Table of Contents

• SEC Updates the Marketing Rule FAQs
• SEC Announces Cyber and Emerging Technologies Unit
• SEC Delays Names Rule, Form PF, and Form SHO Compliance Dates
• SEC Issues No-Action Letter and CD&Is on Rule 506(c) Offerings

SEC UPDATES THE MARKETING RULE FAQS  

The Marketing Rule (Rule 206(4)-1 under the U.S. Investment Advisers Act of 1940 (the “Advisers Act”)) was adopted in December of 2020 and became effective on May 4, 2021.  The Marketing Rule created a single rule governing investment advisor marketing by replacing the then-existing rules on advertising and cash solicitation. The Marketing Rule regulates advisers’ marketing communications to seek to prevent fraudulent, deceptive, or manipulative practices in marketing and advertisements.

Since the Marketing Rule’s adoption, many investment advisors have had interpretative questions about compliance with the rule. In response, the Securities and Exchange Commission (the “SEC”) staff (the “Staff”) provided from time to time responses to frequently asked questions (“FAQs”) about the rule. The Staff continues to update these FAQs, with the most recent update being released on March 19, 2025. These Staff’s interpretations and clarifications are not binding on the SEC, nor do they modify the existing obligations and statutes; they are only intended to assist investment advisers in navigating the Marketing Rule.

Extracted Performance

When displaying extracted performance (defined in the Advisers Act as the performance results of a subset of investments extracted from a portfolio), the Marketing Rule generally requires the net performance of one investment or a group of investments from a private fund or other portfolio to be shown alongside the gross performance. However, the Staff has indicated that they would not recommend enforcement, and advisers may present gross performance alone, if the following conditions are met:

• the extracted performance is clearly identified as gross performance;
• the extracted performance is accompanied by a presentation of the total portfolio’s gross and net performance consistent with the requirements of the rule;
• the gross and net performance of the total portfolio is presented with at least equal prominence to, and in a manner designed to facilitate comparison with, the extracted performance; and
• the gross and net performance of the total portfolio is calculated over a period that includes the entire period over which the extracted performance is calculated.

Portfolio or Investment Characteristics

The Staff has recognized that calculating net versions of portfolio characteristics such as yield and volatility can be impractical. Accordingly, the Staff has advised that it would not recommend enforcement if an adviser presents gross characteristics without net equivalents, provided they follow the following specific disclosure and comparison requirements:

• the gross characteristic is clearly identified as being calculated without the deduction of fees and expenses;
• the characteristic is accompanied by a presentation of the total portfolio’s gross and net performance consistent with the requirements of the rule;
• the total portfolio’s gross and net performance is presented with at least equal prominence to, and in a manner designed to facilitate comparison with, the gross characteristic; and
• the gross and net performance of the total portfolio is calculated over a period that includes the entire period over which the characteristic is calculated.

Compliance with General Prohibitions of Rule 206(4)-1(a) and Sections 206(1) and 206(2) of the Advisers Act

The Staff reiterated that advertisements must still comply with the general prohibitions of the Marketing Rule itself and Sections 206(1) and 206(2) of the Advisers Act (which make it unlawful for an investment adviser to (i) employ a scheme to defraud clients or (ii) engage in a transaction or practice which operates as a fraud or deceit to clients, in each case through the use of mail or any means of interstate commerce).

SEC ANNOUNCES CYBER AND EMERGING TECHNOLOGIES UNIT

On February 20, 2025, the SEC announced the creation of the Cyber and Emerging Technologies Unit (the “CETU”), which will focus on “combatting cyber-related misconduct and to protect retail investors from bad actors in the emerging technologies space.” The CETU will replace the SEC’s current Crypto Assets and Cyber Unit.

The Press Release announcing the CETU’s formation included that the CETU will combat misconduct related to securities transactions in the following priority areas:

• Fraud committed using emerging technologies, such as artificial intelligence and machine learning;
• Use of social media, the dark web, or false websites to perpetrate fraud;
• Hacking to obtain material nonpublic information;
• Takeovers of retail brokerage accounts;
• Fraud involving blockchain technology and crypto assets;
• Regulated entities’ compliance with cybersecurity rules and regulations; and
• Public issuer fraudulent disclosure relating to cybersecurity.

SEC DELAYS NAMES RULE, FORM PF, AND FORM SHO COMPLIANCE DATES

Names Rule

On March 14, 2025, the SEC announced a six-month extension of the compliance date for amendments to Rule 35d-1 under the Investment Company Act of 1940 (the “1940 Act”) and related Form N-PORT reporting requirements (collectively, the “Names Rule Amendments”). The compliance date was extended from December 11, 2025 to June 11, 2026 for fund groups with net assets of $1 billion or more as of the end of their most recent fiscal year, and from June 11, 2026 to December 11, 2026 for fund groups with less than $1 billion in net assets as of the end of their most recent fiscal year.

Continuously offered funds, including open-end funds, generally update their prospectuses annually to comply with the requirement of the Securities Act of 1933 (the “Securities Act”) that information in a fund’s registration statement is no more than sixteen months old. Under the original compliance date requirements, if a fund’s annual update to its registration statement was due prior to the initial compliance date, the fund would have to either (i) comply early to include accurate disclosure regarding the fund’s 80% investment policy in that annual amendment, or (ii) incur the cost of an off-cycle amendment on or before the compliance date. Consequently, the SEC modified the operation of the compliance date to allow for existing open-end funds to comply with the Names Rule Amendments at the time of the effective date of its first annual prospectus update on or following the applicable compliance date.

Existing closed-end funds that rely on Rule 8b-16(b) will be required to be in compliance at the time of the transmittal of its first annual report to shareholders on or following the applicable compliance date. Existing business development companies not engaged in continuous offerings will be required to be in compliance at the time of the filing of its first annual report on Form 10-k on or following the compliance date.

Form PF

On January 29, the SEC and Commodity Futures Trading Commission (the “CFTC”) announced that the original March 12, 2025 compliance date for the amendments to Form PF adopted on February 8, 2024 (the “Form PF Amendments”) was extended to June 12, 2025.

SEC-registered investment advisers with private funds generally file reports on Form PF, a confidential form, and advisers that are also registered with the CFTC as commodity pool operators or commodity trading advisers, at different times depending on the types of private funds they advise and their assets under management, including on an annual or quarterly basis. Some advisers file on a quarterly basis for quarterly reporting funds and then subsequently amend that filing to report about their annual reporting funds. The Form PF Amendments include different questions and require reported data to be computed differently than under the current Form PF requirements.

As the original compliance date was after the fourth quarter of 2024 filing deadline for many quarterly funds, but before the 2024 annual filing deadline for many annual reporting funds, the SEC’s final rule extending the compliance date (the “Form PF Extension”) noted that the original compliance date would cause additional burdens on certain advisers if 2024 data is reported on both versions of Form PF. The Form PF Extension included, as an example, that many private fund advisers with annual and quarterly filing obligations would have to submit 2024 data on the two different versions of Form PF (submitting an initial filing on the current Form PF to report data for the fourth fiscal quarter of 2024 for their quarterly reporting funds, and then submitting an amendment on the Final Form PF for their annual reporting funds with 2024 fiscal year data). As a result, the SEC determined to extend the compliance deadline to mitigate the administrative and technological burdens and costs associated with the original compliance date.

Form SHO

On February 7, 2025, the SEC announced a temporary extension from compliance with Rule 13f-2 under the Securities Exchange Act of 1934 (“Rule 13f-2”) and from reporting on Form SHO. As a result, filings on initial Form SHO reports from institutional investment managers that exceed certain thresholds will be due by February 17, 2026 for the January 2026 reporting period. The original compliance date was January 2, 2025, with institutional investment managers reporting information for the January 2025 reporting period.

Under Rule 13f-2, institutional investment managers that exceed certain thresholds are required to file Form SHO within 14 calendar days of the end of each calendar month to disclose information regarding certain equity securities. The SEC will then publish, on an aggregated basis, certain information regarding equity securities reported by institutional investment managers on Form SHO. The SEC provided the temporary exemption to allow institutional investment managers time to complete implementation of systems builds and to test and work with the Staff to address any operational and compliance questions regarding Form SHO reporting.

SEC ISSUES NO-ACTION LETTER AND CD&IS ON RULE 506(c) OFFERINGS

On March 12, 2025, the SEC’s Division of Corporation Finance issued a no-action letter (the “No Action Letter”) on the investor verification requirements for issuers relying on Rule 506(c) of Regulation D of the Securities Act. On the same day, the SEC published two new Compliance and Disclosure Interpretations (“C&DIs”) related to questions surrounding the investor verification requirement of Rule 506(c).

Regulation D under the Securities Act contains several safe harbors for private offerings under Section 4(a)(2), which exempts from the Securities Act’s registration requirements “transactions by an issuer not involving any public offering.” Before its amendment in 2013 pursuant to the Jumpstart Our Business Startups Act (the “JOBS Act”), the Rule 506 safe harbor permitted sales to an unlimited number of “accredited investors” and up to 35 non-accredited investor purchasers as long as the issuer satisfies enumerated conditions, including refraining from engaging in general solicitation and advertising. Under the JOBS Act amendments, the SEC bifurcated the Rule 506 exemption into Rule 506(b) and Rule 506(c). The old version of the Rule (prohibiting general solicitation or advertising) was preserved as Rule 506(b), and Rule 506(c) was adopted to contain the modifications required by the JOBS Act. Accordingly, Rule 506(c) permits issuers to broadly solicit and generally advertise an offering, provided that (i) all purchasers in the offering are accredited investors; (ii) the issuer takes “reasonable steps” to verify purchasers’ accredited investor status and (iii) certain other conditions in Regulation D are satisfied. Rule 506(b) does not have a specific verification requirement.

Rule 506(c)(2)(ii) includes a list of “non-exclusive and non-mandatory” steps an issuer might take to satisfy the investor verification requirement, including reviewing tax documents, brokerage or bank statements, or obtaining written confirmations or representations from certain third parties (e.g., an attorney, accountant, broker or investment adviser). However, these methods are examples of “safe harbor” procedures, and the issuer is not required to employ any specific steps to verify accredited investor status.  

The “reasonable steps” verification activities outside the safe harbor can present operational challenges, increased administrative burdens, and leave uncertainties as to whether sufficient steps to verify investors were taken. As a result, Rule 506(c) has been limited in application despite its potential to access a much wider audience for capital raising through general solicitation.

The new guidance issued by the SEC Staff in the No Action Letter provides a potentially useful alternative Rule 506(c) verification process that issuers must undertake to verify a purchaser’s accredited investor status. In the No Action Letter, the SEC agreed that, when accepting investments from certain types of investors, absent an issuer’s knowledge of contrary facts, an issuer may reasonably conclude that it has taken “reasonable steps” to verify the investor’s accreditation if:

• Investors must make a minimum investment of at least $200,000 for natural persons and at least $1,000,000 for legal entities;
• The issuer obtains written representations from investors confirming the following:
  • The investor is an accredited investor under Rule 501(a); and
  • The investment is not financed by third parties for the specific purpose of making the investment; and
• The issuer does not have actual knowledge contradicting these representations.

In connection with the No Action Letter, the Staff also published two new C&DIs.

New C&DI Question 256.35 addresses what other methods an issuer can use that will satisfy the requirement to take reasonable steps to verify accredited investor status if the issuer does not undertake the safe-harbor steps described under Rule 506(c)(2)(ii). The SEC Staff responds by reiterating its existing guidance in that the determination of what steps are reasonable is based on an objective, “principles-based” analysis of the particular facts and circumstances but notes that the factors that issuers should consider under this facts and circumstances analysis, among others are: “(i) the nature of the purchaser and the type of accredited investor that the purchaser claims to be; (ii) the amount and type of information that the issuer has about the purchaser; and (iii) the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.”

New C&DI Question 256.36 addresses whether the terms of a Rule 506(c) offering, in particular a high minimum investment requirement, would be enough to satisfy the verification requirement where the issuer (i) has no actual knowledge that any purchaser is not an accredited investor and (ii) has confirmed with each purchaser that its investment is not being financed, in whole or in part, by a third party. In addition to reiterating the existing guidance noted above, the SEC Staff responds by citing the No Action Letter and language from Rule 506(c)’s adopting release, which states that if a purchaser can meet a high investment amount requirement, “the likelihood of that purchaser satisfying the definition of an accredited investor may be sufficiently high such that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party.”

UPCOMING CONFERENCES

2025
Date	Host*	Event	Location
4/29	MFDF	Developments in Registered Funds	Denver, CO
4/30 – 5/2	ICI/IDC	Leadership Summit	Washington, DC
4/30 – 5/2	ICI/IDC	Fund Directors Workshop	Washington, DC
5/6	MFDF	Update on Fund Industry Claims Trends: An Insurer’s Perspective	Webinar
5/7	MFDF	MPI’s Annual Survey of Investment Firm Profitability and Economies of Scale	Webinar
5/22	MFDF	Mutual Fund Director Compensation: The MPI Annual Survey	Webinar
6/17	MFDF	Current Landscape of Securities Lending	Webinar
6/18	MFDF	MFDF Spotlight – Fund Director Independence	Webinar
6/24	MFDF	Director Discussion Series – Open Forum	Virtual
7/9	MFDF	Director Discussion Series – Open Forum	Chicago, IL
9/8-10	ICI/IDC	ETF Conference	Nashville, TN
9/23	MFDF	Latest in Closed-End Funds Litigations	Webinar
10/5-8	ICI/IDC	Tax and Accounting Conference	Palm Desert, CA
10/27-29	ICI/IDC	Fund Directors Conference	Scottsdale, AZ
11/13	MFDF	Mutual Fund CCO Compensation: The MPI Annual Survey Update	Webinar
11/20	ICI/IDC	2025 Closed-End Fund Conference	New York, NY

2026
Date	Host*	Event	Location
1/26	MFDF	2026 Directors’ Institute	Naples, FL
2/3-5	ICI/IDC	2026 ICI Innovate	Houston, TX
3/5	MFDF	2026 Fund Governance & Regulatory Insights Conference	Washington, DC
3/22-25	ICI/IDC	Investment Management Conference	Palm Desert, CA
4/29 – 5/1	ICI/IDC	Leadership Summit	Washington, DC
4/29 – 5/1	ICI/IDC	Fund Directors Workshop	Washington, DC
9/14-16	ICI/IDC	ETF Conference	Nashville, TN
9/27-30	ICI/IDC	Tax and Accounting Conference	Marco Island, FL
10/25-28	ICI/IDC	Fund Directors Conference	Scottsdale, AZ
11/10	ICI/IDC	Closed-End Fund Conference	New York, NY

*Host Organization Key: Mutual Fund Directors Forum (“MFDF”), Independent Directors Council (“IDC”), and Investment Company Institute (“ICI”)

© 2025, Davis Graham & Stubbs LLP. All rights reserved. This newsletter does not constitute legal advice. The views expressed in this newsletter are the views of the authors and not necessarily the views of the firm. Please consult with your legal counsel for specific advice and/or information.

