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Table of Contents:
SEC Adopts Amendments to Enhance Private Fund Reporting
SEC Charges Investment Adviser and Fund Trustees with Liquidity Rule Violations
SEC Charges PIMCO for Disclosure and Policies and Procedures Failures
SEC Adopts New Security-based Swap Rules to Prevent Fraud & Manipulation Promote CCO Independence
SEC ADOPTS AMENDMENTS TO ENHANCE PRIVATE FUND REPORTING
On May 3, the Commissioners of the Securities Exchange Commission (the “SEC” or the “Commission”) voted to adopt final amendments (the “Amendments”) to Form PF and Rule 204(b)-1 the under the Investment Advisers Act of 1940 (“Advisers Act”). Form PF is the confidential reporting form used by certain advisers to private funds to report information to the SEC and the Financial Stability Oversight Counsel (“FSOC”) about private funds.
By way of background, the SEC adopted Form PF in 2011 after the enactment of the Dodd-Frank Wall Street Reform and Accountability Act of 2012 (the "Dodd-Frank Act"), which directed the SEC to collect information about private funds for use by the FSOC to help in its assessment of systemic risk in the financial system. Generally, Rule 204(b)-1 requires advisers to hedge funds, private equity funds, and liquidity funds to file Form PF on a quarterly or annual basis, depending on the size and type of private funds they advise. As explained in the Adopting Release, the Amendments are designed to improve the FSOC's ability to monitor systemic risk, bolster the SEC's regulatory oversight of private fund advisers, and gather information for regulatory purposes, including enforcement, examinations, and rulemaking.
Prior to the Amendments, Form PF comprised five (5) Sections. Most advisers are required to report in Section 1 more generalized information, such as the types of private funds advised (e.g., hedge funds, private equity funds, or liquidity funds), fund size, use of borrowings and derivatives, strategy, and types of investors. Three types of “Large Private Fund Advisers” are required to complete certain additional sections of Form PF, with large hedge fund, liquidity fund, and private equity fund advisers subject to more comprehensive reporting on their dedicated Sections 2, 3, and 4, respectively.
Following the Amendments, Form PF will have seven (7) Sections, creating two new separate Sections of Form PF, Section 5 and Section 6. Former Section 5, the request for temporary hardship exemption, will become new Section 7. A “current report” under the new Section 5 and a “private equity event report” under the new Section 6 will each be filed as a stand-alone document through the same system used to file the rest of Form PF, the Private Fund Reporting Depository (“PFRD”). The Amendments also add and alter questions to existing Form PF Section 4. As applicable, the quarterly and annual reporting timeline has been maintained for existing Sections 1 through 4, with the new Sections 5 and 6 requiring an accelerated timeline of some advisers.
As a result, the Amendments to Form PF will affect only the following categories of advisers:
With respect to the last category, and in a change from its January 2022 Form PF Proposing Release, the Commission has not adopted a lower $1.5 billion in private equity fund assets under management reporting threshold for Large Private Equity Fund Advisers. The existing threshold of $2 billion in private equity fund assets under management will remain.
As under current rules, Exempt Reporting Advisers will not be required to file Form PF as a result of the Amendments.
Section 5 Current Event Reporting For Large Hedge Fund Advisers
The Amendments to Form PF will require Large Hedge Fund Advisers to file a current report on Section 5 to Form PF as soon as practicable but no later than 72 hours from the occurrence of one or more triggering “current reporting events” by a qualifying hedge fund. A “qualifying hedge fund” is a hedge fund, individually or in combination with any feeder funds, parallel funds, and/or dependent managed account, having a net asset value of at least $500 million.
The 72-hour period is a departure from the timeline SEC's January 2022 Form PF Proposing Release which would have required a private fund adviser to file reports as to certain events within one business day of the occurrence of any of such events, which would be the close of the business day following the day the event occurred.
Current reporting events include the following:
In a departure from the proposed amendments, the SEC did not adopt a requirement that an adviser report as a current reporting event a significant decline in holdings of unencumbered cash.
Section 6 Private Equity Event Reporting For All Private Equity Fund Advisers
The Amendments to Form PF will require all Private Equity Fund Advisers to file an event report on Section 6 to Form PF within 60 days of each fiscal quarter end upon the occurrence of one or more of two (2) private equity reporting events.
Private equity reporting events include:
Revised Section 4 Reporting Requirements for Large Private Equity Fund Advisers
The Amendments to Form PF include a number of changes to the existing Section 4 of Form PF that requires Large Private Equity Fund Advisers to identify information about their private equity funds.
