Over the past three years, the Division of Investment Management (Division) of the U.S. Securities and Exchange Commission (Commission) has provided informal guidance and interpretations regarding issues of relevance to the investment management industry, through a guidance update initiative (Initiative). As of the date of this article, the Division staff has published only four guidance updates this year, compared to the publication of 13 and 14 guidance updates during 2014 and 2013, respectively. Although this raises the question of whether the Division will continue to issue guidance updates, the investment management industry must remain mindful, and consider the potential implications, of the Division’s guidance updates.
This article provides a brief overview of the Initiative as well as a summary of the guidance updates published by the Division in 2015. The article concludes by discussing whether, in light of the significant decrease in the number of 2015 guidance updates, the Initiative may be becoming a thing of the past.
Overview of the Initiative
Former Division Director Norm Champ stated his belief that the Division’s guidance updates provide an opportunity to “decrease ambiguity and improve the public’s understanding of the Staff’s view on critical issues” and to increase the level of communication between the Division and the investment management industry.1 Over the past three years, the guidance updates have varied in length and have covered a wide range of topics affecting registered investment companies (funds), fund boards of directors, investment advisers, insurance separate accounts and business development companies. The format of the guidance updates also has varied, with some structured as questions and answers and hypothetical scenarios, while others have been drafted as a more traditional legal analysis. Over the years, various offices within the Division have authored the guidance updates, including the Chief Counsel’s Office, the Disclosure Review Office and the Chief Accountant’s Office. Although the guidance updates clarify and offer insight into the Division staff’s views and interpretations of discrete issues, the guidance updates are not rules, regulations or statements of the Commission, and the Commission itself neither approves nor disapproves the statements of the staff.
Summary of 2015 Guidance Updates
No. 2015-01: Acceptance of Gifts or Entertainment by Fund Advisory Personnel – Section 17(e)(1) of the Investment Company Act
In February 2015, the staff published a guidance update2 to highlight “the conflict of interest that arises when the personnel of a fund’s investment adviser are presented with … forms of consideration (gifts or entertainment) from persons doing business, or hoping to do business, with the fund.” The staff indicated that it published this guidance update to remind the fund industry that the receipt of such consideration could be prohibited under Section 17(e)(1) of the Investment Company Act of 1940 (1940 Act). The staff also stated its view that fund compliance policies and procedures required by Rule 38a-1 under the 1940 Act should address these types of practices.
Section 17(e)(1) generally prohibits any person who is a fund affiliate, or any affiliate of such an affiliate, acting as agent, from accepting any compensation for the purchase or sale of any property to or for such fund. By statute, the prohibition is not applicable to compensation received in the course of such person’s business as an underwriter or broker, but does extend to any compensation other than regular salary or wages. The staff historically has interpreted “compensation” broadly and has taken the position that gifts or entertainment constitute compensation in the context of Section 17(e)(1), although there must be some nexus between the compensation received by the fund and the property bought or sold by the adviser to constitute a violation of Section 17(e)(1).3
The staff stated in the guidance update that Rule 38a-1 requires funds to “[a]dopt and implement written policies and procedures reasonably designed to prevent violation of the Federal Securities Laws by the fund, including policies and procedures that provide for the oversight of compliance by each investment adviser, principal underwriter, administrator, and transfer agent of the fund.” Further, the fund’s board of directors must approve such policies and procedures of the fund, as well as those of the fund’s service providers. Although the staff noted that it may be appropriate for policies and procedures to vary based on a particular adviser’s business, the staff also noted that some advisers may deem it appropriate to: prohibit employees from receiving any gifts or entertainment; or implement certain pre-clearance protocols.
No. 2015-02: Cybersecurity Guidance
In April 2015, the staff published a guidance update4 to highlight the importance of cybersecurity – a topic that has continued to be a focus of the Office of Compliance Inspections and Examinations (OCIE) during recent examinations, as well as a focus during the Division’s senior-level engagement efforts with fund boards and advisory management.5 This guidance update recognized that “[b]oth funds and advisers increasingly use technology to conduct their business activities and need to protect confidential and sensitive information related to these activities from third parties, including information concerning fund investors and advisory clients.” Noting that “the Division will continue to focus on cybersecurity and monitor events in this area,” the staff described “measures that funds and advisers may wish to consider when addressing cybersecurity risks.”
The guidance update provides general and specific recommendations for funds and advisers. Among other examples, the staff recommended that funds and advisers: “identify their respective compliance obligations under the federal securities laws” when assessing their preparedness for cybersecurity threats; “consider reviewing their operations and compliance programs [including under Rule 38a-1] and assess whether they have measures in place that are designed to mitigate their exposure to cybersecurity risk;” “consider assessing whether protective cybersecurity measures are in place at relevant service providers;” and “educate investors and clients about how to reduce their exposure to cybersecurity threats concerning their accounts.” The staff made clear that it believes that funds and their advisers should proactively identify their cybersecurity risks, while recognizing that it would be appropriate to “tailor their compliance programs based on the nature and scope of their businesses.”
