Ropes & Gray’s Investment Management Update February – March 2024

The following summarizes recent legal developments of note affecting the mutual fund/investment management industry.

February – March Alerts

Since our prior Investment Management Update, in separate Alerts, we covered (i) the 2024 Investment Management Conference sponsored by the Investment Company Institute, (ii) the Cboe’s application to the SEC to amend its rules to permit “generic” exchange listing and trading of a mutual fund’s class of shares if the fund receives Vanguard-like share class exemptive relief from the SEC, (iii) two recent SEC enforcement actions that offer a first look at how the SEC is approaching the use of artificial intelligence (“AI”) tools by registered advisers and (iv) FinCEN’s rulemaking proposal to extend certain anti-money laundering program requirements to registered advisers. Each Alert is summarized below with a hyperlink to the full text of the Alert.

2024 Investment Management Conference
April 22, 2024
Ropes & Gray’s memorandum summarizes the 2024 Investment Management Conference sponsored by the Investment Company Institute. The Conference included sessions that discussed the following industry and regulatory developments, among others.

• Keynote Remarks by Eric J. Pan, President and CEO, Investment Company Institute
• A fireside chat with SEC Commissioner Hester Peirce in which she raised concerns about the SEC’s approach to rulemaking
• An assessment of the SEC’s Investment Management rulemaking activity
• Key developments in the unlisted closed-end fund and BDC markets
• Developments affecting advisers that incorporate ESG factors
• Board practices and regulatory developments affecting fund directors
• Innovations in financial offerings for retail investors

Cboe Proposes Rule Changes Related to ETF Share Class Relief
April 18, 2024
On April 15, 2024, Cboe BZX Exchange, Inc. (“Cboe”), a national securities exchange, filed an application pursuant to Rule 19b-4 under the Securities Exchange Act of 1934 with the SEC proposing amendments to Cboe Rule 14.11(l). Cboe Rule 14.11(l) currently sets forth the “generic” listing standards applicable to the listing and/or trading on Cboe of exchange-traded funds (“ETFs”) that operate in reliance on Rule 6c-11 under the 1940 Act.

If approved by the SEC, the proposed amendments to Cboe Rule 14.11(l) would establish a path and set of conditions for Cboe to approve the “generic” listing and/or trading of classes of exchange-traded shares issued by open-end investment companies that also offer non-exchange traded share classes in reliance on exemptive relief granted by the SEC from certain sections of the 1940 Act and the rules thereunder (“ETF Share Class Relief”).

Decoding the SEC’s First “AI-Washing” Enforcement Actions
March 21, 2024
Against the backdrop of its pending proposed rules regarding predictive data analytics and AI, on March 18, 2024, the SEC announced settled charges against two investment advisers involving allegations that the firms’ promotional materials overstated their use of AI or machine learning in their investment services, a practice the SEC has described as “AI-washing.” Finding violations of the Investment Advisers Act rules governing marketing and compliance policies and procedures (Sections 206(2) and 206(4) and Rules 206(4)-1 and 206(4)-7 thereunder), the settlement orders imposed civil penalties against the advisers of $225,000 and $175,000, respectively.

FinCEN Proposes (New) Rule to Extend Anti-Money Laundering Requirements to Registered Investment Advisers (RIAs) and Exempt Reporting Advisers (ERAs)
February 13, 2024
On February 13, 2024, the Financial Crimes Enforcement Network (“FinCEN”), within the U.S. Treasury Department, issued a Notice of Proposed Rulemaking (“Proposed Rule”) that would extend certain anti-money laundering program requirements to (i) investment advisers registered (“RIAs”) with the SEC and (ii) investment advisers that report to the SEC as exempt reporting advisers (“ERAs”).

Among other requirements, the Proposed Rule would require RIAs and ERAs to (i) develop and implement anti-money laundering compliance programs (within 12 months after the effective date of a final rule) and (ii) monitor for and report suspicious activity to FinCEN. FinCEN proposes to delegate its authority for examining compliance with the Proposed Rule’s requirements to the SEC.

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The following summarizes additional recent legal developments of note affecting the mutual fund/investment management industry.

