SEC staff advice on avoiding compliance trouble in 2023

Staffers explain how to approach issues critical to fund boards; SEC bosses promise to match in 2023 the aggressive enforcement that drew complaints this year

The SEC put a lot of effort during the final weeks of 2022 into warning fund boards and investment-company executives that the rulemaking and enforcement that generated so many complaints during 2022 would, if anything, intensify during 2023.

The effort to remind members of the industry of the vigor with which this edition of the commission approaches enforcement started off with a bit of finger-wagging during a Nov 2 speech from SEC Chair Gary Gensler.

Gensler reminded lawyers attending the annual Institute on Securities Regulation conference that they can be held personally accountable for any failure to protect the interests of shareholders, especially if those failures involve conflicts of interest between shareholders and investment advisers or other clients.

“When lawyers — or other gatekeepers, like auditors and underwriters — breach their positions of trust and violate the securities laws, we will not hesitate to take action,” Gensler said.

The commission followed up that message with the publication Nov. 15 of a report showing the SEC’s enforcement effort netted a record $6.44 bn during 2022, and the Nov. 23 release of a five-year plan that predicted SEC enforcement would become even more effective as it ramped up its data-gathering and analytical capabilities in ways that would allow it to spot signs of bad behavior on its own rather than relying as heavily as it does now on whistleblowers.

The penalty is not the point

The commission plans to continue its aggressive approach to enforcement, including its tendency to make examples of major companies caught violating rules that are high on the SEC’s priority list, but not because the agency wants to rack up new records for penalties and disgorgements every year, SEC director of enforcement Gurbir S. Grewal said during one of two regulatory enforcement seminars at which top-level SEC officials spoke in mid-November.

Eye-popping penalties help get the attention of companies that may have become lax in their enforcement of rules that exist not specifically to prevent fraud, but to ensure the whole process is transparent enough to show shareholders and investigators that no fraud is involved, Grewal said, citing the $1.24bn in penalties the SEC levied against 17 firms accused of allowing employees to talk business using off-channel communications methods including personal text, WhatsApp or other non-approved communications apps.

The goal of aggressive enforcement and sky-high penalties is to get registrants to pay attention to and enforce the rules, not to give the SEC the chance to brag every year that it had racked up another new record for penalties and disgorgements, Grewal said.

“We expect behaviors to change,” Grewal said. “We expect compliance.”

So, in an offer to offer some solid advice on how to avoid becoming a high-profile demonstration of SEC enforcement, the commission offered the day-long Compliance Outreach Program National Seminar online seminar Nov. 15, featuring mid- to senior-level staffers offered advice not only on how to comply with rapidly changing regulations, but how to document and report compliance in the clearest way possible.

It’s not the first time the SEC has offered the equivalent of how-to seminars on compliance, but it is a welcome change from an agency working so hard to keep up with its own regulatory agenda that has become difficult for the lawyers representing funds and public companies to get the answers they need about whether the innovative parts of a new strategy or line of business are as legal as the fund lawyer believes.

Questions of trust

“Members of staff continue to be great,” according to one attorney who asked to remain anonymous while talking about day-to-day relationships with SEC staffers. “They’ve just got so many other things pulling them in other directions that it is becoming increasingly difficult to have any of those discussions without feeling as if some change in policy is going to reverse what you thought was a reliable interpretation,” according to the attorney, who is one of several lawyers and fund directors who have made the same point while talking with FundDirections reporters during recent months.

There is also a level of distrust in the agency’s follow-through on things like its statements about the value of full cooperation, according to an analysis posted Dec. 30 by law firm Skadden, Arps, Slate, Meagher & Flom LLP.

“While we did see actions where cooperation resulted in no penalties, we also saw others where significant penalties were imposed despite self-reporting and cooperation,” the analysis read. The division continues to say it values cooperation, but the amount of credit a particular firm can earn by cooperating depends on the circumstances of the violations being investigated, the analysis concluded.

The agency is also, increasingly requiring that companies accepting a settlement also hire an independent compliance consultant to gather information about the company’s overall compliance effort and report that information back to the SEC “especially in cases where there has not been enough time for the division to assess the effectiveness of the company’s compliance program,” according to the report, which was written by attorneys Anita B. Bandy, Raquel Fox and Andrew Hanson.

The three also noted an increasing emphasis from SEC officials on keeping auditors, compliance and legal staffers the SEC refers to as “gatekeepers” accountable for a firm’s overall compliance efforts.

Gensler appeared to confirm that impression during his introduction to the Nov. 15 seminar in which he warned that “advisers have to comply with specific duties relating to care and loyalty. To meet these duties, advisers need to prevent their own interests from inappropriately influencing their recommendations and advice,” Gensler said. The first piece of advice would be that advisers who find themselves in a conflict either avoid giving advice on the topic or “find some other way to ensure that they don’t put their interests ahead of the investor’s interests,” Gensler said.

