As we and the rest of the industry awaits the U.S. Securities and Exchange Commission’s (“SEC”) annual examination priorities in the first quarter of 2023, firms contemplate the transformations and evolution of their business strategies for 2023 –asking “What do we need to be thinking about?” and “What needs to change?”.
Throughout 2022 the SEC’s Division of Examinations (“EXAMS”) routinely provided guidance and insight to important areas through their issued Risk Alerts.
Risk Alerts provide tremendous insight into the most common examination deficiencies found in a particular area, as well as best practices observed from the SEC staff during its recent examinations. Notably, the highlighted deficiencies within the Risk Alerts have become a prominent pain point for firms throughout the examination process.
Risk Alerts often serve as a call to action for firms to address and strengthen their policies and procedures. Risk Alerts also provide timely and relevant information as a way of helping firms mitigate their regulatory, operational, and regulatory risks and advance their compliance efforts. Moreover, they can help your firm prepare for its next SEC examination.
In this month’s Risk Management Tip, we will explore three prominent Risk Alerts of 2022 relating to use of “hedge clauses” by advisers, compliance issues related to an adviser’s code of ethics, and the New Marketing Rule.
The Risk Alert dated January 27, 2022, gave insight into the SEC’s view of an adviser’s duty of care and duty of loyalty through the Division of Examinations’ Risk Alert dated January 27, 2022. Although the Risk Alert specifically addressed advisers of private funds, the insight received can be and likely should be widely applied to most if not all investment advisers. One specifically interesting area that the Risk Alert addressed was the use of “hedge clauses” in agreements and disclosure documents provided to investors.
An Adviser must always uphold their fiduciary duties, these duties cannot be waived and are fully enforceable through section 206 of the Advisers Act. An adviser’s fiduciary duties includes providing disclosures to clients that are full and fair, and not misleading to clients. Through this Risk Alert and over the course of this year the industry has seen a shift in SEC treatment of hedge clauses. We have seen the SEC take a clear stance and warn that any clause that purports to waive an adviser’s fiduciary duties, or is drafted in such a way that is likely to mislead clients in to believing that after consenting to the agreement they would have no legal recourse against an adviser for any cause of action outside of certain express exceptions (such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud) is likely in violation of Section 206 of the Advisers Act.
In the wake of this Risk Alert the industry has taken a closer look at their advisory agreements to either remove provisions that could be reasonably construed as a “hedge clause” or to revise them to maintain certain legal protections but not be misleading to clients.
Code of Ethics
The Risk Alert dated April 26, 2022, in part, was to provide investment advisers, investors, and other market participants with information concerning notable deficiencies that the staff has cited related to Rule 204A-1 (the “Code of Ethics Rule”). The Code of Ethics Rule requires advisers to adopt a “code of ethics” that sets forth, among other things, the standard(s) of business conduct expected from the adviser’s “supervised persons.” Supervised persons include employees, officers, partners, directors and other persons who provide advice on behalf of the adviser and are subject to the adviser’s supervision and control. These written policies and procedures and included code of ethics would require certain supervised persons deemed as “access persons” to report their personal securities transactions and holdings to the adviser’s chief compliance officer (“CCO”) or other designated persons.
The Risk Alert noted some key deficiencies identified by EXAMS staff:
A. Identification of access persons
EXAMS staff observed that advisers Code of Ethics did define “access person” or accurately reflect which employees are considered access persons. Additionally, advisers did not identify and supervise certain employees as access persons in accordance with the Code of Ethics Rule.
B. Access persons did not obtain required pre-approval for certain investments
EXAMS staff observed adviser access persons purchase ownership in initial public offerings and limited offerings without requisite pre-approval. Additionally, EXAMS observed that advisers did not include a provision in their code of ethics requiring access persons to obtain pre-approval before directly or indirectly acquiring any interests in an initial public offering or limited offering.
C. Personal Securities Transactions and Holdings
EXAMS observed instances where advisers could not produce records of supervisory review of access persons holdings and transactions and where their policies and procedures did not include a framework assigning the CCO’s reporting to another member of the adviser – effectively permitting the CCO to self-review his/her own holding and transaction reports.
EXAMS also noted instances where the holdings and/or transaction reports were not submitted by access persons, the adviser’s code of ethics did not include provisions requiring access persons to submit reports, or the reports were not submitted within the timeframes reflected in the Code of Ethics Rule.
D. Written acknowledgement of receipt of the code and any amendments
It is important to acknowledge that the Risk Alert calls attention to instances where observed instances where supervised persons were not provided with a copy of the code of ethics or did not provide written acknowledgement of their receipt of the code of ethics to the adviser.
