United States: Ropes & Gray's Investment Management Update August – September 2023

The following summarizes recent legal developments of note affecting the mutual fund/investment management industry.

SEPTEMBER ALERT

Since our prior Investment Management Update, we covered the SEC's Names Rule adopting release in a September Alert that is summarized below with a hyperlink to the full text of the Alert.

The following summarizes additional recent legal developments of note affecting the mutual fund/investment management industry.

SEC Issues Risk Alert Describing Selection of an Adviser and the Scope of an Examination

On September 6, 2023, the SEC Division of Examinations (the "Division") published a Risk Alert (the "Alert") describing its risk-based approach to selecting advisers to examine and to determining the scope of the examination. The Alert also included an attachment with the Division's "typical initial request" for documents and information.

Selecting Firms to Examine. The Alert stated that the Division may select an adviser to examine for a variety of reasons, including (i) the firm's risk characteristics, (ii) a tip, complaint, or referral, or (iii) the Division staff's interest in a particular compliance risk area.

The Division publishes its annual priorities to indicate to advisers those areas that the Division believes present risks to investors and the integrity of the U.S. capital markets, including certain products, services, and business operations or practices. The Alert notes that, when selecting advisers to examine, the Division considers which advisers provide services, recommend products or otherwise satisfy the criteria relevant to those priorities.

In addition, there are firm-specific risk factors that the Division staff considers when selecting advisers for examination, such as those related to a particular adviser's business activities, conflicts of interest, and regulatory history.

Selecting Examination Focus Areas. The Alert stated that, when an adviser is selected for examination, the Division staff undertakes an additional risk assessment to determine the scope of the examination, such as selecting the particular areas of the firm's business that the staff will review. For this reason, the scope of an examination and, consequently, the documents requested, will vary from examination to examination, depending on the firm's business model and associated risks, as well as the reason for conducting the examination. However, examinations typically include reviewing advisers' operations, disclosures, conflicts of interest, and compliance practices with respect to certain key topics, including custody and safekeeping of client assets, valuation, portfolio management, fees and expenses, and brokerage and best execution.

Selecting Documents to Request – Typical Information Requested. The Alert noted that the Division staff normally sends an adviser a letter notifying the firm of an upcoming examination. The letter typically contains an initial request list identifying certain information, including documents that the staff will review in the examination. An initial request for information typically includes (i) general information to provide the Division staff with an understanding of the adviser's business and investment activities, (ii) information about the compliance risks that the adviser has identified and the written policies and procedures the firm has adopted and implemented to address each of those risks, (iii) information to aid in the testing of trading activities, and (iv) information for the staff to perform its own testing for compliance in various areas.

The Alert's attachment presents the Division's "typical initial request" for documents and information. The topics (in bold) and subtopics in the attachment are categorized as shown in the following table, with more detailed information about each subtopic provided in the attachment.

SIFMA Brings Suit Challenging Missouri Anti-ESG Rules

On August 10, 2023, the Securities Industry and Financial Markets Association ("SIFMA") filed a complaint with the U.S. District Court for the Western District of Missouri. The complaint seeks declaratory and injunctive relief regarding two new Missouri Securities Division rules (the "Investment Adviser Rule" and the "Broker-Dealer Rule" and, together, the "Rules") that went into effect on July 30, 2023.

On October 2, 2023, as this IM Update approached distribution, the defendants – the State of Missouri and its Attorney General – filed a motion to dismiss SIFMA's claims.

Description of the Rules

The Rules make it a dishonest or unethical business practice in Missouri for firms, before providing investment advice to any client, to fail to disclose to the client (or prospective client)¹ that the firm "incorporates a social objective or other nonfinancial objective" into the investment advice it provides. As defined by the Rules:

• "Incorporates a social objective" means the material fact to consider socially responsible criteria in the investment or commitment of customer funds for the purpose of seeking to obtain an effect other than the maximization of financial return to the customer; and
• "Nonfinancial objective" means the material fact to consider criteria in the investment or commitment of customer funds for the purpose of seeking to obtain an effect other than the maximization of financial return to the customer.

