For Investment Advisers & Broker-Dealers
Risk Alert - Division of Examinations’ Continued Focus on Digital Asset Securities. The popularity of Bitcoin and other cryptocurrencies grew exponentially in 2020, while financial regulators struggled to get up to speed. First disregarded by many mainstream financial service firms, digital assets are being embraced as innovative. Regardless, it is essential to recognize and address these assets' unique risks to financial service firms and investors. The SEC’s Division of Examinations released a Risk Alert on February 26, 2021, discussing the compliance challenges raised by investments in digital assets and observations made by the Division’s staff during recent examinations.
Digital assets come in many different flavors. For example, Bitcoin and Ethereum are considered currencies that take the form of tokens or coins and are issued and transferred using blockchain technology. Generally, these cryptocurrencies are not considered securities and are subject to SEC regulation. Other digital assets may, however, be considered securities if they meet the traditional Howey test, which requires an (i) investment of money, (ii) in a common enterprise, (iii) with an expectation of profits primarily from the efforts of other. For investment advisers, the most significant risks include understanding the nature of the digital asset (e.g., whether it is a security or a currency) and its execution and settlement risks. Advisers should also develop compliance policies and procedures to deal with the unique risks associated with custody, disclosure, and valuation of digital assets. For broker-dealers, the SEC identified the risks of (1) safekeeping of funds and operations; (2) registration requirements; (3) Anti-money laundering; (4) offerings; (5) disclosure of conflicts; and (6) outside business activities. Although the alert provides little practical guidance, EXAMS has provided a broad outline of the categories that should be addressed by firms dealing in digital assets. Contributed by Rochelle A. Truzzi, Managing Director.
For Investment Advisers
SEC Presents its 2021 Examination Priorities. The SEC’s Division of Examinations (the “Division” or “EXAMS”) marked its 25th anniversary and, for the ninth year in a row, published its examination priorities. What is striking about this year’s report is the admission that EXAMS seems to be losing ground in its quest to police the industry. “[I]n just the last five years, the number of RIAs the Division oversees increased from about 12,000 to more than 13,900, and the assets under management of RIAs increased from approximately $67 trillion to $97 trillion.” With approximately 1,000 employees, EXAMS examined about 15 percent of the RIA population, or 2,952 RIAs in 2020, down 4.4 percent from 2019. Despite its best efforts, the Division admitted that its “coverage rates will likely not keep pace with the continued growth in the population and complexity, without corresponding staffing increases.”
The exam priorities echoed those from 2020, with a few new ones:
- Protection of retail investors, including investors and those saving for retirement. Like other years, EXAMS will focus on advice given to retirement community residents, teachers, military personnel, and others saving for retirement.
- Compliance with Regulation BI (for dual registrants) and an investment adviser’s fiduciary duty.
- NEW: Turnkey asset management programs (TAMPs). EXAMS will be focusing on advisers that use TAMPs to make sure all fees and revenue sharing arrangements are disclosed.
- Fees, fees, and more fees. The SEC will continue looking at how investment advisers are calculating and charging fees. Look at your process to make sure you (i) exclude unmanaged assets from fee calculation, (ii) apply breakpoints and discounts for aggregated accounts, and (iii) refund prepaid fees for terminated accounts per client agreements and other disclosures.
- Complex products sold to retail investors, such as leveraged and inverse ETFs.
- Selection of mutual fund share classes.
- Cybersecurity, including controls surrounding online and mobile application access to investor account information, electronic storage of books and records, and personally identifiable information maintained with third-party cloud service providers.
- Business continuity and disaster recovery. EXAMS wants to know about changes your firm has made to deal with new risks resulting from a work-from-home environment.
EXAMS will continue to focus on the disclosure of fees and expenses and conflicts of interest. Based on the exam priorities, here are my recommendations for RIAs:
- Document the process for evaluating securities products, accounts types, and advice provided to clients. Exam staff will be taking a close look at the process firms use to determine which products and services to offer, how recommendations are made, and how conflicts are addressed. The SEC wants to see documentation proving you are acting in your clients’ best interest. Compliance officers should be reviewing the firm’s mutual fund share class selection process and the firm’s revenue sources to determine whether conflicts have been adequately disclosed. Firms should also review whether IARs gather and document sufficient information about a client’s financial situations, risk tolerance, and investment goals.
- Cover basic compliance blocking and tackling. The SEC’s exams will continue to focus on compliance program basics, such as custody, best execution, fees and expenses, portfolio management, and valuation of client assets. Dual registrants should expect special attention from regulators on disclosure and management of the conflicts associated with best execution and providing fiduciary advice. RIAs that offer investment strategies focused on ESG (environmental, social, and governance) factors should expect lots of questions from staff.
- Review clients’ holdings for potential problems. Compliance professionals should periodically check client holdings for securities that give regulators heartburn, such as inverse or leveraged ETFs, municipals, microcap securities, and C shares of mutual funds. There may be good reasons for clients to hold these assets; make sure they are documented.