The Skadden, Arps, Slate, Meagher & Flom report also noted that the SEC is paying close attention to other issues, including the effort some companies use to polish their quarterly earnings-per-share results by shipping customer orders early, pulling cash out of reserve accounts or using other accounting tricks that could falsely improve quarterly reports by shifting revenue improperly from one quarter to another.

The SEC is also monitoring “pull-in” and other sales practices as well as efforts to manage order backlogs with accounting that is correct under FASB rules, but may cause earnings, demand or growth reports to be inaccurate or misleading.

The report also warned that the SEC is keeping a close eye on the cybersecurity compliance of broker-dealers and investment advisers, and the ESG compliance of pretty much every registered company, all of which should keep details of the proposed new rules on cybersecurity and ESG marketing in mind even though neither has been finalized yet.


Compliance tips from the SEC Compliance Outreach Program National Seminar, Nov. 15, 2022

Members of the SEC staff and a few experts invited in to provide industry perspective addressed questions and offered advice within their own areas of expertise during this day-long seminar.

The agenda for the event is available here, though the SEC has not yet posted an archived version of the webcast.

Some of the most relevant questions and answers from the session focused on issues related to registered funds are listed below, along with the name and title of the staffer giving the advice:


Topic: Fair valuation processes under valuation Rule 2a-5

From the SEC’s point of view, the valuation rule that went into effect Sept. 8 is primarily a process issue, according to Chris Carlson, senior counsel for the SEC’s Division of Investment Management.

“Performance of fair evaluations in good faith under Rule 2a-5 generally requires assessment and management of valuation risks, establishing and applying fair-value methodologies, the testing of fair-valuation methodologies and evaluation of pricing services,” he said.

The board or a designated expert have to do the initial assessment and risk evaluation of an asset, then periodically re-evaluate material risks, including potential conflicts of interest, apply acceptable fair-valuation methodologies to the evaluation and test whether those methodologies can be applied correctly and without conflict of interest or other risk. They must also test the accuracy and appropriateness of the methods and evaluate pricing services as well as the property being evaluated.


Topic: Role of the board under new valuation rule

The valuation rule is one of the few areas covered by the Investment company Act that imposes specific requirements on the board, according to Craig Ellis, exam manager for the SEC’s Division of Examinations in the Denver Regional Office.

Fund boards have to see that valuations are fair, understand the methodologies and ratify the valuations as fair, rather than delegating the whole process to someone else, Ellis said.

Rule 2a-5 requires that the board set up formal processes to demonstrate that the valuations being made are fair and follow the correct process.

The workflow may not change much for funds that already have a hierarchical set of data on the asset that includes value indicators such as the most recent trading price of the asset.

Funds that don’t have that process in place might once have decided that, if they don’t have a market-value quotation for the asset, could take the risk of creating a fair value in good faith as decided by the board, as they did in the past, but that is an area in which the SEC is accustomed to finding more violations “because the board didn’t always get the information they needed” to make an informed decision, he said.


Topic: Responsibilities of designated valuation evaluator. Rule 2a-5

Rule 2a-5 allows the board to designate the adviser or a fund officer to perform fair valuations in compliance with the rule. A board-valuation designee can ask a sub-adviser, fund administrator, or others for help or information but can’t delegate responsibility to them.

The evaluation designee is required not only to comply with all the requirements for fair valuation but is also required to provide quarterly and annual reports to the board and report any significant event to the board as well, Carlson said. Those reports must include the information requested by the board, a summary of material fair-valuation issues from the prior quarter, information on changes in how management-valuation risks are assessed and other changes. The valuation designee is also required to give the board a report of his or her assessment of the adequacy and effectiveness of the process the designee uses to determine fair value, including a summary of the result of testing other methodologies, an assessment of the resources available and material changes to the rules or functions of people responsible for making those valuations.


Topic: How well have funds adapted to the new valuation rules and what snags still exist?

Fund complexes, most of which had all the methodologies for fair valuation in place already, and had approximately a year to look in detail at new requirements, still had some trouble converting the implicit risk assessment that had been standard operating procedure to an explicit process well documented in writing, according to Francine Rosenberger, chief compliance officer of Transamerica Asset Management, Inc.

For most fund complexes, though, adaptation meant “upping their game and making sure the processes were expanded and documented a little further,” according to Rosenberger, who said the current hurdle is to revamp board-reporting procedures to align with new requirements.

“Here you’ll see some changes,” she said. “Boards are going to have to oversee the valuation process and the designee, which means they’ll be asking for specific information that may differ between complexes to help satisfy their oversight responsibilities. So the challenge is to make sure there’s a tight process in place, especially with respect to making the board aware within five business days of material issues.

