To say that 2022 was jam packed with jaw dropping news when it came to compliance related regulatory updates would not be overly hyperbolic. Investment managers, and private fund managers in particular, appeared to be one of the main targets in the SEC’s crosshairs this year, as regulators filed 760 enforcement actions and recovered a record $6.4 billion in penalties and disgorgement, making 2022 a year of record highs.
Complicating things further for private fund managers in 2022 were the hoops they had to jump through to ensure their compliance programs were prepared for the SEC’s stringent regulatory updates, especially in light of the New Marketing Rule under the Advisers Act, and an increased focus on the retention of electronic communications. But what did not happen, unfortunately, was any official guidance from the SEC, or other regulatory bodies, such as the CFTC, on the issue of what exactly are crypto/digital assets. Are these assets securities? Are they commodities? Are they a form of currency? A growing number of managers yearn to have clarity on these questions so they can stay on the right side of the law.
While there were many other interesting trigger points this year, we would like to provide our insights on the following three critical compliance-related updates that we think private fund managers, and investment advisers overall, should focus on as they prepare and plan for 2023 regulatory filings.
- New Marketing Rule – It is all about Performance and Substantiation
On November 4, 2022, the New Marketing Rule came into full effect, which modernized the existing Marketing and Advertising Rule (Rule 206(4)-1 under the Advisers Act). To read about the impact of the New Marketing Rule on ESG practices, please refer to the year-end piece compiled by Silver’s ESG team here.
Overall, this updated language was a godsend for private fund managers, as it essentially codifies best practices, and an untidy patchwork of No-Action Letters and often incongruent enforcement actions, that many investment advisers have already been following (or maybe, put more accurately, trying their best to interpret and follow). However, the New Marketing Rule may also pose fresh pitfalls for investment managers caught unprepared for the Rule’s new requirements.
There are different approaches to complying with this rule and we would recommend that, depending on your strategy and the use of information and wording in marketing materials (such as performance), those materials should be reviewed carefully and determined on a case-by-case basis on the applicability of the New Marketing Rule. That said, there are two categories that stand out as top priorities for private fund managers: performance and substantiation.
- Performance – The New Marketing Rule has codified SEC No-Action Letters and enforcement actions on how investment advisers should present performance in their marketing materials. Essentially, if a manager presents any fund level performance in a gross format, that performance also must be presented net of fees and expenses. Silver takes the view that certain position level performance, such as individual underlying portfolio company performance, need not be presented net of fees and expenses, so long as the overall fund level performance is presented net.
- Substantiation – Another important update in this revised regulation is the issue of record retention regarding the substantiation of claims made in marketing materials. This can be challenging because, even though there may be instances in which advisers do not necessarily have to explicitly cite a third party or source for something noted in a marketing presentation, advisers must be prepared to substantiate claims and statements in their marketing materials, which very often leads to retaining that supporting documentation.
To be clear: citing a source for a data point mentioned in marketing materials is still very necessary and may fall under the umbrella of substantiation. But the important point in this update to remember is that very often the emphasis of the original Marketing and Advertising Rule was strictly on requiring the citation of sources for data points included in marketing presentations. This updated regulation makes it clear that now it is also very important to substantiate claims and statements that typically do not require a traditional source citation, such as using “pioneer” or “leader” to describe the business; therefore, advisers need to retain support for such claims.
In addition to ensuring compliance with the New Marketing Rule, advisers must remember to evaluate their marketing activities, marketing documents and the procedures related to marketing through the lens of the Anti-Fraud provisions of the Advisers Act as well, which also applies to Exempt Reporting Advisers.
Overall, it is a complex issue that requires review, diligence and analysis to ensure that managers are meeting the SEC’s scrutiny and standards as prescribed by the New Marketing Rule. This is a great opportunity and reminder for managers to review due diligence materials to ensure they are updated in accordance to the New Marketing Rule. Managers should ask themselves whether their DDQs comply with the New Marketing Rule; if the DDQs have the requisite disclosures prescribed by the rule; and are the DDQs aligned with investment manager’s current governing documents of their offerings. Most importantly, make sure the DDQs can substantiate how the manager is describing their business and, in particular, their investment process.
- Record Retention of Electronic Communications – What’s New and What to Avoid
Throughout 2022, Silver has spent a good deal of time digging into the important topic of record retention and for good reason: it remains a very critical item of consideration given the SEC’s continued focus on retaining electronic communications.
As previously stated, 2022 saw record-breaking enforcement actions, along with hefty fines and penalties, which highlighted both individual and firm-level accountability. The most relevant and important of those enforcement actions to learn from and keep in mind include the following:
- JP Morgan – JP Morgan Securities LLC (JPMS) agreed to pay the SEC a $125 million penalty for “widespread and longstanding failures by the firm and its employees to maintain and preserve written communications” on mobile devices, messaging apps and personal emails, coupled with a $75 million fine to the CFTC. JPMS also agreed to implement “robust improvements to its compliance policies and procedures to settle the matter.” The SEC issued a press release about the matter, explicitly stating that recordkeeping remains a top priority for the Commission and that this will not be the last investigation that the SEC undertakes during its crackdown of Wall Street firms under the Biden Administration.
- WhatsApp – Apollo Global Management Inc., Carlyle Group Inc. and KKR & Co. said in regulatory filings in early November 2022 that they received letters from the SEC on their use of electronic messaging for business. This indicates that financial Watchdogs are looking at the biggest private equity firms’ use of WhatsApp and other messaging apps for work, in a signal that the US is ramping up its push to police Wall Street’s electronic communications.
