Publications

(Article from Registered Funds Alert, May 2015)

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SEC 2015 Priorities

In a speech, likely aimed in part at the Financial Stability Oversight Council (FSOC), at the SEC Speaks Conference on February 20, 2015, Mary Jo White, Chair of the Securities and Exchange Commission (SEC), outlined the SEC’s 2015 rulemaking priorities. She indicated that the SEC Staff plans to release initial recommendations on the following topics: (i) modernizing and enhancing data reporting for funds and advisers; (ii) imposing controls on registered funds to effectively identify and manage risks related to modern investment portfolios, including liquidity management and the use of derivatives in mutual funds and exchange-traded funds (ETFs); and (iii) effective planning for possible impacts of market stress events or when an adviser is no longer able to provide advisory services.

More recently, in a series of speeches (found here and here), Dave Grim, Director of the SEC Division of Investment Management,[1] reiterated Chair White’s priorities and expanded upon how they will affect the asset management industry, and advisers in particular. With respect to the asset management industry, Mr. Grim touched on the following specific initiatives:

• Data Reporting: According to Mr. Grim, the SEC Staff is currently considering ways to modernize data reporting by funds, including: (i) updating the information reported on Form N-SAR (which is still filed in MS DOS format) to reflect new market developments, products, practices and risks; (ii) improving the portfolio information reported on Forms N-CSR and N-Q to increase understanding of how funds are implementing their strategies and to help assess the adequacy of fund disclosures; and (iii) considering ways to standardize Form N-CSR and N-Q information regarding certain fund investment practices, such as use of derivatives and securities lending. Mr. Grim also cited the SEC’s recent modernization of money market fund reporting, which requires monthly reports on Form N-MFP, as an example of how recent enhanced reporting measures have been successful.
• Derivatives Use: Mr. Grim discussed some of the questions posed by the SEC in its 2011 Concept Release regarding use of derivatives by funds. He stated that the SEC Staff has been analyzing comments received in connection with the Concept Release and is considering measures that would require funds to “establish broad risk management programs to address risks related to their derivatives use.”
• Liquidity: Mr. Grim stated that the SEC was considering revisiting liquidity management by mutual funds, noting that guidelines limiting open-end fund investments to no more than 15% of net assets are many years old. He explained that the Staff is focused on redemption rights of investors. In this connection, the SEC Staff is considering recommending “a new comprehensive approach to the management of the liquidity risks associated with fund portfolio composition” with the goal of providing better transparency to investors regarding liquidity risks associated with funds.

Regarding advisers, Mr. Grim noted the following priorities:

• Data Reporting: The SEC Staff is currently: (i) analyzing ways to improve the usefulness of Form ADV to investors and (ii) considering whether any additional information, such as information about separately managed accounts, should be reported on Form ADV to help the SEC’s risk assessment efforts.
• Transition Plans: The SEC Staff is currently developing recommendations that would require advisers to create transition plans (in the event of a major disruption). Mr. Grim noted that plans should be tailored to any unique aspects of an adviser’s business, addressing issues such as the departure of key personnel.
• Stress Testing: Mr. Grim noted that the Dodd-Frank Act requires the SEC to implement requirements for annual stress testing by large advisers and funds. He stated that the SEC Staff is developing recommendations for such requirements building upon lessons learned about stress testing through money market reform.

Taken together, these initiatives clearly indicate pressure from the FSOC for the SEC to behave more like a prudential regulator, like many of its cohorts on the FSOC, rather than the traditional rules-based regulator that it has been to date. The data gathering initiative can best be seen as an attempt to provide the SEC with a level of insight into the asset management industry that would justify its role as the primary regulator of the industry. The derivatives, liquidity management, transition planning and stress testing initiatives have clear analogues among the prudential regulators’ regulatory regimes, and the statements in those regards indicate an intent to impose a risk-based analytic approach on the industry. Because risk-based analytics are necessarily dependent on the particular facts and circumstances of a fund, it follows that no “one size fits all” approach would be workable, and thus oversight of rules of this nature would draw the SEC further into the role of prudential regulator.

