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Industry Trends: Registered funds regulatory and tax round-up – Fall 2020

Each quarter the UMB Fund Services registered fund accounting, administration and tax teams consolidate the most impactful regulatory and tax developments in the fund industry. To guide your strategic and operational planning, our registered funds servicing team recommends you review and consider these developments from the prior quarter.

SEC adopts new derivative rule

In October 2020, the SEC adopted a new rule regarding the use of derivatives in registered products (open-end, closed-end, ETFs and business development companies).

Why it matters:

While compliance is more than a year away, funds and boards should begin becoming familiar with the requirements and any implementation requirements. The rule is effective February 19, 2021, with compliance required 18 months later.

The new rule 18f-4:

  • Amends ETF rule to allow leveraged and inverse ETFs to satisfy ETF rule without need for exemptive relief
  • Rescinds related SEC releases, staff guidance, exemptive relief and no-action letters, including senior security coverage requirements and segregated accounts

Under the rule, funds using derivatives must:

  • Adopt a derivative risk management program
  • Name a derivative risk manager
  • Comply with outer limit of use of derivatives based on value at risk or VaR
  • Approve of the derivative risk manager and has oversight of the program including such information to evaluate the adequacy of the program.

The rule also creates a limited use of derivative exception that exempts users from having a derivative risk management program. A fund is limited to derivative exposure of less than 10% of net assets and would exclude currency and interest rate hedges against specific equity or fixed income investments. Changes to N-PORT, N-CEN and new Form N-RN (formerly N-Liquid) are also included.

SEC adopts fair valuation rule

In December 2020, the SEC adopted a new valuation regime focused on process, testing and oversight. The rule applies to all registered funds and business development companies (BDCs) and is effective March 8, 2021 with required compliance 18 months later.

Why it matters:

Rule 2a-5 states that a fund’s board must determine fair value in good faith by carrying out the required functions. The rule, however, permits the board to designate the fund’s “valuation designee,” which the board would continue to oversee, to perform fair value determinations relating to any or all fund investments. “Valuation designee” is defined as the fund’s investment adviser (excluding sub-advisers) or, for internally managed funds, a fund officer or officers.

The SEC cited certain high-level expectations regarding board oversight where the board designates a valuation designee to perform fair value determinations: boards should be objective and approach this oversight with a skeptical view. Effective oversight is not passive but rather involves continuous engagement, and boards should consider this oversight to be an iterative process of identifying issues and opportunities for improvement.

The new rule 2a-5:

  • Defines “readily available market quotations” for purposes of the Investment Company Act definition of “value”
  • Sets forth detailed requirements for determining fair value in good faith
  • Provides that a fund board may designate a valuation designee to perform fair value determinations, subject to several conditions

Under rule 2a-5, determining fair value in good faith involves satisfying four requirements:

  • Periodically assessing material risks associated with determining fair value of fund investments (valuation risks), including material conflicts of interest, and managing identified valuation risks
  • Establishing and applying fair value methodologies, considering the fund’s valuation risks
  • Testing the appropriateness and accuracy of fair value methodologies selected, including identifying testing methods and minimum frequency for their use
  • Overseeing pricing services, if used

OCIE observations: Investment advisor compliance programs

On November 19, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a risk alert providing an overview‡ of compliance issues they identified related to the Investment Advisers Act of 1940 Rule 206(4)-7 (Compliance Rule).

The risk alert outlines examples of compliance rule deficiencies and weaknesses:

  • Inadequate compliance resources
  • Insufficient authority of chief compliance officers (CCOs)
  • Annual review deficiencies
  • Implementing actions required by written policies and procedures
  • Maintaining accurate and complete information in policies and procedures
  • Maintaining or establishing reasonably designed written policies and procedures

SEC adopts new investment advisor marketing rule

On December 22, 2020, the SEC announced that it had finalized reforms under the Investment Advisers Act of 1940‡ to modernize rules that govern investment adviser marketing and payments to solicitors.

Why it matters:

The new rule replaces Rule 206(4)-1 (advertising) and Rule 206(4)-3 (solicitation) with a single Marketing Rule. The Marketing Rule includes:

  • Definition of advertisement
  • General prohibitions
  • Requirements for the use of testimonials and endorsements
  • Requirements for the use of third-party ratings
  • Framework for the performance advertisements

In connection with the adoption of the Marketing Rule, the SEC has also adopted amendments to both the books and records rule and Form ADV. In addition, the SEC has withdrawn no-action letters and other guidance addressing the application of advertising and solicitation rules as such guidance has either been incorporated into the Marketing Rule, or no longer apply. The SEC has set the compliance date to be 18 months after the effective date, which is 60 days after the Marketing Rule’s publication in the federal register.

DOL finalizes ESG rule

On October 30, 2020, the U.S. Department of Labor (DOL) announced a final rule that updates its investment duties regulation to require that Employee Retirement Income and Security Act (ERISA) plan fiduciaries select investments based on pecuniary factors rather than other, nonpecuniary goals or policy objectives.

