On Oct. 16, 2023, the Division of Examinations (“Division” or “Exam Staff”) released its 2024 Examination Priorities (“Priorities”),^[1] months before these have typically been published to more closely align the release with the start of the SEC’s fiscal year, which began Oct. 1. This approach is consistent with the Division’s goal of more transparency, including with a risk alert it issued in September regarding how it selects examination targets.^[2] Much like in the 2023 Examination Priorities, the Priorities combine a specific focus on private funds with other priorities highly relevant to private fund managers. The Division has continued to conduct thematic sweeps of various types of advisers, including private fund managers (e.g., newly registered advisers and those with their principal office and place of business outside of the United States, particularly in the United Kingdom). Areas of focus during thematic sweeps have included marketing rule compliance and use of artificial intelligence, among many others.

In terms of frequency of examinations, the Division indicated that, as in prior years, priorities for being selected for an examination include advisers that have never before been examined (many of which are examined 12 months after registration) and advisers that have been registered for a number of years but have not been examined in recent years.

Focus on Private Fund Managers

Noting that advisers to private funds continue to be a significant portion of the SEC-registered investment advisers, the Division stated that it will again focus examinations on private fund advisers and identified the following topics as priorities:

• Market Volatility and Interest Rate Changes: The Division has historically sought to understand how advisers respond to market stress and volatility, with a focus on how advisers manage risk, whether advisers’ representations regarding risk management have been accurate and whether investors have been treated fairly when losses occur. In the current environment, the Division will focus on funds experiencing poor performance, that are subject to significant withdrawals, hold difficult to value or illiquid assets and utilize significant leverage. This focus aligns with the recently adopted amendments to Form PF, which will, among other things, require that advisers to hedge funds provide timely reporting of significant investment losses, significant investor redemptions, the inability to meet redemption requests or the suspension of redemptions, and thereby give the Exam Staff a means to detect those funds that may be experiencing such events.^[3]
  • In our experience, following – or sometimes during – periods of particular market stress or volatility, the Exam Staff has conducted targeted reviews of firms it believes may be impacted. Other exams often include requests that address risk management, comparison of fund performance to peers and valuations of illiquid assets. When redemptions are suspended or gates imposed, we have seen the Exam Staff spend significant time analyzing communications with investors to determine whether any investors received greater transparency and liquidity that may have disadvantaged other investors. While the new Private Funds Advisers Rule addresses preferential treatment, we expect the Staff to continue approaching these issues from a broader fiduciary perspective as well.
• Fee and Expense Allocations, Calculations and Valuations: Recent examinations and enforcement actions have served to highlight the SEC’s continued focus on the methodologies applied by private fund advisers when calculating and allocating fees and expenses, including the valuation methodologies used to value a fund’s underlying investments (particularly those investments that are hard to value or are illiquid), how management fees are calculated after the commitment period, whether fee offsets were appropriately applied and the consistency of such practices with disclosures. The Priorities confirm this focus will continue.
  • We have seen the Staff heavily scrutinize the valuations of illiquid assets, particularly where fees are calculated on an adviser’s valuations, and will, at times, closely scrutinize the substance of individual valuations, not just the general valuation policy and process. We also see the Staff reviewing all aspects of the fee and expense calculations and allocations, identifying potential ambiguities as well as simple errors.
• Investment Diligence: The Priorities confirm the Exam Staff’s focus on investment diligence and make clear that private fund advisers will face scrutiny of their policies, procedures and disclosures related to investment due diligence, particularly for managers pursuing private equity and venture capital investments. Diligence and disclosures will be reviewed in light of an adviser’s fiduciary duty, specifically its duty of care, which requires that an adviser conduct a reasonable inquiry into a client’s objectives and develop a reasonable belief that advice is in the best interest of the client.
  • We have seen the Exam Staff identify circumstances where private fund managers could not demonstrate adherence to statements made in investor communications and due diligence questionnaires regarding the research and investment process. We have also observed the Exam Staff question whether diligence for specific investments satisfied the manager’s fiduciary duty of care. Although ESG is not listed in the Priorities, we expect the Exam Staff, as part of reviewing disclosures and investment practices, will continue to find fault where ’managers’ claims regarding consideration of ESG in the investment process do not match their practices.
• Conflicts of Interest: The Exam Staff is perennially focused on how private fund managers address conflicts of interest, and 2024 will be no different. Highlighting that an adviser is required to “eliminate or make full and fair disclosure of all conflicts of interest” so a client can “provide informed consent to the conflict,” the Division emphasized that it will continue to examine for advisers’ adherence to their duty of care and duty of loyalty obligations.^[4] Of particular interest will be instances where private funds are managed alongside registered investment companies and the use of affiliated service providers, the latter of which will become even more transparent on account of the quarterly statement requirement in the new Private Fund Advisers Rules.
  • We have seen increasingly specific requests for detailed records with respect to third-party and affiliated service provider due diligence. Exam Staff frequently seek to identify any economic aspect of an adviser’s business operations that might be viewed as creating a conflict (e.g., receipt of fees or other non-pecuniary benefits or offsets or waivers of fees. We expect to continue to see a focus on the conflicts the Commission has identified in connection with GP-led secondaries.
• LPACs and Advisory Boards: Considering the focus on conflicts of interest, it is not surprising that the Exam Staff will review mechanisms in fund organizational and offering documents that call for limited partnership advisory committees and advisory boards to review and/or provide consent to certain conflicts and conflicted transactions. The Exam Staff will seek to confirm that private fund managers are convening and engaging with such bodies, as required under those documents.
  • We have seen, for example, the Exam Staff identify situations where advisers did not seek consent from fund advisory boards for principal transactions, as required by the fund’s organizational and offering documents.^[5]
• The Custody Rule: The Exam Staff will focus on compliance with Rule 206(4)-2 (“Custody Rule”), particularly with respect to Form ADV reporting practices^[6] and the timely completion and delivery of audited financial statements by advisers relying on the audit exception to the independent verification requirement for limited partnerships and other types of pooled investment vehicles. This focus comes at the same time the SEC is considering its Safeguarding Rule proposal, which would substantially expand the obligations of advisers under the Custody Rule.
  • In addition to the recent enforcement actions charging advisers with violating the Custody Rule for failure to deliver timely audits and/or failure to accurately make disclosures with respect to custody in the ADV,^[7] we have seen widespread focus on these issues in adviser examinations and expect that to continue.
• Form PF: Earlier this year, the SEC adopted amendments to Form PF, which require timely reporting of certain events related to hedge and private equity funds, and expanded reporting for large private equity fund advisers. The Priorities indicate that the Staff will focus on whether private fund managers have policies and procedures in place to address the new Form PF requirements by the Dec. 11 compliance date.^[8] For large hedge fund advisers – i.e., any adviser having at least $1.5 billion in regulatory assets under management attributable to hedge funds as of the end of any month in the prior fiscal quarter – the amendments require reporting within 72 hours of a variety of events, some of which involve quantitative analysis and others that require qualitative determinations. This can necessitate building monitoring systems and addressing certain interpretive issues that need to be tailored to the adviser. Thus, it is important that advisers leave themselves sufficient time in advance of Dec. 11 to develop policies and procedures.
  • As has been the case with the Marketing Rule, we expect the Exam Staff to begin reviewing compliance soon after the new rule goes into effect.

