In November of last year, the Securities and Exchange Commission's Office of Compliance Inspections and Examinations issued an alert announcing a series of risk-based examinations focused on mutual funds and exchange-traded funds (ETFs). The alert not only highlights OCIE’s focus areas in the registered funds industry, but also signals the issues that might be the subject of future enforcement activity in the industry. It should be noted that the alert’s focus on mutual funds and ETFs – primary investment vehicles for retail investors – is consistent with SEC Chairman Jay Clayton’s focus on protecting the long-term interests of retail investors. For that reason alone, the industry should expect the staff to pursue any failures or misconduct that results in harm to retail investors or that interferes with their ability to make informed investment decisions when it comes to investing in mutual funds and ETFs.

The alert highlights the following six focus areas:

  • Index funds that track custom-built indexes;
  • Smaller and/or thinly traded ETFs;
  • Mutual funds with aberrational underperformance relative to their peer groups;
  • Mutual funds with higher allocations to certain securitized assets;
  • Side-by-side management of mutual funds and private funds; and
  • Funds managed by advisers that are relatively new to managing registered investment companies.

Within each of these focus areas, the alert discusses the specific issues that the staff will assess. Drawing from these details and reflecting on prior enforcement actions, this article attempts to highlight those issues that might be most concerning to examiners and are most likely to draw enforcement attention.

Disclosure Failures and Fund Governance

As OCIE staff makes its way through the examinations, great attention will be paid to, among other topics, disclosures with respect to fees and expenses, conflicts of interest, risks, liquidity, valuation and trade allocation. As the alert notes, the staff will evaluate disclosures made by advisers both to fund boards and fund investors. For purposes of showing a fraud on the fund under the Advisers Act’s antifraud provisions (Sections 206(1) and 206(2)), the staff looks to what the adviser disclosed or failed to disclose to the fund board. For any type of fraud on the investors, the staff looks to what information was or was not disclosed to them by the adviser.

Because the alert places significant emphasis on disclosure and board oversight, examiners likely will be digging into board materials (including 15(c) materials) and evaluating the interaction between the adviser and fund board, all in an effort to determine whether the adviser provided the board with sufficient information to perform its duties. The staff will want to see that the adviser furnished the board with all information that was reasonably necessary for the board to evaluate the advisory contract. The staff also will be looking to see that the board satisfied its duties by requesting and evaluating such information.

SEC enforcement actions charging violations of Section 15(c) of the Investment Company Act predominantly involve charges against advisers for their failures in the 15(c) process. It is worth noting that certain disclosure failures by the adviser that give rise to a violation of Section 15(c) could also serve as the basis of a fraud violation under Sections 206(1) or 206(2) of the Advisers Act. There has been one enforcement action since 1980 charging board members with Section 15(c) failures. However, the SEC also has charged board members for causing alleged inaccuracies in shareholder disclosures regarding the 15(c) process. Form N-1A requires disclosure of the material factors considered, and conclusions reached, by the board in deciding to approve or renew a fund’s advisory contract. The SEC charged trustees with causing disclosure failures in shareholder reports concerning the trustees’ 15(c) evaluation process. The SEC charged that the reports contained “boilerplate” disclosures that were materially untrue or misleading in violation of Section 34(b) of the Investment Company Act, and that the fund’s administrator made these disclosures based on board minutes reviewed and approved by the trustees. Their review and approval of these alleged untrue statements served as the basis for the SEC to charge them with causing the disclosure violation.

Where relevant, the staff also will focus on communications that occur between the adviser and fund board outside of the 15(c) process, and in particular will look to see that the adviser has provided the board with complete and accurate information so that the board can satisfy its fund oversight duties. The staff also will be looking to see that the board was engaged, diligent, asked the tough questions, and exercised good faith in making decisions.

Performance Advertising

The alert notes that the staff will assess performance advertising as part of its focus on custom-built or bespoke indexes. The staff has consistently been interested in performance advertising, as there have been a number of enforcement actions over the past few years that have charged advisers with performance advertising violations. Prior actions have included charges surrounding the advertised performance of proprietary investment or trading models, particularly the retroactive application of such models, and advisers’ failures to disclose the back-tested nature of performance numbers. Advisers and any third-party providers that are retained to calculate performance – actual, model, hypothetical and/or back-tested – may want to take additional steps to make sure that accurate disclosures are made to investors and that the strategy that served as the basis of the calculated performance is consistent with the actual investment or trading strategy. To the extent any adjustments are made to the strategy or models based on the benefit of hindsight, and those adjustments materially boost advertised performance, failing to disclose such adjustments could render other statements regarding performance materially misleading.

