Table of Contents:

SEC Adopts Amendments to Enhance Private Fund Reporting

SEC Charges Investment Adviser and Fund Trustees with Liquidity Rule Violations

SEC Charges PIMCO for Disclosure and Policies and Procedures Failures

SEC Adopts New Security-based Swap Rules to Prevent Fraud & Manipulation Promote CCO Independence

SEC ADOPTS AMENDMENTS TO ENHANCE PRIVATE FUND REPORTING

On May 3, the Commissioners of the Securities Exchange Commission (the “SEC” or the “Commission”) voted to adopt final amendments (the “Amendments”) to Form PF and Rule 204(b)-1 the under the Investment Advisers Act of 1940 (“Advisers Act”). Form PF is the confidential reporting form used by certain advisers to private funds to report information to the SEC and the Financial Stability Oversight Counsel (“FSOC”) about private funds.

By way of background, the SEC adopted Form PF in 2011 after the enactment of the Dodd-Frank Wall Street Reform and Accountability Act of 2012 (the “Dodd-Frank Act”), which directed the SEC to collect information about private funds for use by the FSOC to help in its assessment of systemic risk in the financial system. Generally, Rule 204(b)-1 requires advisers to hedge funds, private equity funds, and liquidity funds to file Form PF on a quarterly or annual basis, depending on the size and type of private funds they advise. As explained in the Adopting Release, the Amendments are designed to improve the FSOC’s ability to monitor systemic risk, bolster the SEC’s regulatory oversight of private fund advisers, and gather information for regulatory purposes, including enforcement, examinations, and rulemaking.

Prior to the Amendments, Form PF comprised five (5) Sections. Most advisers are required to report in Section 1 more generalized information, such as the types of private funds advised (e.g., hedge funds, private equity funds, or liquidity funds), fund size, use of borrowings and derivatives, strategy, and types of investors. Three types of “Large Private Fund Advisers” are required to complete certain additional sections of Form PF, with large hedge fund, liquidity fund, and private equity fund advisers subject to more comprehensive reporting on their dedicated Sections 2, 3, and 4, respectively.

Following the Amendments, Form PF will have seven (7) Sections, creating two new separate Sections of Form PF, Section 5 and Section 6. Former Section 5, the request for temporary hardship exemption, will become new Section 7. A “current report” under the new Section 5 and a “private equity event report” under the new Section 6 will each be filed as a stand-alone document through the same system used to file the rest of Form PF, the Private Fund Reporting Depository (“PFRD”). The Amendments also add and alter questions to existing Form PF Section 4. As applicable, the quarterly and annual reporting timeline has been maintained for existing Sections 1 through 4, with the new Sections 5 and 6 requiring an accelerated timeline of some advisers.

As a result, the Amendments to Form PF will affect only the following categories of advisers:

• Large Hedge Fund Advisers (i.e., hedge fund advisers with at least $1.5 billion in hedge fund assets under management)
• Private Equity Fund Advisers (i.e., investment advisers with at least $150 million in private equity fund assets under management); and
• Large Private Equity Fund Advisers (i.e., private equity fund advisers with at least $2 billion in private equity assets under management).

With respect to the last category, and in a change from its January 2022 Form PF Proposing Release, the Commission has not adopted a lower $1.5 billion in private equity fund assets under management reporting threshold for Large Private Equity Fund Advisers. The existing threshold of $2 billion in private equity fund assets under management will remain.

As under current rules, Exempt Reporting Advisers will not be required to file Form PF as a result of the Amendments.

Section 5 Current Event Reporting For Large Hedge Fund Advisers

The Amendments to Form PF will require Large Hedge Fund Advisers to file a current report on Section 5 to Form PF as soon as practicable but no later than 72 hours from the occurrence of one or more triggering “current reporting events” by a qualifying hedge fund. A “qualifying hedge fund” is a hedge fund, individually or in combination with any feeder funds, parallel funds, and/or dependent managed account, having a net asset value of at least $500 million.

The 72-hour period is a departure from the timeline SEC’s January 2022 Form PF Proposing Release which would have required a private fund adviser to file reports as to certain events within one business day of the occurrence of any of such events, which would be the close of the business day following the day the event occurred.

Current reporting events include the following:

• Extraordinary Investment Losses: Advisers are required to file a current report if, as of any business day, the 10-business day holding period return of a reporting fund is less than or equal to 20% of the reporting fund aggregate calculated value.
• Significant Increases in Margin, Collateral or an Equivalent: Advisers are required to file a current report in connection with a significant increase in the value of a reporting fund’s requirements for margin, collateral or an equivalent of 20% or more within a rolling 10-business-day period.
• Inability to Meet a Margin Call or Margin Default: Advisers are required to file a current report in connection with a margin default or inability to meet a call for margin, collateral or an equivalent, taking into account any contractually agreed cure period.
• Default of a Counterparty: Advisers are required to file a current report in connection with a counterparty’s margin, collateral or equivalent default or failure to make other payment.
• Prime Broker Relationship Terminated or Materially Restricted: Advisers are required to file a current report following the termination or material restriction of a reporting fund’s relationship with a prime broker.
• Operations Event: Advisers are required to file a current report when the adviser or qualifying hedge fund experiences a “significant disruption or degradation” of the fund’s “critical operations,” whether as a result of an event at the fund, the adviser, or other service providers to the fund. For this purpose, “critical operations” means “operations necessary for (i) the investment, trading, valuation, reporting, and risk management of the fund; or (ii) the operation of the fund in accordance with federal securities laws and regulations.”
• Significant Withdrawals and Redemptions: Advisers are required to file a current report if the reporting qualifying hedge fund receives cumulative requests for withdrawals or redemptions from the reporting fund equal to or more than 50 percent of the most recent net asset value (after netting against subscriptions and other contributions from investors received and contractually committed).
• Inability to Satisfy Redemptions: Advisers are required to file a current report if the reporting fund (i) cannot pay redemption requests or, (ii) has suspended redemptions, and such suspension lasts for more than five consecutive business days.

In a departure from the proposed amendments, the SEC did not adopt a requirement that an adviser report as a current reporting event a significant decline in holdings of unencumbered cash.

Section 6 Private Equity Event Reporting For All Private Equity Fund Advisers

The Amendments to Form PF will require all Private Equity Fund Advisers to file an event report on Section 6 to Form PF within 60 days of each fiscal quarter end upon the occurrence of one or more of two (2) private equity reporting events.

Private equity reporting events include:

• Adviser-Led Secondary Transactions: Private Equity Fund Advisers are required to file a private equity report upon completing an “adviser-led secondary transaction.” An “adviser-led secondary transaction” is defined as any transaction initiated by the adviser or any of its related persons that offers private fund investors the choice to (i) sell all or a portion of their interests in the private fund, or (ii) convert or exchange 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.
• General Partner Removal, Termination of the Investment Period, or Termination of a Fund: Private Equity Fund Advisers are required to file a private equity report when a fund receives notification that fund investors have (i) removed the adviser or an affiliate as the general partner (or similar control person) of the fund; (ii) elected to terminate the fund’s investment period, or (iii) elected to terminate the fund.

Revised Section 4 Reporting Requirements for Large Private Equity Fund Advisers

The Amendments to Form PF include a number of changes to the existing Section 4 of Form PF that requires Large Private Equity Fund Advisers to identify information about their private equity funds.

New questions have been added to Section 4. Question 66 now asks advisers to select from a list of common investment strategies and report the percent of deployed capital for each, even if the categories don’t perfectly match the fund’s specific strategies. Question 68 requires additional information on any fund-level borrowing, including details on each borrowing or cash financing available to the fund, the total dollar amount available, and the average amount borrowed during the reporting period. Question 82 now requires reporting on general partner and certain limited partner clawbacks.

Amendments have also been made to existing questions. Question 74 now requires more detailed information on reported events of default, specifying whether it’s a payment default of the private equity fund, a controlled portfolio company, or a default related to a failure to uphold terms of the borrowing agreement. Question 75 now requires reporting on the institutions providing bridge financing to the adviser’s controlled portfolio companies and the amount of financing provided. Lastly, Question 78 now requires reporting on the geographical breakdown of investments by private equity funds, listing all countries by ISO country code to which a reporting fund has exposure of 10% or more of its net asset value.

There are two effective and compliance dates for different Sections of Form PF. The Amendments to Section 4 take effect June 11, 2024. The Amendments for current and private equity event reporting in Sections 5 and 6 take effect December 11, 2023.

On August 10, 2022, the SEC and the Commodity Futures Trading Commission jointly released an August Proposal relating to technical changes to Form PF, which is still under consideration by the Commission.