- Document updates to your Information Security Program resulting from working from home and increasing cyberattacks in 2020. The SEC will be looking at how firms are managing the operational risks with employees working remotely. Consider implementing training programs to reinforce lessons on how to identify phishing attacks or other malicious email activities. Additionally, EXAMS will “focus on controls surrounding online and mobile application access to investor account information, the controls surrounding the electronic storage of books and records and personally identifiable information maintained with third-party service providers, and firms’ policies and procedures to protect investor records and information.” Contributed by Jaqueline M. Hummel, Partner and Managing Director.
SEC Says New Marketing Rule is “All or Nothing.” As many adviser marketing teams have begun to salivate about finally being able to use client testimonials, the SEC has thrown a regulatory wet blanket over their enthusiasm. In its FAQ on the new marketing rule, the SEC made it clear that compliance is an all-or-nothing proposition. Even though the new rule is effective May 4, 2021, advisers must continue to rely on the existing versions of Rule 206(4)-1 (the advertising rule) and Rule 206(4)-3 (the solicitation rule) until they can meet all of the new rule’s requirements. Advisers have until November 22, 2022 to prepare. Contributed by Jaqueline M. Hummel, Partner and Managing Director.
SEC Updates 13F FAQ to Reflect Amended Reg S-T and the Use of Electronic Signatures on EDGAR filings. Until the November 2020 adoption of amendments to Regulation S-T (“Reg S-T”) and related rules, filers of Form 13F and other EDGAR Filings were required to manually sign a signature page or other document (known as an “Authentication Document”) before or at the time of the filing. Filers were also required to retain those Authentication Documents for five years and provide a copy to the SEC upon request.
The Authentication Document may now be signed electronically subject to certain conditions. To be clear, firms that are still happy maintaining Authentication Documents with manual signatures may continue to do so with no change to their practices resulting from these amendments. Want to start using electronic signatures on your Authentication Documents? Below are the requirements:
- The Authentication Document may still be a signature page or other document authenticating, acknowledging, or otherwise adopting their signature that appears in typed form within the electronic filing. It must still be signed by each signatory to the electronic filing.
- If signed electronically:
- A signatory must first manually sign a document attesting that the use of such electronic signature constitutes the legal equivalent of the individual’s manual signature.
- This manually signed document must be retained for as long as the signatory uses the electronic signature and at least seven years after the most recently signed authentication document.
- An electronically signed Authentication Document is also subject to new requirements in the EDGAR Filer Manual. More specifically, the document must:
- Contain a physical, logical, or digital credential that authenticates the signatory’s identity;
- Reasonably provide for non-repudiation of the signature;
- Contain electronic signatures that are attached, affixed, or otherwise logically associated with the Authentication Document being signed; and
- Include a timestamp to record the date and time of signature.
In recognition of these amendments, the SEC recently updated its FAQ to Form 13F filings to reflect the new electronic signature requirements. Contributed by Cari A. Hopfensperger, Managing Director.
Reg Notice 21-10, Private Placement Filer Form. FINRA Rules 5122 and 5123 require member firms that participate in private placement offerings to adhere to certain disclosure and filing requirements about each offering. The Filer Form is submitted through FINRA Gateway and provides information about the selling member, the issuer, and the offering information (including offering documents). Effective May 22, 2021, the Filer Form will include new questions and clarifications to existing questions and requests for information. For example, FINRA added questions to address contingency offerings, disciplinary histories, the intended use of proceeds, and private securities transactions subject to FINRA Rule 3280. FINRA designed these updates “to enhance oversight in particular areas of risk in the private placement market.”
As a bonus, FINRA included as Attachment B a copy of the Unregistered Offering List Request Template. Firms should leverage the template when reviewing their current process to ensure they capture and report on the information request. Contributed by Rochelle A. Truzzi, Managing Director.
For Mutual Funds
SEC Publishes Small Entity Compliance Guide on Good Faith Determinations of Fair Value. In conjunction with the adoption of the Investment Company Act (the “Act”) Rule 2a-5 (the “Valuation Rule”) on December 3, 2020, the SEC has published a guide to assist registered investment companies, their boards, advisers, and sub-advisers as they plan for compliance. Under the Act, firms must price securities with readily available market quotations at their market value, and the Valuation Rule provides a new clarification of what constitutes “readily available.” By comparison, fund boards must make a good faith determination of fair value for securities that do not have readily available market quotations, and the Valuation Rule establishes certain requirements for investment companies when establishing a fair value, which include:
- Periodically assessing and managing valuation risk;
- Establishing and applying fair value methodologies;
- Testing fair value methodologies; and
- Overseeing pricing services.
The SEC also adopted a new rule (Rule 31a-4) with record-keeping requirements for fair value determinations. The new rules, which end a 50-year stretch since the last regulatory changes on valuation, are effective March 8, 2021, and have an 18-month runway to comply by September 8, 2022. Although this compliance guide targets smaller entities, it provides a helpful summary for any impacted firm. Contributed by Cari A. Hopfensperger, Managing Director.
Photo Credit: Photo by Jerry Wang on Unsplash.