SEC Division of Examinations Issues Registered Funds Risk Alert

The US Securities and Exchange Commission’s (SEC’s) Division of Examinations recently issued a Risk Alert citing recent deficiencies observed during examinations of registered funds, including the mischaracterization of environmental, social, and governance (ESG) factors in advertising materials, inadequate board processes for approving advisory contracts, and untimely reporting of illiquid investments.

STAFF OBSERVATIONS – DEFICIENCIES AND WEAKNESSES

To prepare the Risk Alert, [1] the Staff reviewed deficiency letters issued to registered funds during the last four years of examinations. Three general categories of deficiencies were identified: (1) fund compliance programs; (2) disclosure and regulatory reporting; and (3) fund governance practices, each of which are summarized below.

Fund Compliance Programs

• Lack of Oversight: Failure to perform required assessments, including annual compliance reviews and tests for compliance with exemptive orders or derivative segregation requirements (when applicable), and the omission of material information from—or not documenting—annual compliance reports.
• Insufficient Service Provider Assessments: Failure to review policies and procedures of third-party service providers (including advisers and sub-advisers) for consistency with contractual requirements and representations.
• Inadequate Policies and Procedures: Failure to adopt, implement, and/or enforce policies and procedures relating to critical areas of fund compliance, including custody, derivatives and liquidity risk management programs, valuation, portfolio management, trade allocations and errors, affiliated transactions, and other areas.
• Inaccurate Policies and Procedures: Policies and procedures were not tailored to funds’ business models or did not reflect actual practices, such as those relating to redemption requests and derivatives risk management programs.
• Missing or Inadequate Codes of Ethics, Compliance Reports: Failure to adopt, implement and/or enforce Codes of Ethics and policies and procedures to address breaches thereof (such as trading of restricted securities and not reporting conflicts and covered trades).
• Deficient Annual Compliance Reports: Chief compliance officers (CCOs) failed to provide written annual compliance reports to fund boards, which included instances where funds either did not have a CCO or had an interim CCO who did not prepare a written report.

Fund Disclosures in SEC Filings, Sales Literature, and Other Shareholder Communications

• Incomplete, Outdated, or Potentially Misleading Information: Failure to update or verify information in registration statements, fact sheets, and annual and semi-annual reports. Examples included failing to disclose payments to affiliates, statements about investment processes that were not consistent with advisers’ practices, and failures to manage portfolios according to stated asset investment thresholds. The Staff also observed funds described as “no-load” charging such fees.
• Inaccurate ESG Disclosures: Mischaracterizing the use of ESG factors in investment decision-making processes compared to actual practices.
• Delinquent Filings: Failure to make required filings or filing them on an untimely basis.

Fund Governance Practices

• Missing or Deficient Advisory Agreement Approvals: Fund boards failed to (1) timely review advisory and sub-advisory agreements, (2) request, obtain and/or consider certain information when evaluating advisory agreements, such as information concerning advisory fees and soft dollar arrangements, and (3) consider material changes to advisory agreements (e.g., changes of control at the adviser).
• Inadequate Board Communications: Advisers failed to provide fund boards with sufficient information to effectively oversee fund operations. For example, some fund boards were not notified when illiquid investments exceeded 15% of net assets and were not provided a plan to reduce holdings of illiquid investments.
• Absence of Required Board Actions: Fund boards failed to adopt policies and procedures suitable to oversee fund operations (e.g., anti-money laundering and liquidity risk management programs) or make certain required determinations, such as determining on an annual basis whether certain joint liability insurance policies remained in the funds’ best interest.
• Incomplete Board Meeting Materials: Board minutes did not fully document board actions (e.g., approval of liquidity risk management programs) or accurately reflect the board’s considerations in approving advisory agreements.

KEY TAKEAWAYS AND NEXT STEPS

To some degree, the Risk Alert should be read with a grain of salt, given the results of the November 2024 elections, which are likely to bring shifts in policy and focus at the SEC, which can be expected to trickle down through the divisions and regional offices. Still, even if examination and enforcement priorities shift in the coming months, the areas highlighted in the Risk Alert are largely apolitical in that they relate to the core statutory requirements of registered funds.

Not surprisingly, the deficiencies cited in the Risk Alert relate to areas that have been the subject of heightened attention from the SEC in recent years: increased focus on fund governance practices, oversight of service providers, market-facing disclosures and the materials used by the sales function with prospective investors, and the processes followed by boards when approving advisory agreements.

Although there are few surprises in the Risk Alert, it nonetheless serves as a good reminder of ongoing potential risk associated with the core compliance, operational, and governance functions of registered funds. We suspect that Staff transmitting request lists to newly selected examinees as well as Staff currently conducting exams of registered funds will use the Risk Alert to inform their processes. Registrants could very well start to see the Risk Alert cited to them by the Staff in the context of examinations or during the disclosure review process. Fund boards might also find the Risk Alert useful in that it provides a succinct overview of many of the key supervisory and oversight aspects of registered funds. And fund boards likely will also ask about the Risk Alert as it applies to the funds they oversee, which is another reason for fund operational and compliance teams to familiarize themselves with the Risk Alert.

We also suggest that funds and their advisers review their own practices, policies, and procedures in light of the deficiencies identified in the Risk Alert, as the Staff will consider the Risk Alert to constitute effective notice to registrants of these topics. Fund managers, boards, and CCOs may want to pay attention to the Staff’s comments with respect to the advisory agreement approval process, given the potential for private rights of action in that space.

In addition, we note that the Risk Alert specifically identified misstatements about ESG considerations as a notable deficiency. Although ESG matters were not included among the Division’s stated examination priorities for 2024 or 2025, its inclusion in the Risk Alert, coupled with recent significant enforcement action settlements with registered fund managers, may signal that ESG-related issues—such as “green washing”—remain front-of-mind with the Staff.

For additional information about the SEC Staff’s current focus areas in examinations, read our recent LawFlash on the SEC’s 2025 Examination Priorities.

Law clerk Jake Hermansen contributed to this LawFlash.