SEC CHARGES INVESTMENT ADVISER AND FUND TRUSTEES WITH LIQUIDITY RULE VIOLATIONS

On May 5, the SEC announced charges against Pinnacle Advisors LLC (“Pinnacle Advisors”) for aiding and abetting violations of Rule 22e-4 (the “Liquidity Rule”) under the Investment Company Act of 1940 (the “Investment Company Act”) by a mutual fund it advised and whose liquidity risk management program it administered. Two of the fund’s independent trustees and two officers of both Pinnacle Advisors and the fund were also charged with aiding and abetting Liquidity Rule violations. A third trustee agreed to settle charges that he caused and willfully counseled the fund’s violations.

Under the Liquidity Rule, mutual funds are required to classify each of its investments into one of four categories: “highly liquid,” “moderately liquid,” “less liquid,” and “illiquid.” The Liquidity Rule prohibits mutual funds from investing more than 15% of their net assets in “illiquid” investments. If a fund holds more than 15% of its net assets in illiquid investments, the Liquidity Rule requires the fund to take remedial steps, including requiring the administrator of the fund’s liquidity risk management program (the “Program Administrator”) to report such occurrence to the fund’s board within one business day, with an explanation of the extent and causes of the occurrence and how the fund plans to bring its illiquid investments back into compliance with the 15% limit. If the amount of the fund’s illiquid investments is still in excess of 15% of its net assets thirty (30) days from the occurrence, the fund’s board of directors must assess whether the plan provided to the board in connection with the Program Administrator’s initial notification to the board continues to be in the best interest of the fund.

According to the SEC’s complaint, from June 2019 to June 2020, the fund in question held approximately 21-26% of its net assets in in illiquid investments. The SEC alleges that Pinnacle Advisors and two of its officers classified the fund’s largest illiquid investment as “less liquid” despite there being restrictions, transfer limitations, and no market for the shares representing that investment, and disregarding the advice of fund counsel who resigned over the issue and the fund’s auditors. Additionally, the SEC’s complaint also alleges that Pinnacle Advisors and its officers did not present the fund’s board with a plan to reduce the fund’s illiquid investments below the 15% maximum, or make other filings with the SEC required by the Liquidity Rule. Further, the SEC’s complaint alleges that Pinnacle and the same two officers made false and misleading statements to SEC staff, and aided and abetted the fund’s violations by failing to have the fund submit required reports to the board of trustees and the Commission in a timely manner.

With respect to the fund’s board of trustees, the SEC’s complaint alleges that two of the independent trustees also aided and abetted the fund’s Liquidity Rule violations because they were aware of the facts that rendered the shares illiquid based on their roles as members of the fund’s valuation and audit committees and the advice of the fund’s counsel and auditors, but allowed the fund to improperly classify the shares as “less illiquid” instead of “illiquid.”

This is the first enforcement action involving the Liquidity Rule. Without admitting or denying the findings, one of the trustees consented to an order requiring him to cease and desist from violations of the Liquidity Rule, pay a civil penalty of $20,000, and suspending him from association with any investment adviser or registered investment company, among others, for a six-month period.

SEC CHARGES PIMCO FOR DISCLOSURE AND POLICIES AND PROCEDURES FAILURES

On June 16, the SEC announced that Pacific Investment Management Company LLC (“PIMCO”) will pay $9 million to settle two enforcement actions relating to disclosure and policies and procedures violations involving two funds PIMCO advises.

Rule 206(4)-7 under the Advisers Act requires investment advisers to adopt and implement written policies and procedures that are reasonably designed to prevent violations by the investment adviser and its supervised persons of the Advisers Act and the rules thereunder. Section 34(b) of the Investment Company Act makes it unlawful for any person to make an untrue statement of a material fact, in any registration statement or other document filed or transmitted under the Investment Company Act, or for a person filing or transmitting such documents to omit to state a fact necessary to prevent the statements made therein, in light of the circumstances, from being materially misleading. Rule 206(4)-8 states that it shall constitute a fraudulent, deceptive, or manipulative act, or course of business by an investment adviser to (i) make any untrue statement of a material fact or omit a material fact necessary to make the statements, in light of the circumstances, not misleading, to an investor or prospective investor in the pooled investment vehicle, or (ii) engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to an investor or prospective investor in the pooled investment vehicle.

In the SEC’s first order (“Order 1”), the SEC found that between April 2011 and November 2017, PIMCO failed to accurately waive certain advisory fees consistent with an agreement between PIMCO and a mutual fund for which it serves as the investment adviser. The fund in question is a “fund of funds” and primarily invests in other funds managed by PIMCO (“PIMCO-managed funds”). PIMCO receives an advisory fee from the fund and the other PIMCO-managed funds. According to Order 1, PIMCO entered into a fee waiver agreement providing that PIMCO reduce its advisory fee on the fund to the extent PIMCO receives a certain amount of advisory, supervisory, and administrative fees from other PIMCO-managed funds in which the fund invests. Order 1 states that while PIMCO waived a portion of the agreed upon fee waiver, over the period in question, PIMCO failed to waive approximately $27 million of the fund’s advisory fees due to an error in a formula PIMCO created and provided to its sub-administrator to calculate the fee waiver amount. The miscalculation was discovered by the sub-administrator, who notified PIMCO of the of the error in 2017. In response to the error, PIMCO implemented a remediation plan to reimburse the effected fund over $30 million in unwaived fees, lost performance, and interest and took other steps to enhance its policies and procedures.

Order 1 found that as a result of the conduct described above, until at least 2018, PIMCO did not have reasonably designed policies and procedures to prevent violations of the Investment Advisers Act in relation to its oversight of advisory fee calculations and fee waivers in violation of Section 206(4) of the Advisors Act and Rule 206(4)-7 thereunder.

The SEC’s second order (“Order 2”) related to material omissions regarding PIMCO’s use of paired interest rate swaps for a closed-end fund advised by PIMCO. Order 2 found that from September 2014 to August 2016, PIMCO inadequately disclosed that paired interest rate swaps in a closed-end fund advised by PIMCO had become a material source of distributable income, enabling PIMCO to maintain the fund’s dividend rate. Order 2 also includes that the continued use of paired swaps also contributed to a decline on the net asset value of the fund, and that PIMCO failed to adequately disclose that a significant portion of the fund’s distributions came from paired interest rate swaps.

As described in Order 2, according to PIMCO, a paired swap involves two or more interest rate swaps that have certain offsetting characteristics. Typically, PIMCO entered into an agreement to make floating rate payments and receive fixed income payments for a certain number of years (the “initial leg”), and then agreed that the fund would make fixed rate payments and receive floating rate payments for a certain number of years (the “floating leg”). According to Order 2, the fixed interest payments the fund received on the initial leg were usually greater than the floating rate payments the fund owed, causing the fund to typically receive net interest rate payments, which could be used as a source for investor distributions. In most cases, PIMCO would close out the forward leg of the paired swap before the fund began making the fixed rate payment to the counterparty. In connection with closing out the forward leg, PIMCO typically would make a closeout payment for the fund, resulting in a capital loss to the fund. As a result, when the fund held two interest rate swap legs, the initial leg produced investment income that contributed to the fund’s distributions, but the later closeout of a forward leg typically produced a capital loss. According to the Order, during certain quarters within the period such paired swaps generated capital losses without there being sufficient offsetting returns from other fund investments. As further described in Order 2, under those circumstances, portions of the fund’s dividends derived from payments received by the fund on the initial leg were taxable as ordinary income, but were economically equivalent to a return of capital.

In addition, Order 2 describes inadequate disclosures about paired interest rate swaps. The Order states that the prospectus in connection with the fund’s initial public offering included disclosure that income would be generated by “active[ly] manag[ing] duration and yield curve exposure” of its debt portfolio. According to Order 2, by at least 2014, the fund’s paired swaps produced a material portion of distributable income and many of which did not reflect active duration or yield curve management strategies. Additionally, the Order notes that while the initial prospectus and shareholder reports included risks associated with the fund’s use of interest rate swaps, PIMCO inadequately disclosed information concerning paired interest rate swaps in the fund’s annual shareholder reports during 2014 and 2015.

As a result of PIMCO’s conduct, Order 2 states that PIMCO violated Section 34(b) of the Investment Company Act and Section 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.

Without admitting or denying the SEC’s findings relating to each action, PIMCO agreed to a cease-and-desist order and a censure in each action, and to pay a penalty of $2.5 million in connection with Order 1 and $6.5 million in connection with Order 2.