CONTACT US
Peter H. Schwartz
Alena Prokop
Stephanie Danner
Martine Ventello
Mackenzie Coupens

Table of Contents

• SEC Announces Charges Against Institutional Investment Managers in Connection with 13F and 13H Reporting Violations
• SEC Adopts Reporting Enhancements for Registered Investment Companies and Provides Guidance on Open-End Fund Liquidity Risk Management Programs
• Recordkeeping Enforcement
• Marketing Rule Enforcement

SEC ANNOUNCES CHARGES AGAINST INSTITUTIONAL INVESTMENT MANAGERS IN CONNECTION WITH 13F AND 13H REPORTING VIOLATIONS

On September 17, 2024, the Securities Exchange Commission (the “SEC”) announced settlements with eleven institutional investment managers for failing to timely report on Form 13F. Two managers were also charged with failing to file as “large traders” on Form 13H.

Under Section 13(f)(1) of the Securities Exchange Act of 1934 (“Exchange Act”), institutional investment managers that exercise investment discretion over $100 million or more in Section 13(f) securities are required to file quarterly reports listing positions via Form 13F, due within 45 days after the end of the calendar quarter. Section 13(f) securities are equity securities of a class described in Section 13(d)(1) of the Securities Exchange Act. A list of the Section 13(f) securities – called the Official List of Section 13(f) Securities – is available shortly after the end of each calendar quarter on the SEC’s website. For Section 13(f) purposes, an “institutional investment manager” is an entity that either invests in, or buys and sells securities for its own account, or any a natural person or an entity that exercises investment discretion over the account of any other natural person or entity. An institutional investment manager exercises investment discretion if: (i) the manager has the power to determine which securities are bought or sold for the account(s) under management, or (ii) the manager makes decisions about which securities are bought or sold for the account(s), even though someone else is responsible for the investment decision. A manager also has investment discretion with respect to all accounts over which any natural person, company, or government instrumentality under its control exercises investment discretion. Forms 13F filed with the SEC are available to the public on the SEC’s website.

Under Exchange Act Section 13(h) and Rule 13h-1, any person that directly or indirectly exercises investment discretion over transactions in NMS securities that equal or exceed (i) 2 million shares or $20 million during any calendar day, or (ii) 20 million shares or $200 million during any calendar month must identify themselves as a “large trader” to the SEC via an initial Form 13H “large trader” filing, after which a Large Trader Identification Number is issued for purposes of notifying broker-dealers for which the person has an account. Following an initial filing, large traders must submit an annual filing within 45 days of the end of each full calendar year. If any information on Form 13H becomes inaccurate, a large trader must file an amended Form 13H promptly after the end of the calendar quarter in which the information became inaccurate. An “NMS Security” is defined in Rule 600(b)(46) and refers, in general, to exchange-listed equity securities and standardized options but does not include exchange-listed debt securities, securities futures, or open-end mutual funds, which are not currently reported pursuant to an effective transaction reporting plan. Unlike Form 13F, Form 13H is not publicly available.

The Form 13F and 13H violations stemmed from failures on the part of the managers to make the required Form 13F and Form 13H filings over extended periods, many of whom had failed to make quarterly filings for years.

Nine managers agreed to pay more than $3.4 million in combined civil penalties. Two of the eleven managers were not required to pay any civil penalties in recognition that they self-reported their non-compliance with the Form 13F filing requirements and received cooperation credit. Similarly, the two managers were not ordered to pay a civil penalty or separate fine in relation to their failure to file Form 13H as both managers self-reported their own the Form 13H failures and otherwise cooperated with the SEC’s investigations.

SEC ADOPTS REPORTING ENHANCEMENTS FOR REGISTERED INVESTMENT COMPANIES AND PROVIDES GUIDANCE ON OPEN-END FUND LIQUIDITY RISK MANAGEMENT PROGRAMS

On August 28, 2024, the SEC adopted amendments to Form N-PORT, the form on which registered investment companies, including open-end funds, registered closed-end funds, and exchange-traded funds (collectively, “funds”), report certain portfolio holdings and related information.

Currently, funds are required to file Form N-PORT reports with the SEC on a quarterly basis within sixty days after quarter end. Only the third month in a quarter is made publicly available, with the first and second months remaining confidential. The Form N-PORT amendments will require funds to file reports on Form N-PORT on a monthly basis within thirty days after the end of the month to which they relate and make funds’ monthly reports publicly available sixty days after the end of each month. The SEC’s release announcing the adoption of the amendments states that these changes are intended to give the SEC timelier information to conduct oversight of an “ever-evolving fund industry” and to provide investors information to make more informed investment decisions.

The SEC did not adopt proposed amendments that would have required funds to present portfolio holdings in accordance with Regulation S-X more frequently than is currently required. Additionally, the SEC did not adopt proposed amendments that would have required funds to report information regarding funds’ use of swing pricing or liquidity classifications, noting that the SEC is not adopting the amendments to the underlying rules at this time.

The SEC also adopted amendments to Form N-CEN. Specifically, funds subject to Rule 22e-4 under the Investment Company Act of 1940 (the “Investment Company Act”) will be required to report certain information about the service providers used to fulfill liquidity risk management program requirements. A fund will be required to: (i) name each liquidity service provider; (ii) provide identifying information, including the legal entity identifier, if available, and location, for each liquidity service provider; (iii) identify if the liquidity service provider is affiliated with the fund or its investment adviser; (iv) identify the asset classes for which that liquidity service provider provided classifications; and (v) indicate whether the service provider was hired or terminated during the reporting period.

Additionally, the SEC provided guidance related to certain aspects of open-end fund liquidity risk management program requirements. Rule 22e-4 under the Investment Company Act (the “Liquidity Rule”) requires open-end funds to adopt and implement liquidity risk management programs and requires (i) the assessment, management, and periodic review of a fund’s liquidity risk; (ii) classification of the liquidity of a fund’s portfolio investments into one of four categories (“highly liquid,” “moderately liquid,” “less liquid,” and “illiquid”) with at-least-monthly reviews of classifications; (iii) determination and periodic review of highly liquid investment minimums (“HLIMs”); (iv) limitation of the amount of illiquid investments held by a fund; and (v) board oversight. The guidance includes that the SEC staff (the “Staff”) observed instances where funds were not prepared to review liquidity classifications intra-month in response to changes in market, trading, and investment specific considerations.

As stated in the SEC’s guidance, the Liquidity Rule requires funds to adopt and implement policies and procedures reasonably designed such that a fund can conduct the required intra-month review of classifications if there are changes in the market, trading, and investment specific considerations. The guidance states that funds should consider reviewing classifications if changes in portfolio composition are reasonably expected to materially affect one or more investment classifications. The guidance further states that funds should consider classifying new investments intra-month if acquiring a particular investment is expected to materially change the liquidity profile of a fund, particularly changes that may cause a shortfall below a fund’s HLIM or cause the fund to exceed the Liquidity Rule’s limitations on illiquid investments.

As part of a fund’s determination as to whether to classify an investment as “highly liquid” or “moderately liquid,” funds are required to consider the time in which it expects an investment to be convertible to cash without significantly changing the investment’s market value. The guidance notes that the Staff has observed international funds considering the time in which an investment would be convertible to a different currency other than U.S. dollars as the relevant period for determining when an investment is convertible to cash and funds that have classified any currency as “highly liquid” regardless of the amount of time it would take to convert to U.S. dollars. Among other items, the guidance includes that funds should not base liquidity determinations in an international jurisdiction on the ability to sell, dispose of, or settle an investment into the local currency without also considering the ability to convert that local currency into U.S. dollars. The guidance also included information related to funds with established HLIMs.

The amendments to Form N-PORT and Form N-CEN will become effective on November 17, 2025. Funds will be required to comply with the amendments as of the effective date, except that groups with less than $1 billion in net assets will have until May 18, 2026 to comply with the Form N-PORT amendments.

RECORDKEEPING ENFORCEMENT

The SEC has continued its focus on compliance with recordkeeping requirements in connection with off-channel communications through the use of personal devices. In this quarter alone, the SEC brought four enforcement actions against various registered investment advisers, broker-dealers, municipal advisors, and rating agencies for failure to comply with the recordkeeping provisions of the federal securities laws, resulting in approximately $531 million in penalties.

Section 17(a)(1) of the Exchange Act and Section 204 of the Investment Advisers Act of 1940 (“Advisers Act”) authorize the SEC to issue rules requiring broker-dealers and investment advisers keep certain records, for prescribed periods, for the protection of investors. The rules adopted under Section 17(a)(1) of the Exchange Act, including Rules 17a-4 and 17a-3, impose minimum recordkeeping requirements based on a prudent broker-dealer standard. These requirements include preserving original communications received and copies of communications sent relating to the broker-dealer’s business for specified periods of time. The rules adopted under Section 204 of the Advisers Act, including Rule 204-2, require that advisers preserve original communications received and copies of communications sent that relate to (i) advisers’ recommendations and advice, (ii) receipt or delivery of funds, (iii) the placing of orders to purchase or sell securities, or (iv) securities recommendations.

In October 2022, the Staff initiated a risk-based investigation into whether investment advisers were properly maintaining communications required to be preserved under the Advisers Act. As a result, on August 14, 2024, the SEC announced charges against 26 broker-dealers, investment advisers, and dually registered broker-dealers and investment advisers for (i) widespread failures to maintain and preserve electronic communications through unapproved off-channel communication methods, and (ii) failure to supervise personnel with respect to preventing and detecting recordkeeping violations.

Four of the twenty-six firms charged agreed to pay a penalty of $50 million each for failures to maintain records of off channel communications sent and received by firm personnel in violation of both Exchange Act Rule 17a-4(b)(4) and Advisers Act Rule 204-2(a)(7). 

With respect to one firm (“Firm 1”) certain communications sent from and to personnel were required to be preserved under the Advisers Act because they either related to (i) advisory recommendations or advice, or (ii) the investment adviser’s receipt or delivery of funds or securities. Of the communications that were not preserved, one identified example was text messages on unapproved platforms with recommendations to buy or sell securities of specific companies. The personnel at three other firms (“Firm 2,” and “Firm 3,” and “Firm 4,” respectively, and together with “Firm 1” the “Firms”) each sent and received off-channel communications that were records required to be maintained under Exchange Act Rule 17a-4(b)(4) and/or Advisers Act Rule 204-2(a)(7). The SEC’s orders with respect to these firms included that each firm did not maintain or preserve the substantial majority of these written communications, and that each Firm’s failures were firm wide. With respect to Firms 2 and 3, the SEC’s orders state that the failures involved personnel at various levels of authority throughout the relevant organization. With respect to Firm 4, the personnel involved with such failures included financial advisors who, together with other personnel they supervised, were responsible for generating some of the highest levels of revenue for Firm 4 within the relevant period described in the order (since 2019). As a result of these findings, each Firm was required to pay a civil penalty and obtain compliance consultants.

Of the twenty-six firms charged in the same enforcement action, three of the firms self-reported their violations which resulted in significantly lower penalties. The firms will pay a combined civil penalty of $392.75 million, and each firm has begun implementing improvements to their recordkeeping policies.

This quarter, the SEC also conducted three other enforcement actions resulting in significant penalties:

• On September 24, 2024, the SEC announced charges against twelve firms, including broker-dealers, investment advisers, and one dually registered broker-dealer and investment adviser, for recordkeeping failures. The firms were required to pay combined civil penalties of $88.225 million.
• On September 17, 2024, the SEC charged twelve municipal advisors for failures to preserve electronic communications, and the firms were required to pay combined penalties of $1.3 million.
• On September 3, 2024, the SEC charged six nationally recognized statistical rating organizations (NRSROs) for recordkeeping violations pursuant to Section 17(a)(1) of the Exchange Act and Rule 17g-2(b)(7) thereunder, resulting in combined civil penalties of more than $49 million.

The recent focus by the SEC on recordkeeping violations and the steep combined civil penalties highlight the importance of maintaining and implementing strict recordkeeping policies. However, the SEC places value on both self-reporting and cooperation with SEC investigations. Therefore, in the event of a known violation, self-reporting violations and cooperation with investigations may lessen the impact of such violations.

MARKETING RULE ENFORCEMENT

On September 9, 2024, the SEC announced settlements with nine SEC-registered investment advisers for alleged violations of Rule 206(4)-1 (the “Marketing Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”) in connection with SEC’s ongoing enforcement sweep of investment adviser compliance with the Marketing Rule.

The Marketing Rule underwent significant amendments in 2020, and compliance with the rule became mandatory for all registered investment advisers on November 4, 2022. The September 2024 announcement follows the SEC’s announcement of its second set of settled enforcement cases against five advisory firms in April 2024, following a previous announcement of settled enforcement cases against nine advisory firms in September 2023.

The SEC’s settlements alleged that the nine advisers distributed advertisements that included untrue or unsubstantiated statements of material fact in violation of the Marketing Rule’s principles-based general prohibitions for all advertisements (the “General Prohibitions”) or advertised testimonials, endorsements, or third-party ratings that could not be substantiated or lacked required disclosures.

In addition to the Marketing Rule’s provisions regarding particular aspects of advertisement, the General Prohibitions provide that advertisements may not, among other things, (i) include an untrue statement of a material fact or omit a material fact necessary to make the statement made, in the light of the circumstances under which it was made, not misleading; or (ii) include a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate upon demand by the SEC. To establish a violation of the General Prohibitions of the Marketing Rule, the SEC only needs to demonstrate simple negligence on the part of the adviser and does not need to prove scienter.

Per the SEC’s orders, one adviser disseminated an advertisement on its public website describing it as a member of an organization that did not exist. Relatedly, the SEC also alleged that four advisers had falsely advertised their advice as being free from customer conflicts without providing any context for the claim. However, the SEC cited the various material conflicts of interest disclosed in the advisers’ Form ADV Part 2A brochures as the unreasonable basis for believing the advisers could substantiate such claims.

Under the Marketing Rule, registered investment advisers are prohibited from including any “testimonial” or “endorsement” in an advertisement unless the investment adviser clearly and prominently makes certain disclosures, including that the testimonial was given by a current client or private fund investor, the endorsement was given by a person other than a current client, that cash or non-cash compensation was provided for the testimonial or endorsement (as applicable), and any material conflicts of interest resulting from the investment adviser’s arrangement with such person giving the testimonial or endorsement. Likewise, investment advisers are prohibited from including any third-party rating in an advertisement unless the investment adviser clearly and prominently discloses the date on which the rating was given and the period of time upon which the rating was based, the identity of the third party that created and tabulated the rating, and, if applicable, that compensation has been provided directly or indirectly by the adviser in connection with obtaining or using the third-party rating.

