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OCIE Risk Alert Flags Deficiencies in Boards’ 15(c) Processes

A Risk Alert from the SEC’s Office of Compliance Inspections and Examinations reflects the most often cited deficiencies and weaknesses observed in nearly 300 fund examinations over a two-year period. According to OCIE, the most often cited deficiencies and weaknesses related to the fund compliance rule, disclosure to investors, the board approval process involving advisory contracts, and the fund code of ethics rule. Even though many of the funds examined were not cited for a deficiency or weakness, OCIE believes the following information can assist all funds in assessing compliance risks. Below are the most often cited deficiencies or weaknesses OCIE staff observed in connection with the Section 15(c) process:

  • The staff observed that fund boards may not have requested or considered information reasonably necessary to evaluate the fund’s investment advisory agreement. For example, certain boards did not appear to consider relevant information such as information related to the profitability of the fund to the adviser, economies of scale, or peer group comparisons for the advisory fee. The staff also observed fund boards that received incomplete materials, but did not request the omitted information, such as performance data for the fund and other accounts managed by the adviser and profitability reports.
  • The staff observed funds’ shareholder reports that did not appear to discuss adequately the material factors and conclusions that formed the basis for the board’s approval of an investment advisory contract. In addition, staff observed instances in which boards’ advisory contract review process may not have complied with Section 15(c). In some instances, funds did not keep copies of written materials the board considered in approving advisory contracts. In other instances, because of the lack of supporting documentation, such as board minutes, it was unclear what information fund boards requested and considered.

OCIE staff also examined money market funds for compliance with the amendments to the money market rules that became effective in October 2016. The staff observed instances of deficiencies or weaknesses related to money funds’ portfolio management practices, compliance programs, and disclosures. With respect to policies and procedures, OCIE staff found that some money funds did not have policies and procedures that addressed: (1) periodic board oversight of the money fund’s written guidelines and procedures under which the adviser, when delegated by the fund board, analyzes credit risks and makes minimal credit risk determinations. (2) periodic board oversight of certain money fund information, including the money fund’s net asset value deviation methods and the amount of the deviation.

The Risk Alert covered other deficiencies, notably on fund compliance programs. Some of these deficiencies involved board oversight. For example:

  • The staff observed funds that did not follow or enforce their compliance policies and procedures. For instance, even where funds’ policies and procedures required the fund’s board to approve or ratify the fair valuations determined by the valuation committee, certain funds did not follow or enforce these policies and procedures.
  • Similarly, staff observed funds that did not follow their policies and procedures regarding the funds’ obligations to obtain multiple broker quotes in connection with cross trades to allow the fund’s board to properly evaluate whether the trades had complied with the exemptions under the affiliated transaction rule.
  • OCIE staff observed certain policies and procedures did not provide for any ongoing monitoring or due diligence of service providers’ services relating to pricing of portfolio securities and fund shares. Additionally, the staff observed funds where the policies and procedures of the funds’ sub-advisers had not been approved by the fund’s board.

SEC Extends Temporary Relief for MiFID II’s Research Provisions

SEC staff issued an extension of an Oct. 26, 2017 no-action letter  to assist market participants regarding their U.S.-regulated activities as they seek to comply with the research provisions of MiFID II. Under the extension of the temporary no-action letter, SEC staff would not recommend enforcement action to the Commission against broker-dealers receiving payments in hard dollars or through research payment accounts from clients subject to MiFID II. This no-action letter, which was set to expire July 3, 2020, has been extended until July 3, 2023. Separately, the extension letter notes the continued ability of broker-dealers to receive payments for research under section 28(e) of the Securities Exchange Act of 1934 through client commission arrangements (CCAs) and that the use of CCAs does not affect whether the exclusion for broker-dealers from the definition of “investment adviser” under the Advisers Act may be available. “Today’s extension will allow our staff to continue to monitor the evolving impact of MiFID II and evaluate whether any additional guidance or Commission action is appropriate. In this regard, our staff is focused on ensuring that market participants have flexibility and choice in how they pay for research,” said SEC Chairman Jay Clayton.