SEC ADOPTS NEW SECURITY-BASED SWAP RULES TO PREVENT FRAUD & MANIPULATION PROMOTE CCO INDEPENDENCE

On June 7, the SEC adopted new Rule 9j-1 under the Securities Exchange Act of 1934 (the “Exchange Act”) to seek to prevent fraud, manipulation, and deception in connection with security-based swap (“SBS”) transactions. As described in detail below, the new Rule 9j-1 includes various anti-fraud and anti-manipulation provisions on categories of deceptive or manipulative misconduct related to security-based swap transactions. The new Rule also includes a price manipulation provision and two provisions aimed at ensuring that market participants cannot avoid liability under the new Rule. Lastly, the new Rule includes two affirmative defenses from the liability under the various anti-fraud and anti-manipulation provisions of the new Rule.

The Commissioners also adopted new Rule 15fh-4(c) under the Exchange Act to prohibit undue influence over the Chief Compliance Officer (“CCO”) of a security-based swap dealer or a major security-based swap participant (each, an “SBS Entity”).

As explained in the Adopting Release, the Commission’s particular aspects and characteristics of security-based swaps provide opportunities and incentives for misconduct. The SEC gave several examples of misconduct, noting that, in general, parties to a security-based swap may engage in misconduct in connection with the security-based swap (including in the reference underlying such security-based swap) to trigger, avoid, or affect the value of ongoing payments or deliveries. Accordingly, the new rules are intended to seek to augment the Commission’s oversight of the security-based swap market, which has a gross notional amount outstanding of approximately $8.5 trillion as of late 2022.

Rule 9j-1(a)

Rule 9j-1(a) makes it unlawful for any person, directly or indirectly, to effect any transaction in, or attempt to effect any transaction in, any security-based swap, or to purchase or sell, or induce or attempt to induce the purchase or sale of any security-based swap in connection with the following misconduct:

(1) Employing or attempting to employ any device, scheme, or artifice to defraud or manipulate;

(2) Making or attempting to make any untrue statement of a material fact or omitting a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading;

(3) Obtaining money or property by means of any untrue statement of a material fact or any omission of a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading;

(4) Engaging in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person;

(5) Attempting to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or attempting to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person; or

(6) Manipulating or attempting to manipulate the price or valuation of any security-based swap or any payment or delivery related thereto.

Violations of subsections (1), (2), (5), and (6) require a showing of scienter. Violations of subsections (3) and (4) do not require a showing of the scienter and extend to conduct that is at least negligent.

For purposes of anti-fraud and anti-manipulation provisions, the definitions of purchase and sale encompass, among other things, partial executions, terminations, assignments, exchanges, transfers or conveyances of, or extinguishing of any rights or obligations under, a security-based swap, as the context may require.

Next, new Rule 9j-1(b) provides that wherever communicating purchasing, or selling a security (other than a security-based swap) while in possession of, material nonpublic information would violate or result in liability to any purchaser or seller of the security under either the Exchange Act or the Securities Act of 1933, or any rule or regulation thereunder, such conduct in connection with a purchase or sale of a security-based swap with respect to such security or with respect to a group or index of securities including such security shall also violate, and result in comparable liability to any purchaser or seller of that security under such provision, rule, or regulation. Likewise, the Commission adopted Rule 9j-1(c) which prevents a person from escaping liability under section 9(j) or the new Rule with respect to a security-based swap by limiting all of its actions to purchases or sales of the security, loan, or narrow-based security index underlying that security-based swap.

Lastly, new Rule 9j-1(e) includes two affirmative defenses from the liability under the anti-fraud and anti-manipulation provisions. The first defense is available under Rule 9j-1(e)(1), where the action was taken pursuant to binding rights and obligations in written security-based swap documentation, so long as the security-based swap transaction occurred before the person became aware of the material nonpublic information, and the person acted in good faith. The second defense is available, under Rule 9j-1(e)(2), to entities that demonstrate that the investment decision-maker was not aware of material nonpublic information and that the entity had reasonable policies and procedures in place to prevent violations of the anti-fraud and anti-manipulation provisions.

Rule 15fh-4(c)

Rule 15fh-4(c) will prohibit any officer, director, supervised person, or employee of an SBS Entity, or any person acting under such person’s direction, to take any action to coerce, manipulate, mislead, or fraudulently influence the SBS Entity’s CCO in the performance of their duties under the federal securities laws.

The new Rules 9j-1 and 15fh-4(c) will both go into effect August 29, 2023.

Table of Contents

Divison of Examinations Releases 2023 Examination Priorities

Division of Examinations Release Observations from Examinations of Newly-Registered Advisers Ricks Alert

SEC Adopts Final Rule Shortening the Securities Transaction Settlement Cycle

SC Proposes Amendments to the Custody Rule

Division of Examinations Releases 2023 Examination Priorities

On February 7, 2023, the Securities and Exchange Commission’s (the “SEC” or the “Commission”) Division of Examinations (the “Division”) announced its 2023 examination priorities (the “2023 Priorities”). Below is a summary of certain aspects of the 2023 Priorities.

Notable New and Significant Focus Areas

Compliance with Recently Adopted Rules Under the Investment Advisers Act of 1940 (the “Advisers Act”) and Investment Company Act of 1940 (the “Investment Company Act”). Referencing recent SEC rulemakings, the 2023 Priorities includes that the Division is prioritizing examining for compliance with recently adopted rules, including:

• Rule 206(4)-1 under the Advisers Act (the “Marketing Rule”). The 2023 Priorities note that the Division will assess whether RIAs have: (1) adopted and implemented written policies and procedures that are reasonably designed to prevent violations by the advisers and their supervised persons of the Marketing Rule; and (2) complied with the substantive requirements of the Marketing Rule, including the requirement that RIAs have a reasonable basis for believing they will be able to substantiate material statements of fact and requirements for performance advertising, testimonials, endorsements and third-party ratings.
• Rule 18f-4 under the Investment Company Act (the “Derivatives Rule”). Where a fund relies on the Derivatives rule, the Division will, among other items: (1) assess whether registered investment companies, including mutual funds (other than money market funds), exchange-traded funds (“ETFs”) and closed-end funds, as well as business development companies (“BDCs”), have adopted and implemented policies and procedures reasonably designed to manage derivatives risks and to prevent violations of the Derivatives Rule pursuant to Investment Company Act Rule 38a-1; and (2) review for compliance with Rule 18f-4, including the adoption and implementation of a derivatives risk management program, board oversight, and whether disclosures concerning the fund’s use of derivatives are incomplete, inaccurate or potentially misleading.
• Rule 2a-5 under the Investment Company Act (the “Fair Valuation Rule”). With respect to the Fair Valuation Rule, the Division will among other items: (1) assess funds’ and fund boards’ compliance with the Fair Valuation Rule’s requirements for determining fair value, implementing board oversight duties, setting recordkeeping and reporting requirements, and permitting the funds’ board to designate valuation designees to perform fair value determinations subject to oversight by the board; and (2) review whether adjustments have been made to valuation methodologies, compliance policies and procedures, governance practices, service provider oversight, and/or reporting and recordkeeping.

Registered Investment Advisers (“RIAs”) to Private Funds. Citing the growth in private fund assets in recent years, the 2023 Priorities include that the Division will focus on the following with respect to private fund RIAs: (1) conflicts of interest; (2) calculation and allocation of fees and expenses; (3) compliance with the new Marketing Rule, including performance advertising and compensated testimonials and endorsements, such as solicitations; (4) policies and practices regarding the use of alternative data and compliance with Advisers Act Section 204A; and (5) compliance with the Advisers Act Rule 206(4)-2 (Custody Rule), where applicable, including timely delivery of audited financials and selection of permissible auditors.

Standards of Conduct: Regulation Best Interest, Fiduciary Duty, and Form CRS. The Division will continue to prioritize examinations of broker-dealers and RIAs for compliance with their applicable standard of conduct. These and other examinations will continue to focus on: (1) investment advice and recommendations with regard to products, investment strategies, and account types; (2) disclosures made to investors and whether such disclosures include all material facts relating to the conflicts of interest associated with the advice and recommendations; (3) processes for making best interest evaluations, including those for reviewing reasonably available alternatives, evaluating costs and risks, and identifying and addressing conflicts of interest; and (4) factors considered in light of the investor’s investment profile, including investment goals and account characteristics.

With respect to Form CRS, the 2023 Priorities note that SEC rules require firms to deliver their relationship summaries to retail investors, file their relationship summary with the Commission, and post the summary on the firm’s website, if applicable. The 2023 Priorities state that the Division will continue to prioritize compliance with Form CRS in the Divisions examination of broker-dealers and RIAs.

Environmental, Social, and Governance (“ESG”) Investing. Noting competition among RIAs and registered funds for demand for ESG investments and strategies, the 2023 Priorities include that the Division will continue to focus on ESG-related advisory services and fund offerings, including whether ESG funds and funds that incorporate ESG criteria are operating in the manner described in their disclosures. The Division will also assess whether ESG products are appropriately labeled and whether recommendations of such products to retail investors are made in such investors’ best interest.