Per the SEC’s order, one adviser’s website displayed select testimonials from individuals expressing a positive view of the adviser; however, the quotations presented included one “testimonial” from a person who was no longer a client of the firm and another purported testimonial from a person who the firm was unable to verify had ever been a client. Relatedly, some of the advisers were also alleged to have used misleading third-party ratings from industry rankings such as Reuters, Barron’s, and The Financial Times by omitting the required information about the timing and the nature of awards.

The nine advisers agreed to pay $1,240,000 in combined civil penalties.

UPCOMING CONFERENCES

2024
Date	Host*	Event	Location
11/12	ICI/IDC	Closed-End Fund Conference	New York, NY
11/6	MFDF	Director Discussion Series – Open Forum	Denver, CO
11/7	MFDF	Digital Assets in the Fund Space	Webinar
11/12	ICI/IDC	2024 Closed-End Fund Conference	New York, NY
11/12	MFDF	ETF Share Class	Webinar
11/13	MFDF	Director Discussion Series – Open Forum	Los Angeles, CA
11/14	MFDF	Director Discussion Series – Open Forum	San Francisco, CA
11/18	MFDF	AI and Fund Compliance	Webinar
11/19	MFDF	The Power of Custom In-Kind Baskets	Webinar
11/21	MFDF	Mutual Fund CCO Compensation: The MPI Annual Survey Update	Webinar
12/4-5	ICI/IDC	Foundations for Fund Directors	Virtual
12/10	MFDF	BDC Board Service 101	Webinar
12/11	MFDF	ETF Product Trends: Board Implications	Webinar
12/18	MFDF	Visually Mapping Board Composition: Skills Matrices in Fund Board Rooms	Webinar

2025
Date	Host*	Event	Location
1/7	MFDF	2024 Fair Valuation Pricing Survey: Building and Strengthening the Valuation Operating Model	Webinar
1/9	MFDF	MFDF 15(c) White Paper Webinar Series: Part 2 – Board Processes	Webinar
1/27-29	MFDF	Directors’ Institute	Carlsbad, CA
2/3-5	ICI/IDC	ICI Innovate	Huntington Beach, CA
2/10	MFDF	Director Discussion Series – Open Forum	Stuart, FL
2/11	MFDF	Director Discussion Series – Open Forum	Naples, FL
3/6-7	MFDF	Fund Governance & Regulatory Insights Conference	Washington, DC
3/16-19	ICI/IDC	2025 Investment Management Conference	San Diego, CA
4/2	MFDF	Director Discussion Series – Open Forum	Atlanta, GA
4/15	MFDF	Director Discussion Series – Open Forum	Boston, MA
4/30 – 5/2	ICI/IDC	Leadership Summit	Washington, DC
4/30 – 5/2	ICI/IDC	Fund Directors Workshop	Washington, DC
7/9	MFDF	Director Discussion Series – Open Forum	Chicago, IL
10/5-8	ICI/IDC	Tax and Accounting Conference	Palm Desert, CA
10/27-29	ICI/IDC	Fund Directors Conference	Scottsdale, AZ

*Host Organization Key: Mutual Fund Directors Forum (“MFDF”), Independent Directors Council (“IDC”), and Investment Company Institute (“ICI”)

© 2024, Davis Graham & Stubbs LLP. All rights reserved. This newsletter does not constitute legal advice. The views expressed in this newsletter are the views of the authors and not necessarily the views of the firm. Please consult with your legal counsel for specific advice and/or information.

CONTACT US
Peter H. Schwartz
Alena Prokop
Stephanie Danner
Martine Ventello
Mackenzie Coupens

Table of Contents

• Marketing Rule Compliance Risk Alert and Enforcement
• Private Fund Adviser Rules Vacated by Fifth Circuit
• Securities and Exchange Commission v. Jarkesy
• SEC Adopts Rule Amendments to Regulation S-P to Enhance Protection of Customer Information
• SEC Spring 2024 Regulatory Agenda

MARKETING RULE COMPLIANCE RISK ALERT AND ENFORCEMENT

On April 17, 2024, the Division of Examinations (the “Division”) of the Securities Exchange Commission (the “SEC”) issued a Risk Alert regarding the Staff of the Division (the “Staff”) observations preliminary observations from examinations investment advisers’ compliance with amended Rule 206(4)-1 (the “Marketing Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”). The Risk Alert paid particular attention to the Marketing Rule’s seven principles-based general prohibitions for all advertisements (the “General Prohibitions”).

The Staff provided details on the following critical deficiencies related to the application of the Marketing Rule’s General Prohibitions:

• The Staff observed advertisements that included statements of material fact that appeared untrue or could not be substantiated. The Staff highlighted, among other examples, advertisements: (1) referencing specific investment mandates of the advisers in advertisements when there were no such mandates (e.g., ESG); (2) claiming that investment processes were validated by professional institutions when they were not; and (3) misrepresenting the advisers’ client base, such as describing the adviser as a “private fund adviser” when the firm did not advise any private funds.
• The Staff observed advertisements that omitted material facts necessary to make the statements not misleading in light of the circumstances under which they were made. The Staff highlighted, among other examples, advertisements that: (1) recommended certain investments (e.g., on podcasts or websites) without disclosing the conflicts of interest attributed to the compensation paid to or received by the advisers for such recommendations; (2) represented performance information that did not provide adequate disclosure regarding the share classes included in the performance returns; (3) claimed that the advisers achieved above average performance results without clarifying that the advisers did not yet have clients or performance track records; and (4) included third-party ratings that (i) implied that the Adviser was the sole top recipient of certain awards when the awards went to multiple recipients or the adviser was not the top recipient and (ii) failed to disclose that the adviser or that adviser personnel nominated fellow employees for awards.
• The Staff observed advertisements that included only the most profitable investments or specifically excluded certain investments without providing sufficient information and context to evaluate the rationale, such as investments that were written off as losses or were lower-performing investments.

The Staff’s observations also focused on adviser compliance with the Marketing Rule–related aspects of Form ADV, Advisers Act Rule 206(4)-7 (the “Compliance Rule”), and Advisers Act Rule 204-2 (the “Books and Records Rule”).

• The Staff observed advisers using outdated language in their Form ADVs referencing provisions of the prior Cash Solicitation Rule (Advisers Act Rule 206(4)-3), inaccurately indicating that no referral arrangements existed, and omitting material terms and compensation of referral arrangements on Form ADV, Part 2A, Item 14.
• While the Staff noted that many advisers had adopted compliance policies and procedures that included processes to comply with the Marketing Rule, there were observed instances where advisers’ policies and procedures were not reasonably designed or implemented to address compliance with the Marketing Rule, which resulted in gaps for preventing violations of the Marketing Rule, highlighting policies and procedures that: (1) failed to address applicable marketing channels utilized by the advisers, such as websites and social media and (2) were updated to reflect the Marketing Rule but were not implemented (e.g., policies that required net of fees performance to be included with any performance advertisement but practices of including only gross performance in advertisements).
• The Staff observed Marketing Rule-related Books and Records Rule deficiencies, noting that advisers did not maintain copies of information posted to social media and did not maintain documentation to substantiate claims included in advertisements.

The Risk Alert follows shortly after the SEC announced a second set of settled enforcement cases against five registered investment advisers, after previously announcing a set of settled enforcement cases against nine advisory firms in September 2023. The SEC’s recent settlement orders alleged that the five firms advertised hypothetical performance to the general public on their websites (i) without adopting and implementing policies and procedures reasonably designed to ensure that the hypothetical performance was relevant to the likely financial situation and investment objectives of each advertisement’s intended audience, (ii) without ensuring that the hypothetical performance was not misleading or misrepresentative, and (iii) without substantiating the performance figures presented in their advertisements.

PRIVATE FUND ADVISER RULES VACATED BY FIFTH CIRCUIT

On June 5, the U.S. Court of Appeals for the Fifth Circuit (the “Fifth Circuit”) vacated the entirety of the private fund rules (the “Private Fund Rules”) adopted by the SEC in August 2023 (please see our prior alerts for a description of the Private Fund Rules’ provisions) holding that in adopting the Private Funds Rules the SEC exceeded the statutory authority of section 211(h) and section 206(4) of the Investment Advisers Act of 1940 (the “Advisers Act”).

While, the SEC has not yet indicated whether it will appeal the decision (among its other options, the SEC can file a petition for certiorari seeking review before the U.S. Supreme Court within 90 days) private fund advisers should still prepare for the possibility that certain aspects of the Private Fund Rules will surface as investor requests in negotiations, in future SEC examination and enforcement activities, and in industry best practices.

SECURITIES AND EXCHANGE COMMISSION V. JARKESY

On June 27, 2024, the U.S. Supreme Court (“Supreme Court”) issued its decision in Securities and Exchange Commission v. Jarkesy, ruling that when the SEC seeks civil penalties against a defendant for securities fraud, the Seventh Amendment entitles the defendant to a jury trial. Accordingly, the SEC may no longer pursue civil monetary penalties through administrative proceedings.

By way of background, the SEC may bring an enforcement action in one of two forums. It can file suit in federal court (an “Article III Court”), or it can adjudicate the matter “in-house” in an administrative enforcement action before an SEC-appointed Administrative Law Judge (“ALJ”) or the Commissioners, whose decision is nevertheless ultimately subject to Article III judicial review. Unlike proceedings in Article III Courts where the defendant is entitled to a jury trial presided over by an Article III judge, and for which the Federal Rules of Evidence and Civil Procedure apply, administrative proceedings are not subject to the Federal Rules, and the ALJ or Commission serves as factfinder. However, administrative proceedings can, depending on the circumstances, be timelier and more cost-effective than Article III Court review (for both the government and defendants). The SEC’s use of in-house administrative proceedings is a relatively recent practice, as before passing the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010, the SEC could only seek civil penalties in federal court.

George Jarkesy Jr. (“Jarkesy”) established two hedge funds, with his firm Patriot28, LLC (“Patriot28”), as the investment adviser, managing $24 million in assets from over 100 investors. In 2011, the SEC investigated Jarkesy and Patriot28 and, according to the SEC’s allegations, found that Jarkesy and Patriot28 misled investors and brokers by misrepresenting investment strategies, lying about the identity of the fund’s auditor and prime broker, and overvaluing the funds’ claimed value to collect larger management fees. In 2013, the SEC initiated an administrative enforcement action against Jarkesy and Patriot28, alleging various violations of Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Section 206 of the Advisers Act. In 2014, Jarkesy challenged the SEC’s administrative proceedings in the U.S. District Court for the District of Columbia, citing constitutional infringements, but both the district court and the U.S. Court of Appeals for the D.C. Circuit denied the injunction, finding that the district court lacked jurisdiction. After an evidentiary hearing by an ALJ, Jarkesy was found guilty of securities fraud, and the SEC then ordered Jarkesy to pay a civil penalty of $300,000, with Patriot28 forced to disgorge $685,000 in ill-gotten gains. Jarkesy was also barred from various securities-related activities.

Jarkesy sought review of the ALJ’s decision by the SEC. While that petition was pending, the U.S. Supreme Court decided Lucia v. SEC, holding that SEC ALJs were officers of the United States subject to the Appointments Clause and were improperly appointed. Jarkesy, however, had waived his right to a new hearing.

The SEC affirmed the ALJ’s fraud findings, imposed penalties, and rejected Jarkesy’s argument that it had utilized “unconstitutionally delegated legislative power” to pursue the case in an administrative proceeding rather than in an Article III court. It also rejected Jarkesy’s argument that the proceedings violated his Seventh Amendment right to a jury trial.

He then filed a petition for review in the U.S. Court of Appeals for the Fifth Circuit, which reversed and remanded, finding that the SEC’s administrative proceedings suffered from three significant constitutional defects: (1) that it deprived Jarkesy of his Seventh Amendment right to a jury trial; (2) that Congress “unconstitutionally delegated legislative power to the SEC by failing to provide it with an intelligible principle by which to exercise the delegated power”; and (3) that statutory removal restrictions on ALJs violated Article III. The SEC petitioned for certiorari, which the Supreme Court granted, and the Court heard oral argument on November 29, 2023.

In a 6-3 majority (the “Majority”) opinion by Chief Justice Roberts, the Supreme Court decided the case solely on Seventh Amendment grounds, holding that the SEC’s imposition of civil monetary penalties for securities fraud through administrative proceedings violated Jarkesy’s right to a trial by jury for all “suits at common law.” The Supreme Court did not take up other constitutional issues raised by the Fifth Circuit.

The Majority of the Supreme Court first reasoned that because claims for securities fraud violations (such as fraudulent and misleading statements) target the same conduct prohibited by common law fraud, such actions constitute a “suit at common law” to which the Seventh Amendment applies. Next, focusing on the SEC’s desired remedy — civil penalties — the Majority reasoned further that because civil penalties are a punitive form of monetary relief traditionally awarded in courts of law, such penalties constitute a prototypical common-law legal remedy and, therefore, also implicate the Seventh Amendment. A defendant would, therefore, be entitled to a jury trial on action for securities fraud unless the “public rights” exception to Article III jurisdiction applied.

Broadly, the Supreme Court’s “public rights” exception allows Congress to “assign the matter for decision to an agency without a jury, consistent with the Seventh Amendment.” The Majority concluded that the “public rights” exception did not apply because the SEC’s action was a “matter of private rather than public rights” based upon historical precedent (the anti-fraud provisions of the federal securities laws are modeled on historical common-law fraud claims), thereby making “adjudication by an Article III court . . . mandatory.” The Majority rejected SEC’s position that public rights are necessarily involved where a government agency brings suit under a statutory grant of authority, reasoning that the action did not fall within any of the distinctive areas involving governmental prerogatives where the Court’s jurisprudence had concluded that a matter might be resolved outside of an Article III Court without a jury.

Accordingly, the Court concluded that Jarkesy and Patriot28 were entitled to a jury trial in an Article III Court.

Although it may appear relatively narrow in scope on its face, the legal and practical ramifications of the decision– will be significant for the SEC and other federal agencies that impose penalties through administrative proceedings. For any action that is akin to a “suit at common law” and where the remedy sought is one that traditionally “could only be enforced in court of law,” the Jarkesy ruling strongly supports that the defendant has a right to a jury in an Article III Court.

SEC ADOPTS RULE AMENDMENTS TO REGULATION S-P TO ENHANCE PROTECTION OF CUSTOMER INFORMATION

On May 16, 2024, the SEC adopted amendments to Regulation S-P, which governs the treatment of consumers’ nonpublic personal information by certain financial institutions. Regulation S-P requires (i) brokers, dealers, investment companies, and registered investment advisers to adopt written policies and procedures that address administrative, technical, and physical safeguards to protect customer records and information (the “safeguards rule”) and (ii) the proper disclosure of consumer report information in a manner that protects against unauthorized access to or use of such information (the “Disposal Rule”). The Disposal Rule also applies to SEC-registered transfer agents.