For further information on the cybersecurity guidance update, please refer to Dechert OnPoint, U.S. SEC Division of Investment Management Issues Cybersecurity Guidance.
No. 2015-03: Personal Securities Transactions Reports by Registered Investment Advisers: Securities Held in Accounts Over Which Reporting Persons Had No Influence or Control
In June 2015, the staff published a guidance update5 regarding reports to be provided by “access persons” under Section 204A of the Investment Advisers Act of 1940 (Advisers Act) with respect to their personal securities transactions. Rule 204A-1 under the Advisers Act provides, among other things, that an adviser’s code of ethics must include requirements that certain advisory personnel with access to nonpublic information regarding clients’ securities transactions, securities recommendations to clients, or portfolio holdings of reportable funds (access persons) report such access persons’ personal securities holdings and transactions. However, the rule provides exceptions from these reporting requirements – including when an access person’s securities are “held in accounts over which the access person had no direct or indirect influence or control” (such as, in the staff’s view, a blind trust).
In the guidance update, the staff “express[ed] its views on the application of the rule in the context of [access persons’] trusts and third-party discretionary accounts” – situations that, according to the staff, advisers had asserted were similar to blind trusts. The staff indicated that providing discretionary investment authority to a trustee of a trust or to a third-party manager of a personal account, “by itself,” would not justify reliance on the reporting exception.
The staff provided more granular guidance, clarifying instances in which discussions with a trustee or third-party discretionary manager concerning account holdings might – or might not – reflect control or influence. The staff noted that an “adviser may be able to implement additional controls to establish a reasonable belief that an access person had no direct or indirect influence or control” – for example, by: (i) obtaining information about a trustee or third-party manager’s relationship to the access person; (ii) obtaining periodic certifications by access persons regarding their influence or control over the trust or account; (iii) providing access persons with the text of the reporting exception; and (iv) requesting sample reports on holdings and transactions, in order to identify transactions that would have been prohibited pursuant to the adviser’s code of ethics. However, the staff cautioned that “obtaining general certifications, alone, would likely be insufficient to” support the application of the reporting exception.
No. 2015-04: Employees’ Securities Companies and Escheatment
In October 2015, the staff published a guidance update6 to provide its view regarding compliance by an employees’ securities company (ESC) with the 1940 Act, in circumstances where the ESC’s securities are transferred to a state pursuant to the state’s escheatment law. Specifically, the staff addressed whether an ESC might continue to rely on a 1940 Act exemptive order in such a case.
ESCs are employer-sponsored investment companies, which have been exempted by the Commission from many of the provisions of the 1940 Act. The eligible holders of ECSs are generally limited by the 1940 Act to current and former employees and employer retainers. Although the Commission has issued exemptive orders “permitting ESC securities to be held by certain extended family members of, and trusts established by, eligible holders,” the Commission has not expanded this to include “persons not reasonably related to the categories of eligible holders included in the statutory definition.”
State escheatment laws allow abandoned property – including securities such as ESC securities – to be remitted to a state after a statutorily prescribed period. However, states do not fall within the enumerated categories of persons permitted to hold ESC securities.
In this guidance update, the staff indicated its belief “that the special treatment of ESCs under the 1940 Act …would not be undermined if [s]tates hold ESC securities escheated to them. Accordingly, the Division would not object if an ESC continued to rely on its exemptive order under the 1940 Act” in such instances.
The publication of four guidance updates in 2015 reflects a continuation of the Division’s practice over the prior two years. However, the reduction in the number of published guidance updates may indicate that the Initiative is becoming less of a priority for the Division.
One possible explanation for the decrease in published guidance updates is that the Division’s time and (limited) resources have been devoted primarily to the Commission’s recent rulemaking proposals to modernize the regulatory framework applicable to the investment management industry. In 2015, the Commission has proposed regulations to: (i) modernize fund and adviser reporting and disclosure; (ii) require that funds adopt liquidity risk management programs; and (iii) impose new requirements relating to funds’ use of derivatives. Chair Mary Jo White has indicated that two additional proposals, which relate to plans for the transition of client assets and stress testing for funds and advisers, are under consideration by the Commission's staff.
The decrease may also be due to a change in Division leadership. The Initiative was largely driven by Norm Champ when he served as Division Director. Under the stewardship of David Grim, the Initiative may be less of a priority for the Division.
While the precise reason for the reduction in published guidance updates remains unclear, the industry should continue to consider existing and any future guidance updates to better understand the Division staff’s views on particular matters.