Departure of William Birdthistle from the SEC’s Division of Investment Management

In a February 28, 2024 press release, the SEC announced the March 8, 2024 departure of William Birdthistle from his position as the SEC’s Director of the Division of Investment Management. He assumed the position in December 2021. Mr. Birdthistle stated that “[s]erving at the Securities and Exchange Commission has been the highest honor of my professional career, and I’m tremendously grateful for the inspiration and example set by my dedicated colleagues in the Division of Investment Management.”

SEC Chair Gary Gensler stated that “William has overseen our work to strengthen oversight of investment companies and investment advisers – from data reporting to fund names to money market reforms.” During Mr. Birdthistle’s time at the SEC, the SEC finalized rules concerning money market fund reforms, tailored shareholder reports and revisions to the Fund Names Rule. Mr. Birdthistle “will rejoin academia.” Prior to joining the SEC, Mr. Birdthistle was a faculty member of the Chicago-Kent College of Law.

The former Deputy Director of the Division of Examinations, Natasha Vij Greiner, succeeds Mr. Birdthistle as Director of the Division of Investment Management. Chair Gensler stated that “Natasha brings deep and broad expertise to the Division, both having led the agency’s Investment Adviser/Investment Company examination program and having served in other key leadership roles over her more than two decades at the SEC.” Ms. Greiner served as Deputy Director of the Division of Examinations, and her work as the National Associate Director of the Investment Adviser/Investment Company examination program included work in the Private Funds Unit. She also served as the Associate Director of the Home Office Investment Adviser/Investment Company examination program. Ms. Greiner began her SEC career in the Division of Examinations as a broker-dealer examiner and has served in a variety of roles at the SEC for more than 22 years, including Acting Chief Counsel and Assistant Chief Counsel in the Division of Trading and Markets, where she provided legal and policy advice to the SEC on rules affecting market participants and the operation of the securities markets.

SEC Narrows the Registration Exemption for Internet Investment Advisers

On March 27, 2024, the SEC published a release (the “Release”) adopting amendments to Rule 203A-2(e) under the Advisers Act (the “Internet Adviser Exemption”) and related amendments to Form ADV, as proposed in 2023.¹ The Internet Adviser Exemption exempts certain investment advisers that provide advisory services through the internet (“internet investment advisers”) from the prohibition on registration with the SEC.

Background

Under the current Internet Adviser Exemption, an adviser is exempt from the prohibition on SEC registration if, among other things, the adviser:

• Provides investment advice to all its clients entirely through an interactive website, except that the adviser may provide investment advice to fewer than 15 clients by other means during the preceding 12 months; and
• Maintains a record demonstrating that it provides investment advice to its clients in accordance with the conditions described in the bullet point immediately above.

Amendments to Rule 203A-2(e)

Operational Interactive Website. The current Internet Adviser Exemption requires, among other things, that an internet investment adviser must provide investment advice to all its clients exclusively through an “interactive website,” subject to the 15-client exception discussed above. The Release makes the following amendments to the Internet Adviser Exemption:

• The existing definition of “interactive website” is replaced by “operational interactive website.”
• An “operational interactive website” is defined as a website, mobile application or similar digital platform through which the investment adviser provides digital investment advisory services on an ongoing basis to more than one client (except during temporary technological outages of a de minimis duration).
• “Digital investment advisory service” is defined as investment advice to clients that is generated by the operational interactive website’s software-based models, algorithms or applications based on personal information each client supplies through the operational interactive website.

Elimination of the 15 Non-Internet Client Exception. The current Internet Adviser Exemption permits an internet investment adviser to provide investment advice to fewer than 15 non-internet clients during the preceding 12 months. The Release amends the Internet Adviser Exemption to eliminate this exception. Consequently, an internet investment adviser relying upon the Internet Adviser Exemption will be required to provide investment advice to all its clients exclusively through an operational interactive website.

Form ADV Amendments

The Release amends Form ADV to require that an adviser relying on the Internet Adviser Exemption represent on Schedule D of its Form ADV that, among other things, it (i) provides investment advice on an ongoing basis to more than one client exclusively through an operational interactive website and (ii) maintains a record demonstrating compliance with that requirement.

