Q4 2023 Asset Management Regulatory Update

Table of Contents:

Securities and Exchange Commission Division of Examinations Announces 2024 Priorities

SEC Adopts Rule to Increase Transparency into Short Selling and Amendment to CAT NMS Plan for Purposes of Short Sale Data Collection

Treasury Revisits Past Rulemaking to Bring Investment Advisers Under AML Oversight

Securities Lending Transparency Rules

SEC Releases Form ADV FAQs

SECURITIES AND EXCHANGE COMMISSION DIVISION OF EXAMINATIONS ANNOUNCES 2024 PRIORITIES

On October 16, 2023, the Securities and Exchange Commission’s (the “SEC” or the “Commission”) Division of Examinations (the “Division”) released its 2024 examination priorities (the “Priorities”)^. As noted in the Priorities, the Division will prioritize areas that “pose emerging risks to investors or the markets, as well as examinations of core and perennial risk areas.” This analysis focuses on the Division’s examination priorities with respect to investment advisers, registered investment companies, and broker-dealers, but the Priorities also include discussions of the Division’s priorities with respect to self-regulatory organizations, clearing agencies, and certain other market participants.

Examinations of Investment Advisers

Noting the Division’s priority to examine for advisers’ adherence to their duties of care and loyalty, the Division indicated that it would continue to focus on:

• investment advice provided to clients regarding products, investment strategies and account types, particularly: (i) complex products, such as derivatives and leveraged exchange-traded funds (ETFs); (ii) high cost and illiquid products, such as variable annuities and non-traded real estate investment trusts (REITs); and (iii) unconventional strategies, including those that purport to address rising interest rates;
• processes for determining that advice is provided in clients’ best interests, including processes for: (i) initial and ongoing suitability determinations; (ii) best execution; (iii) evaluating costs and risks; and (iv) identifying and addressing conflicts of interest. With respect to conflicts of interest, the Priorities note that examinations will review how advisers address conflicts, including mitigating or eliminating conflicts and allocating investments to accounts where investors have more than one account;
• Economic incentives that an adviser and its financial professionals may have to make recommendations, such as the source and structure of compensation, revenue or other benefits. The Priorities indicated that examinations will focus on economic incentives and conflicts associated with advisers that are also registered as broker-dealers, use affiliates to perform services for clients and have financial professionals servicing both brokerage customers and advisory clients to identify (i) advice to purchase or hold certain investments or invest through certain accounts when there are other lower cost options available and (ii) investment advice with respect to proprietary products and affiliated service providers that result in additional or higher fees; and
• Disclosures to investors and whether such disclosures include all material facts relating to conflicts associated with investment advice sufficient to allow clients to provide informed consent to the conflict.

Additionally, the Priorities discuss the examination focus on adviser compliance policies and procedures, noting that such examinations will include:

• Marketing practice assessments for whether advisers, including advisers to private funds, have (i) adopted and implemented reasonably designed written policies and procedures to prevent violations of the Advisers Act and its rules including the recent Marketing Rule reforms; (ii) appropriately disclosed marketing-related information on Form ADV; and (iii) maintained substantiation of their processes and other required books and records. Additionally, the Priorities include that marketing practice reviews will also assess whether advertisements include untrue statements of a material fact, are materially misleading, or are otherwise deceptive and, comply with the requirements for performance, third-party ratings, and testimonials and endorsements;
• Compensation arrangement assessments focusing on (i) fiduciary obligations of advisers to their clients, including registered investment companies, particularly with respect to the advisers’ receipt of compensation for services or other material payments made by clients and others; (ii) alternative ways that advisers try to maximize revenue, such as revenue earned on clients’ bank deposit sweep programs; and (iii) fee breakpoint calculation processes, particularly when fee billing systems are not automated;
• Valuation assessments regarding advisers’ recommendations to clients to invest in illiquid or difficult to value assets;
• Safeguarding assessments for advisers’ controls to protect clients’ material non-public information, particularly when multiple advisers share office locations, have significant turnover of investment adviser representatives, or use expert networks; and
• Disclosure assessments to review the accuracy and completeness of regulatory filings, including Form CRS, with a focus on inadequate or misleading disclosures and registration eligibility.

