Safeguarding Client Assets (Custody Rule)
The SEC’s Custody Rule Proposal was made public in February 2023 and, on the surface, the intent is to expand the type of assets that Registered Investment Advisors (RIAs) are required to hold with a Qualified Custodian in order to capture and establish safeguarding controls around digital assets. However, in writing this proposal, the SEC documented changes to several important custodial processes in a way that was inconsistent with industry practice. These proposed changes are especially troublesome in the areas of client cash segregation, custodian indemnification requirements, adviser authority screening and the ability for a qualified custodian to hold every type of asset in custody. The financial services industry responded to this SEC proposal directly and through all relevant industry associations via comment letters and in-person meetings directly with the SEC. At this point, most of the industry feels that the SEC now has a better understanding of how global custody works. There has been insight provided into the ways clients and custodians are protected and risk managed, and hopefully SEC policy makers now have a better grasp on how cash works within global custody accounts. Industry stakeholders are hopeful that the SEC is trying to find workable solutions for this proposal and will address the identified policy concerns with language and direction that is aligned with industry practices. We anticipate that news on this proposal should come during the first half of 2024.
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SEC Climate Disclosure Requirements
The SEC first issued a proposed ESG disclosure rule in March 2022 that would require SEC registered companies to disclose their greenhouse gas emissions (GHG) and other climate-related information. This rule has been delayed but should be finalized in 2024 and in effect by 2026. A major sticking point continues to be the Scope 3 level reporting of GHG emissions which focuses on these emissions along the supply chain, including those of private companies who sell to publicly traded companies:
- Scope 1 focuses on GHG emissions of the company
- Scope 2 on the GHG emissions of the energy providers
- Scope 3 are upstream and downstream emissions that arise from customers in the chain
Scope 3 is problematic since it requires publicly traded companies to seek information from privately held companies who are outside of the SEC’s authority. The SEC appears to be delaying the final rule while trying to find a legal workaround to include Scope 3.
Enhanced Disclosures by Certain Investment Advisers for ESG Practices
For investment fund managers, certain ESG factors are becoming more central to investment management, and investors want more insight into the climate risks associated with their holdings. In response, the SEC has issued a proposal to enhance ESG disclosure requirements for investment fund managers in the hopes of improving consistency and transparency for investors. Applying to all funds that are marketed as ESG funds, the proposal will require more rigorous disclosures. The managers of these ESG funds will now need to report information on the nature of the funds, including registration statements, prospectuses and advisory brochures.
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Open-Ended Liquidity Risk Management Programs and Swing Pricing; Form N-PORT Reporting
In November 2022, the SEC proposed significant revisions to its rulesaimed at making open-ended funds better prepared during economic downturns to mitigate the dilution of shareholder interests.
The proposal’s key features include:
- Mandated swing pricing for all registered open-ended funds other than money market funds (MMFs) and exchange-traded funds (ETFs) based on a complex framework set forth in the proposal
- Requiring funds to establish and implement swing pricing policies and procedures, which must require the fund to adjust its NAV by a swing factor if the fund has net redemption or if the fund has net purchases exceeding its “inflow swing threshold”
- A Swing Pricing Administrator (who is not the Portfolio Manager) to make good faith estimates, supported by data, of the costs the fund would incur if it purchased or sold a pro rata amount of each investment in its portfolio equal to the amount of net purchases or net redemptions (these estimates include a “market impact” determined according to specified estimates and calculations)
- Imposition of a “hard close” for funds required to implement swing pricing under which purchase and sale orders receive the current day’s price only if the fund (or its transfer agent or a registered securities clearing agency (i.e. NSCC)) receives the order before the fund’s net asset value (NAV) pricing time
- Several major changes to the liquidity risk management framework, including:
- Broadened illiquid investment category and elimination of the less liquid investment category
- Mandated highly liquid investment minimums (HLIM) of at least 10% of fund net assets and certain exclusions when determining compliance
- Expansion of the illiquid investment limit to include margin or collateral posted for illiquid derivatives
- Changes to fundamental aspects of liquidity classification, including certain key inputs and timing
- Forms N-1A, N-PORT and N-CEN amendments related to the swing pricing, hard close and liquidity rule-related amendments, including swing factor reporting and reporting of aggregate liquidity classifications
- Increased Form N-PORT filing and publication frequency
Outsourcing
In October 2022, the SEC issued a proposal that would prohibit investment advisers from outsourcing certain services without first conducting due diligence and monitoring the external service providers. This new rule would further require advisers to periodically monitor the performance and reassess the retention of the service provider, in accordance with due diligence requirements, to reasonably determine whether it is appropriate to continue to outsource those services or functions to that service provider. Also proposed were corresponding amendments to the investment adviser registration form to collect census-type information about the service providers defined in the proposed rule. In addition, proposed amendments to the Advisers Act books and records rule include a new provision requiring advisers that rely on a third party to make and/or keep books and records to conduct due diligence and monitoring of that third party and obtain certain reasonable assurances that the third party will meet certain standards.