New questions have been added to Section 4. Question 66 now asks advisers to select from a list of common investment strategies and report the percent of deployed capital for each, even if the categories don't perfectly match the fund's specific strategies. Question 68 requires additional information on any fund-level borrowing, including details on each borrowing or cash financing available to the fund, the total dollar amount available, and the average amount borrowed during the reporting period. Question 82 now requires reporting on general partner and certain limited partner clawbacks.
Amendments have also been made to existing questions. Question 74 now requires more detailed information on reported events of default, specifying whether it's a payment default of the private equity fund, a controlled portfolio company, or a default related to a failure to uphold terms of the borrowing agreement. Question 75 now requires reporting on the institutions providing bridge financing to the adviser's controlled portfolio companies and the amount of financing provided. Lastly, Question 78 now requires reporting on the geographical breakdown of investments by private equity funds, listing all countries by ISO country code to which a reporting fund has exposure of 10% or more of its net asset value.
There are two effective and compliance dates for different Sections of Form PF. The Amendments to Section 4 take effect June 11, 2024. The Amendments for current and private equity event reporting in Sections 5 and 6 take effect December 11, 2023.
On August 10, 2022, the SEC and the Commodity Futures Trading Commission jointly released an August Proposal relating to technical changes to Form PF, which is still under consideration by the Commission.
SEC CHARGES INVESTMENT ADVISER AND FUND TRUSTEES WITH LIQUIDITY RULE VIOLATIONS
On May 5, the SEC announced charges against Pinnacle Advisors LLC (“Pinnacle Advisors”) for aiding and abetting violations of Rule 22e-4 (the “Liquidity Rule”) under the Investment Company Act of 1940 (the “Investment Company Act”) by a mutual fund it advised and whose liquidity risk management program it administered. Two of the fund’s independent trustees and two officers of both Pinnacle Advisors and the fund were also charged with aiding and abetting Liquidity Rule violations. A third trustee agreed to settle charges that he caused and willfully counseled the fund’s violations.
Under the Liquidity Rule, mutual funds are required to classify each of its investments into one of four categories: “highly liquid,” “moderately liquid,” “less liquid,” and “illiquid.” The Liquidity Rule prohibits mutual funds from investing more than 15% of their net assets in “illiquid” investments. If a fund holds more than 15% of its net assets in illiquid investments, the Liquidity Rule requires the fund to take remedial steps, including requiring the administrator of the fund’s liquidity risk management program (the “Program Administrator”) to report such occurrence to the fund’s board within one business day, with an explanation of the extent and causes of the occurrence and how the fund plans to bring its illiquid investments back into compliance with the 15% limit. If the amount of the fund’s illiquid investments is still in excess of 15% of its net assets thirty (30) days from the occurrence, the fund’s board of directors must assess whether the plan provided to the board in connection with the Program Administrator’s initial notification to the board continues to be in the best interest of the fund.
According to the SEC’s complaint, from June 2019 to June 2020, the fund in question held approximately 21-26% of its net assets in in illiquid investments. The SEC alleges that Pinnacle Advisors and two of its officers classified the fund’s largest illiquid investment as “less liquid” despite there being restrictions, transfer limitations, and no market for the shares representing that investment, and disregarding the advice of fund counsel who resigned over the issue and the fund’s auditors. Additionally, the SEC’s complaint also alleges that Pinnacle Advisors and its officers did not present the fund’s board with a plan to reduce the fund’s illiquid investments below the 15% maximum, or make other filings with the SEC required by the Liquidity Rule. Further, the SEC’s complaint alleges that Pinnacle and the same two officers made false and misleading statements to SEC staff, and aided and abetted the fund’s violations by failing to have the fund submit required reports to the board of trustees and the Commission in a timely manner.
With respect to the fund’s board of trustees, the SEC’s complaint alleges that two of the independent trustees also aided and abetted the fund’s Liquidity Rule violations because they were aware of the facts that rendered the shares illiquid based on their roles as members of the fund’s valuation and audit committees and the advice of the fund’s counsel and auditors, but allowed the fund to improperly classify the shares as “less illiquid” instead of “illiquid.”
This is the first enforcement action involving the Liquidity Rule. Without admitting or denying the findings, one of the trustees consented to an order requiring him to cease and desist from violations of the Liquidity Rule, pay a civil penalty of $20,000, and suspending him from association with any investment adviser or registered investment company, among others, for a six-month period.
SEC CHARGES PIMCO FOR DISCLOSURE AND POLICIES AND PROCEDURES FAILURES
On June 16, the SEC announced that Pacific Investment Management Company LLC (“PIMCO”) will pay $9 million to settle two enforcement actions relating to disclosure and policies and procedures violations involving two funds PIMCO advises.
