On October 26, 2021, the SEC’s Division of Examinations (Division) issued a risk alert1 (Risk Alert) that provides observations of the Division’s staff (Staff) from examinations of more than 50 fund complexes (covering more than 200 funds and/or series of funds) and nearly 100 advisers. These examinations were undertaken to assess industry practices and regulatory compliance in specific areas that may have an impact on retail investors (RIC Initiatives or Initiatives). The Risk Alert is intended to highlight risk areas and assist funds and their advisers in developing and enhancing their compliance programs and practices.
Key aspects of the Risk Alert are summarized below.
Focus of Initiatives
The examinations focused on the business practices, risks, and conflicts applicable to each of six RIC Initiatives identified by the Staff in its 2018 risk alert.2 During the examinations, the Staff generally assessed:
- Effectiveness of the compliance policies and procedures of funds and their advisers to address certain risks — particularly in the areas of disclosure, portfolio management compliance, and conflicts of interest — and the efficacy of fund board oversight of fund compliance programs;
- Disclosures by funds to investors and by advisers to fund boards regarding certain risks and conflicts; and
- Fund governance practices, particularly as they relate to oversight of fund compliance programs and assessing fund practices and controls related to certain risks.
Staff Observations from the Examinations
I. Compliance Programs
The Staff observed several deficiencies or weaknesses relating to fund and adviser compliance programs and to board oversight of fund compliance programs. Examples include inadequate policies and procedures in the following areas:
Compliance Oversight of Investments and Portfolios. The Staff observed deficiencies in monitoring for the following: portfolio management compliance (e.g., trade aggregation, trade allocation and best execution); adherence to fund specific investment restrictions; compliance with the “Fund Names Rule”; and specific risks associated with fund investments. The Staff also observed deficiencies with respect to the administration of fund liquidity risk management programs; and oversight of the viability of smaller and/or thinly traded exchange-traded funds and oversight of their liquidation.
Compliance Oversight of Valuation. The Staff noted deficiencies in maintaining an adequate compliance program for valuation of portfolio securities, including with respect to oversight of pricing vendors; and in maintaining appropriate policies, procedures and/or controls for portfolio valuation, including with respect to potential conflicts, such as where portfolio managers are permitted to provide input on prices of securities in funds they manage.
Compliance Oversight of Trading Practices. The Staff identified deficiencies in (1) ensuring appropriate trade allocation among client accounts so that all clients are treated fairly; (2) preventing prohibited principal transactions with affiliates or joint transactions with affiliates; (3) addressing the sharing of soft dollar commissions among clients to ensure that no client is disadvantaged; and (4) identifying cross trades and preventing related violations of the legal requirements for cross trading and principal trading.
Compliance Oversight of Conflicts of Interest. With respect to index providers, the Staff highlighted deficiencies in addressing conflicts of interest, such as certain “dual capacity” instances where the adviser to an index fund also acts as the index provider; and the sharing, or potential misuse, of material non-public information.
Compliance Oversight of Fees and Expenses. The Staff observed deficiencies in monitoring the allocation of expenses between funds and their advisers, subject to fee waivers by the adviser; and in reviewing fee calculations for any inconsistencies between a fund’s contractual expense limitation and its disclosures regarding fund expenses.
Compliance Oversight of Fund Advertisements and Sales Literature. Issues observed related to inadequate reviews of fund advertisements and sales literature and affiliated index provider websites to assess whether the websites reflected sales literature that should be filed with the SEC or FINRA.
Board Oversight. The Staff also identified deficiencies in fund policies and procedures addressing board oversight of fund compliance programs. For example, the Staff observed that certain funds did not have appropriate procedures for monitoring and reporting accurate information to fund boards, and funds that did not complete required annual reviews of fund compliance programs that address the adequacy of policies and procedures and the effectiveness of their implementation.
II. Disclosure to Investors
The Risk Alert notes that funds had inaccurate, incomplete, and/or omitted disclosures in both their filings and other shareholder communications, such as advertisements and sales literature. Examples of the deficient filing disclosures included funds that omitted certain disclosures on principal investment strategies and risks; and funds that provided inconsistent or inaccurate disclosure concerning fund net assets and net expense ratios, contractual expense limitations and/or operating expenses subject to the contractual expense limitations. Regarding other shareholder communications such as fund advertising, the Risk Alert cites inaccurate, incomplete and/or omitted disclosures concerning, among other things, investment strategies and portfolio holdings, fund expenses and fund performance information.
III. Observations Regarding Compliance and Disclosure Practices
The Risk Alert recounts various practices that funds and their advisers may find helpful in their compliance oversight practices. The Staff provides a sampled list of helpful practices in the following areas:
Fund or Adviser Implemented Compliance Programs. Certain funds and their advisers implemented plans that provided for review of existing compliance policies and procedures to ensure consistency with practices,3 conducted periodic testing and reviews for compliance with disclosures and ensured that compliance programs adequately address the oversight of key vendors.
Board Oversight. Certain fund boards provided oversight of fund compliance programs by assessing whether disclosed information was accurate concerning funds’ (1) fees, expenses, and performance, and (2) investment strategies, including changes or risks associated with these strategies. Certain boards also assessed whether funds were adhering to their processes for board reporting, including an annual review of fund compliance programs.
Fund Adopted Procedures Concerning Disclosure. Funds also adopted and implemented policies and procedures concerning disclosure, such as those that required updating of fund website disclosures concurrently with new or amended disclosures in filings or other shareholder communications and review and testing of fund performance advertising for accuracy and appropriateness of presentation and applicable disclosures.
The Risk Alert contains a large number of Staff observations on fund industry practices and highlights key risk areas for funds and advisers. Funds and advisers should carefully review their compliance programs and practices in these highlighted areas and consider enhancements where appropriate in light of the Staff’s observations.
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If you have any questions regarding the matters covered in this memorandum, please contact any member of our Registered Funds Group.