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Industry Challenges on Recently Adopted Rules
Private Funds Adviser Rule
Adopted by the SEC in August 2023, the new rule focuses on disclosure and reporting obligations and imposes restrictions and disclosure requirements on certain activities. RIAs will be required to document their annual review of their compliance policies and procedures. The Rule is softened from its original form, but there remains a great deal of controversy which has caused the SEC to be sued by several organizations. The compliance deadline for quarterly statement and audit rules is March 14, 2025.
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Update:
September 2023 – TheSEC has been legally challenged by several organizations for “exceeding its authority, defying congressional design for private funds, and imposing significant new and unneeded burdens on private capital that fuels thousands of small businesses.”
December 2023 – The SEC submitted its responsive brief which takes issue with the various claims of the trade associations. They argue that the SEC does have statutory authority to impose the PFA rule, that they did not violate the Administrative Procedure Act in promulgating the rule and that the SEC’s cost benefit analysis was sufficient. Counsel for the trade associations submitted their opening brief which is summarized here. The SEC submitted its responsive brief which is available here.
Short Sales Reporting
The SEC is adopting new Rule 13f-2 and new Form SHO pursuant to the Securities Exchange Act of 1934 (“Exchange Act”) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (“DFA”). The new rule and related form are designed to provide greater transparency through the publication of short sale-related data to investors and other market participants. Under the new rule, effective January 2, 2024, institutional investment managers that meet or exceed certain specified reporting thresholds are required to report on a monthly basis, using the related form, specified short position data and short activity data for equity securities. The SEC fact sheet can be found here. Compliance date for Rule 13f-2 and Form SHO will be January 2, 2025 (12 months from effective date) with public aggregated reporting to follow three months later.
Update:
December 2023 – Three hedge fund associations legally challenged the SEC in a bid to vacate the short-selling boosting transparency rule. The groups say that the rule has conflicting stances, in that it allows for transaction reports to be aggregated for investor protection while at the same time requiring other transaction reports to be disclosed individually. According to the lawsuit, the SEC disregarded the nature of the rules and took a contradictory approach to regulating interrelated markets. The groups feel that the SEC needs to develop a more consistent approach in protecting the investors. “These two rules underscore how the SEC has ignored calls from industry, market participants, and Congress to consider the interconnectedness and aggregate impact of its rulemakings,” Alternative Investment Management Association CEO Jack Inglis said in the news release.
In a hearing last month, Rep. Ann Wagner, R-Mo., who leads the House Financial Services Subcommittee on Capital Markets, said the pace of the SEC’s rule-making “raises questions about the agency’s ability to comprehensively evaluate the cumulative effects, indirect costs, and cross-market implications of these rules,” and leaders of two industry groups agreed. The three trade associations that filed the December 12 lawsuit were also a part of the six organizations that sued the SEC in September for its private fund adviser rule. The organizations said the SEC failed to show a need for that rule, exceeded its authority and significantly changed the final version of the rule without allowing for public comment.