The New Marketing Rule
In the EXAMS Risk Alert dated September 19, 2022, EXAMS called attention to the new marketing rule for advisers. On December 22, 2020, the SEC adopted amendments to Rule 206(4)-1 under the Investment Advisers Act of 1940 (“Advisers Act”) to modernize rules that govern the adviser’s marketing efforts and payments to solicitors. With a compliance date of November 4, 2022, any advertisements disseminated on or after the November 4, 2022 are subject to the new Marketing Rule standards.
Specifically, this Risk Alert called attention for the need of advisers to review and possibly revise their written policies and procedures to ensure they are reasonably designed to prevent violations of the New Marketing Rule by the advisers and their supervised persons. Similarly, the Risk Alert highlighted the need for advisers to “to make and keep certain records, such as records of all advertisements they disseminate, including certain internal working papers, performance related information, and documentation for oral advertisements, testimonials, and endorsements.”
The Risk Alert also provided four (4) areas that would be reviewed through the SEC’s examination process, including: (1) review of Policies and Procedures, (2) review of the Substantiation Requirement, (3) review of Performance Advertising Requirements, and (4) review of Books and Records.
A. Policies and Procedures
The SEC has made it clear that they expect and will examine advisers to have adopted and implemented written policies and procedures that are reasonably designed to prevent violations of the New Marketing Rule. In the rule’s Adopting Release, the SEC stated that these policies and procedures “…should include objective and testable means reasonably designed to prevent violations….” Some objective and testable means could include (1) conducting an internal pre-review and approval of advertisements, (2) reviewing a sample of advertisements based on risk, or (3) pre-approving templates.
B. Substantiation Requirement
The Risk Alert calls attention that the SEC will review whether an adviser has a reasonable basis for believing that they can substantiate any material statement of fact in the adviser’s marketing material. Again, the rule’s Adopting Release provides insight into how advisers can comply with the rule: “For example, they could make a record contemporaneous with the advertisement demonstrating the basis for their belief.” As part of risk mitigation an adviser may want to consider having legal counsel draft and help implement policies and procedures to record and maintain such contemporaneous records.
C. Performance Advertising Requirements
The New Marketing Rule contains numerous prohibitions on Performance Advertising unless certain guidelines are met. The Risk Alert clearly calls out that advisers are prohibited from utilizing the following in their marketing initiatives:
- disclosure of gross performance, unless the advertisement also presents net performance;
- any performance results, unless they are provided for specific time periods (not applicable to the performance of private funds);
- any statement that the SEC has reviewed or approved any calculation or presentation of performance results of the adviser;
- performance results of a subset of investments extracted from a portfolio, unless the advertisement provides, or offers to provide promptly, the performance results of the total portfolio;
- hypothetical performance, unless the adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience and the adviser provides certain additional information; and
- predecessor performance, unless the personnel primarily responsible for achieving the prior performance manage accounts at the advertising adviser and the accounts that were managed by those personnel at the predecessor adviser are sufficiently similar to the accounts that they manage at the advertising adviser. In addition, the advertising adviser must include all relevant disclosures clearly and prominently in the advertisement.
D. Books and Records
As noted above, compliance with the New Marketing Rule will require advisers to keep accurate books and records with an eye to compliance with the New Marketing Rule. Additionally, Form ADV has been updated requiring advisers to disclose additional information regarding their marketing practices.
Preparing for 2023
In this evolving regulatory environment, Risk Alerts can serve as a valuable tool in informing advisers of focus areas. Whether you need assistance in determining whether your advisory agreement contains a “hedge clause”, revising your agreements, reviewing Code of Ethics programs or compliance with the new Marketing Rule, JLG can help.
Additionally, the team at JLG incorporates guidance from the year’s Risk Alerts as guidance and foundation when structuring mock regulatory examinations. A mock exam can provide senior management the opportunity to assess the strength and readiness of your firm’s compliance program and provide an opportunity to improve policies, procedures, and internal controls that govern business. If you have not had a mock exam over the past three (3) years, consider adding this to the agenda for your compliance program next year.
Author: Jeremiah Baba Pagano, Esq. LLM; Editor: Michelle L. Jacko, Managing Partner of Jacko Law Group, PC (“JLG”). JLG works extensively with investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks, and corporate clients on securities and corporate counsel matters. For more information, please visit https://www.jackolg.com/.
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 See https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf
 See https://www.sec.gov/files/code-ethics-risk-alert.pdf
 See https://www.sec.gov/files/exams-risk-alert-marketing-rule.pdf