The use of readily available market quotations is limited to level-one securities under the fair-value framework established by GAAP,  which has many fund complexes reassessing their level classifications to fit the new requirements, Rosenberger said,

“The real question is how is the board really going to oversee that valuation designee,” Rosenberger asked. “From the board’s perspective, what does that relationship look like? What is the process going to look like? How will the board evaluate the expertise, resources, and conflicts for the valuation designee?

“The last big challenge, looking forward, is what will the annual report look like?” Rosenberger asked. “Is the annual assessment going to be covered under the CCO’s 30-day report? Is there going to be an independent review? How will that happen? Now that we’re into implementation, we’ve got until September, so those conversations are going to have to happen pretty soon to be sure you can meet that requirement,” she said.


Topic: Allocation of funds between a registered fund and its adviser

There are a lot of details involved, but most of the problems occur between private funds and private fund managers, though at least one major principle applies to both, according to Craig Ellis, exam manager for the SEC’s Division of Examinations in the Denver Regional Office.

”When you talk about allocating expenses, it’s helpful to think about an arm’s length relationship with an individual client and what expenses naturally fall to the individual client without any intervention by the adviser at all,” Ellis said. “For a client with a brokerage account, trading charges will be built into that account, along with custodial fees, margin interest and other fees, but if they want legal services or tax or accounting, they would have to hire those themselves,” he said.

“If an adviser wants a client to pay part of the adviser’s rent, the adviser would have to sent an invoice and the client would probably laugh and tear it up unless that was part of a specific agreement,” Ellis said. “The same is true of research, travel, broken-deal costs, compensation or any other kind of investment-advisory overhead. I think if there’s an expense the adviser would have had to affirmatively send to the client to try to get payment, it shouldn’t be different just because the adviser controls the purse strings.

“Obviously there are a lot of terms and agreements that can call of different types of expense allocations, but there needs to be a really specific agreement with really clear disclosure in order to start billing clients for that sort of thing,” Ellis said. “That’s a good principle to start from.”


Topic: What are some of the concerns examination staff might have when reviewing a fund board’s advisory contract approval process?

“This is a really complex topic, but I picked three categories that might be of interest that I’ve seen recently,” said Craig Ellis, exam manager for the SEC’s Division of Examinations in the Denver Regional Office.

“The first might sound a little pedantic, but one thing we run into from time  to time in looking at board minutes and shareholder reports that say the board reviewed something, often when we dig into board materials, it turns out the board didn’t actually receive the information they said they reviewed.”

The problem is more common with funds that use a lot of sub-advisers, or that have a manager-of-managers model, or with boards that may oversee dozens of funds on which they have to do  15(c) reviews every year, Ellis said.

It is relatively common for boards to have a process in place to request the answers to specific questions, to be provided in a standardized format, but doesn’t get the answers it expects.

“The board might ask for a projection of profits, or costs and expenses for each fund, and maybe the adviser says they can’t do it for each fund, pre say here it is in aggregate, but the board minutes say they reviewed the profits and cost for each fund,” Ellis said. “It seems as if there’s not a process in place where someone checks to be sure the board really got what they asked for. The low-hanging fruit is to make sure you say what the board really reviewed, but the more important thing is to make sure the board received the information it needs.”

The second category is the misunderstanding some companies have about what an economy of scale really means. “If you have a $200m fund that might be big enough to clear its expense caps, so the advisers get the full fee, the question is: If the fund grows five times, from $200m to $1bn, fees are going to go up roughly five times. Do the advisers’ costs to manage the fund also go up five times? Does it require five times the research, five times the floor space, five times the number of portfolio managers? In most cases, the answer is no,” Ellis said. “And yet I’m surprised how often I see advisers dismiss that question offhand as economies of scale, or they’ll see analyses showing costs and growth over time and say there are no economies of scale.

“With an accounting lens, you can see right on the paper that these expenses don’t grow as fast. I think there may be some misunderstanding with some people about what the question about economies of scale is for and what it means,” Ellis said.

“The last thing is more an observation than a problem,” Ellis said. “Examiners tend to look at board materials in two-or three-year chunks. It’s interesting to look at 15(c) reviews over time because we see patterns that don’t show up in just one year. It would be interesting to suggest seeing how an expense comparison changed over time. If there are changes in expense allocation methodology from year to year, it would be interesting to ask why. Sometimes in one year, they’ll say they have no economies of scale but may introduce breakpoints as the fund grows. Two years later, if the fund has grown, it is helpful to look back and remember someone promised there would be breakpoints added if the fund grows. So it really is helpful to look at 15(c) submissions and notes year over year; it can give you insight looking at just one year won’t provide.”