SEC (Finally) Modernizes Advertising and Solicitation Rules; NY Requires IAR Registration; DOL’s New Rule Eliminates ESG from Investment Decisions; SEC to Take Second Crack at Broker-Dealer Reg BI Compliance: Regulatory Update for January 2021

For Investment Advisers

At Long Last – SEC Modernizes the Advertising and Solicitation Rules! Cramming it in just before the end of 2020, the SEC adopted a new rule to replace the existing advertising and cash solicitation rules. The final release clocks in at 434 pages, so unpacking all the changes will take some time. Stay tuned for future posts. Fortunately for advisers, the runway for compliance is long: 18 months after the effective date (which is 60 days after publication in the Federal Register).

The headlines include removing prohibitions on testimonials and past specific recommendations, adding disclosures about advertising practices in Form ADV, and allowing hypothetical and predecessor performance. The SEC also dropped the pre-approval requirement for marketing materials included in the proposing release.

On balance, this is a positive development for investment advisers. The rule provides substantive guidance for many trickier types of disclosures and replaces the current hodge-podge of no-action letters and other guidance, which the SEC plans to withdraw as the new rule becomes effective. Contributed by Jaqueline M. Hummel, Partner and Managing Director.

NY State Updates – Registration of NY IARs and Blue Sky Changes. On December 1, 2020, New York amended its Investment Advisory Act to require Investment Adviser Representatives (“IARs”) that provide investment advice from a place of business in New York to register in that state. The registration requirements apply to IARs (and solicitors) of state-registered and SEC-registered firms. The rule is effective February 1, 2021; however, New York IARs already providing services have until December 2, 2021, to complete their registration, provided their U4 requesting registration in New York is submitted by August 31, 2021. Registration will require IARs to pay a $200 licensing fee and satisfy examination requirements unless a waiver is approved. Fortunately, the examination requirement will be waived initially for IARs already providing services for at least two years before February 1, 2021, provided the IAR is not otherwise subject to any disqualifications that are identified in the new rules. As is the case in other states, IARs may also request waivers if they hold specific designations. State and SEC-registered advisers with IARs (including solicitors) in New York should begin to prepare for registration and waiver requests as applicable. New York issued guidance, which includes links to the proposed and final rules and useful instructions to assist firms and their IARs in implementing the new registration requirement.

In concert with the IAR rule-changes highlighted above, New York also approved new requirements applicable to blue sky filings for securities transactions in the state. Stay tuned for an upcoming Hardin Blue Sky blog post that will break down these new requirements! Contributed by Cari A. Hopfensperger, Managing Director.

DOL Finalizes ESG Rule. At the end of October, the Department of Labor (“DOL”) finalized its rule on Financial Factors in Selecting Plan Investment (the “Final Rule”), amending the “investment duties regulation” issued in 1979. The Final Rule provides ERISA fiduciaries with guidance on evaluating investment opportunities, sending a clear message that financial factors take precedence over environmental, social, and corporate governance (ESG) considerations. The Final Rule requires ERISA fiduciaries to select investments based on pecuniary factors, defined as “any factor that … is expected to have a material effect on risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and funding policy.” Simply put, ERISA fiduciaries “must never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals.”

The Final Rule provides guidance on the duty of prudence, stating that ERISA fiduciaries must compare “reasonably available alternatives with similar risks” when making investment-related decisions. In other words, a fiduciary is not required to scour the universe of investment options but can limit its review to those that are reasonably available.

The Final Rule contains an exception that allows fiduciaries to use non-pecuniary factors when they are “unable to distinguish investment alternatives on the basis of pecuniary factors alone,” also known as the “tie-breaker test.” Fiduciaries must maintain documentation that demonstrates a “careful analysis and evaluation” when taking advantage of the tie-breaker test.

For participant-directed plans, the new rule permits fiduciaries to include funds or investment products with non-pecuniary goals as a plan option for plans with “a broad range of investment alternatives” if the fiduciary satisfies its prudence and loyalty standards under ERISA in the selection process. However, investment products may not be added as a qualified default investment alternative (“QDIA”) if the product’s investment objectives, goals, or principal investment strategies include non-pecuniary factors.

A fact sheet summarizing the final rule is available on the Employee Benefits Security Administration (“EBSA”) site. ERISA fiduciaries will have until April 30, 2022, to implement any necessary changes. Contributed by Cari A. Hopfensperger, Managing Director.

For Broker-Dealers

Broker-Dealers Should Prepare for Second Wave of Exams on Best Interest Compliance. The SEC’s Division of Examinations (formerly known as the “Office of Compliance Inspections and Examinations”) announced its plans to “conduct enhanced transaction testing designed to examine whether broker-dealers have implemented effectively their written policies and procedures” for implementing Reg. BI. Get ready for the staff’s focus on firms’ processes for:

  • selection of investment products,
  • consideration of costs when selecting products,
  • making recommendations to customers, including rollovers, and
  • consideration of complex products and reasonably available alternatives.