Rule 206(4)-7 under the Advisers Act requires investment advisers to adopt and implement written policies and procedures that are reasonably designed to prevent violations by the investment adviser and its supervised persons of the Advisers Act and the rules thereunder. Section 34(b) of the Investment Company Act makes it unlawful for any person to make an untrue statement of a material fact, in any registration statement or other document filed or transmitted under the Investment Company Act, or for a person filing or transmitting such documents to omit to state a fact necessary to prevent the statements made therein, in light of the circumstances, from being materially misleading. Rule 206(4)-8 states that it shall constitute a fraudulent, deceptive, or manipulative act, or course of business by an investment adviser to (i) make any untrue statement of a material fact or omit a material fact necessary to make the statements, in light of the circumstances, not misleading, to an investor or prospective investor in the pooled investment vehicle, or (ii) engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to an investor or prospective investor in the pooled investment vehicle.
In the SEC’s first order (“Order 1”), the SEC found that between April 2011 and November 2017, PIMCO failed to accurately waive certain advisory fees consistent with an agreement between PIMCO and a mutual fund for which it serves as the investment adviser. The fund in question is a “fund of funds” and primarily invests in other funds managed by PIMCO (“PIMCO-managed funds”). PIMCO receives an advisory fee from the fund and the other PIMCO-managed funds. According to Order 1, PIMCO entered into a fee waiver agreement providing that PIMCO reduce its advisory fee on the fund to the extent PIMCO receives a certain amount of advisory, supervisory, and administrative fees from other PIMCO-managed funds in which the fund invests. Order 1 states that while PIMCO waived a portion of the agreed upon fee waiver, over the period in question, PIMCO failed to waive approximately $27 million of the fund’s advisory fees due to an error in a formula PIMCO created and provided to its sub-administrator to calculate the fee waiver amount. The miscalculation was discovered by the sub-administrator, who notified PIMCO of the of the error in 2017. In response to the error, PIMCO implemented a remediation plan to reimburse the effected fund over $30 million in unwaived fees, lost performance, and interest and took other steps to enhance its policies and procedures.
Order 1 found that as a result of the conduct described above, until at least 2018, PIMCO did not have reasonably designed policies and procedures to prevent violations of the Investment Advisers Act in relation to its oversight of advisory fee calculations and fee waivers in violation of Section 206(4) of the Advisors Act and Rule 206(4)-7 thereunder.
The SEC’s second order (“Order 2”) related to material omissions regarding PIMCO’s use of paired interest rate swaps for a closed-end fund advised by PIMCO. Order 2 found that from September 2014 to August 2016, PIMCO inadequately disclosed that paired interest rate swaps in a closed-end fund advised by PIMCO had become a material source of distributable income, enabling PIMCO to maintain the fund’s dividend rate. Order 2 also includes that the continued use of paired swaps also contributed to a decline on the net asset value of the fund, and that PIMCO failed to adequately disclose that a significant portion of the fund’s distributions came from paired interest rate swaps.
As described in Order 2, according to PIMCO, a paired swap involves two or more interest rate swaps that have certain offsetting characteristics. Typically, PIMCO entered into an agreement to make floating rate payments and receive fixed income payments for a certain number of years (the “initial leg”), and then agreed that the fund would make fixed rate payments and receive floating rate payments for a certain number of years (the “floating leg”). According to Order 2, the fixed interest payments the fund received on the initial leg were usually greater than the floating rate payments the fund owed, causing the fund to typically receive net interest rate payments, which could be used as a source for investor distributions. In most cases, PIMCO would close out the forward leg of the paired swap before the fund began making the fixed rate payment to the counterparty. In connection with closing out the forward leg, PIMCO typically would make a closeout payment for the fund, resulting in a capital loss to the fund. As a result, when the fund held two interest rate swap legs, the initial leg produced investment income that contributed to the fund’s distributions, but the later closeout of a forward leg typically produced a capital loss. According to the Order, during certain quarters within the period such paired swaps generated capital losses without there being sufficient offsetting returns from other fund investments. As further described in Order 2, under those circumstances, portions of the fund’s dividends derived from payments received by the fund on the initial leg were taxable as ordinary income, but were economically equivalent to a return of capital.
In addition, Order 2 describes inadequate disclosures about paired interest rate swaps. The Order states that the prospectus in connection with the fund’s initial public offering included disclosure that income would be generated by “active[ly] manag[ing] duration and yield curve exposure” of its debt portfolio. According to Order 2, by at least 2014, the fund’s paired swaps produced a material portion of distributable income and many of which did not reflect active duration or yield curve management strategies. Additionally, the Order notes that while the initial prospectus and shareholder reports included risks associated with the fund’s use of interest rate swaps, PIMCO inadequately disclosed information concerning paired interest rate swaps in the fund’s annual shareholder reports during 2014 and 2015.
As a result of PIMCO’s conduct, Order 2 states that PIMCO violated Section 34(b) of the Investment Company Act and Section 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.