The amendments to Regulation S-P (the “Amendments”) define customer information for any covered institution (excluding transfer agents) as any record containing nonpublic personal information about a customer of a financial institution, whether in paper, electronic or other form, that is in the possession of a covered institution or that is handled or maintained by the covered institution or on its behalf. This information is “customer information” regardless of whether it pertains to individuals with whom the covered institution has a customer relationship or to the customers of other financial institutions where such information has been provided to the covered institution.For transfer agents, customer information is any record containing nonpublic personal information identified with any natural person, who is a securityholder of an issuer for which the transfer agent acts or has acted as transfer agent, that is handled or maintained by the transfer agent or on its behalf.

Pursuant to the Amendments, covered institutions will be required to develop, implement, and maintain written policies and procedures for an incident response program that is reasonably designed to detect, respond to, and recover from unauthorized access to or use of customer information. In particular, a covered institution’s incident response program will be required to have written policies and procedures to assess the nature and scope of any incident that involves unauthorized access to or use of customer information and identify the systems and types of customer information that may have been accessed or used without authorization. The incident response program must also take appropriate steps to contain and control the incident to prevent further unauthorized access or use.

In addition, the Amendments require covered institutions to notify individuals whose sensitive customer information was, or is reasonably likely to have been, accessed or used without authorization. Covered institutions will be required to provide this notice as soon as practicable, but no later than 30 days after the institution becomes aware that unauthorized access or use has occurred or is reasonably likely to have occurred. Notice is not required where the institution determines that the customer information has not been, and is not reasonably likely to be, used in a manner that would result in substantial harm or inconvenience. The notice provided to affected individuals must include details regarding the incident, the breached data, and how the affected individual can respond to protect themself.

With respect to service providers used by covered institutions, covered institutions will be required to establish, maintain, and enforce written policies and procedures reasonably designed to require oversight, including through due diligence and monitoring of service providers, and ensuring that affected individuals receive any required notices.

The effective date of the Amendments is August 2, 2024. The compliance date for larger entities is December 3, 2025, while the compliance date for smaller entities is June 3, 2026. “Larger entities” means: (i) investment companies that, together with other investment companies in the same group of related investment companies, have net assets of $1 billion or more as of the end of the most recent fiscal year; (ii) registered investment advisers with $1.5 billion or more in assets under management; and (iii) all broker-dealers and transfer agents that are not small entities under the Securities Exchange Act for purposes of the Regulatory Flexibility Act.

SEC SPRING 2024 REGULATORY AGENDA

On July 8, 2024, the SEC released its Spring 2024 Regulatory Agenda (the “Regulatory Agenda”). The Regulatory Agenda includes fifteen rules in the proposed rule stage and nineteen rules in the final rule stage. Those in the final rule stage include rules with respect to enhanced disclosures by certain investment advisors and investment companies regarding ESG investment practices; cybersecurity risk management for investment advisers, registered investment companies and business development companies; outsourcing by investment advisers; and Regulation Best Execution.

Rules in the “proposed rule stage” include, among others, rules with respect to Regulation D and Form D improvements; safeguarding advisory client assets; open-end fund liquidity risk management programs; investment company fund fee disclosure and reform; and exchange-traded products.

UPCOMING CONFERENCES

2024
Date	Host*	Event	Location
9/22–25	ICI/IDC	Tax and Accounting Conference	Boca Raton, FL
10/8 & 10	ICI/IDC	Securities Law Developments Conference	Virtual
10/21–23	ICI/IDC	Fund Directors Conference	Chicago, IL
11/12	ICI/IDC	Closed-End Fund Conference	New York, NY
09/26	MFDF	In Focus – The Role of Risk in Effective Board Decision-Making and Corporate Governance	Virtual
10/8	MFDF	Distribution 101 for Fund Boards	Webinar
10/15	MFDF	Continuing Regulatory Impacts on Fund Boards	Naples, FL
10/16	MFDF	Director Discussion Series – Open Forum	Kansas City, MO
11/6	MFDF	Director Discussion Series – Open Forum	Denver, CO
11/7	MFDF	Digital Assets in the Fund Space	Webinar
11/13	MFDF	Director Discussion Series – Open Forum	Los Angeles, CA
11/14	MFDF	Director Discussion Series – Open Forum	San Francisco, CA

2025
Date	Host*	Event	Location
1/27-29	MFDF	Directors’ Institute	Carlsbad, CA
2/3-5	ICI/IDC	ICI Innovate	Huntington Beach, CA
3/6-7	MFDF	Fund Governance & Regulatory Insights Conference	Washington, DC
3/16-19	ICI/IDC	Investment Management Conference	San Diego, CA
4/30 – 5/2	ICI/IDC	Leadership Summit	Washington, DC
4/30 – 5/2	ICI/IDC	Fund Directors Workshop	Washington, DC
10/5-8	ICI/IDC	Tax and Accounting Conference	Palm Desert, CA
10/27-29	ICI/IDC	Fund Directors Conference	Scottsdale, AZ

*Host Organization Key: Mutual Fund Directors Forum (“MFDF”), Independent Directors Council (“IDC”), and Investment Company Institute (“ICI”)

© 2024, Davis Graham & Stubbs LLP. All rights reserved. This newsletter does not constitute legal advice. The views expressed in this newsletter are the views of the authors and not necessarily the views of the firm. Please consult with your legal counsel for specific advice and or information.

CONTACT US
Peter H. Schwartz
Alena Prokop
Stephanie Danner
Martine Ventello
Mackenzie Coupons

On May 20, 2024, the U.S. Fish and Wildlife Service (FWS) listed the dunes sagebrush lizard as endangered under the Endangered Species Act (ESA). The dunes sagebrush lizard exists solely in shinnery oak duneland complexes in the Permian Basin, both in Texas and New Mexico. The listing took effect on June 20, 2024.

FWS has considered dunes sagebrush lizard to be a species of concern for decades. FWS first identified the dunes sagebrush lizard, then known as the “sand dune lizard,” as a candidate for listing in 1982. The species remained a candidate species when FWS proposed to list it in 2010. In 2012, however, FWS withdrew its proposed listing rule after concluding that conservation efforts addressed and alleviated threats to the species adequately for it to continue to be viable into the future.  FWS again proposed to list the species in July 2023, relying on a species status assessment it finalized earlier in 2023.

FWS based its decision to list the dunes sagebrush lizard as endangered principally on past and projected future impacts to the species from oil and gas development and frac sands mining. Specifically, FWS based its endangered listing on threats to the dunes sagebrush lizard from: (1) habitat loss, fragmentation, and degradation; and (2) climate change and climate conditions, both resulting in hotter, more arid conditions with an increased frequency and greater intensity of drought throughout the species’ geographic range.

Notably, FWS has declined to designate critical habitat with the listing rule. FWS stated that the designation of critical habitat is not determinable at this time because FWS is still in the process of assessing the information needed to analyze the impacts of critical habitat.

The Effect of Listing on Land Users
Listing wildlife as endangered has two effects on land users. First, the ESA prohibits take of endangered wildlife. Second, a federal agency must consult with FWS before issuing a permit or land use authorization that may affect an endangered species.

Incidental Take Prohibition
The ESA prohibits take of endangered wildlife, which is defined to include harming, harassing, and killing endangered wildlife, among other actions. The ESA’s prohibition on take includes both intentional take and take that occurs unintentionally as the result of otherwise lawful activities, such as energy development (“incidental take”).

The final rule includes the following non-exhaustive list of actions that may result in prohibited take of dunes sagebrush lizard:

• Destruction, alteration, or removal of shinnery oak duneland and shrubland vegetation;
• Degradation, removal, or fragmentation of shinnery oak duneland and shrubland formations and ecosystems;
• Disruption of water tables in dunes sagebrush lizard habitat;
• Introduction of nonnative species that compete with or prey upon the dunes sagebrush lizard;
• Unauthorized release of biological control agents that attack any life stage of the dunes sagebrush lizard or that degrade or alter its habitat; and
• Herbicide or pesticide applications in shinnery oak duneland and shrubland vegetation and ecosystems.

To engage in land use activities that will result in incidental take of endangered wildlife on private lands, land users must obtain a permit from FWS. To obtain a permit, the land user either must have entered into a candidate conservation with assurances (CCAA) with FWS prior to listing or must develop an approved habitat conservation plan (HCP). Several CCAAs exist in New Mexico and Texas; however, land users cannot enroll in these CCAAs because the listing decision is in effect. Now, a private land user will need to enter into an HCP to secure an incidental take permit. To date, no programmatic HCPs are available for land users.

Section 7 Consultation
In addition to prohibiting take of endangered species, the ESA requires federal agencies to consult with FWS to ensure their actions do not jeopardize the continued existence of endangered species, in a process known as “section 7 consultation.” Section 7 consultation can lead to delay and additional conservation measures. With respect to the dunes sagebrush lizard, the Bureau of Land Management (BLM) must consult with FWS before issuing leases, permits, and rights-of-way for energy and other land uses in southeast New Mexico.

In New Mexico, CEHMM administers a Candidate Conservation Agreement (CCA) on federal lands. Participants who enrolled in this CCA prior to the effective date of the listing will enjoy a streamlined process for section 7 consultation and a high degree of certainty that FWS will not require additional conservation measures.

Critical Habitat Designation
In the final rule, FWS stated it plans to publish a proposed rule to designate critical habitat “in the near future.” Land users will have an opportunity to comment on the proposed critical habitat designation before FWS finalizes it.

Please contact Katie Schroder with questions about the listing rule or its effect.

SEC/SRO Update: SEC Charges Lordstown Motors With Misleading Disclosures; Delaware Court Calls Common Merger Practice Into Question; SEC Updates Ethics Rules Governing Securities Trading By Agency Personnel; SEC Adopts Amendments To Form PF

Read more…

Table of Contents

SEC Adopts Amendments to Enhance Private Fund Reporting

SEC Charges Registered Investment Adviser for Failing to Disclose Influencer’s Role in Connection with ETF Launch

SEC Charges Two Investment Advisers with Making False and Misleading Statements About Their Use of Artificial Intelligence

SEC Charges Advisory Firm for Disclosure Failures Ahead of Acquisition Bid

SEC Adopts Reforms Relating to Investment Advisers Operating Exclusively Through the Internet

SEC Proposes Rule to Update Definition of Qualifying Venture Capital Funds

SEC ADOPTS AMENDMENTS TO ENHANCE PRIVATE FUND REPORTING

On February 8, the Securities Exchange Commission (the “SEC” or the “Commission”) and the Commodities Futures Trading Commission (the “CFTC”) jointly adopted amendments to Form PF, used by certain investment advisers to private funds, including investment advisers that are registered with the CFTC as commodity pool operators (“CPOs”) or commodity trading advisers, to report confidential information regarding the private funds they advise. According to the final rule’s adopting release, the amendments “are designed to enhance the Financial Stability Oversight Council’s ability to monitor systemic risk as well as bolster the SEC’s regulatory oversight of private fund advisers and investor protection efforts.”

The amendments to Form PF (the “Form Amendments”) require separate reporting for each component of master-feeder arrangements and parallel fund structures (other than feeder funds that invest all of its assets in a master fund, U.S. Treasury bills, and/or cash and cash equivalents). Advisers will also be required to include the value of investments in other private funds when determining whether: (i) the adviser is required to file Form PF; (ii) the adviser meets the thresholds for reporting as a large hedge fund adviser, large liquidity fund adviser, or large private equity fund adviser; (iii) a hedge fund is a qualifying hedge fund, as opposed to permitting an adviser to either include or exclude the value of other investments for determining the adviser’s reporting threshold. In a change from the SEC’s initial proposal, which contemplated permitting advisers to report fully owned trading vehicles on an aggregated or disaggregated basis and requiring advisers to report partially owned trading vehicles on a disaggregated basis, the final rule includes that advisers will be required to identify trading vehicles in Section 1b of Form PF and report on an aggregated basis for the reporting fund and all trading vehicles. In addition, the final rule adds an instruction for advisers to specify whether the reporting fund holds assets, incurs leverage, or conducts trading or other activities through a trading vehicle.

Additionally, the Form Amendments amend Sections 1a and 1b of Form PF (applicable to all filers) to require filers to provide “additional identifying information” about the adviser and its related persons and their private fund assets under management. Filers will also be required to provide additional identifying information about the private funds they manage and certain other information about such funds, including the fund’s assets, financing, investor concentration, and performance.

The Form Amendments also amend Section 1c of Form PF (applicable to private fund advisers to hedge funds). Advisers will be required to report the fund’s use of “digital assets as an investment strategy.” With respect to Sections 2a and 2b of the Form, the Form Amendments remove aggregate reporting questions for large hedge fund advisers and require large hedge fund advisers to report information about the reporting fund’s investment exposure, open and large position reporting, borrowing and counterparty exposure, and market factor effects.

The effective date and compliance date for the Form Amendments is March 12, 2025.

SEC CHARGES REGISTERED INVESTMENT ADVISER FOR FAILING TO DISCLOSE INFLUENCER’S ROLE IN CONNECTION WITH ETF LAUNCH

On February 16, the SEC announced that a registered investment adviser (the “IA”) had agreed to pay a $1.75 million civil penalty to settle charges that the IA failed to disclose a social media influencer’s role in the launch of a new exchange-traded fund (“ETF”). The IA launched a social media sentiment ETF designed to track an index “based on ‘positive insights’ from social media, news articles, blog posts and other data.” According to the SEC’s order (the “Order”), the index provider informed the IA that it planned to retain a well-known social media influencer (the “Influencer”) to promote the index in connection with the launch of the Fund. The Order also included that the index provider requested, and the IA agreed, to an index license fee structure that would provide the index provider with a larger percentage of the fee when the ETF’s assets under management reached certain thresholds.

As further described in the Order, the initial discussions between the IA and the index provider with respect to the index license fee resulted in a preliminary agreement in October 2020 that the IA would pay the index provider an index license fee equal to 20% of the management fee the IA received from the ETF, though no agreement was executed at that time. Subsequently, the index provider determined to partner with the Influencer, who would receive a portion of the licensing fees paid to the index provider. In light of this partnership, the index provider proposed new economic terms for the index licensing agreement to incentivize the influencer to raise awareness of the ETF.

Specifically, the Order states that under the new economic terms of the proposed licensing agreement, the index provider would receive, “at least 20% of the net management fee [the IA] accrued (after netting out four basis points attributed to expenses) and as much as 60% of the management fee if the new ETF had in excess of $1.25 billion in assets under management within eighteen months of launching the fund.” In mid-November 2020, representatives of the IA and index provider informally agreed to these terms, though the index licensing agreement was not executed until February 2021.

The ETF’s board of trustees (the “ETF Board”) met in early December 2020, at which time the ETF Board considered the advisory contract with the IA. In connection with such approval, the IA provided a memorandum that discussed certain of the economic terms of the licensing agreement. According to the Order, this memorandum disclosed that the licensing fee would equal 20% of the net management fee, but did not disclose the sliding scale whereby the index provider’s compensation would increase if the ETF reached certain asset thresholds. The materials presented to the ETF Board also did not disclose the influencer’s involvement or discuss the controversies surrounding the influencer.