Additional Topics Relevant to All Advisers, Including Private Fund Managers

Private fund managers should also be prepared for the examination topics the Exam Staff has identified in connection with examinations of all types of registered investment advisers. For example:

The Compliance Rule

Private fund managers can expect that the Exam Staff will continue its work assessing compliance with Rule 206(4)-7 (“Compliance Rule”). The Priorities reiterate the core compliance areas where the SEC has long articulated its expectation that registered investment advisers adopt and implement compliance policies and procedures appropriately tailored to the specific risks of their business, investment strategies and actual practices. The Priorities’ citation to, and incorporation of, the specific topics referenced in the Compliance Rule’s 2003 Adopting Release^[9] signals that the Exam Staff still has its eyes on an adviser’s compliance with their long-standing core compliance obligations and is also consistent with increased enforcement activity related to policy failures.

The Marketing Rule

If the Division’s two risk alerts^[10] on Rule 206(4)-1 (“Marketing Rule”) had not put advisers on sufficient notice, the Priorities make clear that there will be a continued focus on compliance with the not-so-new-anymore Marketing Rule. The Exam Staff will continue to examine whether registered investment advisers have adopted reasonably-designed policies and procedures, can substantiate material facts in advertisements, and disclose their marketing practices accurately on Form ADV (e.g., Item 5.L. of Part 1A). The Division notes that reviews of marketing practices will “assess whether disseminated advertisements include any untrue statements of a material fact, are materially misleading, or are otherwise deceptive and, as applicable, comply with the requirements for performance (including hypothetical and predecessor performance), third-party ratings, and testimonials and endorsements.” This confirms what we have seen on many examinations already, where the Staff has sought back-up files from advisers to support material facts including in advertisements and identified circumstances where advisers utilized a marketing practice (e.g., predecessor performance), but did not appropriately reflect that in Form ADV.

Alternative Data and New Technologies

The Division will continue its focus on certain services provided by investment advisers, including automated investment tools, artificial intelligence and trading algorithms or platforms, and the risks associated with the use of emerging technologies and alternative sources of data. We have already seen this year a targeted (and ongoing) examination sweep of advisers regarding their potential use of artificial intelligence in the research and investment process.

Additional examination topics the Exam Staff will focus on include: Material Nonpublic Information Controls; Accuracy of Regulatory Filings; Supervision of Multiple Offices of the Adviser; Consent to Changes in Governing Documents; and Cybersecurity Risks and Controls.

The Division’s Continued Focus on Crypto, and Sanctions

Given the continued volatility of, and activity around, the crypto markets, the Division will continue to monitor and, when appropriate, conduct examinations related to crypto investing activities. With respect to crypto assets that the SEC believes are funds or securities, the Division emphasized that it will consider whether advisers are complying with the Custody Rule with respect to those assets. In addition, the Division will assess whether any technological risks associated with the use of blockchain and distributed ledger technology have been addressed, including whether compliance policies and procedures are reasonably designed, accurate disclosures are made, and the risks pertaining to the security of crypto asset securities are addressed.

The Priorities also highlight that the Division will review whether advisers are monitoring for and complying with the sanctions laws administered by the US Department of the Treasury’s Office of Foreign Assets Control, which is consistent with some of the sanctions-focused examinations that started in 2022 at the outset of the recent Russia-Ukraine war.

Conclusion

The Priorities highlight that the Division has directed resources to continue focusing on issues specific to private fund managers. This is consistent with the Division of Enforcement’s expanded efforts directed at private fund managers and the adoption of amendments to Form PF and the Private Fund Advisers Rules, which represent the most comprehensive set of new rules affecting private fund managers since the Dodd-Frank Act (not to mention the myriad other proposed rules applicable to advisers). Accordingly, preparing for examination requires careful attention, review and reconsideration of important aspects of a private fund manager’s compliance program and business practices.

