Regulatory Roundup: Exploring SEC Recent Changes in Beneficial Ownership Rules and Examination Priorities

On October 16th 2023, the SEC’s Division of Examinations unveiled its fiscal year 2024 priorities (Oct. 1, 2023 – Sep. 30, 2024). This publication, coupled with a significant increase in field presence and outreach events, underscores the SEC’s unwavering commitment to transparency, investor protection, and strong compliance within regulated entities. The 2024 annual examination priorities summarized below provide valuable insight into areas the SEC believes present potential risks to investors and that will, therefore, be the focus of investment adviser exams over the next year. In alignment with this focus, the SEC recently issued a Risk Alert offering firms insights into its approach as well as the initial document request list they provide investment advisers under examination.

In this article, Arootah Adviser Michelle McGurk delves into what this means and how advisers can use this information to conduct SEC exam readiness self-examination processes to help them respond quickly when the SEC reaches out to them. She will also cover the latest amendments for Beneficial Reporting and its impact on investors.

Selecting Firms to Examine
The SEC employs a dynamic, risk-based approach when selecting a diverse group of investment advisers to examine (spanning from global entities to small asset managers) and when defining the scope of the exam. Their examination selection criteria covers a variety of factors, including tips, complaints, referrals, staff interest in specific compliance risk areas, and firm-specific risk characteristics.

The firm-specific criteria may include:

1. Observations and conduct during prior examinations;
2. An adviser’s outside business activities and conflicts of interest;
3. Supervisory concerns;
4. Length of time since the firm’s registration or last examination;
5. Material changes in a firm’s leadership;
6. Relevant news and media;
7. Indications the adviser may be vulnerable to financial or market stresses;
8. Firm disclosure history (i.e. Form ADV, including the brochure, and Form PF);
9. Access to client/investor assets or service provider compliance risks; and
10. Data provided by certain third-party data providers.

2023-2024 Examination Priorities for Investment Advisers & Private Fund Advisers

Duty of Care & Duty of Loyalty
In their 2024 examination, the SEC will prioritize fiduciary duty, specifically the duty of care and duty of loyalty. Exams will evaluate advisers’ processes for determining best interests through an evaluation of their costs and risks, investor and regulator disclosures, management of conflicts of interest, and especially any economic incentives they earn from recommending products. The SEC will carefully review investment advice related to complex and high-cost products, unconventional strategies, and account types. Exams will thoroughly assess advisers’ compliance programs to determine whether policies align with various aspects of the advisers’ businesses and effectively address market risk.

In their review of compliance programs, the SEC will dive deep into portfolio management processes, trading practices, advisory boards’ adherence to contractual requirements during notification/consent processes, marketing advisory services, valuation processes for illiquid assets, client information protections, disclosures, completing regulatory filings, and business continuity plans.

Marketing Rules
The SEC will continue to pay particular attention to marketing practices, which is no surprise based on the extensive enforcement actions they’ve taken since recent changes to the Marketing Rule. The SEC will assess whether an adviser has adopted and implemented written policies and procedures to reasonably prevent violations, appropriately disclosed marketing-related information on Form ADV, and preserved evidence of their procedures and mandatory documentation.

In marketing practice reviews, the SEC will evaluate the accuracy of disseminated advertisements to ensure they do not contain any false material facts, are not materially misleading, and don’t deceive potential clients. Additionally, the SEC will check for compliance with regard to a firm’s performance disclosure requirements, including hypothetical and predecessor performance, third-party ratings, and testimonials and endorsements.

Compensation Arrangements
The SEC will also focus greater attention on compensation arrangements that focus on advisers’ fiduciary obligations to their clients, including alternative ways that advisers try to maximize revenue.

Due Diligence & Third-Party Service Providers
Additionally, the examinations will focus on policies for due diligence and monitoring of third-party service providers, accurate calculation and allocation of private fund fees, as well as expenses and related disclosures, compliance with Custody Rule requirements (including the timely completion and distribution of a private fund’s audited financial statements and Form ADV disclosures), and policies and procedures for reporting on Form PF.

The SEC also underscores certain critical risk areas that affect diverse market participants and require advisers to heighten vigilance. Specifically, investment managers can expect to see the following target areas during an exam:

• Information Security and Operational Resiliency: Policies, internal controls, governance practices and responses to cyber incidents
• Crypto Assets and Emerging Financial Technology: Automated investment tools, AI, and trading algorithms
• Anti-Money Laundering: AML programs that are tailored towards unique business models, establish robust customer identification programs, fulfill all suspicious activity reporting obligations and are independently tested

Additional Observations: ESG

The 2024 examination priorities closely mirror those of last year, excluding a specific focus on environmental, social, and governance (ESG) matters. Despite not explicitly outlining ESG-related issues in their official priorities, advisers can anticipate that the SEC will continue to address them, especially given their establishment of the ESG and Climate Task Force and the proposed rule changes in Form ADV related to disclosures on ESG strategies.