Information Security and Operational Resiliency

The 2023 Priorities also include risks related to information security and operational resiliency as an area of focus for the Division. The Division’s examinations will focus on firms’ policies and procedures, governance practices, cyber-related event responses (including to ransomware attacks), and compliance with Regulations S-P and S-ID, as applicable. With respect to policies and procedures, the Division will review whether such policies and procedures are designed to safeguard customer records and information, whether stored on registrants’ systems or with third-party providers. The Division will also focus on cybersecurity issues associated with firms’ use of third-party vendors.

Crypto Assets and Emerging Financial Technology

The 2023 Priorities include that examinations of registrants will focus on the offer, sale, or recommendation of, advice regarding and trading in crypto or crypto-related assets. More specifically, the 2023 Priorities state that Division staff will assess whether market participants involved with crypto or crypto-related assets: (1) met and followed their respective standards of care when making recommendations, referrals, or providing investment advice, to the extent required; and (2) routinely reviewed, updated, and enhanced their compliance, disclosure, and risk management practices. The Division also will focus on new or never before examined registrants offering crypto or crypto-related assets. Broker-dealer and RIA examinations will also focus on firms that employ digital engagement practices and the related tools and methods.

Investment Advisers and Investment Companies

Examinations of RIAs. The 2023 Priorities state that during a typical examination of and RIA, the Division reviews the firm’s compliance programs and related disclosures in certain core areas, such as custody and safekeeping of client assets, valuation, portfolio management, and brokerage and execution. Examinations also include a review for conflicts, compliance issues and the oversight and approval process related to RIA fees and expenses, including: (1) the calculation of fees; (2) alternative ways that RIAs may try to maximize revenue, including revenue earned on clients’ bank deposit sweep programs; and (3) excessive fees. In addition to reviewing these “core focus areas,” Division staff also will review RIA policies and procedures for retaining and monitoring electronic communications and selecting and using third-party service providers.

Registered Investment Companies, Including Mutual Funds and ETFs. The perennial focus areas for examinations of registered investment companies, include, among other topics, an assessment of registered investment companies’ compliance programs and governance practices, disclosures to investors, and accuracy of reporting to the SEC. The 2023 Priorities note that the Division will continue to evaluate boards’ processes for assessing and approving advisory and other fund fees, particularly for funds with weaker performance relative to their peers. In addition, the Division will assess the effectiveness of funds’ derivatives risk management programs and liquidity risk management programs, if applicable. The 2023 Priorities note that the Division will also focus on funds with specific characteristics, such as: (1) turnkey funds, to review their operations and assess effectiveness of their compliance programs; (2) mutual funds that converted to ETFs, to assess governance and disclosures associated with the conversion to an ETF; (3) non-transparent ETFs, to assess compliance with the conditions and other material terms of their exemptive relief; (4) loan-focused funds, such as leveraged loan funds and funds focused on collateralized loan obligations, for liquidity concerns and to review whether the funds have been significantly impacted by, and have adapted to, elevated interest rates; and (5) medium and small fund complexes that have experienced excessive staff attrition, to focus on whether such attrition has affected the funds’ controls and operations.

Division of Examinations Releases Observations From Examinations of Newly-Registered Advisers Risk Alert

On March 27, 2023, the Division released its observations from examinations of advisers that are newly-registered with the SEC (the “Risk Alert”). As stated in the Risk Alert, the Division’s examinations of newly-registered advisers often focus on whether these firms have: (1) identified and addressed conflicts of interest; (2) provided clients with full and fair disclosure such that clients can provide informed consent; and (3) adopted effective compliance programs.

Examination Scope

In recent years, the Division has prioritized examining newly-registered advisers within a reasonable period after the adviser’s SEC registration has become effective. Generally, such examinations involve document requests and interviews of advisory personnel that address: (1) business and investment activities; (2) organizational affiliations; (3) compliance policies and procedures; and (4) disclosures to clients. As stated in the Risk Alert, Division staff requests information and documents to assess compliance with the Advisers Act and to determine whether the advisers representations and disclosures to clients in filings with the SEC are consistent with the adviser’s actual practices. The Risk Alert notes the following as examples of information the Division staff typically requests:

General information to provide the staff with an understanding of the adviser’s business and operations, such as: (1) organizational charts; (2) documentation to support eligibility for SEC registration; (3) information about ownership and control of the adviser and its affiliates; (4) information about current and former advisory personnel; (5) financial information; and (6) information about litigation or arbitration involving the adviser or any of its supervised persons.

Demographic and other specific data regarding each advisory client account, including information about: (1) advisory services provided, such as portfolio management, financial planning, and/or bundled wrap fee arrangements; (2) types of client accounts serviced; (3) advisory authority to trade in the account, such as whether it has discretionary authority; (4) advisory personnel servicing and overseeing the account; (5) assets under management advised by the firm; (6) third-party service providers; and (7) investment strategies. The staff often also requests documents supporting the adviser’s representations, such as copies of certain contracts, agreements, or third-party account statements.

Information regarding the adviser’s compliance program, risk management practices and framework, and internal controls, including written compliance policies and procedures and the adviser’s code of ethics.

• Information to facilitate the staff testing for regulatory compliance in certain areas, including portfolio management and trading activities, such as a record of specific information for advisory clients’ securities holdings and transactions.
• Communication used by the adviser to inform or solicit new and existing clients, including disclosure documents and advertising, such as pamphlets, social media, mass mailings, websites, and blogs.

Staff Observations from Recent Newly-Registered Adviser Examinations

The Risk Alert identifies staff observations in the following areas:

Compliance Policies and Procedures. Division staff observed compliance policies and procedures that: (1) did not adequately address certain risk areas applicable to the firm, such as portfolio management and fee billing; (2) omitted procedures to enforce stated policies, such as stating the advisers’ policy is to seek best execution, but not having any procedures to evaluate periodically and systematically the execution quality of the broker-dealers executing their clients’ transactions; and/or (3) were not followed by advisory personnel, typically because the personnel were not aware of the policies or procedures or the policies or procedures were not consistent with their businesses or operations. Additionally, the staff observed advisers’ annual compliance reviews that did not address the adequacy of the advisers’ policies and procedures and the effectiveness of their implementation. For example, Division staff observed advisers that:

• Used off-the-shelf compliance manuals that were not tailored for consistency with the advisers’ operations and business.
• May not have devoted sufficient resources to comply with regulatory requirements and their own policies and procedures (e.g., advisers may have assigned additional and unrelated responsibilities to the chief compliance officer (“CCO”), resulting in limited time for the CCO to dedicate to compliance), or to ensure compliance personnel understood actual business practices.
• Had undisclosed conflicts of interest created by the multiple roles and responsibilities of advisory personnel carrying out the assigned duties, and these conflicts were not mitigated.
• Outsourced certain business and compliance functions without assessing how outsourced responsibilities were being performed or whether they were consistent with the advisers’ compliance policies and procedures.
• Did not have adequate business continuity plans, including succession plans.

Disclosure Documents and Filings. As noted in the Risk Alert, Division staff observed disclosure documents with omissions or inaccurate information and untimely filings related advisers’: (1) fees and compensation; (2) business or operations (including affiliates, other relationships, number of clients, and assets under management); (3) services offered to clients, such as disclosure regarding advisers’ investment strategy (including the use of models), aggregate trading, and account reviews; (4) disciplinary information; (5) websites and social media accounts; and (6) conflicts of interest.

Marketing. According to the Risk Alert, Division staff observed adviser marketing materials that appeared to contain false or misleading information, including inaccurate information about advisory personnel professional experience or credentials, third-party rankings, and performance. The Risk Alert also stated that advisers were also unable to substantiate certain factual claims.

SEC Adopts Final Rule Shortening the Securities Transaction Settlement Cycle

On February 15, 2023, the SEC Commissioners voted to adopt final amendments to Rule 15c6-1(a) under the Securities Exchange Act of 1934 (the “Exchange Act”) to shorten the standard settlement cycle for most securities transactions from two business days after the trade date (T+2) to one business day after the trade date (T+1). The Commissioners also adopted amendments to Exchange Act Rule 15c6-1(c) to shorten the separate standard settlement cycle for firm commitment offerings priced after 4 30 p.m. ET, from four business days after the trade date (T+4) to T+2. The amended Exchange Act rules do not alter the existing ability of underwriters and the parties to a transaction to vary the standard settlement cycle specified in paragraphs (a) and (c) of Rule 15c6-1 under Rule 15c6-1(d) by express agreement in advance of the transaction. The SEC also amended Rule 15c6-1(b) to exclude security-based swaps from the scope of the securities T+1 settlement cycle under Rule 15c6-1(a).

