Investment Management: Compliance Developments & Calendar for Private Fund Advisers

While the Securities and Exchange Commission (SEC) brought several enforcement actions in 2018-19, the most significant new developments were published interpretations and alerts. Other agencies, such as the Commodity Futures Trading Commission (CFTC), also provided new guidance and brought significant enforcement actions.

Fiduciary Interpretation

In June of 2019, the SEC adopted a new interpretation (the “Fiduciary Interpretation”) defining fiduciary duties for investment advisers as consisting of a duty of loyalty and a duty of care, requiring investment advisers to provide advice that is in the best interests of the relevant client without putting the adviser’s interests ahead of the client’s. The Fiduciary Interpretation specifically defines the duty of loyalty, requires precise disclosure regarding conflicts and establishes a duty of care. For private fund and institutional clients, the Fiduciary Interpretation acknowledges a difference between retail and institutional clients.

The Fiduciary Interpretation further defines the duty of loyalty as an obligation not to subordinate the relevant client’s interests to its own. Advisers must try to eliminate conflicts of interest if possible or obtain informed consent after full and fair disclosure. Because of the difference in the ability of retail versus institutional clients, it may be difficult to obtain effective informed consent from retail clients for complicated conflicts of interest under the Fiduciary Interpretation.

As part of the duty of care, the Fiduciary Interpretation requires that advice be in the best interest of the client, based on a reasonable understanding of the client’s interests, seeking best execution and provide advice and monitoring over the course of the relationship. The duty of care can be varied by contract.

However, while the duties can be shaped through disclosure and through contractual language, the fiduciary duties cannot be waived or wholly disclosed away. The Fiduciary Interpretation also clarifies that any use of hedge clauses, especially with retail clients, is inconsistent with the antifraud prohibitions if they create the impression of waiver.

For further information, see our alert at https://www.akingump.com/en/news-insights/sec-adopts-new-interpretation-of-fiduciary-duty.html.

Voting Interpretation

The SEC adopted a new interpretation (the “Voting Interpretation”) in August of 2019, determining that voting obligations apply by default if the investment adviser has investment discretion and applying the concepts of the Fiduciary Interpretation to investment advisers’ obligations to vote securities. The Voting Interpretation requires investment advisers to adopt written policies that are reasonably designed to ensure that (i) votes are cast in the best interests of clients in light of the client needs and (ii) the investment adviser does not place the adviser’s interests ahead of the client’s interests. Investment advisers should also ensure that they are making investment decisions with complete and accurate information. While the voting obligation can be structured through agreement, the costs involved in voting decisions may also, depending on the strategy of the client, favor not voting. The Voting Interpretation applies similar requirements and supervision obligations for investment advisers in their retention of proxy advisory firms.

For further information, see our alert at https://www.akingump.com/en/news-insights/sec-applies-fiduciary-duties-analysis-to-voting-obligations.html.

Form ADV Part 3/Form CRS

At the same time it adopted the Fiduciary Interpretation, the SEC also adopted new rules requiring investment advisers to file a Form CRS that complies with Form ADV Part 3 if (and only if) they provide advice to a retail investor. A Form CRS will typically be limited to two pages consisting of a prescribed summary of the adviser-client relationship, conflicts of interest and disciplinary information.

Registered investment advisers providing investment advice to retail clients may file Form CRS starting on May 1, 2020, and must file a Form CRS that complies with Form ADV Part 3 by no later than June 30, 2020. After June 30, 2020, the SEC will not accept any new registrations that do not contain a Form CRS that complies with Form ADV Part 3 (if applicable).

After it is filed, Form CRS must be posted to the adviser’s website in an easily accessible location. It also must be delivered to new clients before entering into an advisory contract, and must be delivered to existing clients if any new account, service or rollover is recommended. Otherwise, investment advisers must deliver to existing clients within 30 days of filing.

If there are any changes that would make the Form CRS materially inaccurate, the investment adviser must file an amendment within 30 days and must communicate changes within 60 days to retail investors, highlighting the changes.