Without admitting or denying the SEC’s findings relating to each action, PIMCO agreed to a cease-and-desist order and a censure in each action, and to pay a penalty of $2.5 million in connection with Order 1 and $6.5 million in connection with Order 2.
SEC ADOPTS NEW SECURITY-BASED SWAP RULES TO PREVENT FRAUD & MANIPULATION PROMOTE CCO INDEPENDENCE
On June 7, the SEC adopted new Rule 9j-1 under the Securities Exchange Act of 1934 (the “Exchange Act”) to seek to prevent fraud, manipulation, and deception in connection with security-based swap (“SBS”) transactions. As described in detail below, the new Rule 9j-1 includes various anti-fraud and anti-manipulation provisions on categories of deceptive or manipulative misconduct related to security-based swap transactions. The new Rule also includes a price manipulation provision and two provisions aimed at ensuring that market participants cannot avoid liability under the new Rule. Lastly, the new Rule includes two affirmative defenses from the liability under the various anti-fraud and anti-manipulation provisions of the new Rule.
The Commissioners also adopted new Rule 15fh-4(c) under the Exchange Act to prohibit undue influence over the Chief Compliance Officer (“CCO”) of a security-based swap dealer or a major security-based swap participant (each, an “SBS Entity”).
As explained in the Adopting Release, the Commission's particular aspects and characteristics of security-based swaps provide opportunities and incentives for misconduct. The SEC gave several examples of misconduct, noting that, in general, parties to a security-based swap may engage in misconduct in connection with the security-based swap (including in the reference underlying such security-based swap) to trigger, avoid, or affect the value of ongoing payments or deliveries. Accordingly, the new rules are intended to seek to augment the Commission’s oversight of the security-based swap market, which has a gross notional amount outstanding of approximately $8.5 trillion as of late 2022.
Rule 9j-1(a)
Rule 9j-1(a) makes it unlawful for any person, directly or indirectly, to effect any transaction in, or attempt to effect any transaction in, any security-based swap, or to purchase or sell, or induce or attempt to induce the purchase or sale of any security-based swap in connection with the following misconduct:
(1) Employing or attempting to employ any device, scheme, or artifice to defraud or manipulate;
(2) Making or attempting to make any untrue statement of a material fact or omitting a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading;
(3) Obtaining money or property by means of any untrue statement of a material fact or any omission of a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading;
(4) Engaging in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person;
(5) Attempting to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or attempting to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person; or
(6) Manipulating or attempting to manipulate the price or valuation of any security-based swap or any payment or delivery related thereto.
Violations of subsections (1), (2), (5), and (6) require a showing of scienter. Violations of subsections (3) and (4) do not require a showing of the scienter and extend to conduct that is at least negligent.
For purposes of anti-fraud and anti-manipulation provisions, the definitions of purchase and sale encompass, among other things, partial executions, terminations, assignments, exchanges, transfers or conveyances of, or extinguishing of any rights or obligations under, a security-based swap, as the context may require.
Next, new Rule 9j-1(b) provides that wherever communicating purchasing, or selling a security (other than a security-based swap) while in possession of, material nonpublic information would violate or result in liability to any purchaser or seller of the security under either the Exchange Act or the Securities Act of 1933, or any rule or regulation thereunder, such conduct in connection with a purchase or sale of a security-based swap with respect to such security or with respect to a group or index of securities including such security shall also violate, and result in comparable liability to any purchaser or seller of that security under such provision, rule, or regulation. Likewise, the Commission adopted Rule 9j-1(c) which prevents a person from escaping liability under section 9(j) or the new Rule with respect to a security-based swap by limiting all of its actions to purchases or sales of the security, loan, or narrow-based security index underlying that security-based swap.
Lastly, new Rule 9j-1(e) includes two affirmative defenses from the liability under the anti-fraud and anti-manipulation provisions. The first defense is available under Rule 9j-1(e)(1), where the action was taken pursuant to binding rights and obligations in written security-based swap documentation, so long as the security-based swap transaction occurred before the person became aware of the material nonpublic information, and the person acted in good faith. The second defense is available, under Rule 9j-1(e)(2), to entities that demonstrate that the investment decision-maker was not aware of material nonpublic information and that the entity had reasonable policies and procedures in place to prevent violations of the anti-fraud and anti-manipulation provisions.
Rule 15fh-4(c)
Rule 15fh-4(c) will prohibit any officer, director, supervised person, or employee of an SBS Entity, or any person acting under such person's direction, to take any action to coerce, manipulate, mislead, or fraudulently influence the SBS Entity's CCO in the performance of their duties under the federal securities laws.
The new Rules 9j-1 and 15fh-4(c) will both go into effect August 29, 2023.