In connection with the shortened settlement timelines, the SEC adopted a new Rule 15c6-2 under the Exchange Act. As explained in the Adopting Release, new Rule 15c6-2 is intended to improve the processing of institutional trades through new requirements for broker-dealers and registered investment advisers related to same-day affirmations. For transactions that require completion of the allocation, confirmation, or affirmation process, broker-dealers must either: (i) enter into written agreements with the relevant parties or (ii) establish, maintain, and enforce written policies and procedures reasonably designed to ensure completion of allocations, confirmations and affirmations “as soon as technologically practicable” and no later than the end of the day on trade date. In addition, in connection with new Rule 15c6-2, the SEC amended Rule 204-2 under the Advisers Act to require investment advisers who are parties to a contract under Rule 15c6-2 maintain records of each confirmation received.

Lastly, the SEC adopted a new Rule 17Ad-27 to require clearing agencies acting as central matching service providers (“CMSPs”) and their users to facilitate straight-through processing (“STP”) through new policies and procedures and ongoing assessments of STP processes and annual reporting to the Commission via EDGAR.

The Commission’s move to shorten the settlement cycle was partly informed by the increased market volatility resulting from the COVID-19 pandemic and heightened interest in certain “meme” stocks that highlighted potential vulnerabilities in the U.S. securities markets. As explained in the Adopting Release, the Commission’s intention behind shortening the settlement cycle from T+2 to T+1 was to promote investor protection, reduce risk, and increase operational and capital efficiency. The SEC has shortened the settlement timelines twice in recent history, from five business days after the trade date (T+5) to three business days after the trade date (T+3) in 1993 and from T+3 to T+2 in 2017 in response to changes in technology, markets, trading practices, and participant’s operations. As mentioned in the Adopting Release, the SEC readily observed that the industry and market participants have already taken significant steps to operate in a T+1 environment. Accordingly, the SEC is “actively assessing” the feasibility of an eventual shift to a “same-day settlement” (T+0) standard cycle.

The amendments and new rules will be effective 60 days after publication in the Federal Register, and the compliance date is Tuesday, May 28, 2024.

SEC Proposes Amendments to the Custody Rule

On February 15, 2023, the SEC Commissioners voted to propose new rules and amendments (the “Proposal” or Proposed Rule”) to Rule 206(4)-2 (known as the “Custody Rule”) under the Advisers Act. As proposed, new Rule 223-1 (the “Safeguarding Rule”) would redesignate the Custody Rule and enhance the scope of custodial requirements on all registered investment advisers and their qualified custodians. The SEC Proposal also includes complementary amendments to the Advisers Act books and records rule (Rule 204-2) and Form ADV (namely, to amend Item 9 of Part 1A to require new information corresponding to proposed Rule 223-1). The proposed Safeguarding Rule would significantly change the scope and requirements of the Custody Rule and would seek to enhance the vitality of the role of qualified custodians and auditors in many ways.

The Custody Rule, first adopted in 1962 and last amended by the SEC in 2009, is intended to protect advisory clients from the misuse or misappropriation of their funds and securities over which the adviser has “custody.” Currently, a registered investment adviser (and any of its related persons) with “custody” of “client funds or securities” is required by Rule 206(4)-2 to establish a set of controls to safeguard those client assets. Under the current Rule, “custody” means “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” With very limited exceptions, the current Rule 206(4)-2(a)(1) requires that an adviser with custody must maintain client funds and securities with “qualified custodians” either under the client’s name or under the adviser’s name as agent or trustee for its clients. “Qualified custodians” are defined generally as broker-dealers, banks, savings associations, futures commission merchants, and non-U.S. financial institutions that customarily hold financial assets for their customers if the institutions keep the advisory assets separate from their own.

Scope of Client Assets and Expanded Coverage of Custody

The Safeguarding Rule would change the Custody Rule’s definition and scope in two critical ways. First, the proposed Safeguarding Rule would extend the coverage beyond client “funds and securities” to client “assets,” including additional investments held in a client’s account. Consequently, the proposed rule’s definition of assets covers a broader array of client assets and investment activities. For example, it would include investments such as all crypto assets (even in the instances where such assets are neither funds nor securities), financial contracts held for investment purposes, collateral posted in connection with a swap contract on behalf of the client, and physical assets, including artwork, real estate, precious metals, or physical commodities (e.g., wheat or lumber). Second, the proposed rule would make explicit that the current rule’s defined term “custody” includes discretionary authority. Under the current Rule 206(4)-2(d)(2) definition of “Custody,” three prongs serve as examples of custody: (i) physical possession of client funds or securities; (ii) any arrangement under which the adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the adviser’s instruction to the custodian; and (iii) any capacity that gives the adviser or its supervised person legal ownership of or access to client funds or securities. The Safeguarding Rule would retain these three prongs but would amend prong (ii), the “arrangement category,” to state explicitly that discretionary trading authority is an arrangement that triggers the rule.

Qualified Custodians Written Arrangements, Reasonable Assurances, and Qualifications

Like the Custody Rule, the Safeguarding Rule would continue with the qualified custodian requirement but would add new conditions governing the relationship between advisers and their qualified custodians. Specifically, an institution may serve as an adviser’s qualified custodian only if they have “possession or control” of client assets pursuant to a written agreement between the qualified custodian and the investment adviser. “Possession or control” would be defined to mean holding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets, the qualified custodian’s participation would effectuate the transaction involved in the change in beneficial ownership, and the qualified custodian’s involvement is a condition precedent to the change in beneficial ownership.

Moreover, under the Proposal, a qualified custodian and adviser would be required to enter into a written agreement containing certain contractual provisions addressing recordkeeping, client account statements, internal control reports, and the adviser’s agreed-upon level authority to effect transactions in the account. It would further require the adviser to obtain “reasonable assurances” in writing from the custodian regarding certain vital protections for the safeguarding of client assets, including, among others, that the custodian: (i) will exercise due care in accordance with reasonable commercial standards; (ii) will indemnify the client against losses caused by its own negligence, recklessness or willful misconduct; (iii) the custodian will not be relieved of its responsibilities to an advisory client as a result of sub-custodial arrangements; and (iv) the custodian will identify and segregate client assets from the custodian’s assets and liabilities. In the Proposal, the SEC acknowledged that a written agreement between an adviser and its custodian would be a “substantial departure from current industry practice” as under existing market practices, advisers are rarely parties to the custodial agreement, which is generally between an advisory client and a qualified custodian.

The proposed Safeguarding Rule would require a more robust set of qualification requirements for banks, savings associations, and foreign financial institutions to serve as qualified custodians. Specifically, under the proposed Safeguarding Rule, to serve as a qualified custodian, a bank or a savings association would be required to hold client assets “in an account designed to protect such assets from creditors of the bank or savings association in the event of the insolvency or failure of the bank or savings association.” Likewise, to serve as a qualified custodian, a foreign financial institution would have to satisfy seven new conditions, one of which is for the foreign financial institution to comply with anti-money laundering and related provisions similar to those of the U.S. Bank Secrecy Act.

Exceptions for Privately Offered Securities and Physical Assets

The Proposed Rule would also modify the current Custody Rule’s limited exception from the obligation to maintain client assets with a qualified custodian for certain “privately offered securities,” including expanding the exception to include certain physical assets. As explained in the Proposed Rule Release, the Commission “believe[s] that the bulk of advisory client assets are able to be maintained by qualified custodians; however, we understand that is not universally the case, particularly for two types of assets: certain physical assets and certain privately offered securities.” The safeguarding rule’s definition of “privately offered securities” would retain the core elements of the current definition (i.e., un-certificated securities acquired in a private placement that are recorded in the name of the client only on the books of the issuer or its transfer agent and transferrable only with the consent of the issuer or holders of the securities) but amends the second prong of the definition to provide the securities be capable of only being recorded on the non-public books of the issuer or its transfer agent in the name of the client as it appears in the records the adviser is required to keep under Rule 204-2, the books and records rule. As proposed, advisers can utilize the exception provided they meet the following conditions: (1) the adviser reasonably determines documents in writing that ownership cannot be recorded and maintained by a qualified custodian; (2) the adviser reasonably safeguards the assets from loss, theft, misuse, misappropriation, or the adviser’s financial reverses, including the adviser’s insolvency; (3) under a written agreement between an independent public accountant and the adviser, the accountant, upon receipt of notice from the adviser, who in turn is obligated to give notice within one business day of such transfer, performs verification of any asset transfers and notifies the Division within one business day upon finding any material discrepancies; and (4) the existence and ownership of the assets are verified during a surprise examination or as part of a financial statement audit by an independent public accountant.

Surprise Exam and Annual Audit Exemption

Finally, the proposed Safeguarding Rule would amend the surprise exam requirement of the Custody Rule and the audited financial statement exception.