It is not clear, however, that the SEC will have the statutory authority to implement true risk-based, prudential regulations. The SEC’s authority for such regulation, other than the Dodd-Frank requirement to impose stress-testing on pools of a certain size, would need to stem from one of the following three accepted avenues for rule-making: (i) statutory authority that explicitly grants the SEC power to adopt rules to effectuate the particular statutory provisions (for example, Section 17(d), which allows the SEC to effectuate rules regarding affiliated joint transactions); (ii) exemptive rules that can be conditioned on adopting standards imposed by the SEC (most famously, imposing fund governance standards in order to rely on several exemptive rules; Rule 2a-7 is another example); or (iii) disclosure requirements that can require disclosure of non-adoption of SEC-suggested practices (for example, disclosure if a fund does not have a policy on market timing). More controversially, the SEC could also claim a policy is required by Rule 38a-1 (the compliance rule) and prosecute firms for non-compliance with that rule or violations of written policies. None of these bases would seem to exist for, for example, the requirement for firms to stress test for liquidity in various interest rate environments. Given the recent successful challenges to SEC rule-making initiatives in the D.C. Circuit Court, we would expect the SEC to tread carefully in this area. But between these limitations on the one hand, and pressure from the FSOC on the other, the SEC must feel as if it is navigating between Scylla and Charybdis.

OCIE 2015 Priorities

In its Examination Priorities for 2015, the SEC Office of Compliance, Inspections and Examinations (OCIE) identified three “thematic areas” of priorities: (i) matters involving retail investors; (ii) assessment of market-wide risks; and (iii) using data to identify and examine registrants engaged in illegal activity, such as excessive trading. Below is a summary of OCIE’s priorities as they relate to registered funds:

• Noting the “rapid and significant growth” of alternative funds, OCIE will continue to focus on alternative funds and will look at: (i) leverage, liquidity and valuation policies and practices; (ii) the adequacy of internal controls; and (iii) marketing practices.
• With respect to fixed income funds, OCIE noted the impending rise of interest rates and stated that it will review compliance policies and procedures related to investment and trading controls to ensure that fund disclosures align with a fund’s liquidity profile and are not misleading.
• OCIE will continue focusing on cybersecurity in examinations of advisers and broker-dealers, and will expand its efforts to include transfer agents (as discussed in greater detail later in this Alert).
• OCIE will be conducting focused examinations on “never-before-examined” fund complexes (as also further discussed later in this Alert).

AMU 2015 Priorities

In her February 26, 2015, speech titled “Conflicts, Conflicts Everywhere,” Julie M. Riewe, Co-Chief of the SEC Division of Enforcement’s Asset Management Unit (AMU) provided an overview of the AMU’s 2015 priorities. With respect to registered funds, Ms. Riewe listed a number of focus areas, including:

• Valuation of fund assets;
• Performance advertising;
• Deviation from fund investment guidelines or pursuing undisclosed strategies;
• Fund governance, including boards’ and advisers’ discharging of their obligations under Section 15(c) of the Investment Company Act of 1940 (1940 Act); and
• Fund distribution, including whether advisers are causing funds to violate Rule 12b-1 by making distribution payments outside of Rule 12b-1 plans.

Notably, Ms. Riewe specifically described several 2014 enforcement actions regarding performance advertising and Section 15(c), and stated that she expects there to be additional actions brought in these areas. As the title of her speech suggests, Ms. Riewe also discussed conflicts of interest related to registered funds, noting several 2014 cases related to advisers failing to seek best execution for fund clients. She noted that additional conflicts of interest cases are “in the pipeline” and stressed that advisers have a fiduciary obligation to identify, disclose and mitigate conflicts of interest.

SEC Budget for 2016 Fiscal Year

In February 2015, the White House released its budget proposal, which included a $1.722 billion funding request for the SEC. The request, if approved, would represent a nearly 15% increase over the SEC’s 2015 fiscal year budget ($1.5 billion). A large portion of the increased funding request is allocated toward the hiring of approximately 430 new SEC Staff employees (as outlined in the SEC’s FY 2016 Congressional Budget Justification). Given the SEC’s increasing focus on examinations and enforcement actions, it is not surprising that a vast majority of the 430 new Staff positions have been allocated to OCIE and the Division of Enforcement, with the budget calling for 225 new examiners of advisers and 93 new Enforcement positions (although adding additional AMU personnel does not appear to be a priority). The SEC states that the increased funding for additional examiners would expand OCIE’s examination potential, increasing the number of investment adviser examinations from around 10% in 2014 to an estimated 14% of all registered advisers once the new examiners are trained. Coupled with the SEC’s focus on “broken windows,” discussed below, the budget request indicates a strong likelihood of increased enforcement activity in the near future.

[1] At the time of these remarks, Mr. Grim was Acting Director. Chair White announced on May 8, 2015 that he would remain in that position as Director.