(Article from Registered Funds Alert, February 2015)
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Earlier in this Alert, we discuss recent remarks and actions from the SEC and its Staff that suggest that the growth of alternative funds has been seized upon as a basis for greater risk-based regulation in the registered fund industry. This piece focuses on the compliance and regulatory issues identified by the Staff as relating primarily to “alternative” funds (however defined).
As noted above, in a recent pair of high profile speeches (click here and here for links to the speeches), Norm Champ, the outgoing Director of the SEC’s Division of Investment Management, both acknowledged the attractiveness of the traditional registered fund wrapper for alternative strategies—both for sponsors and investors—and highlighted certain key risks.[1] With respect to the attractiveness of the products, Mr. Champ cited investment liquidity, portfolio transparency, lower advisory fees, lower investor minimum requirements and lack of minimum eligibility requirements as key factors that have fueled investor demand compared to similar privately offered funds (to which we would also add simplified tax reporting). But he also cited key compliance risks in managing such products, most notably with respect to the regulatory requirements relating to valuation, liquidity and leverage. He also highlighted certain disclosure and board oversight responsibilities as areas that deserve focus.
Mr. Champ’s remarks are notable in several respects, beyond the implications for rule-making discussed earlier in this Alert. First, and most obviously, he highlights areas for heightened attention by sponsors of new and existing alternative funds. Second, he focused his remarks, particularly in his second speech, not just to sponsors of alternative funds but to sub-advisers of alternative funds who may have limited experience in dealing with the rules and regulations applicable to registered investment companies, indicating a potential Staff focus on those firms’ involvement in the management of alternative funds.
In addition to Mr. Champ’s remarks, OCIE announced a national sweep of alternative funds in early January 2014. This sweep examination is under way, and, unsurprisingly, has focused on many of the same issues identified by Mr. Champ in his speeches.
Valuation
In fulfilling statutory responsibilities for valuation of securities for which market quotations are not “readily available,” Mr. Champ highlighted several key issues for boards of directors and the entities to which they may have delegated day-to-day valuation determinations. In addition to reiterating the need for robust policies and procedures, he suggested that policies should include:
- requirements for monitoring circumstances that may necessitate the use of fair value prices;
- methodologies for determining fair value;
- processes for price overrides;
- assurances that controls are in place to review, monitor and approve all overrides in a timely manner; and
- prompt notification to, and review and approval by, persons not directly involved in portfolio management to mitigate conflicts of interest.
In a sense, these considerations are no different than ones that many fund complexes have already drawn from the recent Morgan Keegan enforcement action against the directors of those funds. The focus on these matters in the alternative fund context, however, is not surprising as many alternative funds use instruments that do not have deep markets or may be bespoke, and in many instances, the portfolio managers will be in the best position to understand the instrument and its proper valuation. Questions posed by OCIE in the sweep examination have similarly focused on many of the issues that arose in Morgan Keegan (for example, by specifically referring to valuation practices for mortgage-backed securities and by asking about the use of indicative broker quotes in valuation). In addition, the OCIE sweep examination has focused on “back-testing” of valuations, indicating a growing expectation that fund complexes will review fair valuation decisions in the context of subsequent market valuations if and when they become readily available, or when the instrument is sold.
Liquidity
Mr. Champ also noted that there was a “close relationship between the liquidity of a portfolio security or asset and the ease with which the security or assets may be valued.” In effect, Mr. Champ stated that the Staff would expect that alternative funds that hold a large number of hard-to-value instruments would face issues with respect to regulatory requirements related to liquidity. For open-end funds, the Staff has typically required that such funds hold no more than 15% of their assets in illiquid securities or assets, defined as an asset that cannot be sold or disposed of in the ordinary course of business within seven days at approximately the value ascribed to it by the fund.
Mr. Champ’s comments suggest an increasing expectation on the part of the Staff that compliance programs for registered investment companies and investment advisers will include written policies and procedures with respect to oversight of fund liquidity.[2] Mr. Champ noted several factors to be considered when assessing liquidity, including:
- frequency of trades and quotes for a security;
- number of dealers willing to purchase/sell the security and the number of potential purchasers;
- dealer undertakings to make a market in the security; and
- the nature of the security and the nature of the marketplace in which the security trades.
Questions posed by OCIE in the sweep examination also have focused on the existence of written policies and procedures and whether investment advisers have stress-tested liquidity expectations under different market scenarios. OCIE’s questions have also focused on board oversight of such policies and stress-tests, as applicable, including by requesting minutes of board meetings where such topics were discussed.