Academics Find Misreporting on Bond Funds’ Risky Assets Lead to Misclassification

A paper by a group of academics from Notre Dame university, Harvard Business School and the University of Texas at Dallas provides “robust evidence” that bond funds on average report significantly safer portfolios than they actually hold, making their funds appear less risky. According to the academics, mutual funds report holding significantly higher percentages of AAA bonds, AA bonds, and all investment grade issues than they actually hold, and often the discrepancy is egregious. Due to this misreporting, funds are then misclassified by Morningstar into safer categories and enjoy higher ratings. However, when these funds are correctly classified based on their actual risk, they were mediocre performers. The academics say such misreporting results in about 30% of funds being misclassified with safer profiles, when compared against their actual, publicly reported holdings. Misclassified funds tend to outperform the actual low-risk funds in their peer groups, receive higher Morningstar Ratings and higher investor flows due to their perceived outperformance, the authors say. Meanwhile, a report in Financial Advisor magazine says that while fund managers for the most part are on top of the requirements of the Liquidity Rule, managers of fixed-income funds are facing challenges. One portfolio manager quoted in the report said assessing liquidity for certain bonds can be a “real nightmare.” Other industry participants quoted in the article say that liquidity can be relative among specific instruments – some bonds are more liquid than others and daily market shifts can quickly change a liquidity classification.

MFDF Webinar: Mutual Fund CCO Compensation: The MPI Annual Survey (2019)

In June, the SEC adopted the long-awaited rulemaking package relating to the standard of conduct broker-dealers and investment advisers owe when providing advice to retail investors.  The package includes:
  • Regulation Best Interest – under which broker-dealers will be required to act in the best interest of a retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.
  • Form CRS – under which registered investment advisers and broker-dealers will provide retail investors a short relationship summary that is intended to allow for comparability among the two different types of firms.
  • Interpretation reaffirming and in some instances clarifying the SEC’s views of the fiduciary duty owed by investment advisers to all of their clients.
Sara Crovitz and Larry Stadulis will provide an overview of the package, focusing on practical implications for fund directors.
This webinar will be broadcast live from 2:00 to 3:00 Eastern Time on Thursday, September 12, 2019. Register online.

SEC Proposes Rule Amendments on Proxy Voting, Proxy Advisors

The SEC in a 3-2 vote proposed amendments to its rules governing proxy advisors. The SEC wrote that its proposal “aims to enhance the accuracy and transparency of the information that proxy voting advice businesses provide to investors and others who vote on investors’ behalf, and thereby facilitate their ability to make informed voting decisions.” The proposal would require increased disclosures from proxy advisory firms on their process and conflicts of interest and allow businesses to review and revise proxy advice before it is issued. Business groups, including the Chamber of Commerce and Business Roundtable, welcomed the SEC proposals according to a report in Pensions & Investments. Proxy advisory firm ISS sued the SEC last week regarding guidance and interpretation the SEC released in August 2019, claiming among other things that the action exceeded the SEC’s statutory authority. ISS’s chief executive wrote in an opinion column for the Financial Times that the provisions in the SEC’s August release and the proposed rulemaking will disrupt the system for proxy voting and tilt the scales in favor of company management.

The SEC also proposedamendments to modernize the rule that governs the process for shareholder proposals to be included in a company’s proxy statement. Among key provisions:

  • The SEC maintained the $2,000 minimum ownership threshold. However, the proposed amendments require that, in order to take advantage of that ownership threshold, a proponent must have held the shares for at least three years in order to demonstrate long-term investment in the company.
  • The “one proposal” rule now clarifies that a single person may not submit multiple proposals at the same shareholder’s meeting on behalf of different shareholders.
  • The proposal would update the levels of shareholder support a proposal must receive to be eligible for resubmission at the same company’s future shareholder meetings.

Commissioners Allison Herren Lee and Robert Jackson opposed the proposals, with Jackson saying the rule changes would limit shareholders’ ability to hold corporate insiders accountable. The proposals will have a 60-day public comment period following publication in the Federal Register.

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