In connection with a board of director’s consideration of an advisory contract, Section 15(c) requires advisers to furnish such information as may reasonably be necessary for the directors to evaluate the terms of the contract. Funds are required to include disclosure in their shareholder reports concerning, among other items, (i) the extent to which economies of scale would be realized as the fund grows, (ii) whether economies of scale are for the benefit of shareholders, and (iii) the costs of services to be provided and profits to be realized by the adviser and its affiliates from its relationship with the fund. According to the Order, the ETF Board did not have ability to consider the economic impact of the sliding scale arrangement as part of its evaluation of the IA’s profitability and the extent to which economies of scale would be realized if the ETF grew. Additionally, the Order included that the IA did not have adequate written policies and procedures for furnishing the Board with accurate information reasonably necessary for the board to evaluate the terms of the advisory contract as well as the material information related to a proposed fund launch.

As a result of the above, the Order stated that the IA violated: (i) Section 15(c) of the Investment Company Act; (ii) Section 206(2) of the Investment Advisers Act of 1940 (the “Advisers Act”), which prohibits an investment adviser directly or indirectly, from engaging in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client; and (iii) Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which required registered investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder.

SEC CHARGES TWO INVESTMENT ADVISERS WITH MAKING FALSE AND MISLEADING STATEMENTS ABOUT THEIR USE OF ARTIFICIAL INTELLIGENCE

On March 18, the SEC announced settled charges against two investment advisers (“Adviser 1” and “Adviser 2”) for making false and misleading statements about their purported use of artificial intelligence (“AI”). As the first set of SEC settlements related to AI claims, the settlements highlight the SEC’s focus on investment adviser’s unsubstantiated claims about using AI – “AI washing” – compared to ESG “greenwashing.”

The SEC charged Adviser 1 with violations of Sections 206(2) and 206(4) of the Advisers Act and Rules 206(4)-1 and 206(4)-7 (the “Antifraud Provisions,” the “Marketing Rule,” and “Compliance Rule”, respectively) thereunder in connection with regulatory filings, advertisements, and social media relating to its purported use of artificial intelligence and machine learning. Per the SEC’s order, Adviser 1 represented that it used artificial intelligence and machine learning to analyze its retail clients’ spending and social media data to inform its investment advice when, in fact, no such data was being used in its investment process. For example, in Adviser 1’s Form ADV brochures from August 2019 through 2021, Adviser 1 claimed that its advice was “powered by the insights it makes when individuals . . . connect their social media, banking, and other accounts . . . or respond to Adviser 1’s questionnaires” which make its investment decisions “more robust and accurate[.]” Moreover, starting in November 2020, Adviser 1’s website claimed that Adviser 1 “turns your data into an unfair investing advantage” and that Adviser 1 “put[s] collective data to work to make our artificial intelligence smarter so it can predict which companies and trends are about to make it big and invest in them before everyone else.” According to the SEC, these statements were false and misleading because Adviser 1 had not developed the capabilities they represented. The Division of Examinations (“EXAMS”) identified Adviser 1’s AI-related statements as problematic during an examination in October 2021, for which Adviser 1 admitted to EXAMS that it had not used any of its client’s data and had not created an algorithm to use client data. Adviser 1 then took certain corrective actions to correct false and misleading statements regarding the use of client data, such as revising its Form ADV Part 2A, hiring an additional compliance manager for its compliance team, and retaining two outside compliance consulting firms to assist with a corrective review of the firm’s marketing and regulatory disclosure documents. Still, Adviser 1 continued to make certain false and misleading advertising statements regarding using client data in various formats through August 2023. For example, investors who joined Adviser 1 in 2021 and 2022 were sent an email communication stating that their data was “helping [Adviser 1] train [its] algorithm for pursuing even better returns” and that Adviser 1 “will pool your data with everyone else’s to power our algorithm.” Similarly, the aforementioned website claims made in November 2020 remained through August 2023. Without admitting or denying the SEC’s findings, Adviser 1 agreed to pay a civil penalty of $225,000.

The SEC charged Adviser 2 with violations of Sections 206(2) and 206(4) of the Advisers Act and Rules 206(4)-1 and 206(4)-7, thereunder in connection with Adviser 2’s false and misleading claims about its purported use of AI on its website and social media sites, as well as in emails to current and prospective clients. According to the SEC, Adviser 2 could not substantiate its claim as the “first regulated AI financial advisor” and falsely claimed on its public website that its technology incorporated “[e]xpert AI-driven forecasts,” when in fact it did not. Adviser 2 was also cited by the SEC for other non-AI related violations of the Marketing Rule (e.g., false claims on Adviser 2’s website and in a press release that it had more than $6 billion of assets on its platform when Adviser 2 did not have or report any regulatory assets under management on its Form ADV; use of hypothetical performance and testimonials on Adviser 2’s website and YouTube without meeting any of the use conditions under the Marketing Rule) as well as other instances of misconduct in violation of the Antifraud Provisions (e.g., an improper liability disclaimer language, commonly referred to as a “hedge clause”). Without admitting or denying the SEC’s findings, Adviser 2 agreed to pay a civil penalty of $175,000.

SEC CHARGES ADVISORY FIRM FOR DISCLOSURE FAILURES AHEAD OF ACQUISITION BID

On March 1, 2024, the SEC announced settled charges against a New York-based investment adviser (the “Adviser”) for its failure to make timely ownership disclosures in the months up to its acquisition bid for a public company (the “Company”), as required under rules governing beneficial ownership reporting under Sections 13(d) and 13(g) of the Securities Exchange Act of 1934. By way of brief background, these rules require investors that beneficially own more than 5% of a public company’s equity securities to publicly disclose their beneficial ownership and other related information in either a Schedule 13D or Schedule 13G. Schedule 13G is available to “passive” investors who acquired shares without intending to change or influence the control of the issuer, as long as their ownership remains below 20%. Once passive intent no longer exists, the investor can no longer file on the shortform Schedule 13G as a passive investor and must file on the longer form Schedule 13D.

According to the SEC, an affiliated hedge fund advised by the Adviser began purchasing Company common stock in August 2021 and first exceeded the 5% beneficial ownership threshold on December 8, 2021. As of December 31, 2021, the Adviser beneficially owned 5.6% of the outstanding common stock of Company. the Adviser disclosed its 5.6% beneficial ownership position on an initial Schedule 13G that it filed with the SEC on February 14, 2022 (the “Company Schedule 13G”).

Under Item 10 of Schedule 13G, a filer relying upon Rule 13d-1(b) or 13d-1(c) must sign a certification specifically attesting to the lack of a “control” purpose or effect. Again, pursuant to Rule 13d-1(e), any person who has filed a Schedule 13G pursuant to Rule 13d-1(b) or 13d-1(c) becomes immediately subject to Rule 13d-1(a) and must file a Schedule 13D if the investor once a passive intent no longer exists and the filer holds the securities with a disqualifying “control” purpose or effect. The term “control” is defined in Rule 12b-2 of the Exchange Act to mean “possession . . . of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.” Nevertheless, the determination of whether securities are held with the purpose or effect to change or influence control is fact specific analysis.

From January 1, 2022 through April 18, 2022, the Adviser purchased an additional 2,050,000 shares of Company common stock, giving it total beneficial ownership of 5,050,000 shares, or approximately 9.9% of the outstanding shares. the Adviser also entered into cash-settled swap agreements between April 27 and May 12, 2022, which provided the Adviser with economic exposure comparable to approximately an additional 450,000 shares or 0.9% of outstanding Company common stock.

On April 26, 2022, the Adviser first considered making its own acquisition bid for Company, with financing to be provided by a private equity firm. On the same day the Adviser began to draft an offer letter to Company with a placeholder offer price of $85 per shares. According to the SEC, these activities shifted the Adviser from passive to control status by no later than that date (April 26, 2022), as the Adviser held its Company common stock with the intent to change or influence “control” of the issuer. Accordingly, because its Company Schedule 13G certification was no longer accurate, the Adviser was therefore required to convert its Company Schedule 13G to a Schedule 13D within ten (10) days, i.e., no later than May 6, 2022.

Instead, on April 27, 2022, the Adviser contacted outside counsel to advise on its Schedule 13D and provided counsel with a draft of the offer letter. On May 12, 2022, the Adviser met with Company management for the first time to discuss whether management would be receptive to an acquisition bid. The Adviser did not file the required Schedule 13D until May 13, 2022, the same day that it submitted to Company management, and publicly announced, its proposal to acquire all Company shares not already held by the Adviser, at $86 per share, approximately a 20% premium to the prior day’s closing trading price on the New York Stock Exchange.

The SEC found that the Adviser’s seven-day delay in filing Schedule 13D violated Section 13(d)(1) of the Exchange Act and Rule 13d-1 thereunder. Without admitting or denying the SEC’s findings, the Adviser agreed to pay a $950,000 civil money penalty to settle the matter.

SEC ADOPTS REFORMS RELATING TO INVESTMENT ADVISERS OPERATING EXCLUSIVELY THROUGH THE INTERNET

On March 27, the SEC adopted amendments to Rule 203A-2(e) under the Advisers Act that exempt certain investment advisers that provide advisory services through the internet (“Internet Advisers”) from the prohibition on SEC registration (the “Internet Adviser Exemption”), as well as related amendments to Form ADV.

Under Section 203A of the Advisers Act, investment advisers are generally prohibited from registering with the SEC unless they reach assets under management threshold, advise an investment company registered under the Investment Company Act of 1940, or qualify for an exemption under SEC rules or another statute. However, Internet Advisers are exempt from the Section 203A prohibition under the Internet Adviser Exemption if they meet certain conditions. As initially adopted in 2002, an adviser could rely on the Internet Adviser Exemption if, among other obligations, it provided investment advice to all of its clients exclusively through an “interactive website,” with a de minimis exception which permitted Internet Advisers to have a limited number (i.e., fewer than 15) of non-internet clients in the preceding 12-month period. According to the SEC’s adopting release, the amendments to the Internet Adviser Exemption are designed to modernize Rule 203A-2(e) to reflect the broader evolution in technology and the marketplace since its adoption in 2002 and to better align current practices in the investment adviser industry with the narrow exemption for certain investment advisers that did not fall neatly within the framework established by Congress.

The SEC’s 2024 amendments change the conditions of the Internet Adviser Exemption in two key ways. First, the amendments rename and redefine Rule 203A-2(e)’s existing defined term “interactive website” as “operational interactive website.” Existing Rule 203A-2(e) defines an “interactive website” as a website in which computer software-based models or applications provide investment advice to clients based on personal information each client supplies through the website. As amended, an “operational interactive website” is defined as a website or mobile application through which the investment adviser provides “digital investment advisory services” on an ongoing basis to more than one client (except during temporary technological outages of a de minimis duration). The amendments also define “digital investment advisory service” as investment advice to clients generated by the operational interactive website’s software-based models, algorithms, or applications based on personal information each client supplies through the operational interactive website. Second, the amendments eliminate the de minimis exception of 15 non-internet clients. Accordingly, under amended Rule 203A-2(e), an Internet Adviser must provide advice to all its clients exclusively through an operational interactive website. As noted in the adopting release, when the SEC initially adopted the fewer than 15 client de minimis exception, the Commission stated that it was similar to the since repealed “private adviser exemption,” which, subject to certain additional conditions, exempted from the requirement to register with the Commission any adviser that during the course of the preceding 12 months, had fewer than 15 clients.

Lastly, the Internet Adviser Exemption amendments amend Form ADV to require an Internet Adviser relying on the Internet Adviser Exemption as a basis for registration to represent on Schedule D of its Form ADV that, among other things, it has an operational interactive website.

The amendments to the Internet Adviser Exemption will become effective July 8, 2024 (90 days after publication in the Federal Register). An Internet Adviser relying on the exemption must comply with the amended rules, including the requirement to amend its Form ADV to include the required representations, by March 31, 2025. An Internet Adviser that is no longer eligible for the exemption and otherwise ineligible for SEC registration must register in one or more states and withdraw its SEC registration by filing a Form ADV-W by June 29, 2025.

SEC PROPOSES RULE TO UPDATE DEFINITION OF QUALIFYING VENTURE CAPITAL FUNDS

On February 14, the SEC proposed a rule that would, if adopted, adjust for inflation the threshold for a fund to qualify as a “qualifying venture capital fund” for the purposes of the Investment Company Act. Qualifying venture capital funds are excluded from the definition of an “investment company” under the Investment Company Act. A “qualifying venture capital fund” is defined under the Investment Company Act as “a venture capital fund that has not more than $10 million in aggregate capital contributions and uncalled committed capital.” Pursuant to the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018, the SEC is required to adjust the threshold for inflation once every five years. The proposed rule would raise the threshold to $12 million aggregate capital contributions and uncalled committed capital, based on the Personal Consumption Expenditures Chain-Type Price Index (PCE Index). The proposed rule also would establish a process for future inflation adjustments every five years.

The period to submit comments on the proposed rule closed on March 22, 2024.

Table of Contents:

Securities and Exchange Commission Division of Examinations Announces 2024 Priorities

SEC Adopts Rule to Increase Transparency into Short Selling and Amendment to CAT NMS Plan for Purposes of Short Sale Data Collection

Treasury Revisits Past Rulemaking to Bring Investment Advisers Under AML Oversight

Securities Lending Transparency Rules

SEC Releases Form ADV FAQs

SECURITIES AND EXCHANGE COMMISSION DIVISION OF EXAMINATIONS ANNOUNCES 2024 PRIORITIES

On October 16, 2023, the Securities and Exchange Commission’s (the “SEC” or the “Commission”) Division of Examinations (the “Division”) released its 2024 examination priorities (the “Priorities”)^.
As noted in the Priorities, the Division will prioritize areas that “pose emerging risks to investors or the markets, as well as examinations of core and perennial risk areas.” This analysis focuses on the Division’s examination priorities with respect to investment advisers, registered investment companies, and broker-dealers, but the Priorities also include discussions of the Division’s priorities with respect to self-regulatory organizations, clearing agencies, and certain other market participants.