Now is also an excellent time to review the Risk Alert on Examinations that Focus on Compliance with Regulation Best Interest to ensure you have the answers to potential SEC examination requests. Contributed by Jaqueline M. Hummel, Partner and Managing Director.

No-Action Relief Under CIP and Beneficial Ownership Rules Extended until December 9, 2022. The SEC, in consultation with FinCEN, extended the no-action relief allowing broker-dealers to rely on a registered investment adviser to perform some or all of their obligations under the customer identification program rule (“CIP Rule”) and the customer due diligence rule regarding beneficial ownership requirements for legal entity customers (“Beneficial Ownership Requirements”). The no-action relief has been extended until December 9, 2022. Broker-dealers must satisfy the other provisions of the CIP Rule and the beneficial ownership requirements, which are:

  1. The broker-dealer’s reliance on the investment adviser is reasonable under the circumstances;
  2. The adviser is an SEC-registered investment adviser; and
  3. The investment adviser enters into a contract with the broker-dealer in which the investment adviser agrees that: (a) it has implemented its own anti-money laundering program consistent with the requirements of 31 U.S.C. 5318(h) and will update it as necessary to implement changes in applicable laws and guidance, (b) it will perform the specified requirements of the broker-dealer’s CIP and/or the broker-dealer’s beneficial ownership procedures, (c) it will promptly disclose to the broker-dealer potentially suspicious or unusual activity detected as part of the CIP and/or beneficial ownership procedures being performed, (d) it will certify annually to the broker-dealer that the representations in the reliance agreement remain accurate and that it is in compliance with such representations, and (e) it will promptly provide its books and records relating to its requirements under the USA PATRIOT Act. Contributed by Rochelle A. Truzzi, Managing Director.

For Broker-Dealers and Investment Advisers

SEC Finds Advisers and Broker-Dealers Unaware of Large Trader Obligations. The SEC Division of Examination issued a risk alert about compliance with the Large Trader Rule, Rule 13h-1 under the Securities Exchange Act of 1934 (the “Exchange Act”). Apparently, the examination staff has been finding enough deficiencies in this area to warrant this reminder to investment advisers and broker-dealers. As explained on our webpage, Rule 13h-1 requires “Large Traders” to identify themselves on Form 13H, obtain a Large Trader Identification Number (LTID) and provide the LTID to broker-dealers through which it trades. Broker-dealers must maintain records of the Large Traders’ transactions, perform certain monitoring, and report to the SEC upon request.

Takeaways from this alert for investment advisers include implementing periodic testing to determine whether trading activity reaches the large trader threshold, especially if the firm has taken on substantial new assets. Broker-dealers should also consider implementing procedures to monitor customer activity to identify customers that may be Large Traders and contacting those who have failed to provide their LTIDs. Contributed by Jaqueline M. Hummel, Partner and Managing Director.

For Mutual Funds

SEC Takes Fund Boards Off the Hook with New Valuation Rule. After 50 years without new rulemaking under the Investment Company Act of 1940 to address mutual funds’ valuation practices, the SEC recently adopted a new valuation rule (Rule 2a-5) and a corresponding recordkeeping rule (Rule 31a-4). Rule 2a-5 establishes an updated regulatory framework for fund valuation practices, including a threshold for when a fair value is required and a definition for “readily available” market quotes. The rule is “designed to clarify how fund boards of directors can satisfy their valuation obligations in light of market developments, including an increase in the variety of asset classes held by funds and an increase in both the volume and type of data used in valuation determinations.” Under the new rule, funds will be required to manage valuation-related risks, testing any fair value methodologies used, and monitor the use of third-party pricing vendors.

According to the SEC, the rule recognizes the investment adviser’s contributions to the valuation process by permitting the board to delegate the valuation determination to the adviser, subject to oversight and conditions. Rule 2a-5 and Rule 31a-4 are effective 60 days after publication in the Federal Register, and funds will have an additional 18 months to comply. Contributed by Cari A. Hopfensperger, Managing Director.

ADI 2020-11 Registered Funds’ Risk Disclosure Regarding Investments in Emerging Markets. The Division of Investment Management’s Disclosure Review and Accounting Office (“DRAO”) reviews registered fund filings with a particular focus on “topics that have proven key to assessing investments, including risk disclosures.” From time to time, DRAO also issues public statements to share observations from its reviews. Recently, DRAO issued a new statement that encourages funds to enhance their risk disclosures related to emerging market investments. The publication (ADI 2020-11) can be accessed here. Contributed by Cari A. Hopfensperger, Managing Director.

Photo Credit: Photo by Chinh Le Duc on Unsplash.

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