Asset Management Regulatory Update

SEC ANNOUNCES CHARGES AGAINST INSTITUTIONAL INVESTMENT MANAGERS IN CONNECTION WITH 13F AND 13H REPORTING VIOLATIONS

On September 17, 2024, the Securities Exchange Commission (the “SEC”) announced settlements with eleven institutional investment managers for failing to timely report on Form 13F. Two managers were also charged with failing to file as “large traders” on Form 13H.

Under Section 13(f)(1) of the Securities Exchange Act of 1934 (“Exchange Act”), institutional investment managers that exercise investment discretion over $100 million or more in Section 13(f) securities are required to file quarterly reports listing positions via Form 13F, due within 45 days after the end of the calendar quarter. Section 13(f) securities are equity securities of a class described in Section 13(d)(1) of the Securities Exchange Act. A list of the Section 13(f) securities – called the Official List of Section 13(f) Securities – is available shortly after the end of each calendar quarter on the SEC's website. For Section 13(f) purposes, an “institutional investment manager” is an entity that either invests in, or buys and sells securities for its own account, or any a natural person or an entity that exercises investment discretion over the account of any other natural person or entity. An institutional investment manager exercises investment discretion if: (i) the manager has the power to determine which securities are bought or sold for the account(s) under management, or (ii) the manager makes decisions about which securities are bought or sold for the account(s), even though someone else is responsible for the investment decision. A manager also has investment discretion with respect to all accounts over which any natural person, company, or government instrumentality under its control exercises investment discretion. Forms 13F filed with the SEC are available to the public on the SEC's website.

Under Exchange Act Section 13(h) and Rule 13h-1, any person that directly or indirectly exercises investment discretion over transactions in NMS securities that equal or exceed (i) 2 million shares or $20 million during any calendar day, or (ii) 20 million shares or $200 million during any calendar month must identify themselves as a “large trader” to the SEC via an initial Form 13H “large trader” filing, after which a Large Trader Identification Number is issued for purposes of notifying broker-dealers for which the person has an account. Following an initial filing, large traders must submit an annual filing within 45 days of the end of each full calendar year. If any information on Form 13H becomes inaccurate, a large trader must file an amended Form 13H promptly after the end of the calendar quarter in which the information became inaccurate. An “NMS Security” is defined in Rule 600(b)(46) and refers, in general, to exchange-listed equity securities and standardized options but does not include exchange-listed debt securities, securities futures, or open-end mutual funds, which are not currently reported pursuant to an effective transaction reporting plan. Unlike Form 13F, Form 13H is not publicly available.

The Form 13F and 13H violations stemmed from failures on the part of the managers to make the required Form 13F and Form 13H filings over extended periods, many of whom had failed to make quarterly filings for years.

Nine managers agreed to pay more than $3.4 million in combined civil penalties. Two of the eleven managers were not required to pay any civil penalties in recognition that they self-reported their non-compliance with the Form 13F filing requirements and received cooperation credit. Similarly, the two managers were not ordered to pay a civil penalty or separate fine in relation to their failure to file Form 13H as both managers self-reported their own the Form 13H failures and otherwise cooperated with the SEC's investigations.

SEC ADOPTS REPORTING ENHANCEMENTS FOR REGISTERED INVESTMENT COMPANIES AND PROVIDES GUIDANCE ON OPEN-END FUND LIQUIDITY RISK MANAGEMENT PROGRAMS

On August 28, 2024, the SEC adopted amendments to Form N-PORT, the form on which registered investment companies, including open-end funds, registered closed-end funds, and exchange-traded funds (collectively, “funds”), report certain portfolio holdings and related information.

Currently, funds are required to file Form N-PORT reports with the SEC on a quarterly basis within sixty days after quarter end. Only the third month in a quarter is made publicly available, with the first and second months remaining confidential. The Form N-PORT amendments will require funds to file reports on Form N-PORT on a monthly basis within thirty days after the end of the month to which they relate and make funds' monthly reports publicly available sixty days after the end of each month. The SEC's release announcing the adoption of the amendments states that these changes are intended to give the SEC timelier information to conduct oversight of an “ever-evolving fund industry” and to provide investors information to make more informed investment decisions.

The SEC did not adopt proposed amendments that would have required funds to present portfolio holdings in accordance with Regulation S-X more frequently than is currently required. Additionally, the SEC did not adopt proposed amendments that would have required funds to report information regarding funds' use of swing pricing or liquidity classifications, noting that the SEC is not adopting the amendments to the underlying rules at this time.

The SEC also adopted amendments to Form N-CEN. Specifically, funds subject to Rule 22e-4 under the Investment Company Act of 1940 (the “Investment Company Act”) will be required to report certain information about the service providers used to fulfill liquidity risk management program requirements. A fund will be required to: (i) name each liquidity service provider; (ii) provide identifying information, including the legal entity identifier, if available, and location, for each liquidity service provider; (iii) identify if the liquidity service provider is affiliated with the fund or its investment adviser; (iv) identify the asset classes for which that liquidity service provider provided classifications; and (v) indicate whether the service provider was hired or terminated during the reporting period.

