Division of Investment Management's guidance reminds firms to comply with conditions and representations in exemptive orders and notes that consequences for noncompliance may be "severe."
In early May 2013, the Division of Investment Management of the Securities and Exchange Commission (SEC) released guidance reminding firms of their obligation to comply with applicable SEC exemptive orders. The guidance suggests that firms adopt and implement policies and procedures reasonably designed to ensure ongoing compliance with each representation and condition in any such order.
The SEC staff's guidance follows both a June 2011 report from the SEC's Office of Inspector General (OIG), which noted repeated instances of noncompliance with exemptive order requirements, and the publication of the Office of Compliance Inspections and Examinations' (OCIE's) 2013 examination priorities, which noted compliance with exemptive orders as an examination priority. Given the SEC staff's focus, investment companies and investment advisers should review their exemptive orders alongside their compliance policies and procedures in order to avoid regulatory violations and pitfalls during an SEC exam.
OIG Report and OCIE Examination Priorities
The SEC may issue exemptive orders to applicant firms relieving such firms from compliance with specific provisions of the federal securities laws and/or regulations. These exemptive orders are issued in reliance on one or more provisions of the federal securities laws. In order to receive exemptive relief, a firm typically makes certain representations and warranties in its application and agrees to comply with certain conditions. Based on its review of a sample of OCIE examination reports, the OIG determined in its 2011 report that many firms failed to comply with the representations and conditions of SEC exemptive orders and no-action letters they have received.
Examples of noncompliance cited in the OIG report include failing to conduct an annual review by the board, failing to include certain performance data disclosures, failing to recall loaned securities to vote proxies, and failing to adhere to fund marketing requirements. The OIG report further notes that the SEC divisions that issue such relief do not have a process for confirming whether firms subsequently comply with the conditions set forth in the relief. The OIG report also set forth five recommendations intended to enhance the SEC's oversight of exemptive order compliance. These recommendations include increased oversight and cooperation by and between SEC divisions. The OIG also recommended that OCIE include compliance with exemptive order conditions in OCIE's risk considerations as part of its examination efforts.
Presumably in response to the OIG report, the priorities that OCIE issued on February 21, 2013 include investment company and investment adviser compliance with exemptive orders. Specifically, OCIE stated that it will "focus on compliance with previously granted exemptive orders, such as those related to closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds."
Additional Policies and Procedures Firms Should Consider
The Division of Investment Management's guidance suggests that firms may address the risk of noncompliance with exemptive order conditions by adopting policies and procedures in accordance with Rule 206(4)-7 under the Investment Advisers Act or Rule 38a-1 under the Investment Company Act. The policies and procedures should be reasonably designed to ensure ongoing compliance with each representation and condition of any exemptive order(s) the entity has received. The guidance discusses the following two approaches a firm could use to ensure compliance:
Interestingly, the SEC guidance does not specifically address compliance with SEC no-action letter requirements, although firms should generally apply the same types of policies, procedures, and oversight processes to ensure compliance with no-action letters as they do to ensure compliance with exemptive orders. The guidance also does not address another closely related area: compliance with exchange-listing requirements and other rules by exchange-traded funds (ETFs) and closed-end funds. ETFs, for example, must comply with exchange-listing standards and, in some cases, specific representations and conditions made by a securities exchange in connection with proposed rule changes to list the ETFs shares pursuant to Rule 19b-4 under the Securities Exchange Act of 1934. As with exemptive orders and no-action letters, firms should adopt appropriate policies, procedures, and oversight processes to comply with these standards.
The following are some practical tips and approaches designed to ensure compliance:
Because of the extent to which the investment industry has come to rely on exemptive orders and no-action letters, well-developed policies and procedures, along with effective oversight of such policies and procedures, are increasingly important. The OIG report, the OCIE examination priorities, and now the Division of Investment Management's guidance indicate that this is a focus area for SEC staff and an area of significant regulatory and compliance risk. However, a thoughtful approach to these issues that takes into account the Division of Investment Management's guidance and that is consistent with the practices outlined above should help firms remain compliant.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis attorneys:
. U.S. Securities and Exchange Commission Office of Inspector General, Oversight of and Compliance with Conditions and Representations Related to Exemptive Orders and No-Action Letters, Report No. 482 (June 29, 2011), available here.
. See, e.g., section 6(c) of the Investment Company Act of 1940 (Investment Company Act) and section 206A of the Investment Advisers Act of 1940 (Investment Advisers Act).
. More specifically, the OIG's report found that the "SEC's Divisions that issue exemptive orders and no-action letters to regulated entities do not have a coordinated process for reviewing those entities' compliance with the conditions and representations contained in the orders and letters, and instead rely on OCIE to review compliance as part of its examinations." See U.S. Securities and Exchange Commission Office of Inspector General, Oversight of and Compliance with Conditions and Representations Related to Exemptive Orders and No-Action Letters, Report No. 482 (June 29, 2011), at vi available here.
. The OIG's report recommended that "OCIE should include compliance with conditions and representations in significant exemptive orders and no-action letters issued to regulated entities as risk considerations in connection with its compliance efforts." Id. at vii.
. National Examination Program, supra note 2, at 6.
. This is not surprising as exchange listings and listing standards are under the purview of the SEC's Division of Trading and Markets and not the Division of Investment Management.
. See, e.g., In the Matter of Northern Lights Compliance Services, LLC, et al., Admin. Proc. File No.3-15313 (May 2, 2013); In the Matter of J. Kenneth Alderman, CPA, et al., Admin. Proc. File No. 3-15127 (Dec. 10, 2012).