Authored by Christopher S. Avellaneda, Allison Scher Bernbach, Michael S. Didiuk, Marc E. Elovitz, Kelly Koscuiszka, Tinika M. Brown, Tarik M. Shah, and Jarret A. Roby.

If you have any questions concerning this Alert, please contact your attorney or one of the authors.

On Aug. 23, 2023, the US Securities and Exchange Commission (“Commission”) adopted amendments^[1] (“Amendments”) to the Securities Exchange Act of 1934 (“Exchange Act”) to require certain SEC-registered dealers that were previously exempt from national securities association^[2] membership to register with the Financial Industry Regulatory Authority (“FINRA”).

Background and Current Regulatory Framework

Section 15(b)(8) of the Exchange Act requires SEC-registered broker-dealers to become FINRA members, unless the broker-dealer effects transactions in securities solely on an exchange of which it is a member.^[3] Currently, Exchange Act Rule 15b9-1 exempts any dealer that transacts on exchanges of which it is not a member or in the off-exchange market from the FINRA membership requirement if such dealer:

1. Is a member of a national securities exchange,
2. Carries no customer accounts, and
3. Primarily earns off-member exchange income from transactions for the dealer’s own account with or through another registered broker-dealer or through an Intermarket Trading System.^[4]

While broker-dealers relying on current Exchange Act Rule 15b9-1 are required to limit the annual gross income they derive from securities transactions otherwise than on a national securities exchange of which they are a member to an amount no greater than $1,000, income derived from transactions for the dealer’s own account with or through another registered broker or dealer do not count towards this limitation.^[5]

Due to the above exclusion of transactions for a dealer’s own account from the de minimis exception, Exchange Act Rule 15c9-1 is currently utilized by dozens of proprietary trading firms to reduce operational costs.

Amendments to Exchange Act Rule 15b9-1

Once effective, Exchange Act Rule 15b9-1 will only apply where a broker or dealer is a member of a national securities exchange, carries no customer accounts, and effects transactions solely on the national securities exchanges of which it is a member, unless one of two narrow exceptions applies.

The first exemption applies to off-member-exchange securities transactions that result solely from orders that are routed by a national securities exchange of which such dealer is a member to comply with order protection regulatory requirements.^[6]

The second exemption applies to off-member-exchange securities transactions that are solely for the purpose of executing the stock leg of a stock-option order. Broker-dealers relying on the second exemption will, under the amended rule, be required to establish written policies and procedures “reasonably designed to ensure and demonstrate that such transactions are solely for the purpose of executing the stock leg of a stock-option order.”^[7] The Adopting Release notes that the SEC anticipates self-regulatory organizations will look to these procedures and related documentation in assessing firms’ compliance with this exemption.^[8]

The Amendments will become effective 60 days after the date of publication in the Federal Register and the compliance date (that is, the time by which impacted firms will need to become registered with FINRA) will be one-year after the date of publication in the Federal Register.

Conclusion

By eliminating the general exclusion of transactions for a dealer’s own account from Amended Exchange Act Rule 15b9-1, dozens of proprietary trading firms that regularly effect transactions through single-dealer platforms, in third-party alternative trading systems or just in over-the-counter dealer transactions that are currently not registered with FINRA, will either need to curtail their proprietary trading activities or become a FINRA member.

As a result of the adoption of the Amendments, FINRA is expected to quickly implement previously proposed amendments to its Transaction Activity Fee (“TAF”) to exclude from the calculation of a firm’s TAF assessment transactions by FINRA-member propriety trading firms that are executed on exchanges of which they are members.^[9] FINRA-member firms that currently operate on-exchange proprietary trading strategies should evaluate separating those strategies into a newly-formed FINRA-member that exclusively engages in propriety trading activities to take advantage of FINRA’s proposed TAF fee exclusions.

Additionally, Private Funds that are currently assessing the potential impact of the SEC’s proposal to redefine the definition of ‘Dealer’ to cover certain private funds and advisors (see Alert here) should incorporate the elimination of most of the benefits of the Exchange Act Rule 15b9-1 exclusion from FINRA membership into their transition planning.

Authored by Julian Rainero, William J. Barbera, Derek N. Lacarrubba, and Kristopher J. Kendall.

If you have any questions concerning this Alert, please contact your attorney or one of the authors.

On July 31, 2023, the staff of the US Securities and Exchange Commission’s (“Commission”) Division of Examinations (“Exam Staff”) issued a risk alert (“Alert”) highlighting various deficiencies in the anti-money laundering (“AML”) programs of certain broker-dealers during the most recent SEC examination cycle.^[1] The Alert highlights the Exam Staff’s observations regarding inadequacies in broker-dealers’ AML programs, including with respect to compliance with independent testing and training requirements, as well as inadequacies relating to implementation of the broker-dealers’ customer identification program (“CIP”) and procedures relating to the customer due diligence (“CDD”) requirement.^[2] The Alert reminds broker-dealers of the Exam Staff’s previous guidance^[3] regarding the requirement to implement adequate policies and procedures related to identifying suspicious activity and filing suspicious activity reports (“SARs”) timely.^[4]

We summarize each of the Exam Staff’s identified AML program deficiencies below.

Independent Testing

The Exam Staff observed that many firms failed to adequately conduct or document the independent testing of their AML programs, including failing to: conduct testing in a timely manner (e.g., on a calendar-year basis) or more frequently, if needed; or maintain documentation sufficient to demonstrate to Exam Staff that the firm conducted such testing and/or to demonstrate that the independent testing adequately tested the firm’s compliance with its AML program. Further, Exam Staff pointed out that in some instances where issues were identified by independent testing, firms failed to timely address such issues or have procedures for addressing such issues.