Additionally, the SEC provided guidance related to certain aspects of open-end fund liquidity risk management program requirements. Rule 22e-4 under the Investment Company Act (the “Liquidity Rule”) requires open-end funds to adopt and implement liquidity risk management programs and requires (i) the assessment, management, and periodic review of a fund's liquidity risk; (ii) classification of the liquidity of a fund's portfolio investments into one of four categories (“highly liquid,” “moderately liquid,” “less liquid,” and “illiquid”) with at-least-monthly reviews of classifications; (iii) determination and periodic review of highly liquid investment minimums (“HLIMs”); (iv) limitation of the amount of illiquid investments held by a fund; and (v) board oversight. The guidance includes that the SEC staff (the “Staff”) observed instances where funds were not prepared to review liquidity classifications intra-month in response to changes in market, trading, and investment specific considerations.

As stated in the SEC's guidance, the Liquidity Rule requires funds to adopt and implement policies and procedures reasonably designed such that a fund can conduct the required intra-month review of classifications if there are changes in the market, trading, and investment specific considerations. The guidance states that funds should consider reviewing classifications if changes in portfolio composition are reasonably expected to materially affect one or more investment classifications. The guidance further states that funds should consider classifying new investments intra-month if acquiring a particular investment is expected to materially change the liquidity profile of a fund, particularly changes that may cause a shortfall below a fund's HLIM or cause the fund to exceed the Liquidity Rule's limitations on illiquid investments.

As part of a fund's determination as to whether to classify an investment as “highly liquid” or “moderately liquid,” funds are required to consider the time in which it expects an investment to be convertible to cash without significantly changing the investment's market value. The guidance notes that the Staff has observed international funds considering the time in which an investment would be convertible to a different currency other than U.S. dollars as the relevant period for determining when an investment is convertible to cash and funds that have classified any currency as “highly liquid” regardless of the amount of time it would take to convert to U.S. dollars. Among other items, the guidance includes that funds should not base liquidity determinations in an international jurisdiction on the ability to sell, dispose of, or settle an investment into the local currency without also considering the ability to convert that local currency into U.S. dollars. The guidance also included information related to funds with established HLIMs.

The amendments to Form N-PORT and Form N-CEN will become effective on November 17, 2025. Funds will be required to comply with the amendments as of the effective date, except that groups with less than $1 billion in net assets will have until May 18, 2026 to comply with the Form N-PORT amendments.

RECORDKEEPING ENFORCEMENT

The SEC has continued its focus on compliance with recordkeeping requirements in connection with off-channel communications through the use of personal devices. In this quarter alone, the SEC brought four enforcement actions against various registered investment advisers, broker-dealers, municipal advisors, and rating agencies for failure to comply with the recordkeeping provisions of the federal securities laws, resulting in approximately $531 million in penalties.

Section 17(a)(1) of the Exchange Act and Section 204 of the Investment Advisers Act of 1940 (“Advisers Act”) authorize the SEC to issue rules requiring broker-dealers and investment advisers keep certain records, for prescribed periods, for the protection of investors. The rules adopted under Section 17(a)(1) of the Exchange Act, including Rules 17a-4 and 17a-3, impose minimum recordkeeping requirements based on a prudent broker-dealer standard. These requirements include preserving original communications received and copies of communications sent relating to the broker-dealer's business for specified periods of time. The rules adopted under Section 204 of the Advisers Act, including Rule 204-2, require that advisers preserve original communications received and copies of communications sent that relate to (i) advisers' recommendations and advice, (ii) receipt or delivery of funds, (iii) the placing of orders to purchase or sell securities, or (iv) securities recommendations.

In October 2022, the Staff initiated a risk-based investigation into whether investment advisers were properly maintaining communications required to be preserved under the Advisers Act. As a result, on August 14, 2024, the SEC announced charges against 26 broker-dealers, investment advisers, and dually registered broker-dealers and investment advisers for (i) widespread failures to maintain and preserve electronic communications through unapproved off-channel communication methods, and (ii) failure to supervise personnel with respect to preventing and detecting recordkeeping violations.

Four of the twenty-six firms charged agreed to pay a penalty of $50 million each for failures to maintain records of off channel communications sent and received by firm personnel in violation of both Exchange Act Rule 17a-4(b)(4) and Advisers Act Rule 204-2(a)(7). 

With respect to one firm (“Firm 1”) certain communications sent from and to personnel were required to be preserved under the Advisers Act because they either related to (i) advisory recommendations or advice, or (ii) the investment adviser's receipt or delivery of funds or securities. Of the communications that were not preserved, one identified example was text messages on unapproved platforms with recommendations to buy or sell securities of specific companies. The personnel at three other firms (“Firm 2,” and “Firm 3,” and “Firm 4,” respectively, and together with “Firm 1” the “Firms”) each sent and received off-channel communications that were records required to be maintained under Exchange Act Rule 17a-4(b)(4) and/or Advisers Act Rule 204-2(a)(7). The SEC's orders with respect to these firms included that each firm did not maintain or preserve the substantial majority of these written communications, and that each Firm's failures were firm wide. With respect to Firms 2 and 3, the SEC's orders state that the failures involved personnel at various levels of authority throughout the relevant organization. With respect to Firm 4, the personnel involved with such failures included financial advisors who, together with other personnel they supervised, were responsible for generating some of the highest levels of revenue for Firm 4 within the relevant period described in the order (since 2019). As a result of these findings, each Firm was required to pay a civil penalty and obtain compliance consultants.