Examinations of Investment Advisers

Noting the Division’s priority to examine for advisers’ adherence to their duties of care and loyalty, the Division indicated that it would continue to focus on:

• investment advice provided to clients regarding products, investment strategies and account types, particularly: (i) complex products, such as derivatives and leveraged exchange-traded funds (ETFs); (ii) high cost and illiquid products, such as variable annuities and non-traded real estate investment trusts (REITs); and (iii) unconventional strategies, including those that purport to address rising interest rates;
• processes for determining that advice is provided in clients’ best interests, including processes for: (i) initial and ongoing suitability determinations; (ii) best execution; (iii) evaluating costs and risks; and (iv) identifying and addressing conflicts of interest. With respect to conflicts of interest, the Priorities note that examinations will review how advisers address conflicts, including mitigating or eliminating conflicts and allocating investments to accounts where investors have more than one account;
• Economic incentives that an adviser and its financial professionals may have to make recommendations, such as the source and structure of compensation, revenue or other benefits. The Priorities indicated that examinations will focus on economic incentives and conflicts associated with advisers that are also registered as broker-dealers, use affiliates to perform services for clients and have financial professionals servicing both brokerage customers and advisory clients to identify (i) advice to purchase or hold certain investments or invest through certain accounts when there are other lower cost options available and (ii) investment advice with respect to proprietary products and affiliated service providers that result in additional or higher fees; and
• Disclosures to investors and whether such disclosures include all material facts relating to conflicts associated with investment advice sufficient to allow clients to provide informed consent to the conflict.

Additionally, the Priorities discuss the examination focus on adviser compliance policies and procedures, noting that such examinations will include:

• Marketing practice assessments for whether advisers, including advisers to private funds, have (i) adopted and implemented reasonably designed written policies and procedures to prevent violations of the Advisers Act and its rules including the recent Marketing Rule reforms; (ii) appropriately disclosed marketing-related information on Form ADV; and (iii) maintained substantiation of their processes and other required books and records. Additionally, the Priorities include that marketing practice reviews will also assess whether advertisements include untrue statements of a material fact, are materially misleading, or are otherwise deceptive and, comply with the requirements for performance, third-party ratings, and testimonials and endorsements;
• Compensation arrangement assessments focusing on (i) fiduciary obligations of advisers to their clients, including registered investment companies, particularly with respect to the advisers’ receipt of compensation for services or other material payments made by clients and others; (ii) alternative ways that advisers try to maximize revenue, such as revenue earned on clients’ bank deposit sweep programs; and (iii) fee breakpoint calculation processes, particularly when fee billing systems are not automated;
• Valuation assessments regarding advisers’ recommendations to clients to invest in illiquid or difficult to value assets;
• Safeguarding assessments for advisers’ controls to protect clients’ material non-public information, particularly when multiple advisers share office locations, have significant turnover of investment adviser representatives, or use expert networks; and
• Disclosure assessments to review the accuracy and completeness of regulatory filings, including Form CRS, with a focus on inadequate or misleading disclosures and registration eligibility.

Examinations of Investment Advisers to Private Funds

As noted in the Priorities, the Division will continue to focus on private fund advisers and prioritize specific topics, including:

• Portfolio management risks where there is exposure to market volatility and higher interest rates, which may include private funds experiencing poor performance, significant withdrawals, and valuation issues, as well as private funds with leverage and illiquid assets;
• Adherence to contractual requirements for limited partnership advisory committees (or similar structures), including adhering to notification and consent requirements;
• Accuracy with respect to the calculation and allocation of fund fees and expenses, including valuation of illiquid assets, calculations of management fees after the close of the commitment period, adequacy of disclosures, and potential offsets to such fees and expenses; and
• Due diligence practices for consistency with policies, procedures, and disclosures, particularly:
  • Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers;
  • Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements; and
  • Policies and procedures for reporting on Form PF, including with respect to certain reporting events.

Registered Investment Companies

Citing their importance to retail investors and retail investors saving for retirement, the Priorities note that the Division continues to prioritize examinations of registered investment companies, including mutual funds and ETFs. The Priorities include that examinations of investment companies may include the following examination focus areas:

• Fees and expenses and reviewing whether registered investment companies have adopted effective written compliance policies and procedures concerning the oversight of advisory fees and implemented any associated fee waivers and reimbursements. The Priorities note that a particular focus will be on (i) charging different advisory fees to different share classes of the same fund; (ii) identical strategies offered by the same sponsor through different distribution channels but have differing fee structures; (iii) high advisory fees relative to peer funds; and (iv) high registered investment company fees and expenses, particularly those of registered investment companies with weaker performance relative to their peers.
• Derivatives risk management assessments to review whether registered investment companies and business development companies have adopted and implemented written policies and procedures reasonably designed to prevent violations of the SEC’s fund derivatives rule (Rule 18f-4 under the Investment Company Act). Review of compliance with the derivatives rule may include review of the adoption and implementation of a derivatives risk management program, board oversight, and whether disclosures concerning the registered investment companies’ or business development companies’ use of derivatives are incomplete, inaccurate or potentially misleading.

Broker Dealers

With respect to broker-dealers and Regulation Best Interest, the Priorities include that in reviewing whether broker-dealer recommendations are in customers’ best interest, the following will be areas of particular importance (i) recommendations with regard to products, investment strategies, and account types; (ii) disclosures made to investors regarding conflicts of interest; (iii) conflict mitigation practices; (iv) processes for reviewing reasonably available alternatives; and (v) factors considered in light of the investor’s investment profile, including investment goals and account characteristics.

The Priorities also include that the Division’s examinations will review the content of the broker-dealers’ relationship summary on Form CRS, compliance with the Net Capital Rule and Customer Protections Rule and related internal processes, procedures and controls, and broker-dealer trading practices.

SEC ADOPTS RULE TO INCREASE TRANSPARENCY INTO SHORT SELLING AND AMENDMENT TO CAT NMS PLAN FOR PURPOSES OF SHORT SALE DATA COLLECTION

On October 13, the Commission adopted new Rule 13f-2 and related Form SHO under the Securities Exchange Act of 1934 (the “Exchange Act”) to require certain institutional investment managers (“Managers”) to report, on a monthly basis on Form SHO, certain short position data and short activity data for certain equity securities required by Rule 13f-2. Additionally, the Commission adopted an amendment to the national market system plan (“NMS Plan”) governing the consolidated audit trail (“CAT”) to require the reporting of reliance on the bona fide market making exception in the Commission’s short sale rules.

Rule 13f-2 will require a Manager to file a Form SHO report via the Commission’s EDGAR system within fourteen (14) calendar days after the end of each calendar month with regard to:

• With respect to any equity security that is of a class of securities registered pursuant to Section 12 of the Exchange Act or for which the issuer of that class of securities is required to file reports pursuant to Section 15(d) of the Exchange Act (a “Reporting Company Issuer”) over which the Manager and all accounts over which the Manager (or any person under the Manager’s control) has investment discretion with respect to a monthly average gross short position that meets or exceeds either (i) a monthly average of daily gross short positions at the close of regular trading hours in the equity security with a U.S. dollar value of $10 million or more, or (ii) a monthly average of daily gross short positions at the close of regular trading hours as a percentage of shares outstanding in the equity security of 2.5% or more; and
• With respect to any equity security that is of a class of securities of an issuer that is not a Reporting Company Issuer over which the Manager and all accounts over which the Manager (or any person under the Manager’s control) has investment discretion with respect to a gross short position that meets or exceeds a gross short position in the equity security with a U.S. dollar value of $500,000 or more at the close of regular trading hours on any settlement date during the calendar month.

For each reported equity security, a Manager will be required to report on Form SHO certain information, including:

• The Manager’s end-of-month gross short position in the equity security at the close of regular trading hours on the last settlement date of the calendar month; and
• For each individual settlement date during the calendar month, the Manager’s “net” activity in the reported equity security, which includes activity in derivatives, such as options.

The Commission will then publish, through EDGAR, and on a slightly delayed basis (expected to be within one (1) month after the end of the reporting calendar month), certain aggregated short sale related information regarding each equity security reported by Managers on Form SHO, including, for example:

• As an aggregated number of shares across all reporting Managers, the Managers’ gross short position in the reported equity security at the close of regular trading hours on the last settlement date of the calendar month, as well as the corresponding dollar value of that reported gross short position; and
• For each settlement date during the calendar month, the net activity in the reported equity security, as aggregated across all reporting Managers.

The amendment to the CAT NMS Plan will require CAT reporting firms to report to the CAT, for the original receipt or origination of an order to sell an equity security, whether the order is a short sale effected by a market maker in connection with bona fide market making activities in the equity security for which the bona fide market making exception in Rule 203(b)(2)(iii) of Regulation SHO is claimed.

Rule 13f-2, Form SHO, and the amendment to the CAT NMS Plan became effective January 2, 2024. The compliance date for Rule 13f-2 and Form SHO is twelve (12) months after the effective date, with public aggregated reporting to follow three (3) months later. The compliance date for the amendment to the CAT NMS Plan is July 1, 2025.

TREASURY REVISITS PAST RULEMAKING TO BRING INVESTMENT ADVISERS UNDER AML OVERSIGHT

On December 11, the U.S. Department of the Treasury (“Treasury”) announced in a Fact Sheet its renewed focus on the perceived money laundering risks associated with investment advisers.

The Fact Sheet covered a broad range of topics, focusing on the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) increased efforts to address the illicit finance and national security threats posed by corruption across various industries and sectors, including asset management. Per the Fact Sheet, investment advisers are not subject to consistent or comprehensive anti-money laundering (“AML”) and countering the financing of terrorism (“CFT”) obligations in the United States. Accordingly, the Treasury is re-examining and updating its September 1, 2015, Notice of Proposed Rule Making (the “2015 Proposal”). Generally, private funds are subject to the AML requirements of the USA PATRIOT Act and similar regulations in other jurisdictions.

The 2015 Proposal proposed to include investment advisers in the definition of “financial institution” in the regulations implementing the Bank Secrecy Act (the “BSA”), which, among other things, would require advisers to comply with suspicious activity reporting requirements, including filing Currency Transaction Reports (“CTRs”) and keeping records relating to the transmittal of funds. The 2015 Proposed Rule stalled following a 2017 moratorium on in-process rules.

Since that time, in January 2021, Congress enacted the Anti-Money Laundering Act of 2020 (the “AMLA”), which made sweeping reforms to the Bank Secrecy Act. Part of the AMLA is the Corporate Transparency Act (the “CTA”). Additionally, in September 2022, under the CTA, FinCEN issued a beneficial ownership reporting rule (the “BOI Rule”), which establishes a beneficial ownership information reporting requirement for certain “reporting companies.” The BOI, which became effective January 1, 2024, is intended to help prevent and combat money laundering, terrorist financing, tax fraud, and other illicit activity. Although there are exemptions to the definition of a “reporting company” under the BOI Rule, the BOI Rule is expected to impact private funds and their advisers and sponsors significantly.

In light of Tresuary’s renewed focus, investment advisers may want to pay particular attention to their compliance programs and consider implementing or enhancing existing procedures to attempt to ensure they are prepared for enacted and potential AML laws and regulations.

SECURITIES LENDING TRANSPARENCY RULES

On October 13, 2023, the Commission voted to adopt new Rule 10c-1a under the Exchange Act, which is intended to increase the transparency and efficiency of the securities lending market. Generally speaking, Rule 10c-1a will require “covered persons” who agree to a “covered securities loan” to provide specified Rule 10c-1a information comprised of certain “data elements” to a registered national securities association (“RNSA”) by the end of the day on which the loan is effected or modified. Rule 10c-1a will also require a RNSA to make publicly available most of the Rule 10c-1a information it receives, by the morning of the next business day, except for the loan amount, which must be made public after 20 business days. The RNSA must keep the “confidential data elements” it receives confidential, in accordance with applicable law and the rule’s requirements regarding data retention and availability. Currently, the Financial Industry Regulatory Authority (“FINRA”) is the only RNSA. Rule 10c-1a became effective on January 2, 2024. Covered persons will have to start reporting information to FINRA by the compliance date, January 2, 2026, which is 24 months after the effective date. However, FINRA will not publicly report information regarding Rule 10c-1a until 90 calendar days after the compliance date.

Covered Persons

Rule 10c-1a requires “covered persons” to report to FINRA by the end of the day. Rule 10c-1a defines the term “covered person” to mean (i) any person that agrees to a covered securities loan on behalf of a lender (an “intermediary”) other than a clearing agency when providing only the functions of a central counterparty or central securities depository; (ii) any person that agrees to a covered securities loan as a lender when an intermediary is not used, unless the borrower is a broker or dealer borrowing fully paid or excess margin securities; or (iii) a broker or dealer when borrowing fully paid or excess margin securities. Rule 10c-1a does not provide any sort of de minimis exemption from the definition of covered person.

Covered Securities Loans

Rule 10c-1a requires the reporting of all “covered securities loans” agreed to by any covered person. A covered securities loan is defined as “a transaction in which any person on behalf of itself or one or more other persons, lends a reportable security to another person.” In turn, a “reportable security” is defined in Rule 10c-1a(j)(3) as any security or class of an issuer’s securities for which information is reported or required to be reported to the consolidated audit trail (“CAT”) as required by Rule 613 and the CAT National Market System Plan, FINRA’s Trade Reporting and Compliance Engine (“TRACE”), the Municipal Securities Rulemaking Board Real-Time Transaction Reporting System, or any reporting system that replaces one of these systems.

Rule 10c-1a Data Elements

Rule 10c-1a prescribes three types of data elements that must be reported. The first set of data elements are public facing and concerns the material terms of the covered securities loan, requiring covered persons to provide in their initial report information regarding the:

• Legal name of the issuer of the securities to be borrowed;
• Ticker symbol of those securities;
• Time and date of the covered securities loan;
• Name of the platform or venue, if one is used;
• Amount of reportable securities loaned;
• Rates, fees, charges, and rebates for the loan;
• Type of collateral provided for the covered securities loan and the percentage of the collateral to the value of the reportable securities loaned;
• Termination date of the covered securities loan; and
• Borrower type, e.g., broker, dealer, bank, customer, bank, clearing agency, custodian.

The second set of data elements concerns information related to modifications of a covered securities loan if the modification impacts any previously reported “data element” submitted to FINRA. In this instance, covered persons are required to provide:

• the date and time of the modification;
• the specific modification and the specific data element being modified; and
• the unique identifier assigned to the original covered securities loan.

The third set of data elements concerns confidential information about the loan not intended to ever become publicly available (though FINRA may share such data with the SEC and such “other persons as the Commission may designate by order upon a demonstrated regulatory need”), and requires covered persons to include in their report:

• The legal names of the parties to the loan, including the person’s CRD or IARD No., MPID and LEI, and whether such person is the lender, the borrower or the intermediary;
• When the lender is a broker-dealer, whether the security loaned to its customer is loaned from the broker-dealer’s inventory; and
• Whether the loan will be used to close out a fail to deliver pursuant to Rule 204 of Regulation SHO or whether the loan is being used to close out a fail to deliver outside of Regulation SHO.

Timing of Reporting

Covered persons must report the required data elements by the end of the day on which the covered securities loan is effected or modified; the reporting obligation does not depend on when the securities loan is actually settled. Importantly, Rule 10c-1a uses the term “day” rather than “business day” when discussing the reporting requirements applicable to covered persons and reporting agents under sections (c) and (d) of the rule, which indicates that loans entered into on non-business days may still be subject to end of day reporting.

