The Division of Examinations staff of the US Securities and Exchange Commission (SEC) published a risk alert on October 26, 2021, titled “Observations from Examinations in the Registered Investment Company Initiatives,” which summarized the observations of the staff coming out of a series of examinations from 2018 and 2019 that focused on mutual funds and exchange-traded funds (ETFs) and, specifically, on certain compliance areas that may impact retail investors.
Through its broad examination function, the SEC staff has a unique ability to observe industry trends with respect to what firms are doing well, and perhaps most importantly, what firms are doing poorly with respect to compliance. Periodically, after completing a series of examinations, the staff of the Division of Examinations publishes what it has learned in the form of an industry-wide risk alert. These risk alerts can be useful to industry participants, particularly where they highlight areas of deficient compliance programs. They also function as somewhat of a roadmap for upcoming areas of examination inquiry, as the staff expects industry participants to make appropriate adjustments to their compliance policies and procedures in response to risk alerts and will often cite to risk alerts in deficiency letters.
The October 26 risk alert notably highlighted deficiencies and weaknesses in almost every area of mutual fund and fund adviser compliance obligations. Specifically, the SEC noted that it had observed deficiencies with respect to firms’ compliance programs and practices relating to the following non-exhaustive list of activities:
- Investment guideline monitoring (including compliance with investment restrictions, limitations on investments in derivatives, and Rule 35d-1, the “Names Rule”).
- The operation of a fund’s liquidity risk management program.
- Trading practices, including trade allocation and aggregation, principal transactions, cross trading, and use of soft dollars.
- Fund valuation processes, including the oversight of pricing vendors and the involvement of investment personnel in the valuation process.
- Engagement of third-party service providers, including index providers, financial intermediaries, and providers of shareholder services.
- Fee calculations and expense allocations.
- Review of marketing and advertising literature, especially back-tested index returns.
- Annual fund contract renewal processes.
- Annual fund compliance review processes.
- Incomplete fund disclosures covering almost every required disclosure required under Form N-1A (the registration form used by US registered mutual funds and ETFs).
The risk alert spends five of its eight-and-a-half pages listing these observations in more detail. The breadth of these observations shows that the SEC examinations can be very wide-ranging and suggests that funds and their advisers should review their policies, practices, and procedures over perhaps the entire range of mutual fund operations and compliance functions. While many of these observations were unsurprising (e.g., marketing material reviews), there were a few observations that may deserve additional focus:
- The staff noted deficiencies in the “oversight of the viability of smaller and/or thinly traded ETFs … and their liquidation,” as well as funds’ failure to have board reporting processes regarding “whether a fund’s liquidation may be in the best interests of the fund and its shareholders.” These findings suggest advisers and fund boards should be periodically discussing the viability of their smaller funds and developing contingency plans where funds fail to gain sufficient traction in the market.
- Another deficiency noted by the staff related to “sharing of soft-dollar commissions among clients to assess whether any client is disadvantaged.” The implicit reference in this observation that advisers must assess disadvantages to individual clients is inconsistent with the soft-dollars safe harbor, which allows advisers to assess whether the amount of commissions paid in the aggregate is reasonable in relationship to the value of research provided for the benefit of the adviser's overall clients.
- The staff also noted that advisers were deficient where they did not review index provider relationships for: (1) conflicts of interest with advisers (e.g., shared personnel or other business relationships, such as revenue sharing); and (2) the sharing, or the potential misuse, of material non-public information. While this observation is not inconsistent with good business practice, we are unaware of any formal guidance from the SEC or the staff to this effect.
- The staff also noted inadequate compliance policies and procedures with respect to “specific risks associated with each fund’s investments such as asset classes that present certain operational or other risks.” This observation is notable because, while recent rulemakings in the derivatives and liquidity spaces have shown that the SEC is a fan of risk management programs, to date, the SEC has not formally required investment or operational risk assessments as part of a fund compliance program.
Although the scope of deficiencies noted in the risk alert was very broad, the risk alert was not entirely critical. The SEC staff noted several observations of compliance practices that “advisers may find helpful in their compliance oversight practices,” such as:
- Conducting periodic testing and reviews for compliance with fund disclosures.
- Reviewing and, where appropriate, amending disclosures to align with practices, including assessing fee and expense disclosures.
- Ensuring fund websites include any new or amended disclosures.
- Performing reviews of compliance policies for consistency with practices.
- Assessing the effectiveness of compliance policies and procedures.
- Including vendor oversight within the remit of the compliance program.
- Reviewing performance advertising.
- Generally adopting compliance policies and procedures that address compliance with law, regulation, exemptive orders, etc.
The risk alert concludes by encouraging registered funds and their advisers to review their practices, policies, and procedures generally. The scope of the risk alert serves as a reminder to funds and advisers to focus not only on the emerging compliance issues, but also to continue to maintain their core compliance programs as reflective of current practice. The breadth of the deficiency observations also allows it to serve as a roadmap or even a checklist for conducting a review of practices, policies, and procedures to ensure their overall programs continue to operate effectively.
Contacts
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Boston
Lea Anne Copenhefer
Barry N. Hurwitz
Roger P. Joseph
Jeremy B. Kantrowitz
Paul B. Raymond
Toby R. Serkin
Mari Wilson
New York
Elizabeth L. Belanger
Orange County
Laurie A. Dee
Philadelphia
David W. Freese
Sean Graber
Timothy W. Levin
John J. O’Brien
Washington, DC
Laura E. Flores
Thomas S. Harman
Christopher D. Menconi
W. John McGuire
Beau Yanoshik
Steven W. Stone
Mana Behbin