In addition, the Exam Staff noted that a number of independent tests appeared ineffective because the tests: did not cover aspects of the firm’s business or AML program; the personnel conducting the testing were not independent or did not have the appropriate level of knowledge of the requirements of the BSA; or the testing was conducted under requirements not applicable to the securities industry.

In addition to these findings by the Exam Staff, the Alert reminds broker-dealers that FINRA has provided additional guidance concerning a broker-dealer’s obligations related to independent testing of the AML program.^[5] Exam Staff notes that, with respect to the independent testing requirements of the AML rules, broker-dealers often failed to conduct adequate independent testing of their AML program by: not testing critical aspects of the AML program for reasonableness; or conducting testing that is not reasonably designed, such as testing that fails to consider whether the reports and systems used in the firm’s AML compliance program are accurately capturing suspicious transactions or are reasonably tailored to the AML risks of the member’s business.

Exam Staff specifically notes that many firms failed to adequately conduct testing in those instances where firms have taken on new products, services or clients that had a material impact on the firm’s AML risk profile.

Training

With regard to AML training, the Exam Staff observed that a number of firms failed to provide adequate training to appropriate personnel, including by:

• Failing to update training materials based on changes in the law, industry developments impacting AML risk, and/or regulatory developments (e.g., the change in law requiring the adoption of the CDD rule);
• Utilizing training materials that were not tailored to the products, services and business activities of the broker-dealer and that failed to address the risks associated with such activities (e.g., training materials focused on bank AML requirements); or
• Failing to demonstrate that all appropriate personnel attended the firms’ training or by not implementing a process for ensuring that personnel who did not attend required training, ultimately completed the training.

CIP Compliance

Exam Staff observed that a number of broker-dealers failed to adequately maintain CIP procedures that were reasonably designed to enable the firm to form a reasonable belief that it knows the true identity of customers, including by failing to:

• Perform any CIP diligence as to investors in a private placement, in instances where a formal customer relationship was established to effect securities transactions;
• Verify the identity of customers, collect adequate customer identifying information (e.g., dates of birth, identification numbers or addresses), or permitted accounts to be opened by individuals providing only a P.O. box address;
• Maintain adequate documentation regarding customer identity, including instances where firms indicated that verification was complete but required information was missing, incomplete or invalid;
• Use exception reports to alert the firm when a customer’s identity is not adequately verified in accordance with the CIP Rules;
• Accurately document the firm’s review of alerts generated by third-party vendors to monitor for missing, inconsistent or inaccurate information; or
• Review and document the resolution of discrepancies in customer information and conducting searches through third-party vendors.

CDD Compliance

Exam Staff also observed that certain broker-dealers failed to update their AML programs, including, where applicable their new account forms, to address the mandate to collect beneficial ownership from certain persons under the CDD rule. Specifically, Exam Staff found that certain firms:

• Maintained procedures that permitted an entity to be listed as a beneficial owner without a corresponding requirement to obtain adequate information about beneficial owners of the entity;
• Permitted the opening of new accounts for legal entity customers without identifying all of the legal entity’s beneficial owners;
• Did not obtain documentation necessary to verify the identity of beneficial owners of legal entity customers, including by accepting expired government issued identification, or did not document the resolution of discrepancies noted by firm personnel or a firm’s third-party identity verification vendor; or
• Failed to obtain information about certain underlying parties acting through omnibus accounts.

Staffing and Compliance Resources

The Exam Staff also found a number of firms failed to devote sufficient resources, including staffing, to AML compliance given the volume of transactions and risks present in their business. Moreover, where a firm’s AML compliance function also devotes resources to sanctions compliance, the Exam Staff observed that firms lacked compliance resources sufficient to properly comply with applicable AML and financial sanctions laws and regulations, especially in light of the frequency in which new and increasing sanctions are currently imposed by the Office of Foreign Assets Control.

Conclusion

AML continues to be an examination priority for the Commission^[6] and FINRA. Firms should expect increased scrutiny by regulators of their AML compliance programs and, in particular, whether any of the deficiencies identified in the Alert are present in the firm’s AML program and compliance function. Firms should continue to proactively review and enhance their AML programs to ensure that their policies, procedures and internal controls are tailored to their specific business risks and appropriately implemented.

Authored by Betty Santangelo, Melissa G.R. Goldstein, Julian Rainero, and Kristopher J. Kendall.

If you have any questions concerning this Alert, please contact your attorney or one of the authors.

The U.S. Securities and Exchange Commission (“Commission”) adopted amendments to Form PF (“Adopted Amendments”), the confidential reporting form for certain investment advisers registered with the Commission. Many advisers to large private funds will need to update their policies and systems, and create new systems, to satisfy the new obligations, which will include identifying, reviewing and analyzing more and different types of information and, in some cases, to report within 72 hours of a triggering event.

In addition to introducing major changes to how respondents must complete Form PF, the Commission and its Staff made it clear that it will use Form PF for general oversight of investment advisers, including as part of the Commission’s examination program. The Commission is expected to use certain reporting events as examination scoping and may be more likely to initiate an examination of an adviser who has experienced certain reporting events, such as an extraordinary investment loss or limited partner clawback.

The Adopted Amendments represent the first round of amendments to Form PF in 2023, and the Commission indicated in its Spring Agency Rule List that the second set of rules affecting Form PF is expected to be released by October.

