Division of Investment Management's guidance reminds firms to comply with conditions and representations in exemptive orders and notes that consequences for noncompliance may be "severe."

In early May 2013, the Division of Investment Management of the Securities and Exchange Commission (SEC) released guidance reminding firms of their obligation to comply with applicable SEC exemptive orders. The guidance suggests that firms adopt and implement policies and procedures reasonably designed to ensure ongoing compliance with each representation and condition in any such order.[1]

The SEC staff's guidance follows both a June 2011 report from the SEC's Office of Inspector General (OIG), [2] which noted repeated instances of noncompliance with exemptive order requirements, and the publication of the Office of Compliance Inspections and Examinations' (OCIE's) 2013 examination priorities, which noted compliance with exemptive orders as an examination priority. [3] Given the SEC staff's focus, investment companies and investment advisers should review their exemptive orders alongside their compliance policies and procedures in order to avoid regulatory violations and pitfalls during an SEC exam.

OIG Report and OCIE Examination Priorities

The SEC may issue exemptive orders to applicant firms relieving such firms from compliance with specific provisions of the federal securities laws and/or regulations. These exemptive orders are issued in reliance on one or more provisions of the federal securities laws. [4] In order to receive exemptive relief, a firm typically makes certain representations and warranties in its application and agrees to comply with certain conditions. Based on its review of a sample of OCIE examination reports, the OIG determined in its 2011 report that many firms failed to comply with the representations and conditions of SEC exemptive orders and no-action letters they have received.

Examples of noncompliance cited in the OIG report include failing to conduct an annual review by the board, failing to include certain performance data disclosures, failing to recall loaned securities to vote proxies, and failing to adhere to fund marketing requirements. The OIG report further notes that the SEC divisions that issue such relief do not have a process for confirming whether firms subsequently comply with the conditions set forth in the relief. [5] The OIG report also set forth five recommendations intended to enhance the SEC's oversight of exemptive order compliance. These recommendations include increased oversight and cooperation by and between SEC divisions. The OIG also recommended that OCIE include compliance with exemptive order conditions in OCIE's risk considerations as part of its examination efforts. [6]

Presumably in response to the OIG report, the priorities that OCIE issued on February 21, 2013 include investment company and investment adviser compliance with exemptive orders. Specifically, OCIE stated that it will "focus on compliance with previously granted exemptive orders, such as those related to closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds." [7]

Additional Policies and Procedures Firms Should Consider

The Division of Investment Management's guidance suggests that firms may address the risk of noncompliance with exemptive order conditions by adopting policies and procedures in accordance with Rule 206(4)-7 under the Investment Advisers Act or Rule 38a-1 under the Investment Company Act. The policies and procedures should be reasonably designed to ensure ongoing compliance with each representation and condition of any exemptive order(s) the entity has received. The guidance discusses the following two approaches a firm could use to ensure compliance:

  • Adopt a specific policy or procedure to address the required representations and conditions of any applicable order.
  • Consider whether any existing policy or procedure relating to other matters sufficiently incorporates the required representations and conditions.

The guidance also includes a reminder to firms that the adequacy and effectiveness of all policies and procedures should be reviewed on an annual basis.

Interestingly, the SEC guidance does not specifically address compliance with SEC no-action letter requirements, although firms should generally apply the same types of policies, procedures, and oversight processes to ensure compliance with no-action letters as they do to ensure compliance with exemptive orders. The guidance also does not address another closely related area: compliance with exchange-listing requirements and other rules by exchange-traded funds (ETFs) and closed-end funds. [8] ETFs, for example, must comply with exchange-listing standards and, in some cases, specific representations and conditions made by a securities exchange in connection with proposed rule changes to list the ETFs shares pursuant to Rule 19b-4 under the Securities Exchange Act of 1934. As with exemptive orders and no-action letters, firms should adopt appropriate policies, procedures, and oversight processes to comply with these standards.

Compliance Tips

The following are some practical tips and approaches designed to ensure compliance:

  • If they haven't already, firms should compile a list of exemptive orders they rely upon. Although not addressed by the guidance, firms also should compile a list of any no-action letters they rely upon and any applicable listing requirements.
  • Firms should create a checklist containing the key terms and conditions of such exemptive relief, as well as the material representations made in the applications for such orders. A similar process should be followed for no-action letters and listing requirements.
  • Firms should compare their current policies and procedures against this checklist to determine if changes are warranted or if new policies and procedures should be adopted. Deficiencies should be addressed and discussed with a firm's chief compliance officer (CCO) and fund boards, as warranted.
  • Firms should designate specific individuals on the compliance or legal teams who are responsible for ensuring that the requirements of each exemptive order and no-action letter are fulfilled. The guidance notes that, as with all policies and procedures under the compliance rules, the adequacy and effectiveness of the implementation of policies and procedures with respect to exemptive order compliance should be reviewed on at least an annual basis. The same process should be used for no-action letter and exchange listing compliance. Fund compliance officers should consider building this process into their periodic reports to fund boards.
  • For activities that require reliance on exemptive orders issued to service providers or issuers (e.g., affiliated securities lending, ETF 12(d)(1) relief), firms should make sure they understand the process used by such service providers and issuers to ensure compliance and should obtain certifications of compliance from such service providers and issuers on a regular basis.
  • A common theme in recent SEC enforcement actions has been board responsibility and oversight.[9] Boards should take an active role to help ensure compliance with applicable requirements. Boards should be aware of their responsibilities pursuant to exemptive orders and no-action letters and periodically review such responsibilities and methods of compliance with trustee counsel and the funds' CCO.

Because of the extent to which the investment industry has come to rely on exemptive orders and no-action letters, well-developed policies and procedures, along with effective oversight of such policies and procedures, are increasingly important. The OIG report, the OCIE examination priorities, and now the Division of Investment Management's guidance indicate that this is a focus area for SEC staff and an area of significant regulatory and compliance risk. However, a thoughtful approach to these issues that takes into account the Division of Investment Management's guidance and that is consistent with the practices outlined above should help firms remain compliant.