US Securities and Exchange Commission Reviews Division Releases Observations of Registered Investment Firm Initiatives | Goodwin
Staff of the US Securities and Exchange Commission (“SEC”) Examinations Division (the “Division”) recently issued a risk alert highlighting observations of its “RIC initiatives” – over 200 mutual fund and ETF reviews and nearly 100 investment advisers between 2018 and 2019. The RIC Initiative sought to answer three questions:
- How strong are the policies, procedures and internal controls of the funds and advisers to address certain risks related to disclosures, portfolio management, conflicts of interest and the effectiveness of program oversight fund board compliance?
- How well are these risks disclosed?
- In the case of funds, how robust are their compliance programs against these risks?
The Risk Alert highlighted a number of frequently cited shortcomings or weaknesses, painting a broad picture of the division’s observations on industry trends where funds and advisers can improve on compliance, while providing insight into the division’s continuing areas of interest. (more details below). The list of gaps and weaknesses (which spanned five of the eight and a half pages of the Risk Alert) covered many, if not most, of the key areas of mutual fund and advisor compliance obligations. , showing that the scope of the Division’s reviews can be broad and suggesting that funds and their advisers should review their policies, practices and procedures on all mutual fund and advisor operations and compliance functions. Division staff noted that the risk alert is intended to “highlight areas of risk and help funds and their advisors develop and improve their compliance programs and practices.”
Staff found that fund and advisor compliance programs did not include adequate policies and procedures in several areas of compliance monitoring, including:
- Investments and portfolios;
- Assessment (including third party service providers);
- Business practices;
- Conflicts of interest;
- Fees and expenses;
- Fund advertising and commercial literature; and
- Board oversight of fund compliance programs.
DISCLOSURES TO INVESTORS
Staff also identified inadequate investor information in SEC filings, advertising and marketing materials, and other communications, including information relating to:
- Certain main investment strategies or risks;
- Potential conflicts associated with the allocation of investment opportunities between overlapping investment strategies (such as a mutual fund and a private fund with similar strategies, managed by the same portfolio manager);
- Modification of a comparative index;
- The net assets of a fund, net expense ratios, contractual expense limitations and / or operating expenses subject to the contractual expense limitation;
- In the case of funds, additional information statements (“SAIs”) regarding the number of accounts and the total assets managed by the portfolio managers in each of the required categories;
- Investment strategies and portfolio holdings;
- Differences in investment objectives between predecessor and successor funds;
- Creation dates;
- Methodologies for calculating the performance of a comparative benchmark; and
- Differences between a general index and a custom index.
The good news is that Division staff provide a broad roadmap in the risk alert for actions funds and advisers can take to improve, including:
- Review policies and procedures to ensure that they cover the various areas of risk, whether related to risk management or risk disclosure to investors;
- For fund advice, assess whether policies and procedures adequately test advisor reports to verify the accuracy of (1) fees, expenses and performance, and (2) investment strategies, including changes and the risks associated with these strategies;
- Test these policies and procedures to make sure they work and provide the opportunity to improve them; and
- Review documents filed with the SEC and any other documents sent to investors, including prospectuses, SAIs and reports to shareholders to ensure that these risks are sufficiently disclosed.
There is an overarching (but unstated) conclusion woven into these areas highlighted, namely that, as part of the funds and advisers adopting and implementing these measures, they should show their work. Maintaining comprehensive policies, documentation outlining all reviews performed, and any applicable changes implemented from those reviews will show reviewers that funds and advisors have effective and “comprehensive” compliance programs.
Finally, the permanent areas of intervention of the staff of the Division are not without change. Division staff have implemented significant changes since 2019 – so have funds and advisors, including:
- Integrate the new SEC Marketing Rule into ongoing compliance, disclosure and record keeping processes;
- Taking into account the new emphasis on compliance of the books and records of the Enforcement Division, in particular by demonstrating tests in this area; and
- Understand the use and nature of any digital engagement practice or “DEP” and ensure that conflicts and disclosures are handled in a reasonable and appropriate manner.
The Risk Alert reiterates the critical importance of compliance and the need to continuously review and update compliance programs to keep pace with new and old requirements as well as changing expectations of regulators. Funds and advisers should ensure that their compliance programs sufficiently address, at a minimum, the areas highlighted in the risk alert, based on their operations.