Conflicts Arising from Side-by-Side Management

Side-by-side management of registered funds and private funds presents a variety of potential conflicts that will draw scrutiny from the staff. The staff will be reviewing to determine whether advisers have taken steps to manage these conflicts and to make sure that all material conflicts are disclosed fully and fairly. The following are examples of certain conflicts that have been the subject of prior enforcement actions, and likely will continue to be areas of interest to the staff.

Trade Allocations

When it comes to trade allocations, examiners will focus on the allocation of profitable trades, and look for any undisclosed conflicts arising therefrom – particularly any allocations that benefit the adviser. In addition to conflicts between the adviser and client, side-by-side fund management presents conflicts across fund clients where one fund benefits and another is harmed. Significantly, the alert’s discussion indicates that the staff also will assess funds with “aberrational underperformance” to determine whether allocation practices contributed to poor performance. This situation could arise as a result of the adviser dumping losing trades into a fund, or consistently allocating winning trades to one fund over another.

The following is a non-exhaustive list of allocation practices that could result in an enforcement action, absent adequate disclosures:

  • Over-allocating profitable trades to a higher-fee-paying client or to a client that pays a performance fee;
  • Over-allocating profitable trades to a proprietary or affiliated fund;
  • Allocating profitable trades to a fund or account in which the adviser has an interest;
  • Allocating profitable trades to family and friends;
  • Allocating trades as part of a quid pro quo; and
  • Allocating contrary to disclosures and/or policies and procedures.

Finally, it is worth noting that the SEC has stated publicly that it is using data analytics to detect improper trade allocation practices.

Affiliated Transactions

While not mentioned in the alert, a side-by-side fund management structure also lends itself to potential issues in the use of affiliated transactions. These transactions typically take place between the adviser (or an affiliate) and the client or between clients. While it often makes sense to engage in certain affiliated transactions for the benefit of clients, such transactions also present the opportunity for self-dealing and preferential treatment of one fund client over another. As a result, affiliated transactions attract the attention of the SEC staff and have been the focus of numerous enforcement actions over the past few years. The enforcement actions typically involve charges of violating Section 206(3) of the Advisers Act or Section 17(a) of the Investment Company Act.

Advisers that manage side-by-side fund structures should expect the examinations staff to review any affiliated transactions involving the adviser (or an affiliate), and to request documentation showing that the adviser complied with Section 206(3) of the Advisers Act by: providing the client with written disclosure of the capacity in which the adviser acted; and obtaining client consent, on a transaction-by-transaction basis. With such transactions, the adviser also should take steps to disclose to the client any associated conflicts of interest and the terms of the transaction, to ensure that the client’s consent is informed. The adviser also should make sure the party providing consent on behalf of a fund client is itself not conflicted.

For affiliated transactions that would otherwise be prohibited or restricted under Sections 10(f) or 17 of the Investment Company Act but for their reliance on certain exemptions (e.g., Rules 17a-7, 17e-1 and 10f-3), the staff will be checking that the transactions satisfy the relevant exemption’s conditions, as well as the fund’s policies and procedures. Pursuant to a recent no-action letter, a fund’s board can rely on a written representation received from the fund’s chief compliance officer that certain affiliated transactions effected in reliance on certain exemptions complied with procedures adopted by the board, instead of the board itself determining compliance. Nonetheless, the SEC staff will be looking to see that fund boards are continuing to focus on conflicts of interest raised by affiliated transactions and whether such transactions are in the best interest of the fund and its shareholders.

Three common findings that are cited in enforcement actions charging cross-trades in violation of Section 17(a) of the Investment Company Act include: (i) pre-arranged, dealer-interposed transactions; (ii) transactions crossed at prices that favored one fund client over the other; and (iii) transactions that included a mark-up or other fee for the broker involved.

Finally, the staff will review to see that, when engaging in cross-trades, an adviser fulfills the fiduciary duties it owes to both funds, including the duty of loyalty and the duty to obtain best execution for both the selling and purchasing funds. Failing to do so could result in a fraud violation under Sections 206(1) or 206(2) of the Advisers Act, in addition to a 17(a) cross-trade violation. Similarly, a principal transaction in violation of Section 206(3) also could result in a 206(1) or 206(2) violation, if the adviser engaged in some form of undisclosed self-dealing as part of the transaction.