Compliance Date

The compliance date for the amended Internet Adviser Exemption is March 31, 2025. An adviser relying on the amended Internet Adviser Exemption must comply with the Release’s conditions, including the condition to maintain the filing of a Form ADV that includes a representation that the adviser is eligible to register with the SEC under the exemption. The compliance date reflects the date by which most investment advisers will have filed their annual updating amendments to Form ADV.

SEC Asserts that Adviser Failed to Make Required Section 15(c) Disclosures

On February 16, 2024, the SEC issued an order settling an administrative proceeding involving an ETF adviser (the “Adviser”) in which the SEC alleged that the Adviser failed to disclose certain compensation arrangements to the ETF’s board in connection with the board’s approval of the ETF’s management agreement.

Based upon its findings (summarized below), the SEC concluded that the Adviser had violated, among other things, Section 15(c) of the 1940 Act, which requires an adviser to provide to the ETF’s board “such information as may reasonably be necessary to evaluate the terms of any” investment advisory agreement. In the order, the SEC made the following findings:

• The ETF passively tracks an index that the Adviser licensed on an exclusive basis from an index provider. The index purports to identify “U.S. common stocks with the most ‘positive insights’ collected from online sources including social media, news articles, blog posts and other alternative datasets.”
• In December 2020, the ETF’s board voted on the proposed organization and launch of the ETF and to approve its advisory contract. A memorandum to the board for its December meeting included a discussion of certain of the economic terms of the index licensing agreement for the proposed ETF. According to the SEC, the board memorandum (i) misstated the anticipated terms of the index licensing fee that was to be paid by the Adviser to the index provider, disclosing only that it would equal 20% of the after-other-expenses net management fee and (ii) failed to disclose that the licensing fee was structured to provide the index provider “with a larger percentage of the fee when assets under management of the [ETF] met certain thresholds.” In addition, the SEC alleged that the memorandum and other board materials failed to disclose:
  • The forecasted profitability to the Adviser or the extent to which economies of scale would be realized as the ETF grew.
  • That the index provider had provided a “well-known and controversial social media influencer” with an equity interest in the index provider in return for the influencer’s promotion of the ETF’s index.
  • Controversies surrounding the influencer and the related brand risk to the Adviser, the ETF and other ETFs managed by the Adviser.
• Following the ETF’s March 2021 launch, in May, the Adviser provided materials to the board as part of the advisory contract renewal process for all the funds overseen by the board, including the ETF, and made a presentation to the board. The board materials included an analysis of economies of scale and the Adviser’s profitability.
• With respect to economies of scale and profitability, the SEC alleged that the Adviser did not disclose “the economic terms of the licensing arrangement” with the index provider. Therefore, because the licensing agreement provided for the index provider “to garner a larger proportion of the management fee if the asset levels of [the ETF] increased to meet certain thresholds,” the board “did not have the ability to consider the economic impact of the sliding scale arrangement, which would have been a relevant factor in evaluating [the Adviser’s] profitability and the extent to which economies of scale would be realized as the . . . ETF grew.”

Based on its findings, the SEC concluded that the Adviser had violated (i) Section 15(c) of the 1940 Act, (ii) the antifraud provisions of Section 206(2) of the Advisers Act and (iii) Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder (written compliance policies and procedures). Without admitting or denying the SEC’s findings, the Adviser agreed to be censured and to pay a civil penalty of $1.75 million.

Regulatory Priorities Corner

The following brief updates exemplify certain trends and areas of current focus of regulatory authorities.

Upcoming Compliance Dates

The following is a reminder of the upcoming compliance dates of significant SEC rulemakings.