Effective/Compliance Dates

The effective/compliance date for new Section 5, which addresses current reporting events for large hedge fund advisers, and new Section 6, which addresses quarterly reporting events for all private equity fund advisers, is Dec. 11, 2023. The effective/compliance date for amended Section 4, which addresses annual reporting for large private equity fund advisers, is June 11, 2024.

We have highlighted the new reporting requirements of the Adopted Amendments by respondent type. Changes made from the Amendments as proposed to the Adopted Amendments are summarized in Attachment A hereto.

I. New Section 5 – Current Reporting Requirements for Large Hedge Fund Advisers to Qualifying Hedge Funds

• Large hedge fund advisers, defined as any adviser having at least $1.5 billion in regulatory assets under management attributable to hedge funds as of the end of any month in the prior fiscal quarter, must file a current report on Form PF Section 5 as soon as practicable upon, but no later than 72 hours after, the occurrence of certain “current reporting events” with respect to any of the adviser’s qualifying hedge funds (i.e., any hedge fund with a net asset value of at least $500 million, individually or together with any feeder funds, parallel funds and/or dependent parallel managed accounts). The effective/compliance date is Dec. 11, 2023.
• Reporting Fund Aggregate Calculated Value – The Commission has introduced a new concept of “reporting fund aggregate calculated value” (“RFACV”), which large hedge fund advisers will need to calculate on a daily basis for purposes of tracking certain current reporting events. RFACV, which differs from a reporting fund’s most recent net asset value, is intended to represent a more recent, reasonable estimate of a reporting fund’s actual value.
  • RFACV is defined as “every position in the reporting fund’s portfolio, including cash and cash equivalents, short positions, and any fund-level borrowing, with the most recent price or value applied to the position for purposes of managing the investment portfolio” and may be calculated using the adviser’s own methodologies and conventions of the adviser’s service providers, provided that these are consistent with information reported internally.
  • The Commission believes calculation of RFACV will be similar to typical practices used by advisers to compute daily profit and loss, by including all items at their most recent, reasonable estimate, which will be marked-to-market for all holdings that can reasonably be marked daily.
  • RFACV is a signed value, meaning it can be positive or negative, and, although RFACV is designed to be calculated on a net basis and not a gross basis, RFACV does not require an adviser to adjust the RFACV for accrued fees or expenses.
  • Position values do not need to be subjected to daily fair valuation procedures, and where one or more portfolio positions are valued less frequently than daily, an adviser can carry forward the last price used for purposes of calculating RFACV.
• Current Reporting Events – Current reporting events include:
  • Extraordinary Investment Losses – If on any business day the cumulative daily rate of return of a reporting fund over a rolling 10-business-day holding period is less than or equal to -20 percent of RFACV.
  • Margin, Collateral or Equivalent Increase – If the difference between (i) the total dollar value of margin, collateral or an equivalent posted by the reporting fund at the end of a rolling 10-business-day period less (ii) the total dollar value of margin, collateral or an equivalent posted by the reporting fund at the beginning of the rolling 10-business-day period is greater than or equal to 20 percent of the average daily RFACV during the period.
  • Notice of Margin Default or Determination of Inability to Meet a Call for Margin, Collateral or Equivalents – If the adviser either (1) receives notification that the reporting fund is in default on a call for margin, collateral or an equivalent, resulting in a deficit that the reporting fund will not be able to cover or address by adding additional funds (taking into account any contractually agreed upon cure period); or (2) determines that the reporting fund is unable to meet a call for increased margin, collateral or an equivalent. Advisers will not be required to file a current report where there is a dispute regarding the amount or appropriateness of a margin call provided that the reporting fund has sufficient assets to meet the greatest of the disputed amount.
  • Counterparty Default – If a counterparty to the reporting fund (1) does not meet a call for margin, collateral or equivalent or fails to make any other payment, in the time and form contractually required (taking into account any contractually agreed upon cure period), and (2) the amount involved is greater than 5 percent of the RFACV.
  • Prime Broker Relationship is Terminated or Materially Restricted – If (1) a prime broker terminates or materially restricts its relationship with the reporting fund, in whole or in part, in markets where that prime broker continues to be active; or (2) the relationship between the prime broker and the reporting fund was terminated by either the reporting fund or the prime broker in the last 72 hours or less (in accordance with the Section 5 current reporting period), and a termination event was activated in the prime brokerage agreement or related agreements, within the last 12 months (e.g. a “key person” trigger).
    • Advisers will need to make a subjective determination of what constitutes a “material restriction,” though the adopting release indicates this generally will include situations such as a prime broker imposing substantial changes to credit limits or significant price increases, or stating that it ceases to support the reporting fund in an important market or asset type, even if the prime broker does not terminate the relationship.
    • A current report is not required for termination events that are isolated to the financial state, activities or other conditions solely of the prime broker.
  • Operations Event – If the reporting fund or adviser experiences a significant disruption or degradation of the reporting fund’s critical operations, whether as a result of an event at a service provider to the reporting fund, the reporting fund or the adviser.
    • “Critical operations” means operations necessary for (i) the investment, trading, valuation, reporting and risk management of the reporting fund; or (ii) the operation of the reporting fund in accordance with the federal securities laws and regulations.
    • Examples may include: a software malfunction at the adviser disrupts trading volume of a reporting fund by 20 percent or more of its normal capacity; operational issues at a service provider significantly disrupts or degrades the adviser’s ability to value the reporting fund’s assets; or a severe weather event causes wide-spread power outages that significantly disrupt or degrade critical operations.
  • Withdrawals or Redemptions – If the reporting 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).
    • The test does not take into account any gates or other limitations on the timing of the withdrawal or redemption and instead looks at the full amount of the withdrawal or redemption requests received, regardless of when those amounts are required to be paid.
    • Due to the timing of when withdrawals and redemptions are generally required to be received relative to when an adviser may receive contractually committed subscriptions, the beneficial impact of netting subscriptions against withdrawals and redemptions will likely be limited.
  • Inability to Satisfy Redemptions or Suspension of Redemptions – If the reporting fund (1) is unable to pay redemption requests, or (2) has suspended redemptions and the suspension lasts for more than five consecutive business days.
• Section 5 also includes an “Explanatory Notes” section where respondents are able to provide any information regarding the current reporting events submitted in the current report.

