Each quarter the UMB Fund Services registered fund accounting, administration and tax teams consolidate the most impactful regulatory and tax developments in the registered 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.

Securities Exchange Commission (SEC) charges advisors for custody rule violations

On September 9, 2022, the SEC announced‡ that it charged nine firms for violations relating to failure to comply with requirements regarding safekeeping of customer accounts and/or failure to update SEC disclosures relating to audits and financial statements for their private funds.

The announcement also indicated that the firms had agreed to pay total charges of more than $1 million across the nine firms. The SEC noted that the firms had failed to have audits performed, or to deliver audited financials to investors, for their provided funds, resulting in violations of Rule 206(4)-2 of the Investment Advisers Act of 1940 (the Custody Rule). Some of the firms also failed to amend their Form ADV promptly to reflect that audited financial reports had been received or to properly describe the status of its financial statement audits.

Why it matters:

The Custody Rule charges arose out of the SEC’s targeted sweep examination earlier in 2022 that targeted private fund firms. Such firms should take note of the SEC’s focus on private fund advisors, especially their practices regarding the safety and security of client assets and updating filings on a timely basis.

SEC charges investment adviser with violations with respect to proxy voting

In September 2022, the SEC charged Toews Corporation‡ with violations of the Investment Advisers Act of 1940 with respect to its proxy voting practices. The violations stem from statements made in the investment adviser’s Form ADV brochures, which implied that Toews would evaluate each proxy prior to voting consistent with its fiduciary duty to shareholders.

However, in practice, the SEC found that Toews had issued a standing instruction to a third-party service provider to always vote proxies in favor of management proposals and against shareholder proposals. The SEC also found that Toews had not reviewed any proxy materials for the relevant shareholder meetings or reviewed whether the votes were being cast in the funds’ best interests.

Why it matters

Investment advisers and boards of regulated funds should review their existing proxy voting disclosures and compliance policies and procedures to ensure they are consistent with the SEC’s publicized statements and expectations relating to an adviser’s proxy voting obligations under Section 206 of the Advisers Act and the Proxy Rule.

Several firms sued over the use of voice print technology

In September 2022, separate class action lawsuits were filed against several financial firms, including Fidelity Brokerage Services, TD Ameritrade, TD Bank and Capital One (collectively, the Firms), alleging that the privacy rights of customers were violated by the Firms’ use of voice print technology. The plaintiffs, who are California-based customers of the Firms, allege that the Firms violated the California Invasion of Privacy Act (CIPA) by using biometric voice print technology to verify customer identities without first obtaining express written consent from customers regarding the use of such biometric data.

Why it matters:

Privacy laws have proliferated across states in recent years, with many new or planned laws including restrictions on the manner in which biometric data may be used. These laws typically require that customers consent to the use of their biometric data for specific purposes, and often provide for statutory damages for a firm’s failure to obtain such consent or the use of biometric data in a manner not authorized by the consent. For example, CIPA allows customers to recover the greater of a customer’s actual damages or $1,000 for each violation.

Active Financing Income Exception may no longer be available now that final Passive Foreign Investment Companies (PFIC) Regulations are in effect

The active financing income exception is no longer available to certain non-bank foreign finance corporations.

Why it matters:

The final PFIC regulations‡ that affect the active financing income exception are now in effect for all taxpayers. The final regulations replace the rule that was in the 2019 proposed regulations that excepted income received in the conduct of an active financing trade or business from PFIC testing and replaced it with a rule that limits the type of financing entities eligible for the exception. Under the final regulations, only entities licensed as banks are eligible for the active financing trade or business exception to PFIC testing. Nonbank foreign finance companies may now be considered PFICs.