1. Enhanced Reporting of Proxy Votes by Registered Funds. The effective date for this release’s rule and form amendments is July 1, 2024. Thus, registered funds are required to file their first reports on amended Form N-PX by August 31, 2024, with these reports covering the period July 1, 2023 to June 30, 2024. July 1, 2024 is also the date that registered funds must disclose in their registration statements that their proxy voting record is publicly available on (or through) their website and available upon request, free of charge. The related SEC release is summarized in a Ropes & Gray Alert.
2. Tailored Shareholder Reports for Mutual Funds and ETFs. July 24, 2024 is the compliance date for this release. The related SEC release is summarized in a Ropes & Gray Alert.
3. Remaining Money Market Reforms. The compliance dates for amended Forms N-MFP, N-CR and PF, as well as distinguishing between U.S. Government agency notes that are coupon-paying and those that are “no-coupon discount” notes in a fund’s website categorization of its holdings, is June 11, 2024. The compliance date for funds required to impose mandatory liquidity fees is October 2, 2024. The related SEC release is summarized in a Ropes & Gray Alert.
4. Beneficial Ownership Reporting. Beneficial owners are required to comply with the revised Schedule 13G filing deadlines on September 30, 2024. The compliance date of the structured data (XML-based language) requirements for Schedules 13D and 13G filers is December 18, 2024. The related SEC release is summarized in a Ropes & Gray Alert.

Risk Alert on Transitioning to T+1 Settlement

On March 27, 2024, the SEC Division of Examinations (“EXAMS”) issued a Risk Alert concerning the May 28, 2024 shortening, from two business days after the trade date (“T+2”) to one business day after the trade date (“T+1”), of the standard settlement cycle for most broker-dealer transactions in U.S. securities. May 28, 2024 is also the compliance date for new rules related to the processing of institutional trades by broker-dealers and certain clearing agencies, as well as certain recordkeeping amendments applicable to registered investment advisers.

To assess preparedness arising from the shortening of the settlement cycle and related rules, the Risk Alert states that EXAMS issued the Risk Alert to provide SEC registrants with additional information about the scope and content of its examinations and outreach. The summary below focuses on issues raised in the Risk Alert that may be of most relevance to investment advisers.

Additional Background

The transition to T+1 settlement includes the following:

• Amendments to Rule 15c6-1(a) under the Exchange Act that shorten the standard settlement cycle for most broker-dealer transactions from T+2 to T+1.
• To promote the completion of allocations, confirmations, and affirmations (“ACA”) by the end of trade date for transactions between broker-dealers and their institutional customers, new Rule 15c6-2 under the Exchange Act requires a broker-dealer to either (i) enter into written agreements with the relevant parties as specified in the rule or (ii) establish, maintain, and enforce written policies and procedures reasonably designed to address certain objectives related to completing ACAs in a timely manner.
• Amendments to Rule 204-2 under the Advisers Act requiring all registered investment advisers to make and keep certain records for any transaction that is subject to the ACA requirements of Rule 15c6-2, above. The required records include each confirmation received, and any allocation and each affirmation sent or received, with a date and time stamp for each allocation and affirmation that indicates when the allocation and affirmation was sent or received.

The Risk Alert notes that the Securities Industry and Financial Markets Association and the Investment Company Institute commissioned a publication titled T+1 Securities Settlement Implementation Playbook (Dec. 2023).

Potential EXAMS Items for Advisers

The Risk Alert’s appendix provides a list of requests for information that EXAMS may seek to obtain in examinations or outreach. The list includes the following items that EXAMS may seek to obtain from SEC registrants (each a “Registrant”) that may be of interest to investment advisers:

1. Information regarding how a Registrant is preparing for the movement to T+1, including whether any specific group, person, or vendor was tasked with identifying necessary changes and the process through which identified changes were to be implemented.
2. Information regarding changes to a Registrant’s policies and procedures, as well as operational risk management, technology systems and processes, to comply with the shortening of the settlement cycle and related new regulatory requirements.
3. Information regarding any outreach a Registrant has had to counterparties, clients, vendors, or others on any changes to the ACA or settlement process.
4. Information regarding any changes made by a Registrant to its written agreements for completing the ACA process in a timely manner, as well as the timeframe and status for re-papering the agreements.
5. Information regarding processes assessed, or any changes made, for when counterparties are located in another time zone.
6. Information regarding how a Registrant will handle ACA for end-of-the-day transactions.
7. Information regarding any changes made to a Registrant’s process for stock lending and changes relating to recalls of loaned securities.
8. Information regarding any funding/liquidity concerns foreseen by a Registrant for transactions (e.g., international securities that settle T+2, ETF creations/redemptions (underlying securities that do not settle on T+1), etc.).