OCIE Staff Alerts and Exam Priorities

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has published multiple risk alerts during 2018 and 2019 that are meant to identify recurrent issues in examinations of registered investment advisers and remind investment advisers of their obligations under SEC rules. In 2018 and 2019, OCIE published alerts regarding:

• Best execution issues (including the failure to document reviews or involve employees with intimate knowledge of broker performance, such as traders, in the review of brokers).
• The cash solicitation rule (provides a summary of the requirements for retention of persons that may locate managed account clients).
• Registered investment advisers’ (and exempt reporting advisers’) obligations with respect to electronic books and records under the books and records rules.
• Obligations to provide privacy notices and implement policies to protect personal information.
• Obligations to properly use safeguards and third-party security features for customer records and information in network.
• Its findings on supervision and disclosure of conflicts of interest (with a focus on disclosure and supervision of employees with disciplinary histories) (the “Supervision Initiative Alert”).
• Obligations to provide disclosure and obtain consent for agency and principal cross transactions.

While each of the above is notable for the fact that OCIE is alerting registered investment advisers to focus on these areas, the alerts on (i) electronic books and records, (ii) the Supervision Initiative Alert, (iii) Regulation S-P and (iv) network storage solutions provide significant additional guidance in those areas.

The electronic books and records risk alert provides a list of best practices with respect to electronic messaging that OCIE observed in its limited-scope examination initiative. OCIE recommended that advisers limit electronic communications to certain expressly permitted applications, and it identified particularized risks associated with so-called ephemeral messaging apps and apps that allow for anonymous communication. Relatedly, the electronic books and records risk alert addresses monitoring, review and retention of social media posts and activity, personal websites and personal email that relate to adviser business. The electronic books and records alert also focused on the additional risks posed by the use of non-firm-owned computer equipment in an adviser’s information technology environment. Accordingly, the risk alert identifies the benefits of security applications or other software that allow advisers to: (i) automatically load cybersecurity tools and patches on employee-owned devices; (ii) monitor employee-owned devices for prohibited applications; (iii) remotely delete locally stored information from the device if it is lost or stolen; and (iv) require the use of virtual private networks or other security applications when employees access firm email servers or other business applications. See https://www.akingump.com/en/news-insights/sec-ocie-issues-guidance-on-advisers-recordkeeping-requirements.html for further information.

The Supervision Initiative Alert summarizes OCIE’s findings of 50 examinations of investment advisers that have employed individuals with disciplinary events, focusing on whether their compliance programs were designed to detect and prevent violations of the Investment Advisers Act of 1940 (“Advisers Act”) and its supervised persons, whether the disclosures were full and fair, and whether conflicts of interest were properly identified, addressed and disclosed. OCIE noted that several investment advisers relied on the supervised persons to self-report violations, did not provide complete information regarding violations (such as the number of violations or fines imposed) or promptly report those violations and did not have policies and procedures that were reasonably designed to ensure that the self-reporting was accurate and complete. OCIE also observed that investment advisers did not clearly set forth expectations for supervised persons or have adequate oversight over those supervised persons, especially supervised persons in remote locations. OCIE recommended policies and procedures to specifically address (i) diligence requirements before hiring, including background checks, social media and internet searches, contacting references and verifying educational claims, (ii) establishing heightened supervision practices for supervised persons with disciplinary histories, (iii) adopting written policies for addressing client complaints and (iv) oversight of persons operating out of remote offices.

The risk alerts relating to Regulation S-P and third-party safeguards are described under the privacy and cybersecurity section in the complete publication.

The SEC also published its 2019 Examination Priorities (available at https://www.sec.gov/files/OCIE%202019%20Priorities.pdf). High on the list of priorities for fund managers are (i) fees and expenses, including disclosure and accuracy of calculations and adequacy of disclosure of brokerage practices, (ii) conflicts of interest, including the use of affiliated service providers and “non-purpose” loans and lines of credit that are secured by a securities account but cannot be used for acquiring or trading securities, (iii) portfolio management and trading, including suitability, style drift (especially without disclosure) and appropriate monitoring, (iv) digital assets, including the offer and sale, trading and management of assets, safety of client funds and assets, pricing of portfolio and internal controls and (v) the identification and management of cybersecurity risks, including configuration of network storage devices, information security governance and policies and procedures related to retail information security, governance, risk assessment, access rights and controls, data loss protection, vendor management, training and incident response. In addition, the staff will continue to focus on examining microcap trading and never-before examined investment advisers and retail investors.

The complete publication, including footnotes, is available here.