Though originally proposed to clarify the DOL’s position regarding environmental, social and government (ESG) investments in ERISA plans, the final rule does not explicitly reference ESG or ESG-themed funds.

Why it matters:

The DOL stated that it “expects the final rule will result in higher returns by preventing fiduciaries from selecting investments based on non-pecuniary considerations and requiring them to base investment decisions on financial factors.” The final rule became effective January 12, 2021 with a compliance date of April 30, 2022.

SEC issues ADI for risk disclosure for funds investing in emerging markets

On December 16, 2020, the SEC’s Division of Investment Management’s Disclosure Review and Accounting Office released an Accounting and Disclosure Information (ADI) aimed a risk disclosure by registered funds regarding investments in emerging markets.

Why it matters:

Noting that significantly less information about public companies may be available in emerging markets, the ADI encourages funds to consider the following factors when drafting risk disclosures:

  • Risks related to, but not limited to, lack of liquidity, market manipulation concerns, limited reliable access to capital, political risk, and foreign investment structures
  • Whether and how emerging markets risks arising from differences in regulatory, accounting, auditing, and financial reporting and recordkeeping standards could impede an adviser’s ability to evaluate local companies or impact the fund’s performance
  • Any limitations on the rights and remedies available to the fund, individually or in combination with other shareholders, against portfolio companies
  • If an index fund, whether the index provider will have less reliable or current information—e.g., due to issues associated with the regulatory, accounting, auditing, and financial reporting and recordkeeping standards in the relevant emerging market—when assessing if a company should be included in an index or determining a company’s weighting within the index
  • If an index fund, any limitations concerning the adviser’s ability to assess the index provider’s due diligence process over index data prior to its use in index computation, construction and/or rebalancing; and
  • Whether the limitations stated above could impact the stated investment objective of the fund.

The ADI also notes that certain jurisdictions do not currently provide the Public Company Accounting Oversight Board (PCAOB) with sufficient access to inspect audit work papers and practices, or otherwise do not cooperate with U.S. regulators, which may expose investors in U.S. capital markets to significant risks.

DOL issues final version of fiduciary rule

On December 15, 2020, the U.S. Department of Labor (DOL) issued the final version of its fiduciary rule‡ to regulate “investment advice fiduciaries” under the Employee Retirement Income Security Act of 1974, as amended (ERISA).

Why it matters:

The final rule is very similar to the version proposed in the summer of 2020 and officially confirms the reinstatement of the five-part test for determining whether a person renders investment advice for purposes of ERISA. The rule also creates a new prohibited transaction class exemption for investment advice fiduciaries that is based on the “impartial conduct standards,” which were previously adopted as a temporary policy during the rulemaking process.

The DOL stated that the rule is meant to complement the SEC’s Best Interest rule, which was finalized last June. The rule will become effective on February 16, 2021.

SEC adopts rules to improve exempt offering framework

On November 2, 2020, SEC amended certain rules in order to harmonize, simplify, and improve the multilayer and overly complex exempt offering framework. The rule amendments are intended to promote “capital formation and expand investment opportunities while preserving or improving important investor protections.”

Why it matters:

The amendments generally:

  • Establish more clearly the ability of issuers to move from one exemption to another;
  • Increase the offering limits for Regulation A, Regulation Crowdfunding, and Rule 504 offerings, and revise certain individual investment limits
  • Set clear and consistent rules governing certain offering communications, including permitting certain “test-the-waters” and “demo day” activities
  • Harmonize certain disclosure and eligibility requirements and bad actor disqualification provisions.

A more in depth description of the amendments can in the SEC’s news release‡.

CFTC amends Form CPO-PQR

On October 6, 2020, the Commodity Futures Trading Commission (CFTC) approved a final rule adopting amendments to Form CPO-PQR for commodity pool operators (CPOs).

Why it matters:

The amendments to Form CPO-PQR:

  • Eliminate existing Schedules B and C of the form, except for the Pool Schedule of Investments
  • Amend the information requirements and instructions to request Legal Entity Identifiers (LEIs) for commodity pool operators and their operated pools that have them, and to delete questions regarding pool auditors and marketers
  • Make certain other changes due to the rescission of Schedules B and C, including the elimination of all existing reporting thresholds.

The final rule also amends CFTC Regulation 4.27 to permit reporting CPOs to file NFA Form PQR, a comparable form required by the National Futures Association, in lieu of filing the CFTC’s revised form. The rulemaking also eliminates substituted compliance with Form CPO-PQR filing requirements via the CFTC’s and the SEC’s Joint Form PF.

In addition to updating the instructions to the revised Form CPO-PQR, the Commission has directed the staff to publish frequently asked questions to assist CPOs required to complete and file the revised Form CPO-PQR. The amendments became effective on December 10, 2020 and are available at federalregister.gov‡.

SEC adopts new fund of fund rules 

On October 7, 2020, the SEC voted to adopt a new rule and certain other rule amendments to update the regulatory framework governing fund of fund arrangements. Currently, Section 12(d)(1)(A) creates certain prohibitions, known as the “3/5/10 Rule,” to regulate registered investment companies’ acquisition of shares of another investment company.