Short-Form Registration Statements on Form N-2 and Timeliness of Required Reports Filed by WKSIs and Other Seasoned Issuers

On March 6, 2024, SEC staff in the Division of Investment Management’s Disclosure Review and Accounting Office published a notice (the “Notice”) to registrants regarding the eligibility requirements for closed-end funds and BDCs to file short-form registration statements on Form N-2. A closed-end fund or BDC must qualify as a “seasoned issuer” to be eligible to use the short-form registration statement on Form N-2.

The Notice reminds registrants that, to be eligible to file a short-form registration statement (or, under certain circumstances, to continue using an effective short-form registration statement) on Form N-2, a fund must timely file all reports that are required to be filed under Section 30 of the 1940 Act and Sections 13 or 15(d) of the Exchange Act, as applicable, during the twelve calendar months (and any portion of a month) immediately preceding the filing of the registration statement (“eligibility testing period”). For example, the Notice stated, during the eligibility testing period, a registered closed-end fund must have timely filed all reports required under Section 30 of the Investment Company Act, such as reports on Forms N-PX, N-CEN and N-PORT. Registered closed-end funds must have also timely filed all annual and semi-annual reports to shareholders on Form N-CSR, and a BDC must have filed all annual and quarterly reports on Forms 10-K and 10-Q.

The Notice also stated that registrants are reminded that, subject to certain limited exceptions, seasoned issuers are required to file a new shelf registration statement every three years.

Additional Ropes & Gray Alerts and Podcasts Since Our December 2023 – January 2024 Update

California Law for Asset Managers: California ESG Landscape
April 1, 2024
On this episode of Ropes & Gray’s California Law for Asset Managers podcast series, Josh Lichtenstein, a benefits partner and head of the ERISA fiduciary practice, and Catherine Skulan, an asset management partner, discussed the ESG landscape in California, including its climate-related disclosure regime, as well as a fossil fuel divestment bill, which remains pending in the legislature, but if adopted, would impact managers overseeing state pension assets.

Ropes & Gray Crypto Quarterly: Digital Assets, Blockchain and Related Technologies Update
March 22, 2024
The landscape of government enforcement, private litigation and federal and state regulation of digital assets, blockchain and related technologies is constantly evolving. Each quarter, Ropes & Gray attorneys analyze government enforcement and private litigation actions, rulings, settlements and other key developments in this space. This Alert distills the flood of industry headlines so that you can identify and manage risk more effectively, and it contains the takeaways from this quarter’s review.

A Word for Our Sponsors: Contours of a Good Compensation Plan
March 8, 2024
On this episode of Ropes & Gray’s podcast series, A Word for Our Sponsors, Deb Lussier, a co-leader of the sponsor solutions practice, and Yoni Levy, a partner in the asset management practice, explored employment and compensation decisions among private equity firms and other alternative asset managers. To provide additional insights and to help them navigate the discussion, they were joined by Jonathan Goldstein, the regional managing partner for the Americas in the private equity practice at Heidrick & Struggles.

Covered Funds in Limbo in Face of California’s Recent Diversity Reporting Law
February 28, 2024
This Alert is a follow-up to our October 9, 2023 Alert regarding Fair Investment Practices by Investment Advisers (“SB 54”), the recent California law intended to provide transparency with respect to founder diversity in certain investments made by “venture capital companies” (which the law defines broadly enough to seemingly capture a wide range of private investment funds, including traditional venture capital funds and private equity funds, as well as other investment vehicles) meeting certain criteria under the law.

Registered Closed-End Funds May Exclude Investor’s Advisory Proposal to Declassify Board
February 20, 2024
In a February 16, 2024 no-action letter, the staff of the SEC’s Division of Investment Management assented to the request of three Nuveen closed-end funds not to recommend enforcement action if the funds exclude a shareholder proposal by a self-described “activist” investor, Saba Capital Management, L.P., from the funds’ proxy materials in reliance on Rule 14a-8(b)(1) under the Securities Exchange Act of 1934. Because Saba’s proposal was not among the enumerated matters for shareholder voting in the funds’ declarations of trust, Saba was not a holder of securities entitled to vote on the proposal under Rule 14a-8(b)(1).

 

If you would like to learn more about the developments discussed in this Update, please contact the Ropes & Gray attorney with whom you regularly work or click here.