The Rules additionally require that the required disclosure must be substantially in the form of a specified "written acknowledgement and consent" signed by each client either when the relationship with the firm is established or prior to the firm providing investment advice. Thereafter, each firm must make the same required disclosure to its clients at least annually and obtain a renewed written acknowledgement and consent from each client every three years. The specified written acknowledgement and consent under the Investment Adviser Rule is:

SIFMA's Arguments

SIFMA's complaint seeks injunctive and declaratory relief to invalidate the Rules and make them unenforceable. The complaint makes the following arguments:

NSMIA Preemption

1. Under the National Securities Markets Improvement Act of 1996 ("NSMIA"), states are largely preempted from regulating federally registered investment advisers. States are only allowed to (i) investigate and bring enforcement actions with respect to fraud against a federally registered investment adviser, (ii) to require filings, for notice purposes only, of documents filed with the SEC, and (iii) to require payment of state filing, registration, and licensing fees.
   
   The Investment Adviser Rule, which does not fall into any of these three categories, applies to investment adviser representatives of federally registered investment advisers if the representative maintains an office in Missouri, has more than five clients who are natural persons, and has a client base more than 10% of which consists of natural persons. To the extent the Investment Adviser Rule applies to federally registered investment advisers and investment adviser representatives, the Rules are preempted by NSMIA.
2. NSMIA preempts state regulation of broker-dealers with respect to requirements concerning capital, custody, margin, financial responsibility, making and keeping records, bonding, or financial or operational reporting. States are prohibited from establishing requirements in these areas that are different from, or in addition to, federal requirements. The Broker-Dealer Rule requires broker-dealers to obtain a written acknowledgement and consent from customers, to provide the required consent disclosure to customers on an annual basis, and to obtain a renewed written acknowledgement and consent from customers every three years. These records required by the Broker-Dealer Rule are not required by federal law or SEC rules and, therefore, NSMIA preempts the Broker-Dealer Rule.
3. NSMIA identified a class of securities called federally "covered securities," generally consisting of all exchange-listed securities and securities issued by mutual funds. NSMIA prohibited states from directly or indirectly imposing conditions upon the offer or sale of federally covered securities based on the merits of the offering. The Rules restrict the ability of firms to recommend or advise strategies that include the purchase of covered securities issued by operating companies and mutual funds that have "non-financial" objectives. The Rules thereby impose merit-based conditions on the offer or sale of covered securities and, therefore, the Rules are preempted by NSMIA.

ERISA Preemption

ERISA broadly preempts "any and all State laws insofar as they may now or hereafter relate to any employee benefit plan." To the extent that the Rules apply to ERISA plan assets such as pension accounts, the Rules are preempted by ERISA.

Additional Constitutional Claims

1. The Rules require firms to secure written consents conforming to the state's specified language concerning a controversial matter of public debate that is not purely factual. Firms are required to describe common investment strategies and many federal covered securities as "not solely focused on maximizing a financial return for me or my account" even in situations where the firm does not believe that statement to be accurate. Therefore, the Rules violate the First Amendment protection against compelled speech by requiring firms to adopt and express the government's position.
2. Under Constitutional due process principles limiting state regulation, a state enactment or rule is void for vagueness if its prohibitions are not clearly defined. A state rule is unconstitutionally vague if it fails to "give the person of ordinary intelligence a reasonable opportunity to know what is prohibited, so that he may act accordingly."
   • The Rules require firms to issue disclosures and obtain written consents if their advice "incorporates a social objective or other nonfinancial objective" into offering a recommendation or making an investment decision on its client's behalf. The Rules do not define what it means to "consider" socially responsible criteria or other nonfinancial objectives and do not define what "the maximization of financial return to the customer" means. Thus, the Rules fail to provide firms with the ability to ascertain with certainty what strategies or securities include "social" or "nonfinancial objectives" (e.g., firms that rely on faith-based investment approaches, on rural development, or on volatility management instead of purely on expected financial return). For this reason, the Rules are void as unconstitutionally vague.

REGULATORY PRIORITIES CORNER

The following brief updates exemplify certain trends and areas of current focus of regulatory authorities.

SEC Settles Administrative Actions Involving Failures to Maintain Messaging-Platform Communications

On August 8, 2023, the SEC issued a press release announcing that, in nine separate orders, it had settled nine administrative actions against 10 broker-dealers and, in one of those actions, a dually registered broker-dealer and investment adviser for "widespread and longstanding failures by the firms and their employees to maintain and preserve electronic communications."

