAMPs. Disclosure of fees and revenue sharing related to use of turnkey asset management platforms (TAMPs), which provide technology, research, portfolio management and other outsourcing services. Leading TAMP providers include Envestnet, SEI, AssetMark, and Orion.
Although the Division said the identified priorities will not be its only areas of focus, investment advisers should make sure they are appropriately addressing these items, to the extent applicable.
Cross Trading
Investment company cross trading of municipal bonds and certain other fixed income securities may no longer be allowed starting in September 2022, unless the SEC makes certain amendments to Rule 17a-7 before then.
A few compliance tips are suggested based on past SEC enforcement actions involving cross trading.
Cross Trading and RAMQs. In December 2020, the SEC adopted a new investment company valuation rule (Rule 2a-5) under the 1940 Act.8 This rule, which has a September 8, 2022 compliance date, defines readily available market quotations (RAMQs) as reliable quoted prices in active markets for identical investments that are accessible on the measurement date, consistent with the definition of a level 1 input in U.S. GAAP’s fair value hierarchy.
Municipal bonds and other fixed income securities that are not actively traded generally do not have RAMQs as so defined. As a result, when Rule 2a-5 becomes effective, these securities may no longer be eligible for investment company cross trading under Rule 17a-7, an exemptive rule under the 1940 Act that permits cross trading of securities with RAMQs if certain requirements are satisfied.
In the Rule 2a-5 adopting release, the SEC said the new RAMQs definition will apply for all purposes under the 1940 Act, including Rule 17a-7, despite commenter recommendations to limit the definition to Rule 2a-5 so current investment company cross trading practices would not be affected. The SEC acknowledged these practices may be affected, and said it was reviewing for potential withdrawal prior no-action letters that permit cross trading of municipal bonds under Rule 17a-7.9
A cross trade, which is a trade an investment adviser knowingly effects between two or more of its clients (sometimes referred to as an “internal cross” or a “client cross”), generally benefits clients by avoiding the transaction and market impact costs associated with an open market trade.10 But a cross trade also involves a conflict between the interests of the transacting clients when it comes to setting the trade price and thereby allocating these cost savings, and the investment adviser effecting the trade may have incentives to favor one client over another.11 As a result, the 1940 Act prohibits cross trades for investment companies unless they comply with Rule 17a-7 or an SEC exemptive order.
Rule 17a-7 seeks to neutralize the actual and potential conflicts associated with cross trades. The RAMQs requirement seeks to ensure independent reliable price information is available for the traded securities, and the pricing requirements seek to ensure equitable allocation of the trade’s cost savings to the participating clients. ERISA takes a similar approach for cross trades involving ERISA clients, but is even more restrictive and burdensome than Rule 17a-7. Also, cross trades for all types of clients are subject to an investment adviser’s fiduciary duty under the Advisers Act, which the SEC views as prohibiting the adviser from favoring one client over another, particularly if the practice is not adequately disclosed.
Regarding investment company cross trading, the SEC said in the Rule 2a-5 adopting release that it welcomed public input on potential changes to Rule 17a-7. On March 11, the SEC Division of Investment Management followed up by requesting public comment on ways to enhance the regulatory regime for investment company cross trading, saying feedback on Rule 17a-7’s RAMQs requirement would be particularly helpful.12 The deadline for submitting comments is April 12.
In addition, the Division recently published an FAQ saying it will not object if an investment company complies with Rule 2a-5 before its September 8, 2022 compliance date but does not apply the RAMQs definition to its Rule 17a-7 cross trading practices until September 8, 2022.13 In this limited way, early partial compliance with the new RAMQs definition is permitted.
Cross Trading Compliance Tips. Non-compliant cross trading has been a regular target of SEC enforcement actions, particularly for investment advisers that manage fixed income assets and regardless of whether they manage investment company assets. To protect against violations in this area, investment advisers should address cross trading in their compliance policies and procedures and in compliance training so relevant employees, including traders and portfolio managers, understand what a cross trade is and, if the firm permits such trades, what requirements must be satisfied, including how and by whom.
In particular, it should be made clear that a prearranged trade between clients will be a cross trade even if one or more brokers are used. Using a broker to execute a cross trade is referred to as “interpositioning” and this practice has featured in many SEC enforcement actions involving cross trading violations.14
In addition to appropriately training employees, investment advisers should make adequate disclosures of cross trading practices and also require and perform compliance reviews of firm trading activity and communications with brokers for indications of non-compliant cross trading – for example, a uniform spread over time between sale and purchase prices of securities sold and then bought for clients from a particular broker (this may suggest prearranged, interpositioned cross trades).