SEC starts looking at board approach to derivative rules

The Securities and Exchange Commission began examining fund compliance with the derivatives rule in September 2022. In information requests, the SEC requested:

  • Meeting minutes or draft meeting minutes for every board meeting “that related to any aspect of the program” between Feb. 28, 2021 and Aug. 31, 2022.
  • Materials and written reports provided to the board that addressed the operation of the program, including material connected to directors’ approval of the designation of the derivatives risk manager; the programs management, stress- and back-testing; the fund’s non-compliance with any VaR tests.
  • Material and written reports provided to the board about limited derivatives users, written reports to the board when the fund’s derivatives exposure exceeded 10% of net assets for more than five days.
  • The report submitted to the board no less than annually by the derivatives risk manager “that addresses the operation of the program and assesses its adequacy and effectiveness of its implementation, including the derivatives risk manager’s basis for the designated reference portfolio.”

Why it matters:

The SEC’s 2020 Rule 18f-4 allows mutual funds, exchange-traded funds, and certain other products to conduct derivatives transactions that Section 18 previously forbade unless the registrant obtained an exemptive order or other relief. Among other things, it requires fund directors to approve the designation of a derivatives risk manager to administer a fund derivatives risk management program and oversee both.

Funds and fund boards should expect to see similar items on future examinations.

Deloitte’s 20th fair valuation survey

Deloitte conducts and publishes an annual survey of industry valuation practices‡.

Why it matters:

The industry has been busy adopting new policies and procedures to the new 2a-5 Valuation Rule. Some of the key findings include making changes from current practices as it related to board reporting, risk assessment procedures, periodic testing procedures, assessment of third-party providers and recordkeeping. To date there is no clear evidence that funds will make changes to their valuations because of the new Rule. However, most are expecting that board reporting will become more important along with providing back-testing results, price challenge results, use of secondary sources and internally fair-valued securities.

The survey identified a difference of opinion on what is material change requiring prompt board reporting.

  • 55% are using the penny per share
  • 24% using a reprocessing threshold
  • 7% a reasonable person standard
  • 14% some other standard

Other findings include 53% of survey participants are only conducting due diligence visits of pricing vendors virtually, while 45% indicated that they will conduct some virtually and some in-person depending on the pricing vendor. Sixty-two percent of fair-valuation survey participants reported using a zero trigger to determine when to adjust the prices of fair value equities that trade on foreign exchanges closing before 4 p.m. ET, compared with 61% last year. Finally, 59% of fair-valuation survey participants use bid pricing exclusively when valuing fixed-income securities, nearly unchanged from the prior year, and 31% use mean pricing.

SEC staff issues guidance on treasury inflation-protected securities (TIPS) in computing SEC Yields

The staff of the SEC’s Division of Investment Management recently issued guidance on computing standardized yield (SEC Yield) for registered investment companies that invest significantly in TIPS funds.

Why it matters:

The staff noted that, while the SEC sets forth methodologies to compute SEC Yields, the methodologies do not address TIPS inflation adjustments and some TIPS funds appear to exclude the inflation adjustment to principal from the yield calculation. Others appear to include the adjustment as income for purposes of the yield calculation.

The guidance indicates that both approaches are consistent with the methodologies to compute SEC Yield, and that TIPS funds should evaluate which methodology is most appropriate for investors. It adds that TIPS funds that include the inflation adjustment as income may need to add disclosure during periods of rapidly changing inflation. This is because the SEC Yield calculation looks back only 30 days and is annualized and, thus, may cause the SEC Yield to be exceptionally high and unlikely to be repeated. In these circumstances, the staff believes TIPS funds should explain to investors that the 30-day inflation adjustment may cause these results and that such disclosure should be tailored to the circumstances and current market conditions.

Alternatively, the staff states that it would not object if, instead of including the inflation adjustment over the prior 30-day period and annualizing it, a TIPS fund uses an inflation adjustment over the prior 12-month period to reduce the volatility of the SEC Yield from month to month.

Click here to review the Summer 2022 – Regulatory lookback: Registered funds regulatory and tax insights.

Learn more about UMB can support your firm’s registered and alternative investment fund administration needs, or contact us to be connected with a fund services team member.

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