On September 29, 2023, the SEC issued another press release announcing that, in six separate orders, it had settled administrative actions against five broker-dealers, three dually registered broker-dealers and investment advisers, and two affiliated investment advisers for "widespread and longstanding failures to maintain and preserve electronic communications."

• Both press releases state that the affected firms admitted that, from at least 2019, their employees often communicated through various messaging platforms on their personal devices, including iMessage, WhatsApp, and Signal about the business of their employers without maintaining or preserving "the substantial majority of these off-channel communications, in violation of the federal securities laws." These recordkeeping issues "involved employees at multiple levels of authority, including supervisors and senior executives."
  
  
• The facts underlying the orders covered by both SEC press releases are similar to the facts described in a September 2022 SEC press release (described in a Ropes & Gray IM Update) announcing that the SEC had settled 11 administrative actions against 15 broker-dealers and, in one of those actions, an affiliated investment adviser, for similar off-channel communications and recordkeeping violations.

Orders Involving an Investment Adviser

In the orders involving an investment adviser, the SEC did not provide any meaningful analysis as to why Rule 204-2(a)(7) was violated by the investment advisers (i.e., what exactly is a communication relating to an investment recommendation, etc.), and simply stated that employees sent and received electronic communications that "related to recommendations made or proposed to be made and advice given or proposed to be given" (or "related to providing and recommending investment advice to clients") and that Rule 204-2(a)(7) was violated. In one September order, the SEC additionally described investment adviser texts that "discussed recent performance of certain accounts and a recommendation they intended to provide to an advisory client."

These SEC orders, combined with the ongoing enforcement sweep of investment advisers regarding texting, serve as a reminder that any off-channel communications sent by investment adviser personnel that are not preserved carry enforcement risk.

SEC Settles Enforcement Matter with ETF Adviser, Interested Trustee and Adviser's Parent

On August 1, 2023, the SEC issued an order announcing the settlement of an administrative matter involving an investment adviser to a group of ETFs (the "Adviser"), the Adviser's parent company (the "Parent") and Samuel R. Masucci ("Masucci" and, with the Adviser and the Parent, the "Respondents").

During the relevant period, Masucci was the majority owner of the Parent, CEO of the Adviser, the sole interested trustee of the three-member board of the trust of which the ETFs were separate series, and a portfolio manager of one of the ETF series of the trust, ETFMG Alternative Harvest ETF ("Harvest ETF").

In the order, the SEC made the following findings:

1. Since September 2018, Company A, in its role as Harvest ETF's securities lender, had earned more than $10 million from Harvest ETF's securities lending.
2. In May 2019, the Respondents urgently needed tens of millions of dollars to settle private litigation brought against Masucci, the Adviser, and the Parent, without which the Adviser and the Parent risked bankruptcy and the loss of the Adviser's advisory contracts with Harvest ETF and its other ETF clients.
3. Soon after learning of the litigation exposure, Masucci began soliciting financing from various financial institutions. He found only one entity, Company A, that was willing to provide the rescue financing that the Respondents needed.
4. The Respondents used Harvest ETF's securities lending revenue stream (i) to negotiate rescue financing for the Parent on favorable terms from Company A and (ii) to obtain Company A's promise to provide free investment banking services to the Parent to raise additional financing. In exchange for these arrangements, Masucci agreed to keep Harvest ETF's securities lending business at Company A, notwithstanding offers from other securities lenders with better fee splits that could have resulted in significantly greater revenues to Harvest ETF, as well as other benefits (e.g., higher cash collateral cushions and indemnification against certain borrower defaults).
5. Masucci informed Harvest ETF's two independent trustees about the terms of Company A's rescue financing. However, he did not inform them that the financing arrangements with Company A were conditioned on Company A's retention of Harvest ETF's securities lending business. Instead, Masucci inaccurately informed the independent trustees that Harvest ETF had no viable option besides Company A as a securities lender.