In past enforcement actions involving cross trading violations, the SEC has also found investment advisers violated the Advisers Act’s compliance program rule (Rule 206(4)-7) by failing to make adequate efforts to prevent and detect non-compliant cross trading, including by merely accepting trader statements that there had been no such trading and by not conducting appropriate compliance training. The orders for most of these enforcement actions (see Endnote 14 below) contain useful, specific guidance on what the SEC considers adequate compliance practices in this sensitive area.
Enforcement Wrap-Up
SEC enforcement activity in March targeted a range of conduct, including private fund-related misconduct, offering fraud, communications with analysts, stock tweets, and sales of purported insider tips.
During March, the SEC Division of Enforcement targeted an interesting array of securities-related behavior, including by bringing civil charges in federal court in the following matters:
- Investment Adviser Fraud. The SEC charged an individual for operating an investment adviser fraud through private hedge funds he controlled, alleging he misrepresented the funds and their performance, including by using false account statements, and raised at least $90 million from investors, including another investment adviser.15
- Offering Fraud. The SEC brought charges of offering-related fraud relating to investments in (i) a “sham” Colorado-based bottling company billed as environmentally friendly, (ii) a now-bankrupt San Francisco-based medical testing company alleged to have been falsely portrayed as a successful startup, and (iii) limited liability companies that owned apartment complexes.16
- Pump-and-Dump Scheme. The SEC charged seven individuals and a company with a fraudulent scheme to gain control of a public company, promote its stock, and defraud investors.17 The SEC alleged that the scheme raised nearly $45 million.
- Regulation FD. The SEC charged a large public company with repeatedly violating Reg. FD, and three of its Investor Relations executives with aiding and abetting these violations, by selectively disclosing in calls to analysts that its quarterly earnings would not meet estimates.18
- Stock Tweets. The SEC charged an individual with fraud for allegedly making false and misleading statements on Twitter about a defunct company and his trading of its securities, which netted profits of more than $929,000.19
- Insider Stock Tips. The SEC charged an individual for selling false insider stock tips, which he allegedly misrepresented as MNPI, on the dark web in return for approximately $27,000.20 The complaint in this matter includes an interesting description of the dark web.
Administrative proceedings in March included SEC findings of misrepresentations and other disclosure violations in connection with private fund offerings, including failures by an individual recommending investments in a fund to adequately disclose to advisory clients his receipt of finder’s fees from the fund’s portfolio companies and also financial interests he and his family had in certain of these companies.2
[1] SEC Announces Enforcement Task Force Focused on Climate and ESG Issues (Mar. 4, 2021), www.sec.gov/news/pressrelease/2021-42.
[2] Commission Guidance Regarding Disclosure Related to Climate Change, Rel. No. 33-9106 (Feb. 8, 2010), www.sec.gov/rules/interp/2010/33-9106.pdf.Public Input Welcomed on Climate Change Disclosures (Mar. 15, 2021), www.sec.gov/news/public-statement/leeclimate-change-disclosures.
[3] Enhancing Focus on the SEC’s Enhanced Climate Change Efforts (Mar. 4, 2021), www.sec.gov/news/publicstatement/roisman-peirce-sec-focus-climate-change.
[4] Enhancing Focus on the SEC’s Enhanced Climate Change Efforts (Mar. 4, 2021), www.sec.gov/news/publicstatement/roisman-peirce-sec-focus-climate-change.
[5] www.banking.senate.gov/newsroom/minority/toomey-presses-sec-on-new-climate-enforcement-task-force.
[6] US Department of Labor Releases Statement on Enforcement of its Final Rules on ESG Investments, Proxy Voting by Employee Benefit Plans (Mar. 10, 2021), www.dol.gov/newsroom/releases/ebsa/ebsa20210310.
[7] SEC Division of Examinations Announces 2021 Examination Priorities (Mar. 3, 2021), www.sec.gov/news/pressrelease/2021-39.
[8] Good Faith Determinations of Fair Value, Rel. No. IC-34128 (Dec. 3, 2020), www.sec.gov/rules/final/2020/ic-34128.pdf.
[9] The SEC cited the following no-action letters as among those it was reviewing for potential withdrawal: United Municipal Bond Fund (pub. avail. Jan. 27, 1995), Federated Municipal Funds (pub. avail. Nov. 20, 2006). These letters permitted investment companies to cross trade municipal bonds (excluding defaulted bonds and bonds with embedded derivatives) under Rule 17a-7 even though such bonds were acknowledged not to have the required RAMQs. One commentator has suggested this was appropriate in part because municipal bonds often trade generically by rating and thus often are substitutable. See Plaze, R. E., Fund directors: What do you need to know about cross trades?, Fund Board Views (Sept. 23, 2015), www.fundboardviews.com/Content_Free/Viewpoints-RobertPlaze-CrossTrading.aspx. Also, the Federated letter pointed out that, separate from the need to comply with Rule 17a-7 (if applicable), an investment adviser’s decision to cause clients to enter into a cross trade must comply with the adviser’s fiduciary duty to each client, including the duties of best execution and loyalty.
