Category: SEC News

The SEC Grapples with Artificial Intelligence

The Securities and Exchange Commission looks to have opened at least two fronts in the adoption of artificial intelligence in financial services. The Division of Examinations has apparently started a sweep, sending out information requests on AI-related topics. SEC Chair Gary Gensler has expressed skepticism about the technology.

The first issue is a marketing-related issue for firms. Chair Gensler was reported to have made speech last week that warned against “AI Washing.” As there have been cases against firms purporting to based investment decisions using ESG factor, but not actually doing so (greenwashing). Chair Gensler warned about firms marketing themselves as AI enable, but not actually using AI.

You can’t oversell your AI capabilities.

The other issue is watching the risks with actually using AI for investment decision. As an example, there is concern that there is only a few underlying AI platforms, a whole lot of investment decisions could go rampaging in the wrong direction together, off a cliff. We’ve seen isolated cases of this at firms with trading algorithms that stop working. They unplug. If you’ve got a robot, you’ve got to make sure you can shut down the robot if (when?) the robot goes bad.

Earlier this year, the SEC released a proposed rule on Conflicts of Interest Associated With the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers that calls for investment advisers and broker dealers to:

“Eliminate, or neutralize the effect of, certain conflicts of interest associated with broker-dealers’ or investment advisers’ interactions with investors through these firms’ use of technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes.” – Release Nos. 34-97990 / IA-6353

It reads like a rule that is very skeptical of AI. It’s so broad and meandering that I’m not sure where it will end up. The intent is clear. Don’t let your AI do bad things.

Sources:

SEC Updates its RegFlex Agenda Fall 2023

The Securities and Exchange Commission published its twice-annual rule list agenda for the Fall 2023.

Back in June, four items caught my attention: Private Fund Reform, Cybersecurity, Outsourcing, and Safeguarding. Only one made it to publication. Unless you’ve been on vacation for a few months, you know the Private Fund Reforms became effective last month.

Cybersecurity (3235-AN08) has been pushed back to the Spring of 2024. It proposed mandatory cyber breach reporting and cybersecurity policies and procedures. The breach reporting was proposed as 48 hours. In my view that is way to short.

Outsourcing (3235-AN18) had been pushed back to Spring 2024 and it remains there. That rule had some fuzzy requirements about appropriateness of outsourcing and a requirement to conduct due diligence on service providers. I know the Division of Examinations has been compiling information as part of their exams.

Safeguarding (3235-AM32) has been pushed back to the Spring 2024. This replacement of the Custody Rule went too far in requiring custodians for more than just cash and securities.

What else caught my attention?

Regulation D and Form D Improvements (3235-AN04) is letting us know that the SEC is thinking about “amendments to Regulation D, including updates to the accredited investor definition, and Form D to improve protections for investors.” Nothing proposed, just a thought.

Predictive Data Analytics (3235-AN14) is an interesting swing in this current era of Artificial Intelligence mania and fear. I’m not sure the SEC is taking the right approach on this. On the other hand, one research report showed that the AI GPT-4 will insider trade knowing its against company policy and then lie about. (The Robots will Insider Trade). The SEC has a final action set for Spring 2024.

I missed the proposed rule amending the internet investment adviser rule in August. (I was on my bike for the Pan-Mass Challenge) It would amend Rule 203A-2(e) and narrow the exemption. Examinations are finding some abuse of the exemption.

“We are blessed with the largest, most sophisticated, and most innovative capital markets in the world. But we cannot take this for granted. Even a gold medalist must keep training.” – Chair Gary Gensler’s Statement

What proposed rules are catching your attention?

Sources:

The Private Fund Rule Is Coming

The Securities and Exchange Commission has set the agenda for its August 23 meeting.

ITEM 2: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews

OFFICE: Division of Investment Management

STAFF: William A. Birdthistle, Sarah G. ten Siethoff, Melissa Harke, Marc Mehrespand, Tom Strumpf, Robert Holowka, Shane Cox, Neema Nassiri

The Commission will consider whether to adopt rules and amendments under the Investment Advisers Act of 1940 (“Advisers Act”) for private fund advisers and whether to adopt amendments to the compliance rule under the Advisers Act.