Why it matters:

The newly adopted rule, Rule 12d1-4, will permit an investment company to acquire shares of another investment company in excess of the current limits provided conditions of the new framework are met.

While the new rule permits registered investment companies to act as both acquiring and acquired funds, it does not expand an unregistered investment company’s ability to acquire shares of registered investment companies. Though Rule 12d1-4 expands investment companies’ abilities to engage in fund of fund arrangements, it also imposes enhanced conditions on such companies. It is important for investment companies to work with their legal counsel to interpret the impact of the new regulatory framework.

The rule becomes effective 60 days after publication into the Federal Registrar, but the SEC extended the compliance date to late 2022 to facilitate a smooth transition. The SEC press release regarding the Fund of Fund Rules can be found here‡.

SEC adopts final amendments to auditor independence rule 

On October 16, 2020, the SEC announced it adopted final amendments to rules relating to auditor independence‡.

Why it matters:

The amendments were meant to modernize the rules by focusing on preventing scenarios that are most likely to create independence issues and harm shareholders. Among other things, the amendments:

  • Shorten the audit look back period for certain audit engagements
  • Amend the definitions surrounding affiliates and investment company complex to focus on material relationships
  • Add certain loan types – including student loans and de minimis consumer loans – to the exclusion list for the so-called “loan rule”

The amendments will take effect 180 days after publication into the Federal Registrar, but firms are able to voluntary comply with the amendments if they comply in full at that time.

IRS issues additional guidance on transition from LIBOR

The U.S. Department of the Treasury and Internal Revenue Service (IRS) have issued Revenue Procedure 2020-44‡ to facilitate the market’s transition from the London Interbank Offered Rate (LIBOR) and other interbank offered rated (IBORs) to alternative rates through adoption of fallback language recommended by the Alternative Reference Rates Committee (ARRC) and the International Swaps and Derivatives Association (ISDA).

Why it matters:

In support of the ARRC’s phased transition plan to assist market participants as they prepare for this transition away from IBORs, this revenue procedure provides that certain modifications to a contract with terms referencing an IBOR will not be treated as an exchange of property for other property differing materially in kind or extent for purposes of § 1.1001-1(a) of the Income Tax Regulations. In addition, this revenue procedure provides that such modifications will not be treated as legging out of an integrated transaction, a termination of a qualified hedge, or as a disposition or termination of either leg of a hedging transaction.

This revenue procedure is effective for modifications to contracts occurring on or after October 9, 2020, and before January 1, 2023. A taxpayer, however, may rely on this revenue procedure for modifications to contracts occurring before October 9, 2020.

FASB ASU addresses premium amortization for callable debt securities with multiple call dates

The Financial Accounting Standards Board (FASB) released an Accounting Standards Update (ASU) No. 2020-08, Codification Improvements to Subtopic 310-20, Receivables-Nonrefundable Fees and Other Costs‡, that addresses premium amortization for callable debt securities with multiple call dates.

In 2017, FASB released ASU No. 2017-08, Premium Amortization on Purchased Callable Debt Securities, that required callable debt securities purchased at a premium to be amortized to the earliest call date, rather than the ultimate maturity date.

Why it matters:

ASU No. 2020-8 amendments clarify that an entity should reevaluate whether a callable debt security that has multiple call dates is within the scope of its guidance for each reporting period. For each reporting period, to the extent that the amortized cost basis of an individual callable debt security exceeds the amount repayable by the issuer at the next call date, the excess (that is, the premium) shall be amortized to the next call date, unless the guidance is applied to consider estimated prepayments.

UMB Fund Services takes the FASB ASU into consideration in its application of amortizing premium on debt securities with multiple call dates.

IRS issues final guidance on PFICs

The IRS released passive foreign investment company (PFIC) final‡ and proposed‡ regulations on December 4, 2020. The final regulations finalize the proposed regulations issued in 2019  and retain the basic approach and structure of the 2019 proposed regulations, with certain revisions.

Why it matters:

The current proposed regulations address the determination of whether a foreign corporation is treated as a PFIC. The current proposed regulations also provide guidance regarding the treatment of income and assets of a qualifying insurance corporation (QIC) that is engaged in the active conduct of an insurance business (PFIC insurance exception). The current proposed regulations also address the treatment of qualified improvement property (QIP) under the alternative depreciation system (ADS) for purposes of calculating qualified business asset investment (QBAI) for purposes of the global intangible low-taxed income (GILTI) and the foreign-derived intangible income (FDII) provisions.

UMB Fund Services uses a third party to provide PFIC analysis and identification that takes into consideration the final and proposed regulations.

UMB Fund Services is a national leader with decades of experience in registered and alternative investment fund servicing. Visit our website to learn how UMB Fund Services can support your firm, or contact us to be connected with a fund services team member.


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When you click links marked with the “‡” symbol, you will leave UMB’s Web site and go to Web sites that are not controlled by or affiliated with UMB. We have provided these links for your convenience. However, we do not endorse or guarantee any products or services you may view on other sites. Other Web sites may not follow the same privacy policies and security procedures that UMB does, so please review their policies and procedures carefully.