Based on these findings, the SEC concluded that (i) the Adviser, the Parent, and Masucci willfully violated Section 17(d) of the 1940 and Rule 17d-1 thereunder, which generally prohibit any affiliated person of a registered fund (or any affiliated person of an affiliated person), acting as principal, from effecting any joint transaction with the registered fund and (ii) the Adviser and Masucci violated Sections 206(1) and 206(2) of the Advisers Act, which make it unlawful for an investment adviser to defraud any client.

Solely for the purpose of the SEC proceeding and without admitting or denying the findings in the SEC order, among other things, Masucci agreed to being barred from the industry for a period of three years and to pay a civil money penalty of $400,000. The Adviser and the Parent similarly agreed, jointly and severally, to pay civil money penalties of $4 million.

ADDITIONAL ROPES & GRAY ALERTS AND PODCASTS SINCE OUR JUNE – JULY UPDATE

SEC Adopts Changes to the Registered Fund Names Rule
September 28, 2023
On September 20, 2023, the SEC issued a release adopting changes to the Names Rule, Rule 35d-1 under the 1940 Act (as amended, the "Final Rule"), and related form amendments. The Final Rule and the amendments substantially expand the applicability of current Rule 35d-1 and include new disclosure, compliance testing, reporting and recordkeeping requirements.

Ropes & Gray Crypto Quarterly: Digital Assets, Blockchain and Related Technologies Update
September 18, 2023
The landscape of government enforcement, private litigation, and federal and state regulation of digital assets, blockchain and related technologies is constantly evolving. Each quarter, Ropes & Gray attorneys analyze government enforcement and private litigation actions, rulings, settlements, and other key developments in this space. We distill the flood of industry headlines so that you can identify and manage risk more effectively. The attached newsletter includes takeaways from this quarter's review.

December 1 Deadline for Dept. of Labor Proxy Voting Rule: Managers of Pooled ERISA Investment Vehicles Should Act Now
September 13, 2023
In recent months, there has been a lot of focus on how the U.S. Department of Labor (DOL)'s 2022 final rule on fiduciary investment duties (the so called "ESG rule") impacts investment selection and ESG considerations for ERISA-covered retirement plans. As we approach the fall, it is critical for managers of plan asset funds or commingled vehicles that include the assets of multiple ERISA plans to also focus on the upcoming proxy voting requirements of the final rule and to determine what concrete steps they will take to comply with a rapidly approaching December 1, 2023 deadline that applies to certain of those requirements. Managers of commingled funds that are subject to ERISA and that have not already obtained consent to their proxy voting polices must have their plan investors accept certain proxy voting policies by this December 1 to avoid compliance risks when those funds vote proxies.

Commercial Real Estate Joint Ventures and Funds: What's the Difference?
September 12, 2023
On this Ropes & Gray podcast, real estate partner Sally Davis and asset management partner Eric Requenez discussed some of the key similarities and differences between terms in real estate joint ventures and terms in real estate funds, including considerations for investors and practitioners in the space who are looking to invest through either of these structures or any of the various "hybrid" models found somewhere in between.

Massachusetts Court Validates Broker-Dealer Fiduciary Duty Rule, Increasing Threat of Patchwork Standards of Care
September 8, 2023
In its August 25, 2023 decision in Robinhood Financial LLC vs. Galvin, the Massachusetts Supreme Judicial Court (the "SJC") reversed a trial court's decision and validated a 2020 Massachusetts state regulation requiring broker-dealers (including those located outside Massachusetts) that provide investment recommendations or advice to retail customers in Massachusetts to comply with a defined fiduciary duty, bringing the fiduciary obligations of broker-dealers in line with those of investment advisers (the "Massachusetts Fiduciary Rule").

The SJC's decision adds Massachusetts to the group of states that require broker-dealers to satisfy both Regulation Best Interest and state-specified fiduciary obligations. For national broker-dealers having operations in Massachusetts, including those operating internet platforms, the decision further complicates compliance and increases associated costs.

The Inevitable Rise of NAV Financing
September 8, 2023
Private fund sponsors are increasingly turning to NAV (net asset value) financing to meet a variety of needs and objectives. On this podcast, Ropes & Gray finance counsel Patricia Teixeira was joined by Anastasia Kaup, managing director and partner of Fund Finance Partners, to discuss key terms and negotiating points in NAV credit facilities, market trends, and predictions for the future.