While the SEC has continually scrutinized off-channel communication and acted against firms that don’t comply with regulations related to it, off-channel communication is absent from the current priorities. Advisers should, however, remain vigilant with regard to their compliance with electronic communications policies, given the SEC’s history of enforcement actions.

Key Takeaways

The 2024 Examination Priorities report underscores the SEC’s steadfast commitment to safeguarding investor interests and addressing current and emerging market risks through compliance. To remain compliant and well-prepared amid the growing complexity of the regulatory landscape, advisers should integrate these priorities into their annual compliance program review. This integration ensures they are taking a proactive stance, fostering continual exam readiness, and preparing to adapt to regulatory expectations when necessary.

SEC Adopts Final Rules Amending Beneficial Ownership Reporting (Schedule 13D/13G)

With regard to Beneficial Ownership reporting, the SEC also recently introduced amendments to Regulation 13D – G under the Securities Exchange Act of 1934. These amendments affect the reporting requirements for investors acquiring more than 5% beneficial ownership of a voting class of equity securities registered under Section 12 of the Exchange Act.

The key changes to these regulations specifically address the acceleration of deadlines for beneficial ownership disclosures on both initial and amended Schedules 13D and 13G filings in the context of today’s fast- paced financial markets. Additionally, the amendments clarify an investor is required to disclose interests in derivative securities (including securities-based swaps) and require the use of XML* when filing Schedules 13D and 13G with the SEC. These amendments mark the first time in almost 50 years that filing deadlines for 13D and 13G have changed.

The revised regulations will require investors to implement enhancements to their systems monitoring beneficial ownership to facilitate more prompt reporting, which may pose challenges for smaller investors. While the SEC has recognized these challenges, it has also emphasized the importance of modernizing the beneficial ownership reporting framework to enhance operational efficiency and address information asymmetries in the market as a means of protecting investors.

Changes adopted under the Regulation 13D Amendment

Changes adopted under the Regulation 13G Amendment

Enhancing Accessibility: XML Filing Mandates for Schedules 13D and 13G
The amendments mandate the use of a structured, machine-readable XML-based language for information disclosed on Schedules 13D and 13G (excluding exhibits). This structured language enhances accessibility, compilation, and analysis of the disclosed information for investors and markets.

Additional Schedule 13D Changes – Guidance on Disclosure of Interests in Derivative Securities
The amendment brings clarity to the disclosure requirements for derivative securities, including all cash-settled derivatives tied to an issuer’s equity security as a reference security. Notably, the SEC has opted not to adopt proposed amendments and will rely on guidance to address beneficial ownership concerns related to cash-settled derivatives. The disclosure mandate, now articulated in Item 6 of Schedule 13D, includes cash-settled security-based swaps and derivatives settled exclusively in cash. This ensures that purely synthetic positions are disclosed when triggering a Schedule 13D filing, removing ambiguity without requiring these positions to contribute to the beneficial ownership threshold. The SEC emphasizes a fact-specific approach in determining beneficial ownership of cash-settled derivatives, drawing on past guidance to develop a robust framework of analysis. This amendment aims to provide investors with a more comprehensive understanding of Schedule 13D filers’ economic interests, fostering transparency and alignment with investors’ interests.

Compliance Dates

Key Takeaways

The recent SEC amendments to beneficial ownership reporting rules will directly impact market participants in several key ways. First, they may impact investment strategies focused on shareholder activism in addition to M&A as shortened filing deadlines could limit an activist investors’ ability to accumulate positions discreetly; these limitations could potentially affect an investor’s leverage and acquisition costs. The disclosure of derivative securities on Schedule 13D is now mandatory and QIIs, exempt investors, and passive investors must update compliance processes and costs to meet accelerated reporting requirements. These considerations underscore the need for proactive adaptation and strategic planning in response to the evolving regulatory landscape.

Bottom Line

The SEC’s unveiling of its fiscal year 2024 priorities signals the Commission’s resolute dedication to transparent, investor-focused examinations and the promotion of strong compliance cultures. Advisers are urged to integrate these priorities into their compliance programs, fostering continual preparedness amid the evolving regulatory landscape. The amendments underscore the necessity for proactive adaptation and strategic planning to navigate the changing terrain of securities regulations.

Unsure of this process and need help getting started? Our team of experts can help ensure you are compliant. Take the first step and find out how Arootah’s Hedge Fund Advisory can support you.

*XML is a technical specification of how the reporting data needs to be transmitted to the SEC, or abbreviation used for eXTensible Markup Language

References

https://www.sec.gov/files/2024-exam-priorities.pdf

https://www.sec.gov/files/risk-alert-ia-risk-and-requesting-documents-090623.pdf

https://www.federalregister.gov/documents/2023/11/07/2023-22678/modernization-of-beneficial-ownership-reporting

https://www.sec.gov/news/press-release/2023-222

https://www.sec.gov/files/rules/final/2023/33-11253.pdf

https://www.sec.gov/files/33-11253-fact-sheet.pdf

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