Examinations of Investment Advisers to Private Funds

As noted in the Priorities, the Division will continue to focus on private fund advisers and prioritize specific topics, including:

• Portfolio management risks where there is exposure to market volatility and higher interest rates, which may include private funds experiencing poor performance, significant withdrawals, and valuation issues, as well as private funds with leverage and illiquid assets;
• Adherence to contractual requirements for limited partnership advisory committees (or similar structures), including adhering to notification and consent requirements;
• Accuracy with respect to the calculation and allocation of fund fees and expenses, including valuation of illiquid assets, calculations of management fees after the close of the commitment period, adequacy of disclosures, and potential offsets to such fees and expenses; and
• Due diligence practices for consistency with policies, procedures, and disclosures, particularly:
  • Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers;
  • Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements; and
  • Policies and procedures for reporting on Form PF, including with respect to certain reporting events.

Registered Investment Companies

Citing their importance to retail investors and retail investors saving for retirement, the Priorities note that the Division continues to prioritize examinations of registered investment companies, including mutual funds and ETFs. The Priorities include that examinations of investment companies may include the following examination focus areas:

• Fees and expenses and reviewing whether registered investment companies have adopted effective written compliance policies and procedures concerning the oversight of advisory fees and implemented any associated fee waivers and reimbursements. The Priorities note that a particular focus will be on (i) charging different advisory fees to different share classes of the same fund; (ii) identical strategies offered by the same sponsor through different distribution channels but have differing fee structures; (iii) high advisory fees relative to peer funds; and (iv) high registered investment company fees and expenses, particularly those of registered investment companies with weaker performance relative to their peers.
• Derivatives risk management assessments to review whether registered investment companies and business development companies have adopted and implemented written policies and procedures reasonably designed to prevent violations of the SEC’s fund derivatives rule (Rule 18f-4 under the Investment Company Act). Review of compliance with the derivatives rule may include review of the adoption and implementation of a derivatives risk management program, board oversight, and whether disclosures concerning the registered investment companies’ or business development companies’ use of derivatives are incomplete, inaccurate or potentially misleading.

Broker Dealers

With respect to broker-dealers and Regulation Best Interest, the Priorities include that in reviewing whether broker-dealer recommendations are in customers’ best interest, the following will be areas of particular importance (i) recommendations with regard to products, investment strategies, and account types; (ii) disclosures made to investors regarding conflicts of interest; (iii) conflict mitigation practices; (iv) processes for reviewing reasonably available alternatives; and (v) factors considered in light of the investor’s investment profile, including investment goals and account characteristics.

The Priorities also include that the Division’s examinations will review the content of the broker-dealers’ relationship summary on Form CRS, compliance with the Net Capital Rule and Customer Protections Rule and related internal processes, procedures and controls, and broker-dealer trading practices.

SEC ADOPTS RULE TO INCREASE TRANSPARENCY INTO SHORT SELLING AND AMENDMENT TO CAT NMS PLAN FOR PURPOSES OF SHORT SALE DATA COLLECTION

On October 13, the Commission adopted new Rule 13f-2 and related Form SHO under the Securities Exchange Act of 1934 (the “Exchange Act”) to require certain institutional investment managers (“Managers”) to report, on a monthly basis on Form SHO, certain short position data and short activity data for certain equity securities required by Rule 13f-2. Additionally, the Commission adopted an amendment to the national market system plan (“NMS Plan”) governing the consolidated audit trail (“CAT”) to require the reporting of reliance on the bona fide market making exception in the Commission’s short sale rules.

Rule 13f-2 will require a Manager to file a Form SHO report via the Commission’s EDGAR system within fourteen (14) calendar days after the end of each calendar month with regard to:

• With respect to any equity security that is of a class of securities registered pursuant to Section 12 of the Exchange Act or for which the issuer of that class of securities is required to file reports pursuant to Section 15(d) of the Exchange Act (a “Reporting Company Issuer”) over which the Manager and all accounts over which the Manager (or any person under the Manager’s control) has investment discretion with respect to a monthly average gross short position that meets or exceeds either (i) a monthly average of daily gross short positions at the close of regular trading hours in the equity security with a U.S. dollar value of $10 million or more, or (ii) a monthly average of daily gross short positions at the close of regular trading hours as a percentage of shares outstanding in the equity security of 2.5% or more; and
• With respect to any equity security that is of a class of securities of an issuer that is not a Reporting Company Issuer over which the Manager and all accounts over which the Manager (or any person under the Manager’s control) has investment discretion with respect to a gross short position that meets or exceeds a gross short position in the equity security with a U.S. dollar value of $500,000 or more at the close of regular trading hours on any settlement date during the calendar month.