Under the Proposal, the surprise examination requirement would be amended to state that the adviser must reasonably believe that a written agreement has been implemented. The current Custody Rule requires a written agreement between the adviser and the accountant. However, it does not expressly require an investment adviser to have a reasonable belief about implementing the written agreement between the adviser and the accountant.

The Custody Rule’s annual audit exception would also be modified by expanding its availability to “any other entity” (i.e., not just pooled investment vehicles). For single-purpose vehicles established to hold investments of a pooled investment vehicle (“SPV”), an adviser would have the choice of whether to treat the SPV as a separate client or treat the SPV’s assets as the pooled investment vehicle’s assets, which it has custody indirectly. However, if the SPV has third-party investors, the adviser would be required to treat the SPV’s assets as a separate client for purposes of the Safeguarding Rule. As is the case with the current Custody Rule, the proposed Safeguarding Rule would require all audited financial statements to be prepared in accordance with U.S. GAAP and be distributed within 120 days of fiscal year end but would extend the delivery deadline to 180 days in the case of a fund of funds or 260 days in the case of a fund of funds of funds of the entity’s fiscal year-end. The Safeguarding Rule would, however, add a new requirement for the auditor’s engagement letter to require the auditor to notify the SEC upon the auditor’s termination or the issuance of a modified opinion.

Timing and Comment Period on the Proposal

The SEC proposed a one-year transition period, with a more extended 18-month period for advisers with up to $1 billion in regulatory assets under management following the Proposals’ effective date. The comment period will remain open until 60 days after the publication of the Proposal release in the Federal Register.

SEC/SRO Update: SEC Brings Enforcement Action For Undisclosed CEO Perks; DOJ And SEC Charge Executive With Insider Trading And Misuse Of 10b5-1 Trading Plan; SEC Proposes Changes To Regulation S-P To Enhance Protection Of Customer Information

Read more…

This week, the U.S. Fish and Wildlife Service (“USFWS”) extended the effective dates of its decisions to list populations of the lesser prairie-chicken as threatened and endangered and to reclassify the northern long-eared bat as endangered under the Endangered Species Act (“ESA”).

Last year, the USFWS announced a final rule listing a distinct population segment of the lesser prairie-chicken as threatened and another distinct population segment as endangered. At the same time, the USFWS announced a rule under section 4(d) of the ESA that prohibited take of threatened lesser prairie-chicken, with limited exceptions. The listing rule and accompanying 4(d) rule were scheduled to take effect on January 24, 2023. In other words, as of January 24, 2023, take of endangered and threatened lesser prairie-chicken would be prohibited, except as provided in the 4(d) rule.

On January 24, 2023, the USFWS published a rule
extending the effective date of the listing rule and 4(d) rule by 60 days until March 27, 2023. The USFWS extended the effective date in part to allow land users to enroll in conservation mechanisms such as Candidate Conservation Agreements with Assurances. Thus, the prohibitions of take of lesser prairie-chicken under the ESA and 4(d) rule will become effective on March 27, 2023.

Last year, the USFWS also announced a final rule that reclassified the northern long-eared bat, which had been listed as threatened, as endangered. The reclassification was scheduled to become effective on January 30, 2023. On January 26, 2023, the USFWS published a rule
extending the effective date of the reclassification rule until March 31, 2023. The USFWS cited a need to finalize tools to facilitate section 7 consultation over projects such as wind energy development as justification for delaying the effective date of the reclassification.

Please contact Katie Schroder with questions about these listing decisions or delayed effective dates.

The U.S. Fish and Wildlife Service (FWS) published a proposed rule in the Federal Register that, if adopted, would revise the regulations related to eagle take permitting under the Bald and Golden Eagle Protection Act.[1] The proposed rule has garnered a lot of attention from multiple stakeholders. Indeed, the FWS was forced to increase the comment period by 30 days to accommodate the high number of responses.

The stated purpose of the proposed rule is “to increase the efficiency and effectiveness of permitting, facilitate and improve compliance, and increase the conservation benefit for eagles.” The rationale behind the purpose is due to a couple of factors. First, as the FWS notes in the proposed rule, bald eagle populations are increasing at a sizable rate, which has led to more interactions with humans, creating a surge in demand for eagle take permits. Second, while the bald eagle population continues to grow, the golden eagle population has decreased in recent years. According to the proposed rule, the decrease is due, in part, to the fact that while there are over 1,000 wind-energy projects, the FWS has issued only 26 permits since the promulgation of the 2016 eagle permit rule, far fewer than anticipated. As a result of the lack of permitting, there has been an unauthorized golden eagle take without any mitigating conservation. Finally, the current permitting process is seen as burdensome and creates uncertainty for those individuals and entities hoping to obtain a permit.

If adopted, the proposed rule would fall under a newly created Subpart E in 50 C.F.R. Part 22. Some provisions of the new rule include (1) the administration of specific and general permits for incidental take, (2) specific activity-specific eligibility criteria and permit requirements in four sections based on activity and type of eagle, (3) changes to monitoring requirements, (4) compensatory mitigation, and (5) changes to the application fees. A summary of the key terms is set forth below.

General Permits

Pursuant to the proposed rule, a “general permit” is defined as “a permit that is issued to an individual or entity with nationwide or regional standard conditions for a category or categories of activities that are substantially similar in nature.” FWS is proposing general permits for four types of activities: incidental take at wind-energy generation facilities, incidental take by power-line infrastructure, disturbance take of bald eagles and bald eagle nest take. Under the proposed rule, the FWS hopes to simplify and expedite the permitting process for activities that have relatively consistent and low effects on eagles by allowing general permit applicants to self-identify eligibility, register with FWS, and certify that they (1) meet the eligibility criteria and (2) will implement permit conditions and reporting requirements. The FWS would ensure that applicants are interpreting and using the general permit process properly by conducting annual audits for a small percentage of all general permits. Further, the FWS proposes limiting the duration of general permits for incidental take to a maximum of five years and for disturbance take or nest removal to a maximum of one year.

Incidental Take for Permitting Wind Energy. Eligibility for general permits for wind-energy generation projects, must be located in areas characterized by seasonal relative abundance values specified in the regulations for each species, be placed greater than 660 feet from bald eagle nests and greater than two miles from golden eagle nests, and have had less than four eagle mortalities of either species discovered at the project. Take of both species would be authorized under the general permit without a specific number listed on the permit.

Incidental Take for Permitting Power Lines. To be eligible for a general permit for incidental take of eagles by power lines, the applicant must (1) ensure that all new construction and reconstruction of poles is electrocution-safe, as limited by the need to ensure human health and safety; (2) must consider eagle nesting, foraging, and roosting areas in siting and design, as limited by human health and safety; (3) develop reactive retrofit strategy that governs retrofitting of high-risk poles when an eagle electrocution is discovered; (4) implement a proactive retrofit strategy to convert all existing infrastructure to electrocution-safe; (5) implement an eagle collision response strategy; (6) implement an eagle-shooting response strategy; and (7) adequately train personnel to scan for eagle remains when onsite and implement internal reporting and recordkeeping procedures.

Eagle Disturbance Take Permits. This proposed general permit would authorize disturbance of bald eagles by specific activities taken near bald eagle nests, generally within the distances outlined in the National Bald Eagle Management Guidelines; such activities include building and linear infrastructure construction, alteration of shorelines or vegetation, recreation activities, etc. Under the proposed new rule, permitees would have to implement measures to avoid and minimize nest disturbance, however it does not specify what those measures would involve. General permits for disturbance take of golden eagles would not be available.

Permits for Take of Bald Eagle Nests. This proposed general permit would authorize bald eagle nest take for four purposes: emergency, health and safety, removal from human-engineered structures, and other purposes. In addition to the first four stated purposes, FWS proposes an exception to this specific permit for other purposes by authorizing a general permit only in Alaska for bald eagle nest take for other purposes. General permits for disturbance take of golden eagles would not be available.

Monitoring Requirements

Industry stakeholders will be pleased that FWS is proposing to remove the current third-party monitoring requirement from eagle incidental take permits, including specific permits.

Under the proposed rule, for general incidental take permits, to better understand the program’s impacts and to verify that the general permit program is compatible with the preservation of eagles, FWS plans to use the permit application and administration fees for program-scale monitoring (instead of the current project-scale monitoring required of the permittee). FWS plans to compile information on general permits issued on an annual basis.

Some monitoring requirements will still apply to most general permit holders. For the wind-energy and power-line incidental take general permits, training relevant employees to recognize and report eagle take as part of their regular duties, including scanning for injured eagles and eagle remains during inspections, maintenance, repair, and vegetation management at and around project infrastructure would be required. For disturbance permits, implementation of monitoring of in-use nests that is sufficient to determine whether nestlings have fledged from the nest would be required and this information would have to be included on its annual report. For a one-year nest removal general permit, no monitoring would be required.

