Experts on the recent behavior of the SEC’s Examinations and Enforcement divisions consistently use a single word in their advice to fund boards or advisers tempted to confess their procedural failings to regulators.
The word is ‘don’t.’
Don’t follow the advice of SEC officials including SEC Enforcement chief Gurbir S. Grewal, who urged registrants in October 2023 and in February of this year to “self-report their potential securities law violations and proactively cooperate with our investigations. Such parties may face substantially reduced civil penalties or even no penalties at all.”
And don’t follow the advice of Sarah ten Siethoff, deputy director and associate director for rulemaking in the SEC’s Division of Investment Management (DIM), who advised investment-company executives wondering how to interpret the language of new SEC rules on marketing, naming and other potentially gray areas should write out their questions in detail and send them in for possible inclusion in one of the FAQs the Commission puts out in response to such questions from registrants.
“Please don’t,” asked Dalia Blass, former director of the DIM and current senior partner with Sullivan & Cromwell’s Financial Services Group said during a March 18 panel discussion at the Investment Company Institute’s Investment Management Conference in Palm Desert, Calif.
“When you take all your questions to the Commission you are leaving room open for the Commission, not Commission staff, to amend something that was already adopted,” Blass said. “It’s not necessary. The industry can come up with its own answers. There is a process for how these FAQs go through the building and let me tell you: Do not engage with it. That’s my two cents,” Blass said.
Ten Siethoff conceded that the Commission does not try to provide answers individually or in the form of published FAQs to every question the staff sees frequently, either because the solutions registrants suggest are in line with what the staff expected, or because their situations are too idiosyncratic to be relevant to the rest of the industry “so we don’t see any benefit in transmitting it.”
“If people are applying something in a way we don’t agree with they’re going to find out about it,” ten Siethoff said. “There are cases where there can be a variety of answers and our best foot forward is not to step into it,” she said.
“I don’t 100% agree with what Dalia said, but there are cases where what we want you to do your job, answer the question yourself and apply it – and if you feel confident then it is probably fine,” ten Siethoff said.
For rules that define aspects of marketing, naming or behavior that don’t directly threaten to violate issues related to fiduciary duty or other major problems, it is often better for investment advisers to come up with their own interpretation of the rule, as long as that interpretation is fully documented and compliance staff can demonstrate the steps they took to make sure the firm’s policies and procedures are consistent with that interpretation, the panel concluded.
Members of several panels at the ICI conference agreed that the best way to demonstrate a firm is acting in good faith in its efforts to implement rules that are difficult to interpret is to document the process of developing their own interpretation, not just the result of that process, and documenting the steps the firm took to make sure that interpretation is reflected in the firm’s products and procedures.
Lack of trust
The worry that an investment firm could be identifying itself as a target for examination simply by asking how to interpret complex new rules is one example of what the leaders of several industry associations have called a growing sense of distrust among industry firms suspicious about the priorities of SEC leaders and the way those priorities are reflected in the enforcement of new rules.
In the past, the SEC has worked in tandem with industry associations to develop and test new rules in isolated environments before they were formally proposed, especially if they were broad enough in scope to change the structure or dynamics of the market as is the case with many rules proposed during the past three years, according to ICI officials, including ICI president and CEO Eric Pan, who used his keynote at the conference to slam as “harmful” the aggressive rulemaking agenda of the SEC under current chair Gary Gensler.
Regulations like the Fund Names rule were pitched as a way to make sure fund names didn’t mislead investors about investment strategies, “but the final mandate goes much further, sweeping three-quarters of all U.S. funds into its dragnet,” Pan said.
The SEC has also based controversial proposals including the liquidity risk-management rule that would mandate swing pricing for open-end U.S. funds, on questionable evidence and unsupported accusations that wrongly portray investment advisers as a problem to be solved rather than members of an industry behaving exactly as they are supposed to behave under existing regulations, he said.
SEC officials have been quite aggressive about touting the reduction in penalties granted to companies that self-reported violations, but few involved in those disputes seem willing to trust the SEC’s promises of clemency.
Promises of light penalties for self-reporting have been especially thick in cases involving the use of mobile text, WhatsApp or other off-channel, unmonitored methods of communication, which have been a high priority for Enforcement since at least September of 2022, when it announced 16 companies had paid a total of $1.1bln in penalties for “pervasive” use of off-channel communications.
But the promise of lower fines for companies that reported violations, fixed the problem themselves and cooperated with SEC investigations was too inconsistent for attorneys to recommend self-reporting as a viable option for most companies, even right after the first round of off-channel communications fines were announced and SEC officials began talking up the benefits of self-reporting, according to analysis posted Dec. 30, 2022 by law firm Skadden, Arps, Slate, Meagher & Flom LLP.
Even now, “I haven’t seen situations where I think self-reporting really materially changes the outcome for the benefit of registrants,” according to Amy Doberman, a partner at Wilmer Cutler Pickering Hale and Dorr LLP, who spoke about managing the downside of attention from SEC examiners during a March 20 panel at the ICI conference.
The June, 2023 announcement that the SEC would fine Pacific Investment Management Company LLC (PIMCO) $9m to settle charges that it failed to inform investors of charges that would impact their dividends of one fund and failed to waive advisory fees as required in connection with another, undercut the credibility of the SEC’s promise to go easy on penalties for companies willing to admit fault and cooperate, Doberman said.
“When a client comes to me and says we have an error that’s been going on a while, my reaction is to fix it properly, pay interest if you need to; disclose it to the client; disclose it to the board; do the right thing,” she said. “but it seems to me that [PIMCO] did everything right, and ended up with a multimillion-dollar penalty. So it’s really questionable to me what the benefit is of self reporting.”