Leverage
In August 2011, the SEC issued a “concept release” relating to the use of derivatives by registered investment companies. While the SEC and its Staff have not taken any action with respect to the concept release to date, the release catalogued long-standing guidance by the Staff relating to maintaining “asset coverage” of derivative positions to maintain an adequate limit on leverage and to avoid treatment of the instruments as senior securities under the 1940 Act. Mr. Champ’s recent remarks with respect to alternative funds’ use of derivatives suggest that the SEC may be looking for boards or investment advisers to take on a more extensive risk management oversight function in connection with the use of derivatives than previously suggested by the SEC or its Staff. OCIE’s examination questions in the sweep examination have focused on compliance with the existing guidance, but also have asked for descriptions of limits on “economic leverage,” presumably in contrast to “regulatory” leverage. Nonetheless, there appears to be an expectation that alternative funds will be subject to a level of risk oversight not otherwise mandated by prior guidance. While such oversight might be employed by most firms in practice, it remains to be seen whether OCIE will expect some form of formalization of such practices and procedures upon inspection.
During a speech in December 2014, Chair White discussed a set of initiatives, which included a plan to enhance risk monitoring specifically related to the use of derivatives.[3] While the imposition of additional caps on derivative use is unlikely, a rule or guidance might suggest that firms develop policies to assess and manage risk specific to the use of derivatives. Specifically, Chair White indicated that such policies may require a decrease in derivative use during periods of high redemptions. Further, Chair White indicated a need to significantly increase disclosure regarding to fund investments in derivatives.
Disclosure
Mr. Champ also noted several key considerations regarding disclosures for funds which invest in alternative investment strategies. First, he noted that all funds should assess whether current disclosures are in conformity with the plain English standards of the federal securities laws. Secondly, Mr. Champ underscored the Staff’s expectation that all disclosures regarding alternative investment strategies be specifically tailored to the particular fund’s expected investment strategies and management of those strategies, and noted that the Staff was actively engaged in looking at data regarding fund investments and tying that data back to disclosure. Third, Mr. Champ noted that all such disclosures should reflect the specific fund’s “complete risk profile … taken as a whole,” instead of a list of various investment strategies. Specifically, Mr. Champ indicated that alternative funds should include disclosure relating to risks associated with volatility, leverage, liquidity and counterparty creditworthiness. Finally, Mr. Champ suggested that registrants should assess disclosure on an “ongoing basis” to evaluate the completeness and accuracy of disclosures “in light of its actual operations,” a suggestion which he reiterated in a speech in October 2014. Our attorneys have publicly taken issue with this statement, advocating that shareholder report disclosure is a more effective tool to educate investors about changes in operations and the associated risks.[4]
Board Oversight
Mutual fund boards traditionally oversee the investment companies’ key service providers and those service providers’ compliance programs and policies as they relate to the operation of those investment companies. Boards have a statutory obligation to oversee the fair valuation of securities for which there are no readily available market quotations, and in several other aspects are called upon, by statute or rule, to protect fund shareholders in situations where service providers might overreach in navigating conflicts of interests. Mr. Champ, in his speeches, has specifically highlighted board obligations to oversee policies and procedures relating to each of the key risk areas identified by Mr. Champ and discussed above. To the extent that Mr. Champ has indicated the intention of the Staff to expand registrants’ obligations with respect to practices discussed above, in the context of alternative funds, one would expect a concomitant increase in the responsibilities of board members to oversee those practices.
Additionally, Mr. Champ also highlighted the importance of board oversight regarding conflicts of interest, particularly with respect to allocation decisions, when the portfolio manager of a strategy also manages a similar strategy in a private fund wrapper. In this regard, Mr. Champ’s remarks focused on sub-advisers who were advising registered funds for the first time. In a speech in September 2014, Mr. Champ also warned advisers that were becoming first-time sub-advisers to registered funds “to proceed thoughtfully and cautiously before becoming advisers in registered funds.” These remarks, coupled with OCIE requests for findings of material non-compliance by sub-advisers to alternative funds, indicate a particular attention to complexes using third-party sub-advisers as they expand into the alternative fund space.
[1] Mr. Champ explicitly excluded closed-end funds and business development companies from his discussion.
[2] Indeed, as discussed above, the SEC, in announcing its 2015 agenda, stated that the adoption of a liquidity management rule would be a priority.
[3] See also Andrew Ackerman, SEC Details Plan to Target Risks at Asset Managers, The Wall Street Journal, Dec. 11, 2014, available at http://www.wsj.com/articles/sec-chief-calls-for-stress-testing-of-mutual-funds-other-asset-managers-1418312083.
[4] See Peter Ortiz, SEC, Finra: Liquid Alts Not Always Used as Directed, IGNITES, Nov. 3, 2014 (quoting Rajib Chanda)