For each reported equity security, a Manager will be required to report on Form SHO certain information, including:

• The Manager’s end-of-month gross short position in the equity security at the close of regular trading hours on the last settlement date of the calendar month; and
• For each individual settlement date during the calendar month, the Manager’s “net” activity in the reported equity security, which includes activity in derivatives, such as options.

The Commission will then publish, through EDGAR, and on a slightly delayed basis (expected to be within one (1) month after the end of the reporting calendar month), certain aggregated short sale related information regarding each equity security reported by Managers on Form SHO, including, for example:

• As an aggregated number of shares across all reporting Managers, the Managers’ gross short position in the reported equity security at the close of regular trading hours on the last settlement date of the calendar month, as well as the corresponding dollar value of that reported gross short position; and
• For each settlement date during the calendar month, the net activity in the reported equity security, as aggregated across all reporting Managers.

The amendment to the CAT NMS Plan will require CAT reporting firms to report to the CAT, for the original receipt or origination of an order to sell an equity security, whether the order is a short sale effected by a market maker in connection with bona fide market making activities in the equity security for which the bona fide market making exception in Rule 203(b)(2)(iii) of Regulation SHO is claimed.

Rule 13f-2, Form SHO, and the amendment to the CAT NMS Plan became effective January 2, 2024. The compliance date for Rule 13f-2 and Form SHO is twelve (12) months after the effective date, with public aggregated reporting to follow three (3) months later. The compliance date for the amendment to the CAT NMS Plan is July 1, 2025.

TREASURY REVISITS PAST RULEMAKING TO BRING INVESTMENT ADVISERS UNDER AML OVERSIGHT

On December 11, the U.S. Department of the Treasury (“Treasury”) announced in a Fact Sheet its renewed focus on the perceived money laundering risks associated with investment advisers.

The Fact Sheet covered a broad range of topics, focusing on the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) increased efforts to address the illicit finance and national security threats posed by corruption across various industries and sectors, including asset management. Per the Fact Sheet, investment advisers are not subject to consistent or comprehensive anti-money laundering (“AML”) and countering the financing of terrorism (“CFT”) obligations in the United States. Accordingly, the Treasury is re-examining and updating its September 1, 2015, Notice of Proposed Rule Making (the “2015 Proposal”). Generally, private funds are subject to the AML requirements of the USA PATRIOT Act and similar regulations in other jurisdictions.

The 2015 Proposal proposed to include investment advisers in the definition of “financial institution” in the regulations implementing the Bank Secrecy Act (the “BSA”), which, among other things, would require advisers to comply with suspicious activity reporting requirements, including filing Currency Transaction Reports (“CTRs”) and keeping records relating to the transmittal of funds. The 2015 Proposed Rule stalled following a 2017 moratorium on in-process rules.

Since that time, in January 2021, Congress enacted the Anti-Money Laundering Act of 2020 (the “AMLA”), which made sweeping reforms to the Bank Secrecy Act. Part of the AMLA is the Corporate Transparency Act (the “CTA”). Additionally, in September 2022, under the CTA, FinCEN issued a beneficial ownership reporting rule (the “BOI Rule”), which establishes a beneficial ownership information reporting requirement for certain “reporting companies.” The BOI, which became effective January 1, 2024, is intended to help prevent and combat money laundering, terrorist financing, tax fraud, and other illicit activity. Although there are exemptions to the definition of a “reporting company” under the BOI Rule, the BOI Rule is expected to impact private funds and their advisers and sponsors significantly.

In light of Tresuary’s renewed focus, investment advisers may want to pay particular attention to their compliance programs and consider implementing or enhancing existing procedures to attempt to ensure they are prepared for enacted and potential AML laws and regulations.