Allocation of Fees and Expenses

Fee and expense allocation has been a consistent area of focus for the staff and a repeat subject of enforcement actions. While the basic adviser-to-a-single-fund structure presents an opportunity to misallocate fees and expenses between the adviser and the fund, a side-by-side management structure presents a greater opportunity for misallocation of fees and expenses. For that reason, the staff will examine to make sure that fees and expenses are being allocated in a manner that is consistent with the relevant disclosures made to fund investors. Similar to trade allocation, the focus will be on whether the adviser is favoring itself by causing the funds to pay its fees or expenses, and/or favoring one fund over another by allocating one fund’s fees or expenses to another fund. Here, advisers may want to review their allocation of fees and expenses, and be able to point to language in fund governing documents that support the allocation of any fee or expense to a fund client. If there is any ambiguity or room for interpretation in the fund disclosures as to how fees and expenses should be allocated, the staff likely will question any interpretation by the adviser that favors the adviser over the fund client and its investors, based on the fiduciary duty the adviser owes to the fund.

Valuation

The alert notes that examination staff will assess valuation and pricing policies and procedures, as part of its review of mutual funds that hold securitized assets. The role and involvement of the board is likely to be examined as part of this process. If market quotations are not readily available for these securitized assets, the staff will look to see how the board is satisfying its responsibilities regarding the fair value of such securities pursuant to Section 2(a)(41) of the Investment Company Act. While the board may engage others to assist it in calculating the fair value, under SEC guidance, the board is required to determine the methodologies to be used, and to periodically reevaluate the appropriateness of those methodologies.

Rule 38a-1 under the Investment Company Act requires each investment company to “adopt 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….” In the adopting release for this rule, the Commission specifically stated that the rule “requires funds to adopt policies and procedures that … provide a methodology or methodologies by which the fund determines the current fair value of the portfolio security….” In one enforcement action, the SEC charged, and settled with, board members for causing the fund to violate Rule 38a-1 due to certain alleged failures surrounding the valuation of fair value securities. To the extent that the pricing policies and procedures allow for discretion or overrides of valuation determinations, consistently exercising such discretion or overrides in a manner that results in higher valuations might raise red flags.

Valuation in both the registered and private fund industries has been the subject of numerous enforcement actions. SEC valuation cases have involved the following:

  • Valuing contrary to disclosures and/or policies and procedures;
  • Ignoring relevant observable inputs;
  • Using sham quotes or friendly broker marks; and
  • Valuing at a price other than the price the fund would reasonably expect to receive for selling the securities.

It is likely that the SEC will continue to focus on valuation issues, in order to determine whether inflated valuations are being used to: capture additional management and performance fees; advertise false performance; or market a new fund.

Compliance Program

As with any sweep of this nature, and as the alert makes clear, the staff will review the compliance program of both the adviser and the fund. As part of this review, examiners will consider whether compliance is being provided with the resources necessary to operate a reasonably designed and effective compliance program that takes into account the nature of the firm’s business. The staff also will consider how compliance personnel are fulfilling their responsibilities.

Investment Adviser Registration for Bespoke Index Providers

In March 2018, Dalia Blass, Director of the SEC’s Division of Investment Management, delivered a keynote speech at the ICI’s 2018 Mutual Funds and Investment Management Conference. In that speech, she raised the question of whether index providers for bespoke or narrowly focused indexes should be registered as investment advisers. Although she recognized that this is a facts-and-circumstances analysis, she also cautioned against assuming that operating as an index provider alone saves a provider from registering as an adviser. She further noted that the publisher’s exclusion from the definition of “investment adviser” – which many providers of broad-based indexes rely upon for not registering as an investment adviser – might not be available for providers of bespoke or narrowly based indexes. She encouraged a new analysis of the issue.

Because the staff will be looking at these bespoke indexes, generally, and because the Director of Investment Management addressed this issue in a speech, the industry should expect the staff to examine for the unregistered adviser issue as part of its larger focus on custom indexes and index providers.

Conclusion

OCIE’s focus on registered funds aligns with the Commission’s larger focus on retail investors. Prior SEC enforcement actions have charged advisers, broker-dealers and associated persons with fraud, compliance failures and supervisory failures in connection with selling certain complex products to retail investors, including reverse convertible notes, leveraged and inverse ETFs, and market-linked investments. This recent alert from OCIE – and its references to “custom-built indexes,” “smaller and/or thinly traded ETFs,” “funds with higher allocations to securitized assets,” “side-by-side management,” and “advisers that are relatively new to managing registered investment companies” – signals additional areas of staff concern. Here, however, the staff is extending its focus beyond those who sell the products, by looking at those parties responsible for bringing the products to market and how they are exercising ongoing management, monitoring, and oversight of the products on behalf of retail investors. Based on the close collaboration and coordination between OCIE and Enforcement, this alert might also serve as an indicator of where the industry will see future enforcement actions.