FINRA Publication of Data

The final rule requires FINRA to make publicly available the data elements (except for the loan amount), the unique identifier assigned to the loan by FINRA, and the LEI, ISIN, CUSIP, FIGI, or other security identifier(s) that FINRA determines is appropriate to identify the relevant reportable security, as well as information pertaining to the aggregate transaction activity and distribution of loan rates for each reportable security and those security identifier(s), not later than the morning of the business day after the covered securities loan is effected. On the 20th business day after the covered securities loan is effected, FINRA will publicize the loan amount. Likewise, the modification of any data element will be made public by FINRA on the day after the modification and any modification to the loan amount will be disclosed on the 20th business day after the covered securities loan is modified.

SEC RELEASES FORM ADV FAQS

On October 26, the SEC’s Division of Investment Management staff updated the “Frequently Asked Questions on Form ADV and IARD” (the “FAQs”) for investment advisers that submit Form ADV to the SEC pursuant to the Investment Advisers Act of 1940, as amended (the “Advisers Act”), either as “exempt reporting advisers” (“ERAs”) or registrants (“RIAs”). By way of background, Form ADV is the uniform form used by investment advisers to register with both the SEC and state securities authorities. ERAs must also file a Form ADV, although the specific requirements and deadlines may vary. The form consists of three parts. Parts 1 and 2 are used by the SEC and the states. Part 3 is used by the SEC and some states.

The FAQs provide additional guidance from the staff concerning specific questions concerning Form ADV and the Investment Adviser Registration Depository (“IARD”) system, which filers submit Form ADV and amendments thereto. The FAQs include both technical updates to previously existing FAQs as well as new FAQs on a variety of topics.

A summary of some of the more significant new and amended the FAQs are set forth below.

New FAQ on Audits for Newly Created Private Funds

Item 7.B.(1) requires RIAs to complete a separate Section 7.B.(1) of Schedule D for each private fund it advises. Section 7.B.(2) of Schedule D requires RIAs to report information about each private fund, including information about the fund’s service providers, such as its auditor, prime broker, custodian, administrators, and marketers. In a new FAQ on question 23(a) of Schedule D, Section 7.B.(1) related to auditors, the staff stated that an adviser to a newly created private fund should not report that a private fund’s financial statements are subject to an annual audit if an auditing firm has not been engaged to conduct an audit for the applicable fiscal year.

Modified FAQ on Delivery of Private Fund Audits

Question 23(g) of Schedule D, Section 7.B.(1) asks whether the private fund’s audited financial statements for the most recently completed fiscal year were distributed to the private fund’s investors. For RIAs relying on the “audit approach” for their compliance with the Custody Rule (Rule 206(4)-2), audited financial statements must be delivered to investors within 120 days of the pool’s fiscal year-end and within 180 days of the fiscal year end of a fund-of-funds. Due to the timing of the annual update (within 90 days after the end of your fiscal year), some RIAs to private funds may have neither received the audit reports nor distributed them at the time of filing the Form ADV annual update. As a result, these RIAs may not have distributed the audit reports by the Form ADV filing deadline.

In a modified FAQ, the staff clarified that if the applicable deadline for distributing the private fund’s audited financial statement has not yet passed, an adviser may answer “Yes” if it has engaged an auditor, and the audited financial statements will be distributed as required. Otherwise, an adviser should answer “No” if the applicable deadline for distribution has passed and audited financial statements were not delivered to clients for the most recently completed fiscal year.

New FAQ on Material Changes to ADV Part 2A

The instructions to Item 2 of Part 2A require prompt disclosure of any material changes to Part 2 that an RIA may make a part of its annual update for Form ADV. A new FAQ clarifies the staff’s expectations that providing a list of material changes is not a sufficient discussion; instead, an adviser must identify and discuss material changes.

New FAQ on Typos and Mistakes in an Annual Updating Amendment

In a new series of FAQs on Filing an annual Updating Amendment, the staff addressed the mistaken submission of an “other-than-annual amendment” instead of an Annual Updating Amendment and the occurrence of typos in an adviser’s annual amendment filing. The staff noted that it cannot change the date (or any information filed) on Form ADV filing. Accordingly, filing an other-than-annual amendment is not a substitute for filing an annual updating amendment. In both scenarios, an adviser must file another Form ADV annual updating amendment with the correct year. The adviser may wish to consider entering a note in the Miscellaneous section of Schedule D explaining the reason for filing an amended annual updating amendment.

Miko Brown serves as Associate General Counsel at Airbnb, Inc., where she leads the Community Trust Team. Prior to joining Airbnb, Miko was a partner in the Trial Department at Davis Graham and defended high-profile companies in catastrophic personal injury lawsuits nationwide, including moving vehicle accidents, product liability matters, and mass torts. She has extensive experience in civil rights and employment matters and has successfully defended breach of contract and intellectual infringement cases. In 2013, Miko launched the Women in Leadership Lecture Series (WILLS), which continues to be held at Davis Graham to this day.

What does a typical day look like for you at Airbnb?

Putting out fires and damage control. Because I lead the trust and safety legal team, I jump from one crisis to the next – shootings, stabbings, drug trafficking, discrimination, etc. – I’ve seen it all!

What was it like to transition from law firm partner to in-house counsel during the pandemic?

It was very challenging. Having to learn a new role at a new organization over Zoom isn’t ideal. But the biggest challenge was building trusting relationships with people I had never met in person. I didn’t realize how important face-to-face meetings were until they were no longer an option.

What do you value most about your time at Davis Graham?

The friends I made at the firm. I’ve never worked with so many smart, supportive, and genuinely kind people.

Who are some of the people at Davis Graham that had the greatest influence on you and why?

Shannon Stevenson, Kristin Lentz, Chad Williams, and Kenzo Kawanabe. When I think of the term “leader,” these are four individuals who immediately spring to mind. They lead with humility and empathy, which is rare and what drew me to Davis Graham.

In all of your time at Davis Graham and beyond, you have been a champion of women and diverse lawyers. Recently, you launched Project Ganesha. Tell us how Project Ganesha is furthering this mission.

Project Ganesha is named after the Hindu god, Ganesha, known as the remover of obstacles. The aim of Project Ganesha is to increase the number of women and diverse law firm leaders and rainmakers with a heavy emphasis on mental and physical health. To accomplish this goal, I created easy-to-implement training and playbooks for Partners and Associates that provide simple tools for reducing attrition, boosting well-being, and improving Associates’ substantive and business development skills. All Project Ganesha proceeds will go towards funding grants for women and diverse law students and Law School…Yes We Can! Fellows who are interested in pursuing careers in private practice. You can check out the Project Ganesha website at www.projectganesha.org.

What can we expect from Project Ganesha in the future?

I’m hoping that the practices taught by Project Ganesha become the new law firm standard and we see a marked increase in the number of women and diverse Associates who become successful law firm Partners.

What is your best advice for associates on a partnership track?

Read and follow the Project Ganesha Associate Playbook!

Table of Contents:

SEC Adopts Final Private Fund Adviser Rules

SEC Adopts Final Amendments to the Investment Company Names Rule

SEC Adopts Money Market Fund Reforms

SEC ADOPTS FINAL PRIVATE FUND ADVISER RULES

On August 23, 2023, the Securities and Exchange Commission (the “SEC” or the “Commission”) voted to adopt a final set of new rules and amendments under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) (collectively the “Private Fund Adviser Rules” or the “Rules”) that expand the regulatory compliance requirements for both registered, and to some extent, private fund advisers. The Private Fund Adviser Rules consist of five regulations and prohibitions:

• Restricted Activities Rule,
• Preferential Treatment Rule,
• Quarterly Statement Rule,
• Private Fund Audit Rule, and
• Adviser-Led Secondaries Rule.

The Rules also include amendments to the Advisers Act’s Books and Records Rule that will require SEC-registered advisers to retain records to facilitate the SEC’s ability to assess such adviser’s compliance with the Final Rules, including the delivery of quarterly statements and annual audited financials to private fund investors, as well as certain records related to the Restricted Activities Rule and the Preferential Treatment Rule.

Notably, the Private Fund Adviser Rules do not apply to investment advisers to securitized asset funds. Along that same vein, the Rules apply specifically to “private funds.” Section 202(a)(29) of the Advisers Act defines the term “private fund” as an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940, as amended (the “Investment Company Act”), but for section 3(c)(1) or 3(c)(7) of that Act. Real estate funds relying on Section 3(c)(5)(C), as well as others, are outside the technical scope of the Rules.

As explained in the Adopting Release, the Private Fund Adviser Rules were designed specifically to address consequences relating to transparency, conflicts of interest, and governance mechanisms for client disclosure, consent, as well as oversight matters that are common in an adviser’s relationship with private funds and their investors.

In addition to these new Rules, the SEC also adopted amendments to the existing Compliance Rule for all registered investment advisers, whether or not advising private funds.

By way of background, the SEC proposed the initial form of the Private Fund Adviser Rules (collectively, the “Proposed Rules”) on February 9, 2022. The Proposed Rules drew significant industry debate with more than 300 public comments submitted by various industry participants, groups, and stakeholders over two rounds of comment period. In their initial form, the Proposed Rules departed in many ways from the Adviser Act’s disclosure-based regulatory regime for conflicts of interest, prescribing and prohibiting specific actions by advisers instead of focusing on the quality of advisers’ disclosures or negotiations between advisers and private fund investors. Similarly, the Proposed Rules did not include a “grandfathering” provision to reduce the burden of amending existing agreements or changing certain practices in older private funds to comply with the Proposed Rules. The SEC ultimately chose not to adopt Proposed Rules relating to prohibitions on charging fees for unperformed services (e.g., accelerated monitoring fees) and limiting adviser liability and related indemnification/exculpation in a private fund’s governing documents. Likewise, the SEC chose to include grandfathering provisions, as the Final Rules provide “legacy status” and disapply certain portions of the Restricted Activities Rule and Preferential Treatment Rule with respect to preexisting contractual arrangements. Although the final Private Fund Adviser Rules are less extensive than the Proposed Rules, they still introduce new obligations and limitations expected to change business practices significantly and lead to additional administrative responsibilities and expenses. The new Rules also remain shrouded in controversy: on September 1, 2023, a lawsuit was filed jointly by six trade associations with the Fifth Circuit Court of Appeals in New Orleans, challenging the validity and enforceability of the Private Fund Adviser Rules. While the lawsuit does not automatically stop the transition periods of the Rules or delay their compliance date, a stay of the Rules may be requested or granted, either by court order as part of the proceedings or as otherwise determined by the SEC.

Generally, advisers covered by the Final Rules will have either a 12-month or an 18-month compliance transition window following the November 13 effective date, depending on their status as “Larger” or “Smaller” Private Fund Advisers. The Adopting Release defines Larger Private Fund Advisers with $1.5 billion or more in private fund assets under management. Smaller Private Fund Advisers are advisers with private fund assets under management of less than $1.5 billion in private funds assets. For the Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule, the compliance date for Larger Private Fund Advisers is September 14, 2024, and for Smaller Private Fund Advisers, March 14, 2025. For the Private Fund Audit and Quarterly Statement Rule, the compliance date for all SEC-registered private fund advisers, regardless of size, will be March 14, 2025.

The compliance date for the Compliance Rule amendments regarding a Written Annual Review is November 13, 2023.

Restricted Activities Rule (Rule 211(h)(2)-1)

The Restricted Activities Rule generally prohibits all advisers to private funds — regardless of whether they are registered with the SEC — from engaging in certain “restricted” practices unless the prescribed disclosure-based or disclosure and consent-based requirements are followed. Departing from the SEC’s flat probation on certain adviser activities and expense practices as Proposed, the adopted Rules include exceptions for each “restricted” activity. For example, Unlike the Proposed Rules, the Final Rules do not explicitly prohibit advisers from charging portfolio investment monitoring fees, servicing fees, consulting fees, or other similar fees in respect of any services the investment adviser does not or does not reasonably expect to, provide to the portfolio investment.

The Restricted Activities Rule will restrict private fund advisers from the following activities:

• Regulatory, Compliance, and Examination Expenses Restriction: Private fund advisers are restricted from reducing charging or allocating fees regulatory or compliance fees and expenses of the adviser or its related persons unless the adviser distributes a written notice of any such fees or expenses, and the dollar amount thereof, to the investors of such private fund client within 45 days after the end of the fiscal quarter in which the charge occurs.
• Post-Tax Clawback Restriction: Private fund advisers are restricted from reducing the amount of an adviser-carried interest clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders unless it sends a written notice to the investors of the private fund that sets forth the aggregate dollar amounts of its clawback before and after any such tax reduction for actual, potential, or hypothetical taxes within 45 days after the end of the fiscal quarter in which the adviser in which the clawback occurs.
• Non-Pro-Rata Allocation of Fees and Expenses Restriction: Private fund advisers may not directly or indirectly charge or allocate fees or expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment unless the adviser meets two requirements: (i) the non-pro rata charge or allocation is fair and equitable under the circumstances and (ii) before charging or allocating such fees or expenses to a private fund client, the investment adviser distributes to each investor of the private fund a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.
• Investigation Expenses Restriction: Private fund advisers may not charge private fund clients for fees and expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority, even if the conduct would otherwise be indemnifiable under the applicable private fund governing documents unless the adviser requests and obtains consent of a majority in interest of investors that are not related persons of the adviser. Under the Rule, regardless of disclosure and consent, an Adviser may not chargeback fees or expenses related to an investigation that results in sanction(s) for violating the Advisers Act. The SEC noted that investor consent to bearing such fees and expenses is likewise impermissible, as the SEC would view any waiver as invalid under section 215(a) of the Advisers Act.
• Borrowing Restriction: Private fund advisers may not borrow money, securities, or other fund assets or receive an extension of credit from the fund unless the adviser (i) provides written notice to each investor of the material terms of such transactions and (ii) obtains advance consent from at least a majority in interest of investors that are not related persons of the adviser.

As explained in the Adopting Release, the consent-based exceptions require informed consent from the fund’s investors; approval from fund governance bodies, such as LPACs, advisory boards, or boards of directors, are deemed insufficient to satisfy the consent requirements. Moreover, consent must be obtained from a majority-in-interest of investors who are not “related persons” of the adviser (as defined in Form ADV).

The SEC has extended “legacy status” to a portion of the Restricted Activities Rule that requires informed investor consent for the adviser to borrow from a private fund or to charge certain investigation fees and expenses. Specifically, for any private funds commencing operation prior to the applicable compliance date (“existing private funds”), the restrictions do not apply so long as the existing private fund’s contractual agreements were in place prior to the compliance date and would require the parties to amend the agreement in order to comply. The “commencement of operations” includes any bona fide activity directed towards operating a private fund, including investment, fundraising, or operational activity. Examples of such bona fide activity include issuing capital calls, setting up a subscription facility for the fund, holding an initial closing, conducting due diligence on potential fund investments or making an investment on behalf of the fund.