Of the twenty-six firms charged in the same enforcement action, three of the firms self-reported their violations which resulted in significantly lower penalties. The firms will pay a combined civil penalty of $392.75 million, and each firm has begun implementing improvements to their recordkeeping policies.

This quarter, the SEC also conducted three other enforcement actions resulting in significant penalties:

• On September 24, 2024, the SEC announced charges against twelve firms, including broker-dealers, investment advisers, and one dually registered broker-dealer and investment adviser, for recordkeeping failures. The firms were required to pay combined civil penalties of $88.225 million.
• On September 17, 2024, the SEC charged twelve municipal advisors for failures to preserve electronic communications, and the firms were required to pay combined penalties of $1.3 million.
• On September 3, 2024, the SEC charged six nationally recognized statistical rating organizations (NRSROs) for recordkeeping violations pursuant to Section 17(a)(1) of the Exchange Act and Rule 17g-2(b)(7) thereunder, resulting in combined civil penalties of more than $49 million.

The recent focus by the SEC on recordkeeping violations and the steep combined civil penalties highlight the importance of maintaining and implementing strict recordkeeping policies. However, the SEC places value on both self-reporting and cooperation with SEC investigations. Therefore, in the event of a known violation, self-reporting violations and cooperation with investigations may lessen the impact of such violations.

MARKETING RULE ENFORCEMENT

On September 9, 2024, the SEC announced settlements with nine SEC-registered investment advisers for alleged violations of Rule 206(4)-1 (the “Marketing Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”) in connection with SEC's ongoing enforcement sweep of investment adviser compliance with the Marketing Rule.

The Marketing Rule underwent significant amendments in 2020, and compliance with the rule became mandatory for all registered investment advisers on November 4, 2022. The September 2024 announcement follows the SEC's announcement of its second set of settled enforcement cases against five advisory firms in April 2024, following a previous announcement of settled enforcement cases against nine advisory firms in September 2023.

The SEC's settlements alleged that the nine advisers distributed advertisements that included untrue or unsubstantiated statements of material fact in violation of the Marketing Rule's principles-based general prohibitions for all advertisements (the “General Prohibitions”) or advertised testimonials, endorsements, or third-party ratings that could not be substantiated or lacked required disclosures.

In addition to the Marketing Rule's provisions regarding particular aspects of advertisement, the General Prohibitions provide that advertisements may not, among other things, (i) include an untrue statement of a material fact or omit a material fact necessary to make the statement made, in the light of the circumstances under which it was made, not misleading; or (ii) include a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the SEC. To establish a violation of the General Prohibitions of the Marketing Rule, the SEC only needs to demonstrate simple negligence on the part of the adviser and does not need to prove scienter.

Per the SEC's orders, one adviser disseminated an advertisement on its public website describing it as a member of an organization that did not exist. Relatedly, the SEC also alleged that four advisers had falsely advertised their advice as being free from customer conflicts without providing any context for the claim. However, the SEC cited the various material conflicts of interest disclosed in the advisers' Form ADV Part 2A brochures as the unreasonable basis for believing the advisers could substantiate such claims.

Under the Marketing Rule, registered investment advisers are prohibited from including any “testimonial” or “endorsement” in an advertisement unless the investment adviser clearly and prominently makes certain disclosures, including that the testimonial was given by a current client or private fund investor, the endorsement was given by a person other than a current client, that cash or non-cash compensation was provided for the testimonial or endorsement (as applicable), and any material conflicts of interest resulting from the investment adviser's arrangement with such person giving the testimonial or endorsement. Likewise, investment advisers are prohibited from including any third-party rating in an advertisement unless the investment adviser clearly and prominently discloses the date on which the rating was given and the period of time upon which the rating was based, the identity of the third party that created and tabulated the rating, and, if applicable, that compensation has been provided directly or indirectly by the adviser in connection with obtaining or using the third-party rating.

Per the SEC's order, one adviser's website displayed select testimonials from individuals expressing a positive view of the adviser; however, the quotations presented included one “testimonial” from a person who was no longer a client of the firm and another purported testimonial from a person who the firm was unable to verify had ever been a client. Relatedly, some of the advisers were also alleged to have used misleading third-party ratings from industry rankings such as Reuters, Barron's, and The Financial Times by omitting the required information about the timing and the nature of awards.

The nine advisers agreed to pay $1,240,000 in combined civil penalties.

UPCOMING CONFERENCES

*Host Organization Key: Mutual Fund Directors Forum (“MFDF”), Independent Directors Council (“IDC”), and Investment Company Institute (“ICI”)

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