Compensatory Mitigation

Any permit authorizing take that would exceed the applicable Eagle Management Unit (EMU) take limit will require compensatory mitigation. Additionally, a permit may require compensatory mitigation if FWS determines that the persistence of the local area population of an eagle species in the project area may not be maintained.

Permit Fees

The proposed general permit fees vary by general permit type. For incidental take by wind-energy generation, the application fee is $500, and the permit-administration fee is $2,625 per turbine. For incidental take by power lines, the proposed application fee is $500, and the proposed permit-administration fee is $5,000 for each state for which the power-line entity is seeking authorization. For the bald eagle disturbance and nest-take general permits, the application fee is $100, with no administration fee.

[1]Fish and Wildlife Service, Permits for Incidental Take of Eagles and Eagle Nests, Proposed Rule, 87 Fed. Reg. 59,598, 59,599 (Sept. 30, 2022).

Four solar farm owners agreed in November 2022 to pay major fines in settlements with the Department of Justice (“DOJ”) and Environmental Protection Agency (“EPA”) to resolve stormwater management and construction permit violations. The federal court lawsuits involved two completed and two under-construction large-scale solar generating facilities, AL Solar A LLC (“AL Solar”) in Alabama, American Falls Solar LLC (“American Falls”) in Idaho, and Prairie State Solar LLC (“Prairie State”) and Big River Solar LLC (“Big River”) in Illinois. All four projects used a common construction contractor. The suits alleged violations of Clean Water Act (“CWA”) stormwater construction permits; failure to install and maintain proper stormwater controls; failure to conduct site inspections; failure to use qualified personnel for inspections; failure to accurately report and address stormwater issues; and the unauthorized discharge of sediment into waterways.

The fines against AL Solar totaled $500,000; against American Falls, $416,500; against Prairie State, $225,000; and against Big River, $175,000, coming to a total of over $1.3 Million. EPA and DOJ were clear that, in imposing these penalties, the agencies intended to send a strong warning to the solar and other renewable energy industries that, while these renewable energy projects are highly valued and critical to achieving sustainability and climate action goals, the agencies will strictly enforce and ensure compliance with stormwater and other environmental protection regulatory requirements. In the official EPA Notice of these settlements, Acting Assistant Administrator Larry Starfield of the EPA’s Office of Enforcement and Compliance Assurance emphasized, “These settlements send an important message to the site owners of solar farm projects that these facilities must be planned and built in compliance with all environmental laws, including those that prevent the discharge of sediment into local waters during construction.”

Four takeaways should be noted from these major fines:

• First and foremost, these large penalties should be an alarm to the owners and operators of solar and other renewable energy facilities that, while such operations are highly valued by the current Administration as critical to achieving its ambitious climate goals, federal agencies are and will be strictly overseeing and ensuring compliance with stormwater and other environmental protection requirements at renewable energy projects.
• Second, although nearly all states have been delegated authority over most stormwater and other CWA programs, the federal government always retains concurrent oversight and enforcement authority. Operators should both be aware of the sometimes unique additional requirements of each state where they operate and be prepared to prove compliance to both the lead state agency as well as EPA.
• Third, both the states and EPA have the authority to impose administrative penalties. Where, as here, the EPA and the states choose to involve DOJ or their state equivalent to bring a judicial enforcement action, they are sending a strong signal that these types of violations will be stringently punished.
• Finally and significantly, these cases demonstrate that the owners and operators of renewable energy projects will be held responsible for the environmental regulatory violations of their construction and other contractors.

Please contact a Davis Graham lawyer if you have any questions about these cases, compliance with stormwater management, or other regulatory requirements at your facilities.

SEC/SRO Update: DOJ Obtains First Criminal Sherman Act Monopolization Conviction in Decades; SEC Proposes New Oversight Requirements for Certain Services Outsourced by Investment Advisers; SEC Charges Mattel with Financial Misstatements and Former PwC Audit Partner with Improper Professional Conduct

Read more…

As part of ongoing attempts by the U.S. government to promote domestic availability of “critical minerals,” certain provisions of the Inflation Reduction Act (the “Inflation Act”) use tax credits as an incentive. Davis Graham wrote about critical minerals in our November 22, 2021 article on the Infrastructure Investment and Jobs Act (the “Infrastructure Act”).

The Inflation Act covers a wide range of policy topics, but the concept of critical minerals appears exclusively in Parts 4 and 5 of the act, addressing Clean Vehicles and Investment in Clean Energy Manufacturing and Energy Security, respectively.

Part 4 of the Inflation Act addressing Clean Vehicles modifies the existing New Qualified Plug-In Electric Drive Motor Vehicles credit in Section 30D of the Internal Revenue Code, renaming it the Clean Vehicle Credit. It provides for a maximum federal income tax credit of $7,500 for purchasing a new electric vehicle depending on the source of critical minerals used in the vehicle’s batteries if final assembly occurs in North America. The Inflation Act enhances the credit by increasing the baseline dollar limit, expanding the eligible vehicles, allowing a taxpayer to transfer the credit to a registered dealer, and eliminating the prior limit on credit-eligible vehicles.

With respect to critical minerals used in Clean Vehicle batteries, beginning in 2023, at least 40% of their value must be extracted or processed in the United States, or in any country with which the United States has a free trade agreement in effect, or must be recycled in North America. The required percentage of critical minerals value increases each year, up to 80% in 2027. Vehicles not meeting the value threshold are subject to a halving of the tax credit to $3,750. Additionally, if at least 50% of the vehicle’s battery components are manufactured or assembled in North America, an additional tax credit of $3,750 is available. Notably, the Inflation Act also renders vehicles ineligible for the tax credit if the vehicle’s batteries contain critical minerals or components extracted, processed, recycled, manufactured or assembled by “foreign entities of concern,” as defined in the Infrastructure Act. These nations currently include China, Russia, Iran and North Korea.

Department of Treasury guidance is required to be issued by December 31, 2022, regarding recordkeeping requirements to track the use and integration of critical minerals in the Clean Vehicle Credit program.

Part 5 of the Inflation Act establishes a new Advanced Manufacturing Production Tax Credit in Section 45X of the Internal Revenue Code. The credit applies to eligible components produced by a taxpayer/manufacturer in the United States and sold by the taxpayer. The critical minerals tax credit is 10% of the “costs incurred by the taxpayer with respect to production of such mineral.” Eligible components include any applicable critical mineral, defined in the Inflation Act to include aluminum, antimony, barite, beryllium, cerium, cesium, chromium, cobalt, dysprosium, europium, fluorspar, gadolinium, germanium, graphite, indium, lithium, manganese, neodymium, nickel, tellurium, tin, tungsten, vanadium, yttrium, and 23 other minerals – if they are purified to 99 percent by mass.

Outside of the Inflation Act, the U.S. government and other organizations may use other definitions and rely on additional criteria to identify a mineral as “critical.” For example, the Energy Act of 2020 (the “Energy Act”) defines a “critical mineral” as a non-fuel mineral or mineral material essential to the economic or national security of the U.S. and which has a supply chain vulnerable to disruption.

In addition to defining mineral criticality, the Energy Act directed the Department of the Interior’s U.S. Geological Survey (“USGS”) to update and publish a revised List of U.S. Critical Minerals (the “CML”). The initial CML, published in 2018 in response to Executive Order No. 13817, included 35 commodities and groups on the final list.[1] The USGS revised the list in 2022 to include 50 critical minerals;[2]
however, the increase in mineral commodities actually resulted from splitting the rare earth elements and platinum groups.[3] The 50 minerals included on the 2022 CML encompass those defined as critical minerals in Part 5 of the Inflation Act.

In preparing the 2022 CML, USGS removed Helium, Potash, Rhenium, and Strontium. Somewhat counterintuitively, USGS also removed Uranium from the CML, even though one might assume it would be a “critical” mineral because of the safety and national security concerns associated with nuclear power and nuclear weapons. However, in removing Uranium, the USGS relied upon the Mining and Mineral Policy Act of 1970, which defined Uranium as a fuel mineral, and, under the Energy Act, critical minerals do not include fuel minerals; water, ice, or snow; or common varieties of sand, gravel, stone, pumice, cinders, and clay.

While the Infrastructure Act did not make an express designation of mineral criticality, the 2022 CML is timely guidance for the use of Infrastructure Act funds, both for the USGS and other U.S. agencies and international partnerships. Like the Inflation Act, the Infrastructure Act contains several provisions aimed at increasing domestic production of rare earth elements and critical minerals to promote domestic supply chains and to alleviate the economic and national security concerns associated with the United States’ dependence on foreign suppliers. For the USGS specifically, the Infrastructure Act provided $320 million in funding for the Earth Mapping Resource Initiative (EMRI), for which the 2022 CML is the focus of USGS research quantifying critical mineral potential within the U.S. Relatedly, the Department of Energy (“DOE”)’s Critical Materials RDD&CA Program, piloted under the Energy Act, was expanded and supported by the Infrastructure Act. Backed by a $140 million investment, the DOE is also working to develop a full-scale rare earth element and critical minerals extraction and separation refinery using unconventional resources.