II. New Section 6 – Quarterly Reporting Requirements for Advisers to Private Equity Funds

• Private Equity Event Report – All private equity fund advisers that are required to file Form PF will be required to file a Section 6 “private equity event report” upon the occurrence of certain “private equity reporting events” within 60 calendar days after the end of the fiscal quarter in which the event occurred. The effective/compliance date is Dec. 11, 2023. Private equity reporting events include:
  • Adviser-Led Secondary Transaction – Upon the completion of an adviser-led secondary transaction, which is defined as any transaction initiated by the adviser or any of its related persons that offers private fund investors the choice to: (1) sell all or a portion of their interests in the private fund; or (2) 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; Election to Terminate Investment Period or Fund – Upon receipt by the reporting fund or its adviser of notification that investors have elected to: (1) remove the advisor or an affiliate as GP or similar control person; (2) terminate the fund’s investment period; or (3) terminate the fund, in each case as contemplated under the reporting fund’s governing documents.
• Similar to Section 5, Section 6 also includes an “Explanatory Notes” section where respondents are able to provide any information regarding the event(s) submitted in the private equity event report.

III. Amended Section 4 – Annual Reporting Requirements for Large Private Equity Fund Advisers

• Large private equity fund advisers, defined as any adviser having at least $2 billion in regulatory assets under management attributable to private equity funds as of the last day of the adviser’s most recently completed fiscal year, will also be required to submit more detailed information in their annual Form PF filings as part of the newly amended Section 4. The effective/compliance date is June 11, 2024, thus, for a private equity fund adviser with a Dec. 31 fiscal year end, the changes will be relevant for the adviser’s Form PF to be submitted by April 30, 2025.
• Revised Section 4 will require the following additional information:
  • Private Equity Fund Investment Strategies – New Question 66 has been added to require information on the reporting fund’s investment strategy(ies). Respondents will choose from a list of strategies in a drop-down menu and, for any fund that employs multiple strategies, the adviser must provide a good faith estimate of the percentage of deployed capital attributable to each strategy.
    • Investment strategies generally include: private credit (and sub-strategies such as distressed debt, senior debt, special situations, etc.); private equity (and sub-strategies such as early stage, buyout, growth, etc.); real estate; annuity and life insurance policies; litigation finance; digital assets; GP stakes investing and others.
    • If a respondent selects “other” for its reporting fund’s strategy, it must provide an explanation.
  • Geographical Breakdown of Investments – Question 67 (previously Question 78) has been amended to require more specific country-level exposure information. Rather than report based on a static group of regions and countries, the adviser will list each country for which the reporting fund’s exposure represents 10 percent or more of the reporting fund’s net asset value, and provide the level of exposure as a percentage of the reporting fund’s net asset value.
  • Fund–Level Borrowings – New Question 68 has been added to require additional information on any fund-level borrowing or other cash financing available to the reporting fund. “Other cash financing” is meant to capture where a reporting fund has access to capital that would not be considered borrowing, such as where an adviser agrees to provide a cash infusion to the reporting fund.
  • Events of Default – Question 77 (previously Question 74) has been amended to require more granular information about reported events of default, including whether the default stemmed from a payment default of the private equity fund or of a controlled portfolio company, or pursuant to a failure to uphold terms of the applicable borrowing agreement.
  • Bridge Financing to Controlled Portfolio Companies – Question 78 (previously Question 75) has been amended to require additional identifying information about bridge financing providers and counterparties to controlled portfolio companies, such as the counterparty’s legal entity identifier, if any, whether the counterparty is affiliated with a major financial institution and, if so, the name of the major financial institution.
  • General Partner and Limited Partner Clawbacks – New Question 82 has been added to require reporting of (i) any general partner clawback or (ii) a limited partner clawback or clawbacks in excess of an aggregate amount equal to 10 percent of the reporting fund’s capital commitments.
• Explanatory Information – Similar to Sections 5 and 6, Question 83 has been added to allow an adviser to provide an optional narrative response if it believes that the additional information is helpful in explaining responses made in Section 4.

IV. Considerations for Advisers Subject to New Form PF Reporting Requirements

Given the accelerated compliance timeline, advisers subject to the new Section 5 and/or Section 6 reporting requirements should begin preparations now, particularly to identify the types of information that will need to be monitored on a regular basis. This is especially important for large hedge fund advisers that will be subject to the 72-hour reporting requirements, as having adequate procedures in place will be critical in order to detect current reporting events in a timely manner and to provide ample time to prepare responses, including any elective narrative responses for the Explanatory Notes subsection. As noted, we also expect that the Commission Staff may follow up with respect to Section 5 or Section 6 reports filed with the Commission and, in addition to focusing on the particular event that gave rise to the report, the Commission Staff may focus on an adviser’s general procedures around tracking and reporting specified events. We also expect the Commission to look at procedures as part of the general examination process.

