(Article from Registered Funds Alert, May 2015)
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The SEC’s growing focus on alternative funds is well documented, including in our prior Alert. Alternative funds have been featured in OCIE’s annual list of priorities since 2013. In 2014, OCIE published a risk alert regarding due diligence and oversight of alternative investment managers as advisers and sub-advisers to mutual funds and announced a sweep examination of alternative funds. While these actions have attracted the bulk of the industry’s attention, certain other SEC priorities also have implications for alternative funds.
Broken Windows
In October 2013, SEC Chair Mary Jo White declared that the SEC would have a renewed focus on minor violations of securities laws or “broken windows,” harkening back to the famous strategy that Mayor Rudy Giuliani employed in his efforts to clean up the streets of New York City. The rise of alternative funds has attracted advisers with no previous experience advising registered mutual funds, meaning that these new advisers may lack experience with the nuanced requirements of the 1940 Act. A recent SEC enforcement action signals that alternative fund managers may be a target for the “broken windows” approach. On February 12, 2015, the SEC announced a settled administrative proceeding against Water Island Capital LLC (Water Island), which serves as an investment adviser and sub-adviser to various alternative funds. Although the relevant funds suffered no losses or other actual harm, the SEC order alleged that Water Island violated Section 17(f)(5), Section 12 and Rule 12b-1(h), and Rule 38a-1 under the 1940 Act by failing to implement policies and procedures that the funds had in place to abide by these regulations. The SEC noted that it discovered these issues during an examination of Water Island, but it is unclear whether this was connected with OCIE’s sweep examination of alternative funds.
Section 17(f)(5) addresses the safeguarding of fund assets. If a fund maintains its portfolio holdings in the custody of a bank, its other cash assets must also be kept in bank custody. The SEC order states that Water Island’s funds generally kept fund investments in the custody of a bank, thereby triggering the requirements of Section 17(f)(5). As Water Island’s investment strategy involves the use of various derivatives, including swaps, the relevant funds were required to post cash as collateral for various swap agreements. The SEC order alleges that Water Island allowed approximately $247 million to be held in the custody of the broker-dealer counterparties to the swap agreements, instead of being held in the custody of the fund’s custodian bank through a tri-party arrangement (the common industry practice).
Section 12 and Rule 12b-1(h) require an adviser to keep a list of approved brokers for executing fund transactions, and to document the relevant fund’s compliance with directed brokerage requirements. The SEC order alleges that Water Island failed to create the required lists and did not maintain the required documentation.
The SEC order also includes a violation of Rule 38a-1, which requires funds to adopt and implement policies and procedures reasonably designed to prevent violations of federal securities laws. While the SEC order states that the relevant funds had adopted policies and procedures to address the requirements noted above, Water Island allegedly failed to implement those policies and procedures.
In a certain sense, the allegations against Water Island could be viewed as violations of “Mutual Funds 101.” In a broader sense, however, the particular practices are unique to the mutual fund regulatory scheme, and a regulator with a different view of its mission may have treated these as deficiencies rather than as enforcement matters, particularly where no shareholder harm was alleged.
Disclosure, Conflicts and Fixed-Income
During a February 2015 webinar, Raymond Slezak, Assistant Regional Director of the SEC’s New York Regional Office, discussed several other current and future SEC initiatives that have implications for alternative funds. One initiative is the SEC’s increasing focus on mutual fund disclosure issues. Mr. Slezak stated that while the SEC would expect all funds to have accurate and complete disclosure that is presented in plain English, alternative funds could face a tougher task in meeting these expectations. For instance, alternative funds may change the way they implement their investment strategies as new derivative products enter the market. When that happens, alternative funds must make sure that their day-to-day investment strategy matches the fund’s prospectus disclosure. Additionally, Mr. Slezak noted that alternative funds with multiple sub-advisers should be wary of marketing materials overstating the due diligence process regarding the fund’s sub-advisers.
Conflicts of interest have also been on the SEC’s radar, as evidenced by Julie Riewe’s speech titled “Conflicts, Conflicts Everywhere,” discussed earlier in this Alert. Mr. Slezak, expanding on this theme, explained that alternative fund advisers are often advisers to hedge funds with similar investment strategies, thus presenting the possibility for the mutual fund to be treated less favorably than a hedge fund (the latter of which often pays the adviser performance fees). He noted that the SEC has identified two particular risks in this area: (i) favoring hedge funds in allocating investment opportunities and (ii) allowing a hedge fund to take a short position in a security immediately prior to a mutual fund selling its interest in that security.
Additionally, the SEC has been vocal about potential liquidity issues and stress testing for fixed-income funds, in light of potential changes in interest rates. Mr. Slezak expressed his belief that alternative funds operating in the fixed-income space should be conducting stress testing to ensure that their portfolios can comply with the 1940 Act’s liquidity requirements in changing market conditions. Given that alternative funds may be starting from a baseline of investing in less liquid investments than traditional funds, changes in interest rates could be more likely to cause alternative funds to run up against the 1940 Act’s liquidity requirements. Mr. Slezak’s comments presumably were focused on open-end funds, as opposed to closed-end funds and business development companies, which are common structures for alternative funds and not subject to particular 1940 Act liquidity requirements.