Preferential Treatment Rule (Rule 211(h)(2)-3)

The Preferential Treatment Rule prohibits all advisers to private funds — regardless of whether they are registered with the SEC — from providing preferential redemption rights to a subset of investors or providing portfolio holdings or investment exposure information to a subset of investors, with certain limited exceptions.

Specifically, advisers will be prohibited from granting preferential redemption rights that would have a material, negative effect on the other investors in the fund or similar pool or assets unless (1) such redemptions are required by law or (2) the adviser has offered the same redemption ability to existing/future investors without qualification.

Advisers are also prohibited from granting preferential rights related to portfolio holdings or fund exposure information if the adviser reasonably expects or should expect that the disclosure would have a material, negative effect on other investors in the fund or similar pool of assets unless the adviser offers such information to all other existing investors at substantially the same time. The Rule applies to all types of investor communications: formal, informal, written, visual, and oral.

Whether any particular preferential treatment is expected to have a “material, negative effect” on other investors in the private fund is a facts and circumstances analysis.

The Final Rule defines a “similar pool of assets” as a pooled investment vehicle (other than an investment company registered under the Investment Company Act of 1940 or a company that elects to be regulated as such) with similar investment policies, objectives, or strategies to those of the private fund managed by the adviser or its related persons. The SEC noted that the term will capture parallel funds, funds-of-one, and co-investment vehicles. However, separately managed accounts are excluded from the definition.

In addition, the Preferential Treatment Rule prohibits all private fund advisers from directly or indirectly providing any “other preferential treatment” to an investor unless (1) the adviser provides advance disclosure to prospective investor’s investment of material economic terms granted preferentially to other investors and (2) the adviser or its related persons has provided to other investors in the same private fund notice of all preferential terms “as soon as reasonably practicable” after the end of the fundraising period (for illiquid funds) or the investor’s investment (for liquid funds) and at least annually after that (if new preferential terms are granted since the last notice).

“Material economic terms” are terms that a prospective investor “would find most important and significantly impact its bargaining position.” The SEC gave the example of co-investment rights as a term that would generally qualify as a material, economic concession to the extent they include materially different fee and expense terms from those of the main fund (e.g., no fees or no obligation to bear broken deal expenses).

The SEC has extended limited legacy status to the Preferential Treatment Rule only with respect to the prohibition of preferential treatment relating to redemption and information rights. Critically, “legacy status” will apply only to existing private fund’s contractual agreements entered into before the compliance date if the Preferential Treatment Rule would otherwise require the parties to amend such an agreement.

Accordingly, existing funds must disclose “other” preferential treatment previously granted but not yet disclosed. This means the preferential terms of side letters agreements and other confidential arrangements providing preferential treatment entered into prior to the compliance will need to be disclosed (1) to prospective investors investing in the fund after the compliance date and (2) to all investors (i) with respect to liquid funds, as soon as reasonably practicable following the new investor’s investment in the private fund and (ii) with respect to illiquid funds, as soon as reasonably practicable following the final closing date.

Quarterly Statement Rule (Rule 211(h)(1)-2)

Under the Quarterly Statement Rule, SEC-registered private fund advisers (or their administrators) will be required to prepare and distribute quarterly statements for each private fund that contain certain fund-level fee and expense disclosures, investment-level compensation disclosures, and specific performance disclosures, the content of which, depends on whether the private fund is a liquid fund or an illiquid fund, as determined by the adviser. For standard private funds, the quarterly statements are due within 45 days after the end of the first three fiscal quarters of each fiscal year and 90 days after the end of each fiscal year (with an extended timeline for fund of funds to 75 and 120 days, respectively). Investors may not waive the Quarterly Statement rule.

Specifically, the fee and expense-related quarterly statement must include a “fund table” with fund-level reporting across (i) all compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the private fund, (ii) all fees and expenses (including separate line items for organizational, accounting, legal, administration, audit, tax, due diligence and travel), (iii) any offsets or rebates carried forward to reduce future management fee payments. Moreover, the investment level compensation quarterly statement must also include a “portfolio Investment table” with investment-level reporting across all “portfolio investment compensation” allocated or paid by each “covered portfolio investment” (including origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments by the covered portfolio investment to the investment adviser or any of its related persons). In the Adopting Release, the SEC noted no exclusions for de minimus expenses, general grouping of more negligible expenses into broad categories, or labeling expenses as miscellaneous; instead, advisers must list and label each expense category.

The performance-related quarterly statements must provide fund-level performance data specified intervals (the past 10 fiscal years or since inception) depending on the type of private fund (illiquid or liquid) through the latest quarter-end computed with and without the impact of any “fund-level subscription facilities,” that includes (1) Gross IRR and Gross MOIC, (2) Net IRR and Net MOIC, (3) Gross IRR and Gross MOIC for the realized and unrealized portions of the fund’s portfolio (shown separately) and (4) statement of contributions and distributions. “Fund-level subscription facilities” are defined as any subscription facilities, subscription line financing, capital call facilities, capital commitment facilities, bridge lines, or other indebtedness incurred by the private fund that is secured by the unfunded capital commitments of the private fund’s investors. The definition of an illiquid fund is based primarily on the lack of withdrawal and redemption capability. An “illiquid fund” is defined as a private fund that (1) is not required to redeem interests upon an investor’s request and (2i) has limited opportunities, if any, for investors to withdraw before termination of the fund. A “liquid fund” is defined as a private fund that is not an illiquid fund.

The Quarterly Statement Rule also requires that reports include prominent disclosure as to the manner of calculation, including cross-references to the applicable sections of a private fund’s operative documents. While advisers do not need to provide all supporting calculations as part of a quarterly statement, the SEC noted that advisers generally should make them available upon request from an investor.

Private Fund Audit Rule (Rule 206(4)-10)

The Private Fund Audit Rule requires SEC-registered private fund advisers to obtain an annual financial statement audit of each covered private fund they advise that complies with the current “Custody Rule” (rule 206(4)-2). The private fund audit must be: (1) performed by an independent public accountant registered with and subject to PCAOB oversight; (2) meet the definition of audit in rule 1-02(d) of Regulation S-X; (3) be prepared in accordance with U.S. GAAP as required under the custody rule; and (4) delivered to investors (i) annually, within 120 days of the private funds fiscal year-end and (ii) promptly upon liquidation. Because the Private Fund Audit Rule effectively mandates that private advisers rely on the “audit exception” under the Custody Rule, the Rule eliminates the surprise audit option for private funds under the Custody Rule. As such, private fund advisers currently relying on the “surprise examination” option under the Custody Rule for private funds will need to be audited annually per the audit requirements of the Custody Rule.

The Private Fund Audit Rule also imposes a separate standard for funds and advisers that are not in a control relationship. An adviser needs only to take reasonable steps to cause the private fund to undergo an audit if the adviser is not in a control relationship.

Adviser-Led Secondaries Rule (Rule 211(h)(2)-2)

The Adviser-Led Secondaries Rule requires that SEC-registered private fund advisers conducting “adviser-led secondary transactions” must, before the due date of the election, (i) obtain and distribute to investors a fairness opinion or a valuation opinion from an independent opinion provider and (ii) prepare and distribute to investors a summary of any material business relationships among the adviser and the independent opinion provider for the two years prior to the issuance of the opinion.

The SEC defined “adviser-led secondary transaction” as any transaction initiated by the investment adviser or any of its related persons that offers private fund investors the choice between (1) selling all or a portion of their interests in the private fund and (2) converting or exchanging all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons. The SEC noted that whether the adviser or its related person initiates a secondary transaction requires a facts and circumstances analysis.

Compliance Rule Amendments (Rule 206(4)-7)

Although preparing written annual reviews is a widely adopted “best practice” among advisers, the Advisers Act’s Compliance Rule did not explicitly require it. However, the Final Rules will now mandate that all SEC-registered advisers, including those who do not advise private funds, document the annual review of their compliance policies and procedures in writing. As noted in the Adopting Release, the review should consider any compliance issues that have arisen during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that may require revisions to policies and procedures.

SEC ADOPTS FINAL AMENDMENTS TO THE INVESTMENT COMPANY NAMES RULE

On September 20, 2023, the Commissioners of the SEC voted to adopt final amendments and changes to Rule 35d‑1 (the “Names Rule”) under the Investment Company Act.

By way of background, the Names Rule generally requires a registered investment company or business development company (“BDC,” and together with registered investment companies, “Registered Funds”) with a name that suggests it has a focus on particular types of investments, industries or geographic regions, or whose distributions are tax-exempt, to adopt a policy to invest at least 80% of the value of its assets in investments that are consistent with its name (an “80% investment policy”).

The amendments broaden the scope of funds that are subject to the 80% investment policy requirement required by Rule 35d-1 to include fund names with terms suggesting that the fund focuses on investments that have or investments whose issuers have particular characteristics, including a name with terms such as “growth,” “value,” or terms that reference a thematic investment focus such as indicating that the fund’s investment decisions incorporate one or more ESG factors. The amendments require Registered Funds subject to the 80% investment policy requirement to disclose in their prospectuses the definitions of the terms used in their names, including the criteria the funds use to select the investments the term describes.

Beyond the expansion of the scope of the 80% investment policy, the amendments revised Rule 35d-1 to provide for in the event of a fund’s departure from its 80% investment policy as a result of a drift or other-than-normal circumstances, the fund will now have 90 days to get back into compliance with the 80% investment policy requirement.

The amendments also clarified that registered funds must use the notional amount of a derivatives instrument (with certain adjustments) rather than its market value to determine compliance with the 80% investment policy.

Moreover, registered funds subject to the 80% investment policy requirement will be required to disclose on their quarterly Form N-PORT the definitions of terms used in their names, the value of their 80% baskets, and each investment included in the 80% basket.

The amendments also include specific recordkeeping requirements, requiring Registered Funds with an 80% investment policy requirement to document compliance with the amended Rule.

The compliance date is September 22, 2025 (24 months following the effective date) for larger entities and March 20, 2026 (30 months following the effective date) for smaller entities. The Adopting Release defines larger entities as funds that, together with other investment companies in the same “group of related investment companies” (as that term is defined in Rule 0-10 under the Investment Company Act) have net assets of $1 billion or more as of the end of the most recent fiscal year, and smaller entities are funds that together with other investment companies in the same “group of related investment companies” have net assets of less than $1 billion as of the end of the most recent fiscal year.

SEC ADOPTS MONEY MARKET FUND REFORMS

On July 12, the SEC adopted rule and form amendments concerning money market funds (“MMFs”) under Rule 2a-7 of the Investment Company Act. As noted in the Adopting Release, the amendments are designed to improve the resilience and transparency of money market funds and address concerns about prime and tax-exempt money market funds highlighted by raised by large outflows from money market funds during the COVID-19 pandemic.

Increase of the Minimum Daily and Weekly Liquidity Requirements

The amendments increase the minimum liquidity requirement to at least 25% of the fund’s total daily liquid assets and at least 50% of a fund’s total assets in weekly liquid assets. The increased thresholds are designed to provide a more substantial buffer to equip MMFs better to manage significant and rapid investor redemptions. The amendments also incorporate a new board reporting requirement for funds that fall below certain liquidly thresholds: an MMF holding less than 12.5% of its total assets or weekly liquid assets equal to less than 25% of its total assets will be required to notify its board within one business day of the shortfall and provide the board with a description of the circumstances leading to the shortfall within 4 business days of the event.

Removal of Temporary Redemption Gates

MMFs will no longer be able to impose temporary gates to suspend redemptions. Specifically, the amendments remove provisions in Rule 2a-7 that permit an MMF to impose a temporary redemption gate. The amendments also remove provisions in Rule 2a-7 that tied a money market fund’s ability to impose liquidity fees to its level of weekly liquid assets. Accordingly, MMFs will no longer be permitted to impose liquidity fees if their weekly liquid assets fall below a certain threshold.

Liquidity Fee Requirement

Under the new amendments, the SEC has introduced a revised framework for liquidity fees that incorporates both mandatory liquidity fees for institutional money funds and discretionary liquidity fees for non-government MMFs. The new framework separates the fee type from the fund’s weekly liquid assets, meaning that whether the fee is mandatory or discretionary will not depend on the fund’s weekly liquid assets. A money fund’s board will be responsible for making liquidity fee determinations under the mandatory and discretionary liquidity fee requirements and is permitted to delegate this responsibility to the fund’s investment adviser or officers, subject to certain oversight requirements.

Under the amendments, institutional prime and institutional tax-exempt MMFs will be required to impose mandatory liquidity fees when the fund experiences daily net redemptions over 5% of net assets. Accordingly, the amount of the liquidity fee must be a good faith estimate, supported by data, of the costs the fund would incur if it sold a pro-rata amount of each security in its portfolio (a “vertical slice”) to satisfy the amount of net redemptions, including transaction costs and market impacts.

The SEC retained the ability of a non-government MMF’s board to impose a discretionary liquidity fee. Accordingly, non-government MMFs must impose a discretionary liquidity fee of up to 2% if the fund’s board determines a fee is in the fund’s best interest.

Other Amendments

In addition to the changes detailed above, the amendments will require funds to calculate Weighted Average Maturity (“WAM”) and Weighted Average Life (“WAL”) based on the percentage of each security’s market value in the portfolio.

The amendments also address potential negative interest rates on the operation of government MMFs and retail MMFs that seek to maintain a stable share price. Under the amendments, retail and government money market funds may handle a negative interest rate environment either by converting from a stable share price to a floating share price or by reducing the number of shares outstanding to maintain a stable net asset value per share (a “reverse distribution mechanism”), subject to certain board determinations and disclosures to investors.

The amendments also incorporate corresponding changes to Form N-CR concerning reporting of liquidity threshold events and amend Form N-MFP to include additional information about shareholders, portfolio securities sold by institutional prime MMFs, liquidity fees, and use of share cancellation, as well as to make certain conforming changes to Form N-1A to reflect certain of the other amendments. The SEC also adopted amendments to reporting by large liquidity fund advisers in respect of the liquidity funds that they manage in Section 3 of Form PF, the confidential reporting form for certain SEC-registered investment advisers to private funds, to maintain consistency with the reporting requirements for registered MMFs under amended Form N-MFP and the final amendments.

The amendments also include amendments to the recordkeeping rule under the Investment Company Act (Rule 31a-2) to require money funds to preserve records that document how they determine the amount of any liquidity fee.

The SEC adopted a tiered approach to the transition periods for compliance with the amendments. MMFs will no longer be permitted to impose redemption gates immediately upon October 2, 2023, the effective date of the amendments. The effective and compliance date for the amendments to Forms N-MFP, N-CR, and PF is June 11, 2024. Further, on April 2, 2024, six months from the effective date of the amendments, MMFs will be required to comply with the increased daily and weekly liquid asset minimums.

Finally, funds will be required to comply with the amendment’s liquidity fee framework on October 2, 2024, 12 months from the effective date of the amendments.

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