In addition to speaking with your attorney at Schulte Roth & Zabel, advisers should begin operational planning in advance of the effective/compliance dates. The following are some operational planning steps that advisers may consider:

• Draft desk procedures that appoint who is responsible for monitoring each reporting event, when and how such monitoring will be performed and, for current reporting events, who is responsible for completing and submitting a report.
• Update the adviser’s systems to integrate reporting event monitoring into existing reporting to the extent possible.
• Identify the appropriate calculation of the new RFACV metric.
• Review and revise the adviser’s compliance policies and procedures to account for the Adopted Amendments.
• Conduct firm-wide, department-wide and/or targeted training for reporting events that are not department- or employee-specific (e.g., operations events).
• Conduct scenario testing to ensure desk procedures and systems are working properly.
• For those advisers that believe their investment strategies and advisory business may trigger frequent reporting for one or more current reporting events, prepare draft narrative responses to include in the Explanatory Notes subsection to explain why such current reporting event occurred and is not indicative of systemic risk or investor protection issues.

Authored by Christopher S. Avellaneda, Marc E. Elovitz, Kelly Koscuiszka, and Anthony J. Taylor.

If you have any questions concerning this Client Alert, please contact your attorney or one of the authors.

Highlights

The Securities and Exchange Commission (the “SEC”) has proposed new rules that would dictate with great specificity the manner in which advisers oversee their service providers. While the proposed rule is described as covering “outsourcing” by investment advisers, in fact it would go far beyond delegation arrangements. The service providers covered by the rule as proposed would also include those who “assist” the adviser with certain services or functions, for example a valuation firm that assists the adviser in fair valuation determinations even though the fair valuation determinations are performed by the adviser. Advisers would not only be required to satisfy the specific ongoing oversight requirements prescribed by the proposed rule, they would also have to disclose in Form ADV the fact that they have “outsourced” such services and disclose the names and addresses of all of the outsourced service providers and the nature of the services provided. Failure to satisfy the specific oversight and documentation requirements dictated by the rule could be charged as fraud under the Advisers Act.

The Proposed New Oversight, Recordkeeping and Reporting Regime

On Oct. 26, 2022, the SEC proposed a new rule under the Investment Advisers Act of 1940 (the “Advisers Act”) that imposes due diligence, monitoring, recordkeeping and disclosure obligations on registered investment advisers that outsource certain functions to service providers. Although Proposed Rule 206(4)-11 (the “Proposed Rule”) is presented as “a means reasonably designed to prevent fraudulent, deceptive, or manipulative acts, practices, or courses of business within the meaning of section 206(4) of the Act”,^[1] it will likely have a greater direct impact on advisers’ outsourced arrangements across a wide range of products, services and service providers.

“Covered Functions” Provided by “Service Providers”

The Proposed Rule does not use or define the term “outsourcing”. Rather, the types of relationships covered under the Proposed Rule are defined by new and vague standards. The Proposed Rule applies to any registered investment adviser that retains a “service provider”^[2] to perform a “covered function,” which is defined as a function or service: (1) that is necessary for the adviser to provide its investment advisory services in compliance with the federal securities laws and (2) that, if not performed or if performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services.^[3] To help identify the types of third parties that might provide covered functions, the Proposing Release includes some examples: “Adviser/Subadviser; Client Services; Cybersecurity; Investment Guideline/Restriction Compliance; Investment Risk; Portfolio Management (excluding Adviser/Subadviser); Portfolio Accounting; Pricing; Reconciliation; Regulatory Compliance; Trading Desk; Trade Communication and Allocation; and Valuation.”^[4] The list is not exhaustive and it suggests that advisers should take a critical eye to how the Proposed Rule might impact many of its critical third party arrangements.

The first part of the covered function test is aimed at “functions or services that are related to an adviser’s investment decision-making process and portfolio management.”^[5] The Proposing Release encourages a broad interpretation of the first part of the test by including as examples services like portfolio accounting services, compliance services and valuation and pricing services. It adds, however, that “certain of these functions may be covered functions for one adviser but not for another adviser, depending on the facts and circumstances.”^[6]

The SEC provides as an example a valuation service provider. “For example, an adviser may use valuation service providers to assist in fair value determinations. Such services would be included under the proposed rule as covered functions, as opposed to, for example, common market data providers providing publicly available information.”^[7] Although the valuation service provider is not delegated the authority to value the investments, the SEC indicates that by utilizing such a service provider to assist in fair valuations, the adviser has “outsourced” its valuation function.

The second part of the covered function test is also unclear. What is a function that, if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services? Will it be possible for advisers to rule out certain services under this formulation? The Proposing Release suggests that an “adviser should consider a variety of factors when determining what would be reasonably likely to have a material negative impact, such as the day-to-day operational reliance on the service provider, the existence of a robust internal backup process at the adviser, and whether the service provider is making or maintaining critical records, among other things.”^[8]

The Proposing Release includes a number of examples, some of which suggest that this part will be interpreted broadly, as well. The SEC advises that “if an adviser licenses a commonly available index and its stated investment strategy involves management against that index, failure to receive the index or an inaccurate delivery of the index could have a material negative impact on the adviser’s ability to manage that portfolio.”^[9] In this case, the adviser’s relationship with the index provider would, presumably, be subject to the Proposed Rule.

Due Diligence and Ongoing Monitoring Requirements

Once an adviser determines that a service provider will perform a covered function, the Proposed Rule requires due diligence that directs advisers to confirm and document six aspects of the intended covered function services, including:

• The nature and scope of the services;
• Potential risks resulting from the service provider performing the covered function, including how to mitigate and manage such risks;
• The service provider’s competence, capacity and resources necessary to perform the covered function;
• The service provider’s subcontracting arrangements related to the covered function;
• Coordination with the service provider for federal securities law compliance; and
• The orderly termination of the provision of the covered function by the service provider.