Court Grants Victory to Grayscale
September 7, 2023
On August 29, 2023, a three-judge panel of the D.C. Circuit Court of Appeals unanimously sided with Grayscale in its long-running battle with the SEC regarding its application to launch the first bitcoin ETF. Observing that the SEC's denial of Grayscale's proposal was "arbitrary and capricious" because it was inconsistent with the SEC's treatment of similar products, the Court vacated the SEC's June 2022 rejection of a proposed rule change that would allow NYSE Arca to list Grayscale Bitcoin Trust ("GBTC") shares on its exchange. The Court's Order and implications for the future of spot bitcoin exchange-traded product ("ETP") listings are summarized in this Alert.

Activism for Non-Activists
September 7, 2023
On this Ropes & Gray podcast, Jeff Katz, the head of the firm's shareholder engagement practice, and Bryan Lowrance, an associate in the same practice, discussed how active asset managers are successfully—and often quietly—engaging with public companies to increase value and improve corporate governance. On this episode, Jeff and Bryan discussed what they mean by "activism for non-activists" and provide a framework for successful constructive engagement.

Carbon Talk: An Introduction to the Global Carbon Markets
September 6, 2023
On this inaugural episode of Ropes & Gray's podcast series, Carbon Talk, asset management partner Jeremy Liabo and associate Anne Fox provided listeners with an introduction to the global carbon markets. Throughout their discussion, Jeremy and Anne outlined the chief differences between mandatory carbon markets, on the one hand, and voluntary carbon markets, on the other hand. As part of this overview, Jeremy and Anne addressed a variety of topics including the different types of carbon "credits" and how they are each generated or issued, purchased by primary market participants and traded on the secondary market.

SEC Adopts New Private Fund Adviser Rules
August 29, 2023
The SEC adopted its much anticipated private fund reforms on August 23, 2023. These reforms include several quarterly reporting requirements with respect to performance and fees and expenses, increased transparency regarding side letters and other "preferential treatment" for fund investors, prohibitions on certain liquidity rights and information sharing with fund investors, and limitations on the ability of fund managers to obtain reimbursement from private funds for costs associated with government investigations. Nevertheless, taken as a whole, the reforms are less transformational than the proposal from February 2022.

F/m Investments Files for Exemptive Relief for a Mutual Fund Share Class of an ETF
August 25, 2023
Flipping the script on the notion of offering an ETF share class of a mutual fund, F/m Investments LLC ("F/m") filed an application with the SEC to permit its passive Treasury ETFs to offer a mutual fund share class. F/m's filing comes on the heels of a recent filing by Dimensional Fund Advisors that sought to build upon longstanding but unique ETF share class relief obtained by Vanguard two decades ago.

California Law for Asset Managers: California Fee Disclosure Law
August 24, 2023
On this episode of Ropes & Gray's California Law for Asset Managers podcast series, asset management counsel Catherine Skulan and Chelsea Childs provided an overview of California's fee disclosure law, its implications in connection with fundraising with California pension plans and how the market has responded and adapted to the law since its enactment over five years ago.

The Sponsor's Edge: Insights on Growth and Venture Investing—Alternatives to Down Rounds and Bridging Valuation Gaps (Part II)
August 17, 2023
On this episode of Ropes & Gray's podcast series, The Sponsor's Edge: Insights on Growth and Venture Investing, asset management counsel Catherine Skulan hosted the second of a two-part conversation between Brad Flint, partner and co-lead of Ropes & Gray's venture investing & emerging companies practice, and Raj Banerjee, a senior associate in that practice. Brad and Raj covered some traditional means of bridging valuation gaps before discussing the emergence of additional terms and investor protection mechanisms recently taking root in the market.

California Law for Asset Managers: An Overview of Lobbying Laws Applicable to Soliciting California Pension Plans and Retirement Systems
August 10, 2023
On this episode of Ropes & Gray's California Law for Asset Managers podcast series, asset management counsel Catherine Skulan and Chelsea Childs provided an overview of the lobbying law regime and registration requirements applicable to asset managers seeking investments from California pension plans and retirement systems.

Footnote

1. The Investment Adviser Rule refers to "clients" and the Broker-Dealer Rule refers to "customers."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.