The staff of the U.S. Securities and Exchange Commission’s (“SEC”) Division of Examinations (the “Division”) recently published a risk alert spotlighting observations from its “RIC Initiatives” — 200+ examinations of mutual funds and ETFs and nearly 100 investment advisers between 2018 and 2019. The RIC Initiative sought to answer three questions:
- How robust are funds’ and advisers’ policies, procedures, and internal controls to address certain risks related to disclosures, portfolio management, conflicts of interest, and the efficacy of the oversight of funds’ compliance programs by fund boards?
- How well are these risks disclosed?
- In the case of funds, how robust are their compliance programs related to these risks?
The risk alert highlighted a number of frequently cited deficiencies or weaknesses, painting a broad picture of the Division’s observations of industry trends of where funds and advisers can improve with respect to compliance, while at the same time providing a peek into the Division’s evergreen focus areas (more on that below). The list of deficiencies and weaknesses (which spanned five of the risk alert’s eight-and-a-half pages) covered many, if not most, of the key areas of mutual fund and adviser compliance obligations, showing that the scope of Division examinations can be wide-ranging and suggesting that funds and their advisers should review their policies, practices, and procedures over the entire range of mutual fund and adviser operations and compliance functions. The Division staff noted that the risk alert is intended to “highlight risk areas and assist funds and their advisers in developing and enhancing their compliance programs and practices.”
The staff found that funds’ and advisers’ compliance programs did not include adequate policies and procedures in several areas of compliance oversight, including:
- Investments and portfolios;
- Valuation (including third-party service providers);
- Trading practices;
- Conflicts of interest;
- Fees and expenses;
- Fund advertisements and sales literature; and
- Board oversight of fund compliance programs.
Disclosures to Investors
The staff also identified inadequate disclosures to investors in filings to the SEC, advertising and marketing materials, and other communications, including disclosures related to:
- Certain principal investment strategies or risks;
- Potential conflicts associated with allocating investment opportunities among overlapping investment strategies (such as a mutual fund and a private fund with similar strategies, managed by the same portfolio manager);
- Change in a comparative index;
- A fund’s net assets, net expense ratios, contractual expense limitations and/or operating expenses subject to the contractual expense limitation;
- In the case of funds, statements of additional information (“SAIs”) concerning the number of accounts and total assets managed by the portfolio managers within each of the required categories;
- Investment strategies and portfolio holdings;
- Differences in investment objectives between predecessor and successor funds;
- Inception dates;
- Methodologies for calculating the performance of a comparative benchmark; and
- Differences between a broad-based and bespoke index.
The good news is that the Division staff offers a general roadmap in the risk alert regarding steps funds and advisers can take to improve, including:
- Review policies and procedures to ensure that they cover the various risk areas — whether they are related to addressing risks or disclosing risks to investors;
- For fund boards, assess whether policies and procedures allow for adequate testing of advisers’ reports for accuracy related to (1) fees, expenses, and performance, and (2) investment strategies, including any changes and risks to such strategies;
- Test these policies and procedures to make sure that they work, and allow for an opportunity to improve them; and
- Review filings to the SEC and any other documents sent to investors, including prospectuses, SAIs, and shareholder reports to ensure that these risks are sufficiently disclosed.
There is an overarching (yet unstated) takeaway woven throughout these highlighted areas, which is that, as part of funds and advisers adopting and implementing these measures, they should show their work. Maintaining fulsome policies, documentation describing any reviews performed, and any applicable changes implemented from these reviews, will show examiners that funds and advisers have effective, “full circle” compliance programs.
Finally, the Division staff’s evergreen focus areas are not without evolution. The Division staff has implemented significant changes since 2019 — so too should funds and advisers, including by:
- Incorporating the SEC’s new Marketing Rule into ongoing compliance, disclosure, and recordkeeping processes;
- Being mindful of the Division of Enforcement’s newly energized focus on books and records compliance, including by evidencing testing in this area; and
- Understanding the use and nature of any digital engagement practices or “DEPs” and ensuring that conflicts and disclosures are reasonably and appropriately addressed.
The risk alert serves as a reminder of the critical importance of compliance and the need to continually review and refresh compliance programs to keep pace with new and legacy requirements alike as well as the evolving expectations of regulators. Funds and advisers should ensure that their compliance programs sufficiently address, at a minimum, the areas highlighted in the risk alert, as applicable to their operations.