The Proposed Rule requires documentation of an adviser’s third-party due diligence assessment, including “any policies or procedures or other documentation showing how the adviser would mitigate and manage the risks it identifies, both at a covered function and a service provider level.”^[10] The Proposed Rule also requires ongoing monitoring of the covered function services, assessments of the engaged service provider’s performance, and that an adviser retain books and records associated with the monitoring and assessment of the service provider.

Additional Requirements for Outsourcing of Recordkeeping Functions

The Proposed Rule also includes requirements specific to advisers that rely on third parties to make and/or keep any books and records required by the recordkeeping rule (“Recordkeeping Function”). In particular, the Proposed Rule requires advisers to conduct due diligence and monitoring for all third parties performing Recordkeeping Functions and obtain reasonable assurances that the recordkeepers will meet certain standards. In particular, the investment adviser must have reasonable assurance that the third party recordkeeper will:

• Adopt and implement internal processes and/or systems for making and/or keeping records that meet the requirements of the recordkeeping rule applicable to the adviser in providing services to the adviser;
• Make and/or keep records in a matter that meet all of the requirements of the recordkeeping rule applicable to the adviser;
• For electronic records, provide access to electronic records by the adviser and the SEC; and
• Ensure the continued availability of required books and records if the third party’s operations or relationship with the adviser cease.

Recordkeeping Requirements

The Proposed Rule’s recordkeeping requirements will obligate advisers “to make and keep a list or other record of covered functions that the adviser has outsourced to a service provider and the name of each service provider, along with a record of the factors, corresponding to each listed function, that led the adviser to list it as a covered function.”^[11]

Form ADV Disclosures

The SEC also has proposed amendments to Form ADV under new Item 7.C in Part 1A and Section 7.C in Schedule D, which would require advisers to provide “census-type information” about the third parties that provide covered functions. Such information would include the names and addresses of the service providers and an indication as to the types of services provided. All of this would be categorized in the ADV as “outsourced” functions.

Comment Period and Engagement with the SEC

Comments on the proposal are due on the later of Dec. 27, 2022, or 30 days from the date of publication in the Federal Register. We are preparing comments on the Proposed Rule to provide information and perspective to the Commission and welcome dialogue with our clients on these issues.

Authored by Allison Scher Bernbach, Marc E. Elovitz, Kelly Koscuiszka, and Philip J. Bezanson.

If you have any questions concerning this Client Alert, please contact your attorney or one of the authors.

On Sept. 15, 2022, the U.S. Securities and Exchange Commission (“SEC”) settled enforcement actions against four investment advisers for violating Rule 206(4)-5 under the Investment Advisers Act of 1940, as amended (the “Pay-to-Play Rule”).^[1]

The Pay-to-Play Rule. Among other things, the Pay-to-Play Rule prohibits advisers from providing investment advisory services for compensation to a government entity within two years after the adviser or one of its “covered associates” makes a contribution to an official of the government entity that is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by the government entity or has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by the government entity.^[2] Compliance with the Pay-to-Play Rule requires a high degree of care because the technical requirements of the rule are very specific and intent is irrelevant. In light of the upcoming elections, it is particularly important for investment advisers, including exempt reporting advisers^[3], to focus on compliance with the Rule.  

The Recent Enforcement Cases. In all four cases, political contributions of $1,000 or less by personnel of investment advisers mandated a two-year “time-out” from receiving fees from the pension plans invested in funds managed by the advisers because the recipient of the contribution was an “official” of the pension plan due to the recipient’s role with respect to the pension plan. Notably, in all of the cases, the investment advisers had established advisory relationships with the pension plans prior to the contributions. None of the cases involved allegations of any intent to actually influence the allocation of pension investments – the very type of quid pro quo arrangement the Pay-to-Play Rule is designed to address. In fact, in three of the cases, the investments by the pension plans were made years before the political contributions were made and the funds were closed-end funds with no redemption rights.

These settlements demonstrate the SEC’s continued aggressive enforcement of the Pay-to-Play Rule^[4] and other prophylactic rules.^[5] Moreover, violations of the Pay-to-Play Rule are easily detected by the Staff due to the increasing public availability of information about many political contributions. Coupled with the strict liability nature of the statute, political contributions by personnel of investment advisers make for “low hanging fruit.”

What Should Investment Advisers Be Doing? This aggressive enforcement – and strict liability – make it critically important for investment advisers to maintain robust policies and procedures designed to prevent improper contributions from being made in the first place. While the Pay-to-Play Rule provides for an exception to the two-year “time out” for returned contributions, this exception is only available when the contribution has been discovered within four months of being made, is less than $350 and is returned within 60 calendar days from the date of discovery. Pre-clearance of all political contributions – irrespective of the recipient or the amount – helps to prevent improper contributions, as does periodic training. Electronic records searches can help identify contributions that may not have been cleared, as can reviews of publicly available information about contributions. Advisers also should keep in mind that contributions to candidates for federal office may be covered by the Pay-to-Play Rule if the candidate is currently a state officeholder at the time of the contribution. Additionally, contributions to PACs, political parties and other committees require heightened diligence with respect to the ultimate recipient of the funds.^[6] In light of the upcoming midterms, now is a good time to remind your personnel of your policy with respect to political contributions, including, if applicable, the need to pre-clear all contributions.

Authored by Allison Scher Bernbach, Marc E. Elovitz, Peter D. Greene, and Kelly Koscuiszka.

If you have any questions concerning this Alert, please contact your attorney or one of the authors.