Welcome to the second edition of On The Docket, which is the recently-ascribed name to the Beach Street Legal blog. This edition is again longer than anticipated, but the SEC has been keeping the industry busy with new rule proposals and adoptions in recent weeks as you’ll see below.
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Happy reading.
– Chris
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SEC Rulemaking Firehose Continues Unabated
The SEC rulemaking firehose continues with two new proposals issued on July 26, 2023:
- To amend the “internet adviser” path to SEC registration by eliminating the current de minimis exception for non-internet clients & requiring such advisers to maintain an operational interactive website at all times through which ongoing advice is rendered.
Read the internet adviser rule proposal here. - To require advisers that use or may use “analytical, technological, or computational functions, algorithms, models, correlation matrices, or similar methods or processes that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes of an investor” to identify any associated conflicts of interest and eliminate or neutralize such conflicts of interest (not just disclose such conflicts). The proposal would also require prescriptive policies & procedures.
Read the predictive data analytics rule proposal here.
For a thoughtful critique of the predictive data analytics rule proposal, check out Commissioner Hester Peirce’s statement of dissent:
The best thing I can say for this proposal is that it serves, perhaps unintentionally, as a mirror reflecting the Commission’s distorted thinking. In that mirror, you will see the Commission’s attitude toward technology, which is not neutral, but hostile. It reflects this Commission’s loss of faith in one of the pillars of our regulatory infrastructure: the power of disclosure and the corresponding belief that informed investors are able to think for themselves. Another glance through the looking glass will reveal the Commission’s continued degradation of a principles-based regulatory regime, replacing it once again with overly prescriptive rules. And a final look reveals the Commission’s indifference to operational feasibility. I dissent from this proposal and the thinking it embodies.
SEC Officially Requires Annual Compliance Program Reviews to be Memorialized in Writing
The SEC buried the lede when it adopted various new and revised rules ostensibly applicable just to private fund advisers:
- Press Release title: SEC Enhances the Regulation of Private Fund Advisers
- Fact Sheet title: Private Fund Adviser Reforms: Final Rules
Just applicable to private fund advisers, right? Wrong.
The lede, at least for advisers that are not advisers to private funds, is that annual compliance program reviews must now be documented in writing. While many (if not most) advisers may already document annual compliance program reviews in writing, it’s now officially required.
My primary takeaway from the Adopting Release for non-private fund advisers is as follows:
No specific documentation elements are prescribed. The SEC describes advisers that may memorialize, e.g.:
- A lengthy written report with supporting documentation;
- Quarterly documentation, aggregated at year end;
- A presentation to a board or another governing body;
- A short memorandum summarizing the findings; or
- Informal documentation, such as a compilation of notes throughout the year.
In other words, there are a number of ways an adviser may choose to document its annual compliance program review. This rule does not prescribe a specific format of the written documentation, instead, allowing an adviser to determine what would be appropriate.
Marketing Rule Enforcement Action
While the SEC’s first enforcement action under the new[ish] Marketing Rule is evidence of increased SEC scrutiny of adviser marketing efforts at first blush, this particular case would likely have made headlines even without the new[ish] Marketing Rule for several reasons:
- The advertised strategy involved crypto (the SEC has a skeptical view of digital assets generally).
- The advertised annualized return was 2,700% (how could you not peel back the onion layer on this return calculation methodology?).
- The 2,700% annualized return was extrapolated from a period of only 3 weeks without hypothetical performance disclosure (the logic was that a 3-week return of 21% = annualized return of 2,700%).
- Client agreements contained impermissible hedge clauses (a recent SEC exam focus, as further explained in this past blurb).
- Employees applied >3,000 electronic client signatures to move money authorizations without clients’ knowledge that their signatures were being applied to such authorization docs.
My guess is we are still a few months or more away from seeing SEC enforcement actions more acutely related to the specific nuances of the new[ish] Marketing Rule based on the SEC’s current sweep exams in this regard. More optimistically, we will also hopefully see a Risk Alert down the line in this vein.
You can access the complete administrative proceeding here.
2024 Registration Renewal Calendar
The 2024 investment adviser registration renewal calendar is now available. Key dates and links below:
- Preliminary renewal statements will be available 11/6/23 with final payments due by 12/11/23.
- Final renewal statements will be available 1/2/24 with final payments due by 1/26/24.
Failure to pay registration renewal fees by the stated deadlines may result in “registrations terminating due to a ‘failure to renew’ with the appropriate jurisdiction regulators” (i.e., advisers will no longer be registered or authorized to conduct advisory business).
The renewal program main page can be found here.
The renewal program calendar can be found here.
Practice Tip – Proper Conflict of Interest Disclosure
The SEC continues to focus on undisclosed or insufficiently disclosed conflicts of interest both during exams and enforcement actions. Here’s a general framework to follow when drafting conflicts of interest disclosure for your Form ADV Part 2 brochure:
- Describe the practice or arrangement that creates the conflict of interest.
- Identify the practice or arrangement as a conflict of interest.
- Describe how you address or mitigate the conflict of interest.
E.g.: “XYZ product sponsor reimburses us for the costs we incur in hosting client events. This creates a financial incentive for us to recommend XYZ product sponsor to our clients, which is a conflict of interest. We address this conflict of interest by fully disclosing it in this brochure, by only recommending investment products we believe to be best suited for our clients’ needs without regard for any financial arrangements they offer to us, and by following corresponding policies and procedures.”
PS: avoid prefacing a conflict of interest description by stating that it “may” occur or exist. Either it does or it doesn’t. The SEC is not a fan of coy disclosure.
PPS: no adviser is completely conflict-free.
Practice Tip – References to Series Exams
The Series 65 (or any other series exam) is not a “license” or a “designation” and shouldn’t be referred to as such in an individual advisor’s bio or advisory firm marketing material.
A series exam is technically just an exam that qualifies an individual advisor to register as an investment adviser representative of an advisory firm.
From time to time we see series exams incorrectly positioned this way, and thought it worth pointing out.
Practice Tip – Lexicon of Adviser Authority / Responsibility
The lexicon of adviser authority/responsibility over client accounts is far from uniform, but here’s at least how we bucket them (from most permissive to most restrictive):
Discretionary Management
- Trading authority via LPOA
- Ongoing management responsibility
- No client pre-trade approval
Non-Discretionary Management
- Trading authority via LPOA
- Ongoing management responsibility
- Client pre-trade approval
Client-Directed
- Trading authority via LPOA
- No ongoing management responsibility
- Client pre-trade approval
Reporting-Only or “Courtesy” Accounts
- No trading authority via LPOA
- No ongoing management responsibility
- No trading
Importantly: If an adviser is to be granted different degrees of authority/responsibility over different accounts for the same client, the client’s advisory agreement should ideally specify such authority/responsibility on a per-account basis.