SECURITIES LENDING TRANSPARENCY RULES

On October 13, 2023, the Commission voted to adopt new Rule 10c-1a under the Exchange Act, which is intended to increase the transparency and efficiency of the securities lending market. Generally speaking, Rule 10c-1a will require “covered persons” who agree to a “covered securities loan” to provide specified Rule 10c-1a information comprised of certain “data elements” to a registered national securities association (“RNSA”) by the end of the day on which the loan is effected or modified. Rule 10c-1a will also require a RNSA to make publicly available most of the Rule 10c-1a information it receives, by the morning of the next business day, except for the loan amount, which must be made public after 20 business days. The RNSA must keep the “confidential data elements” it receives confidential, in accordance with applicable law and the rule’s requirements regarding data retention and availability. Currently, the Financial Industry Regulatory Authority (“FINRA”) is the only RNSA. Rule 10c-1a became effective on January 2, 2024. Covered persons will have to start reporting information to FINRA by the compliance date, January 2, 2026, which is 24 months after the effective date. However, FINRA will not publicly report information regarding Rule 10c-1a until 90 calendar days after the compliance date.

Covered Persons

Rule 10c-1a requires “covered persons” to report to FINRA by the end of the day. Rule 10c-1a defines the term “covered person” to mean (i) any person that agrees to a covered securities loan on behalf of a lender (an “intermediary”) other than a clearing agency when providing only the functions of a central counterparty or central securities depository; (ii) any person that agrees to a covered securities loan as a lender when an intermediary is not used, unless the borrower is a broker or dealer borrowing fully paid or excess margin securities; or (iii) a broker or dealer when borrowing fully paid or excess margin securities. Rule 10c-1a does not provide any sort of de minimis exemption from the definition of covered person.

Covered Securities Loans

Rule 10c-1a requires the reporting of all “covered securities loans” agreed to by any covered person. A covered securities loan is defined as “a transaction in which any person on behalf of itself or one or more other persons, lends a reportable security to another person.” In turn, a “reportable security” is defined in Rule 10c-1a(j)(3) as any security or class of an issuer’s securities for which information is reported or required to be reported to the consolidated audit trail (“CAT”) as required by Rule 613 and the CAT National Market System Plan, FINRA’s Trade Reporting and Compliance Engine (“TRACE”), the Municipal Securities Rulemaking Board Real-Time Transaction Reporting System, or any reporting system that replaces one of these systems.

Rule 10c-1a Data Elements

Rule 10c-1a prescribes three types of data elements that must be reported. The first set of data elements are public facing and concerns the material terms of the covered securities loan, requiring covered persons to provide in their initial report information regarding the:

• Legal name of the issuer of the securities to be borrowed;
• Ticker symbol of those securities;
• Time and date of the covered securities loan;
• Name of the platform or venue, if one is used;
• Amount of reportable securities loaned;
• Rates, fees, charges, and rebates for the loan;
• Type of collateral provided for the covered securities loan and the percentage of the collateral to the value of the reportable securities loaned;
• Termination date of the covered securities loan; and
• Borrower type, e.g., broker, dealer, bank, customer, bank, clearing agency, custodian.

The second set of data elements concerns information related to modifications of a covered securities loan if the modification impacts any previously reported “data element” submitted to FINRA. In this instance, covered persons are required to provide:

• the date and time of the modification;
• the specific modification and the specific data element being modified; and
• the unique identifier assigned to the original covered securities loan.

The third set of data elements concerns confidential information about the loan not intended to ever become publicly available (though FINRA may share such data with the SEC and such “other persons as the Commission may designate by order upon a demonstrated regulatory need”), and requires covered persons to include in their report:

• The legal names of the parties to the loan, including the person’s CRD or IARD No., MPID and LEI, and whether such person is the lender, the borrower or the intermediary;
• When the lender is a broker-dealer, whether the security loaned to its customer is loaned from the broker-dealer’s inventory; and
• Whether the loan will be used to close out a fail to deliver pursuant to Rule 204 of Regulation SHO or whether the loan is being used to close out a fail to deliver outside of Regulation SHO.

Timing of Reporting

Covered persons must report the required data elements by the end of the day on which the covered securities loan is effected or modified; the reporting obligation does not depend on when the securities loan is actually settled. Importantly, Rule 10c-1a uses the term “day” rather than “business day” when discussing the reporting requirements applicable to covered persons and reporting agents under sections (c) and (d) of the rule, which indicates that loans entered into on non-business days may still be subject to end of day reporting.