[10] A different type of cross trade is an agency cross trade, which is a trade an investment adviser effects for a client while knowing it or an affiliate is acting as broker for the other party to the trade. An investment adviser that effects agency cross trades must comply with disclosure and other requirements for such trades under Advisers Act Section 206(3) or Rule 206(3)-2.
[11] In SEC enforcement actions involving cross trading violations, investment advisers typically have favored buying clients over selling clients (for example, by pricing sales at bids and purchases at small premiums over bids) in violation of (i) the investment adviser’s fiduciary duties to clients under Advisers Act Section 206, and (ii) where an investment company was involved, Rule 17a-7’s cross trade pricing requirements.
[12] Staff Statement on Investment Company Cross Trading (Mar. 11, 2021), www.sec.gov/news/publicstatement/investment-management-statement-investment-company-cross-trading-031121.
[13] Valuation Frequently Asked Questions (Updated Mar. 18, 2021), www.sec.gov/investment/valuation-faq.
[14] See, e.g., Western Asset Management Co., Rel. No. IA-3762 (Jan. 27, 2014), Hamlin Capital Management, LLC, Rel. No. IA-4983 (Aug. 10, 2018) (non-compliant cross trading for SMA clients, and also a cross trade with a private fund that was a non-compliant principal trade under Advisers Act Section 206(3) because firm personnel owned more than 25% of the fund), Cushing Asset Management, LP, Rel. No. IC-33226 (Sept. 14, 2018) (sale and purchase of MLP units in an amount greatly exceeding historical daily trading volume found to be a non-compliant cross trade even though different brokers were used for the sale and purchase), Putnam Investment Management, LLC et al., Rel. No. IA-5050 (Sept. 27, 2018), Palmer Square Capital Management LLC, Rel. No. IA-5586 (Sept. 21, 2020). Non-compliant interpositioned cross trading has typically involved payment of compensation to the brokers involved, which violates Rule 17a-7’s prohibition of such compensation (other than “customary transfer fees”) in connection with cross trading.
[15] SEC v. George Heckler (Dist. NJ, Mar. 9, 2021).
[16] SEC v. Chatfield PCS Ltd. et al. (Dist. Colo., Mar. 3, 2021), SEC V. Jessica Richman and Zachary Apte (ND Cal., Mar. 18, 2021), SEC v. Seth P. Levine (Dist. NJ, Mar. 18, 2021).
[17] SEC v. Airborne Wireless Network et al. (SDNY, Mar. 2, 2021).
[18] SEC v. AT&T, Inc. et al. (SDNY, Mar. 5, 2021).
[19] SEC v. Andrew L. Fassari (CD Cal., Mar. 2, 2021).
[20] SEC v. James Roland Jones (SD Ind., Mar. 18, 2021).
[21] Ettro Capital Management Corp. et al., Rel. No. IA-5697 (Mar. 15, 2021), Scott T. Wolfrum, Rel. No. IA-5706 (Mar. 24, 2021), Tyler C. Sadek, Rel. No. IA-5707 (Mar. 24, 2021), Troy E. Marchand, Rel. No. IA-5705 (Mar. 24, 2021).
© MPS Legal, 2021.
NOTE: This report is dated April 7, 2021 (FS Spotlight Issue #2) and is for general informational purposes only and is, or may be, attorney advertising. It is not intended as legal advice and should not be relied upon as such. The author believes statements of fact in the report 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 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; “BCP” is business continuity plan; “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; “CIO” is Chief Investment Officer; “DOL” is
Department of Labor; “DR Plan” is disaster recovery plan; “ERISA” is the Employee Retirement Income Security
Act of 1974, as amended; “ESG” is environmental, social and governance; “ETF” is exchange-traded fund;
“FCPA” is the Foreign Corrupt Practices Act of 1977, as amended; “FDIC” is the Federal Deposit Insurance Corporation; “FinCEN” is the Financial Crimes Enforcement Network; “FINRA” is the Financial Industry
Regulatory Authority; “MSRB” is the Municipal Securities Rulemaking Board; “NFA” is the National Futures Association; “OCC” is the Office of the Comptroller of the Currency; “OFAC” is the Office of Foreign Assets Control; “Reg. 9” is OCC Regulation 9; and “SEC” is the Securities Exchange Commission.