United States: Market Trends 2018/19: Investment Companies

This market trends article reviews the Securities and Exchange Commission (SEC) regulatory agenda, releases, speeches, and statements for hints on how the SEC may regulate investment companies, as well as where regulations may be headed in the coming months. Rulemaking got off to a slow start in 2019, as the year opened in the midst of the government shutdown, which lasted from December 22, 2018 until January 25, 2019. Since then, the SEC has been playing catch up.

Reading the regulatory tea leaves, we are seeing a trend towards a regulatory approach that focuses more on principles-based regulations that are designed to reduce, or at least not increase, regulatory burdens on financial firms.

There also appears to be a continuing trend that the SEC may shift its enforcement efforts to focus on major fraud cases and place less emphasis on policing minor violations (known as the broken windows approach). In past years, many criticized the broken windows approach as a misplaced use of limited resources.

Legal and Regulatory Trends

The Office of Management and Budget's Spring 2019 Unified Agenda of Federal Regulatory and Deregulatory Actions (the Spring 2019 Agenda), which reports near and longterm regulatory actions, provides a window into the current thinking of certain administrative agencies, including the SEC. Here are some of the most relevant items on the SEC's regulatory agenda, as disclosed on the Spring 2019 Agency Rule List.

Pre-rule Stage

The staff of the SEC (the Staff) is considering recommending that the SEC seek public comment on ways to harmonize and streamline the SEC's rules for exempt offerings.

Proposed Rule Stage

The Staff is considering proposing to the SEC the following initiatives:

  • Custody rules for investment companies and investment advisers. In what may be one of the SEC's most important and potentially controversial rules, the Division of Investment Management said that it is considering recommending that the SEC propose amendments to rules concerning custody under the Investment Company Act of 1940 (the 1940 Act) and the Investment Advisers Act of 1940 (the Advisers Act). We expect that the proposed amendments will address custody of digital assets, but this is by no means assured.
  • Use of derivatives by registered investment companies and business development companies. The Division of Investment Management is considering recommending that the SEC re-propose a new rule designed to enhance regulation of the use of derivatives by registered investment companies and business development companies, as further discussed below.
  • Marketing rules under the Investment Advisers Act of 1940. The Division of Investment Management is considering recommending that the SEC propose amendments to Rules 206(4)-1 and 206(4)-3 under the Advisers Act regarding marketing communications and practices by investment advisers.
  • Fund of funds arrangements. On December 19, 2018, the SEC proposed new rules and amendments to allow funds to acquire shares of other funds (known as "fund of funds" arrangements), including arrangements involving exchange-traded funds (ETFs), without first obtaining exemptive orders from the SEC. The proposal drew more than 90 public comments, including some that questioned limitations on the amount of shares that a fund of funds could redeem of a portfolio fund that it holds.
  • Expedited application review process. The Division of Investment Management is considering recommending that the SEC propose amendments to Rule 0-5 under the 1940 Act to establish an expedited review procedure for certain types of applications. This proposal would be a welcome step to reducing the time and cost associated with the process for applying for exemptive orders.
  • Volcker Rule. On December 21, 2018, the SEC proposed revisions to the rules implementing Section 619 of the Dodd-Frank Act, known as the Volcker Rule, which restrict proprietary trading and certain relationships with covered funds (proposed jointly with other financial regulators).
  • Regulation S-X and Regulation S-K amendments. The SEC staff is considering to recommend proposed amendments to certain disclosure requirements in Regulation S-X and Regulation S-K that have become redundant, duplicative, overlapping, outdated, or superseded in light of other accounting and disclosure requirements.

Final Rule Stage

Exchange-Traded Funds

On March 11, 2018, the SEC proposed rules and amendments to allow certain ETFs to operate without first obtaining exemptive orders from the SEC. If adopted as proposed, Rule 6c-11 would replace most individual exemptive orders issued to existing ETFs. One of the SEC's stated goals is to create a level playing field among all ETFs subject to the rule. Geared ETFs would be excluded from the exemptive rule, and would be required to obtain individual orders. (The SEC proposed similar ETF relief more than a decade ago without taking any further action on it.)

Regulation Best Interest

On June 5, 2019, the SEC approved Regulation Best Interest and related guidance and interpretations on responsibilities of investment professionals relating to standards of conduct to their retail customers, as further discussed below.

Investment Company Reporting Modernization

On June 5, 2018, the SEC adopted Rule 30e-3 under 1940 Act, which was originally proposed in May 2015 as part of the SEC's broader investment company reporting modernization proposal. Rule 30e-3 permits, but does not require, registered investment companies to deliver certain reports to shareholders electronically by making them accessible on their website.

The Auditor Loan Rule

On June 18, 2019, the SEC adopted rules governing auditor independence with respect to certain loans or debt-credit relationships. Under the prior rule, an auditor that has obtained a loan from an entity that is the beneficial owner of more than 10% of the outstanding securities of a fund may find its independence in question with respect to that fund and other funds in the complex. The rule replaces the 10% bright-line test with a significant influence test. The new rule becomes effective 90 days after the date of publication in the Federal Register.

Long-Term Actions

In the Spring 2019 Agenda, the SEC published its list of backburner (Long-Term Action) status regulatory initiatives. These include:

  • Rules to improve and modernize the current disclosure framework of funds under the 1940 Act to improve the investor experience
  • Rules and form amendments to improve and modernize the current disclosure framework for investment company fees under the 1940 Act
  • The listing and trading of exchange-traded products (ETPs), other than ETFs
  • Requirements to disclose in proxy statements information about the diversity of board members and nominees
  • Rules implementing Section 953(a) of the Dodd-Frank Act, to require issuers to disclose information that shows the relationship between executive compensation actually paid and the financial performance of the issuer
  • Rules that would (1) amend the net capital rule to require broker-dealers to conduct regular liquidity stress testing and maintenance requirements, (2) add additional notification requirements for broker-dealers concerning their financial condition, and (3) amend certain brokerdealer recordkeeping requirements concerning transfer of customer accounts to another carrying broker-dealer

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