As regards critical minerals in the international context, in June of 2022, the State Department announced the establishment of the Minerals Security Partnership (“MSP”) to “bolster critical mineral supply chains.” The 11-member alliance between the U.S. and key partner countries is part of the Biden administration’s continued focus on critical mineral resources. This past week at a ministerial meeting of the MSP in New York, U.S. Secretary of State Antony Blinken remarked that the United States and its allies in MSP stand ready to support successful critical mineral projects. Noting that critical minerals production and processing “requires lots of investment and undertaking lots of risk,” Blinken reaffirmed that the MSP was committed to helping with both, including “providing a loan guarantee or debt financing.” The ministerial meeting included representation from the MSP member countries Australia, Canada, Finland, France, Japan, the Republic of Korea, Norway, Sweden, the United Kingdom, the United States, and the European Union. Additional minerals-rich countries in attendance included Argentina, Brazil, the Democratic Republic of the Congo, Mongolia, Mozambique, Namibia, Tanzania, and Zambia.

[1] Aluminum (bauxite), antimony, arsenic, barite, beryllium, bismuth, cesium, chromium, cobalt, fluorspar, gallium, germanium, graphite (natural), hafnium, helium, indium, lithium, magnesium, manganese, niobium, platinum group metals, potash, the rare earth elements group, rhenium, rubidium, scandium, strontium, tantalum, tellurium, tin, titanium, tungsten, uranium, vanadium, and zirconium. Final List of Critical Minerals 2018, U.S. Department of the Interior, 83 Fed. Reg. 23295, 2018, https://www.govinfo.gov/content/pkg/FR-2018-05-18/pdf/2018-10667.pdf

[2] Aluminum, antimony, arsenic, barite, beryllium, bismuth, cerium, cesium, chromium, cobalt, dysprosium, erbium, europium, fluorspar, gadolinium, gallium, germanium, graphite, hafnium, holmium, indium, iridium, lanthanum, lithium, lutetium, magnesium, manganese, neodymium, nickel, niobium, palladium, platinum, praseodymium, rhodium, rubidium, ruthenium, samarium, scandium, tantalum, tellurium, terbium, thulium, tin, titanium, tungsten, vanadium, ytterbium, yttrium, zinc, and zirconium. Final List of Critical Minerals 2022, U.S. Department of the Interior, 87 Fed. Reg. 10381, 2022, https://www.govinfo.gov/content/pkg/FR-2022-02-24/pdf/2022-04027.pdf

[3] Platinum group metals (Iridium, Palladium, Platinum, Rhodium, Ruthenium, and Osmium) were previously listed together as one group; in the 2022 CML, they have been separated, and Iridium and Osmium have been removed from the list. Likewise, metals belonging to the rare earth elements group (Cerium, Gadolinium, Lanthanum, Neodymium, Praseodymium, and Samarium) were previously listed together as one group; in the 2022 CML, they have been separated.

In Northwest Landowners Association v. State, No. 20210148, 2022 N.D. Lexis 152 (N.D. Aug. 4, 2022), the North Dakota Supreme Court held that portions of Senate Bill 2344 related to pore space violated the takings clauses of the North Dakota and United States constitutions.

In 2019, the North Dakota Legislative Assembly enacted S.B. 2344, which amended and reenacted sections to three existing statutes (N.D.C.C. §§ 38-08-25, 38-11.1-01, and 38-11.1-03) and created and enacted a new statutory section (N.D.C.C. § 47-31-09). The legislation was enacted to clarify the use of pore space.

In S.B. 2344, the Legislative Assembly defined pore space as “a cavity or void, whether natural or artificially created, in a subsurface sedimentary stratum,” and vested the surface owner with pore space ownership (N.D.C.C. §§ 47-31-02 and 03). Section 1 of S.B. 2344 added a subsection to N.D.C.C. § 38-08-25, which allowed an oil and gas operator to use subsurface pore space and denied the surface owner the right to exclude others or to demand compensation for the subsurface use. Section 2 of S.B. 2344 amended N.D.C.C. § 38-11.1-01 to supplement existing legislative findings and add an interpretative provision. Additionally, section 3 of S.B. 2344 amended and adopted a new definition of “land” to “exclude pore space” in the North Dakota Damage Compensation Act, with the result being that a mineral developer would not be required to compensate the surface owner for “lost land value, lost use of and access to the surface owner’s land, and lost value of improvements caused by drilling operations” (N.D.C.C. §§ 38-11.1-03 and 04). Lastly, section 4 of S.B. 2344 barred tort claims, including trespass and nuisance claims, for injection or migration of substances into pore space.

The Northwest Landowners Association sued the state, arguing that S.B. 2344 constitutes a taking because “it strips landowners of their right to possess and use the pore space within their lands and allows the State of North Dakota to directly redistribute that right to others without the consent of or compensation to the landowners.” The district court granted summary judgment in favor of the Northwest Landowners Association and concluded that S.B. 2344 constitutes a taking under both federal and state law because it takes landowners’ property without compensation for the benefit of private parties and also bars landowners from seeking tort remedies. The district court declared the entirety of S.B. 2344 invalid and issued an injunction preventing enforcement of the law.

The North Dakota Supreme Court agreed with the district court and affirmed that S.B. 2344 constitutes a per se taking because it would allow third-party oil and gas operators to physically invade a landowner’s property by injecting substances into the landowner’s pore space without the surface owner’s consent or compensation. Additionally, the court held that the newly-enacted definition of “land” was unconstitutional because it excludes “pore space.” And, finally, the court held that section 4 of S.B. 2344 barring tort claims for injection or migration of substances into pore space was unconstitutional. However, the court declined to find the entire bill invalid, and reversed the district court’s decision to the extent it declared the remainder of S.B. 2344 invalid. Thus, the bill’s definition of surface owner (“any person who holds record title to the surface estate on which a drilling operation occurs or is conducted”) and pore space (as defined above) remain valid.

By invalidating the most significant provisions of S.B. 2344, the North Dakota Supreme Court has cast uncertainty on rights to pore space for carbon capture use and sequestration (“CCUS”) in that state. Clear legislation of pore space can reduce some risk and uncertainty surrounding CCUS projects. For help navigating CCUS projects, please contact John Jacus, Katie Schroder, Katie Roux, or Kathleen Pritchard.

On September 14, 2022, the U.S. Fish and Wildlife Service (USFWS) published a proposed rule to list the tricolored bat as endangered under the Endangered Species Act (ESA). Notably, the USFWS declined to propose to designate critical habitat for the species after finding such a designation would not be prudent.

The tricolored bat’s range includes some or all of 39 states, including eastern Colorado, eastern New Mexico, eastern Wyoming, Kansas, Oklahoma, and Texas:

Source: USFWS Environmental Conservation Online System.

During the winter, tricolored bats are often found in caves, abandoned mines, and road-associated culverts. During the remainder of the year, tricolored bats mainly are found in forested habitats but may also be found in Spanish moss, pine trees, and occasionally human structures.

The USFWS’s listing proposal followed several years of inactivity by the agency regarding the species. In 2016, the Center for Biological Diversity filed a petition requesting that the USFWS list the species as threatened or endangered. In 2017, the USFWS published a 90-day finding that the petition presented substantial scientific or commercial information indicating that listing may be warranted. Since then, the USFWS had not taken any action on the petition. In the proposed rule, the USFWS specified that the proposed rule also serves as the 12-month finding on the listing petition.

The USFWS identified white-nosed syndrome, a disease caused by a fungal pathogen affecting bats, as the principal threat to the species. The USFWS, however, identified wind energy-related mortality as a “consequential stressor” to the species at local and regional levels. The USFWS also identified habitat loss and climate change as impacting the tricolored bat.

In the proposed rule, the USFWS declined to designate critical habitat. The USFWS found this designation not to be prudent because the species is not principally threatened by human activity and because a critical habitat designation would not benefit the species.

The USFWS is accepting comments on the proposed listing until November 14, 2022. On October 12, 2022, the UFWS will hold an informational meeting from 6 to 7:30 pm (ET) and a public hearing from 7:30 to 8:30 pm (ET).

The ESA requires the FWS to publish one of the following by September 14, 2023: a final rule listing the tricolored bat; a notice withdrawing the proposed rule; or a notice that the USFWS requires an additional six months to either publish a final rule or withdraw the proposed rule.