- Big Banks – The SEC announced settlements with 16 broker-dealers (11 firms and 5 affiliates) after each was charged with violating recordkeeping requirements and with failing reasonably to supervise employees with a view to preventing and detecting such violations. Essentially, the SEC found that the firms’ employees, including supervisors and senior executives, routinely communicated about business matters using various text messaging applications on their personal devices with the substantial majority of these communications not being preserved.
The aforementioned matters are important because it illustrates that advisers should prepare for rules to be interpreted broadly by both the examination and enforcement staff. To keep investment managers above board when it comes to staying compliant with retaining records, Silver recommends following the below practical steps to mitigate risk:
- Review Policies: Advisers should undertake a review of their existing policies and procedures to understand what is allowed and what is prohibited to ensure the firm’s current practices are compliant.
- Employee Awareness: Advisers should take proactive steps to heighten employee awareness of the risks associated with off-channel communications, such as distributing alerts, hosting topical trainings and requiring employees to routinely attest to their compliance of the firm’s electronic communications policy.
- Surveillance: In conducting reviews of employee emails, advisers should include indicators of off-channel communications by searching, at a minimum, for terms such as “WhatsApp” or phrases like “take offline.”
- Identify and Address Violations: Advisers should be actively working to identify violations rather than ignoring red flags, especially for employees with repeat violations.
The increased scrutiny behind record retention practices and policies is vital to investment advisers and it is especially important for crypto and digital asset managers, given they are typically and predominately using less traditional types of communications (like Telgram, Signal and Slack), which segues into the last compliance update – the world of crypto/digital assets.
- Crypto – The Heat is on Following the Collapse of FTX
In the SEC’s Fiscal Year 2023 Report on Objectives, the crypto/digital asset space took up a lot of air time given the overall tumult in the space. As a result, managers are trying to guess if the digital assets they are trading are securities, in light of the lack of current guidance by regulators.
Given the SEC’s likely heightened examination and investigation of crypto/digital asset managers in the year ahead, Silver believes the following issues are the most crucial for investment managers to keep in mind leading into 2023:
- Custody requirements – Due to the FTX collapse and subsequent bankruptcies from crypto companies like BlockFi, the issue of custody has been a major point of discussion among industry players. Given the lack of regulatory framework from the SEC at this point in time around critical issues surrounding custody of crypto and digital assets, such as the qualifications of a qualified custodian of these assets, Silver recommends a less traditional approach for crypto and digital asset managers to comply with the Custody Rule: self-custody crypto and digital assets, noting that certain existing crypto exchanges can certainly meet the standards of a traditional qualified custodian; however for those crypto and digital assets that are completely decentralized or for which a manager believes the security of those assets is better held in a known proprietary protocol, self-custody can adhere to the spirit of the Custody Rule. But this approach can change as more guidance gets delivered from the regulators. The issue of custody is an important one across the board. For example, institutional investors must review a variety of factors when they are looking to invest with crypto managers, with one vital factor being where and how those managers custody their funds’ crypto and digital assets. Additionally, for all advisers, irrespective of their registration status, the regulators will apply the Custody Rule to ensure that these assets are secure and readily available pursuant to a manager’s liquidity demands. Therefore, it is essential for managers incorporating crypto and digital assets into their portfolio to consider the current benefits of self-custodying these assets.
- Due diligence of service providers – Counterparties are a common challenge throughout the industry. Silver consistently receives the question of what kind of due diligence should be conducted on counterparties in the crypto space. This issue is now more important than ever because of the proposed SEC rule of due diligence of service providers. This is a requirement that, if enacted, could impact advisers in their obligations to conduct due diligence on their key critical service providers, including digital asset management software providers, digital asset custodians, digital asset exchanges and cryptocurrency fund administrators. Remember: crypto represents a new asset class in an established asset management space. A fund manager investing in crypto or digital assets should conduct the same level of diligence on its critical service providers as a manager investing in a traditional asset class, like equities. Dig deep and if red flags are uncovered, do not hesitate to dig deeper. If something does not pass the smell there is most likely an issue worth investigating.
- Record retention – Crypto managers often use non-traditional means to execute their investment strategies, so they need to figure out how to adhere to the overall record retention requirements as it relates to all aspects of their business. The SEC expects the books and records of all registered investment advisers, regardless of their strategy, to meet the standards provided under the Books and Records Rule of the Advisers Act. The records of crypto managers may not conform to these requirements (e.g., transactional activities on the blockchain may not look like a traditional “trade blotter”), therefore Silver encourages crypto managers take time to ensure that they have documentation to support their investment activities and that these documents can meet the expectation of the regulators.
The bottom line is that there is a separation between the requirements of various asset classes of investment advisers, and seemingly, for crypto managers specifically. Regulators and managers alike are dealing in an asset class that has yet to be classified as a security, which puts managers behind their peers from a regulatory perspective. This is a huge issue because, just like their peers, many private fund crypto managers are SEC registered investment advisers and they have the same fiduciary duties and obligations as other investment advisers. Yet, there are so many unknowns in terms of what’s next from a regulatory standpoint.
As the calendar turns into 2023, Silver encourages all investment managers to take the opportunity to review their current compliance policies and procedures, with particular attention paid to the above-mentioned areas of focus, as they will continue to be top priorities for regulators in the New Year and beyond.
Investment advisers should also be keeping an eye on other issues, such as the enhanced requirements to Form ADV; the growing importance of due diligence with regard to counterparty service providers; and new developments with respect to marketing. Silver will be covering those topics in our “Top Compliance Trends to Watch in 2023” article coming soon. Watch this space for more insights in the New Year.