FINRA Publication of Data

The final rule requires FINRA to make publicly available the data elements (except for the loan amount), the unique identifier assigned to the loan by FINRA, and the LEI, ISIN, CUSIP, FIGI, or other security identifier(s) that FINRA determines is appropriate to identify the relevant reportable security, as well as information pertaining to the aggregate transaction activity and distribution of loan rates for each reportable security and those security identifier(s), not later than the morning of the business day after the covered securities loan is effected. On the 20th business day after the covered securities loan is effected, FINRA will publicize the loan amount. Likewise, the modification of any data element will be made public by FINRA on the day after the modification and any modification to the loan amount will be disclosed on the 20th business day after the covered securities loan is modified.

SEC RELEASES FORM ADV FAQS

On October 26, the SEC’s Division of Investment Management staff updated the “Frequently Asked Questions on Form ADV and IARD” (the “FAQs”) for investment advisers that submit Form ADV to the SEC pursuant to the Investment Advisers Act of 1940, as amended (the “Advisers Act”), either as “exempt reporting advisers” (“ERAs”) or registrants (“RIAs”). By way of background, Form ADV is the uniform form used by investment advisers to register with both the SEC and state securities authorities. ERAs must also file a Form ADV, although the specific requirements and deadlines may vary. The form consists of three parts. Parts 1 and 2 are used by the SEC and the states. Part 3 is used by the SEC and some states.

The FAQs provide additional guidance from the staff concerning specific questions concerning Form ADV and the Investment Adviser Registration Depository (“IARD”) system, which filers submit Form ADV and amendments thereto. The FAQs include both technical updates to previously existing FAQs as well as new FAQs on a variety of topics.

A summary of some of the more significant new and amended the FAQs are set forth below.

New FAQ on Audits for Newly Created Private Funds

Item 7.B.(1) requires RIAs to complete a separate Section 7.B.(1) of Schedule D for each private fund it advises. Section 7.B.(2) of Schedule D requires RIAs to report information about each private fund, including information about the fund’s service providers, such as its auditor, prime broker, custodian, administrators, and marketers. In a new FAQ on question 23(a) of Schedule D, Section 7.B.(1) related to auditors, the staff stated that an adviser to a newly created private fund should not report that a private fund’s financial statements are subject to an annual audit if an auditing firm has not been engaged to conduct an audit for the applicable fiscal year.

Modified FAQ on Delivery of Private Fund Audits

Question 23(g) of Schedule D, Section 7.B.(1) asks whether the private fund’s audited financial statements for the most recently completed fiscal year were distributed to the private fund’s investors. For RIAs relying on the “audit approach” for their compliance with the Custody Rule (Rule 206(4)-2), audited financial statements must be delivered to investors within 120 days of the pool’s fiscal year-end and within 180 days of the fiscal year end of a fund-of-funds. Due to the timing of the annual update (within 90 days after the end of your fiscal year), some RIAs to private funds may have neither received the audit reports nor distributed them at the time of filing the Form ADV annual update. As a result, these RIAs may not have distributed the audit reports by the Form ADV filing deadline.

In a modified FAQ, the staff clarified that if the applicable deadline for distributing the private fund’s audited financial statement has not yet passed, an adviser may answer “Yes” if it has engaged an auditor, and the audited financial statements will be distributed as required. Otherwise, an adviser should answer “No” if the applicable deadline for distribution has passed and audited financial statements were not delivered to clients for the most recently completed fiscal year.

New FAQ on Material Changes to ADV Part 2A

The instructions to Item 2 of Part 2A require prompt disclosure of any material changes to Part 2 that an RIA may make a part of its annual update for Form ADV. A new FAQ clarifies the staff’s expectations that providing a list of material changes is not a sufficient discussion; instead, an adviser must identify and discuss material changes.

New FAQ on Typos and Mistakes in an Annual Updating Amendment

In a new series of FAQs on Filing an annual Updating Amendment, the staff addressed the mistaken submission of an “other-than-annual amendment” instead of an Annual Updating Amendment and the occurrence of typos in an adviser’s annual amendment filing. The staff noted that it cannot change the date (or any information filed) on Form ADV filing. Accordingly, filing an other-than-annual amendment is not a substitute for filing an annual updating amendment. In both scenarios, an adviser must file another Form ADV annual updating amendment with the correct year. The adviser may wish to consider entering a note in the Miscellaneous section of Schedule D explaining the reason for filing an amended annual updating amendment.