It would be really unusual for the rule to not be adopted if its on the agenda. The question is “what will be in the final rule?”

The proposed rule in second quarter of 2022 had proposals that could be very problematic:

  • Limitations on indemnification for private fund advisers
  • Limitations on clawbacks for taxes
  • Limitations on different treatment for different investors
  • Standards for fee and expense disclosure
  • Not allowing existing contractual arrangement to continue if they differ from the rule requirements

The proposed rule was a kitchen sink of items with no unifying theme, other than to try to make private funds more like mutual funds without the liquidity. The rule could have a profound impact on the private fund industry.

Sources:

SEC’s Regulatory Agenda

The Securities and Exchange Commission has published the Spring update to its agency rule list: Agency Rule List – Spring 2023 Securities and Exchange Commission. While none of this is carved in stone it does give us some sense of what the SEC is working on, what it has given up on, and when things may come out.

The first item on my mind is the proposed Private Fund Rule. That was first proposed in the first quarter of 2022 with a Buffet of Private Fund Regulations piled into one proposed rule. I have heard little about what end up in the rule. It’s still on the agenda and has a proposed final action in October 2023.

Cybersecurity for investment advisers is also still on the agenda. This was another of the first quarter 2022 rulemaking. My biggest concern is that the rule would likely make a cyber breach a fraud violation. Seems like that’s a problem given that the US government is noting a widespread cyberattack today: US government agencies hit in global cyberattack. Nonetheless, the rule still on the agenda and has a proposed final action in October 2023.

Outsourcing by investment advisers remains on the agenda. Any final action is pushed off to April 2024. I think the SEC is struggling with how to scope the rule.

“A covered function is defined in the proposed rule as a function or service that is necessary for the adviser to provide its investment advisory services in compliance with the Federal securities laws, and that, if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services.”

If I hire a bad elevator contractor for my private real estate fund’s assets and all the elevators stop working, I think that makes it a “covered function” that would be subject to the proposed rule.

The new Safeguarding Advisory Client Assets rule looks like it its on the fast track. It was just published in the first quarter of 2023 and is scheduled for final action in October 2023. That rule is targeting at killing crypto. In the process, it’s taking a sledgehammer to all alternative investments.

It looks like we’ve got three big regulatory changes coming out this fall. Sounds like we should rest up this summer to get ready.

Sources:

SEC ALJs Violate the Right to a Jury Trial

Among the many, many, many legislative actions in Dodd-Frank, one section gave the Securities and Exchange Commission broader authorization to bring enforcement actions through its internal administrative law judges instead of through federal courts. The SEC decides which cases to bring to the ALJs and which it wishes to bring in federal court. In federal court you can have a jury trial. With the SEC’s ALJs you do not get a jury trial.

If you find this problematic, the Fifth Circuit Court of Appeals agrees with you. With its coverage of Texas, Louisiana and Mississippi, this Court fired a blistering attack on the SEC in the opinion.

Congress has given the Securities and Exchange Commission substantial power to enforce the nation’s securities laws. It often acts as both prosecutor and judge, and its decisions have broad consequences for personal liberty and property. But the Constitution constrains the SEC’s powers by protecting individual rights and the prerogatives of the other branches of government. This case is about the nature and extent of those constraints in securities fraud cases in which the SEC seeks penalties.

The case was launched by the SEC in 2011 against a fund manager for overvaluing fund assets to collect more in fees. The timing of the alleged fraud and SEC litigation is such that the fund manager was not required to be registered with the SEC as an investment adviser. I can’t find a provision in the opinion that talks about whether this distinction matters.

The biggest point in the opinion is that the fund manager was deprived of its constitutional right to a jury trial by the SEC bringing the vase through the administrative law process. The Court hangs its argument on its view that a case of fraud is traditional action of “suits at common law” described in the Seventh Amendment to the Constitution which can include “suits brought under a statute as long as the suit seeks common-law-like legal remedies.” (page 7) The Court points out that fraud prosecutions were regularly brought in English courts at common law. Even though the SEC brought non-monetary remedies against the fund manager that doesn’t invalidate the right to a jury trial.

Sources:

ESG Regulation is Coming to Investment Advisers

Maybe.

The Securities and Exchange Commission is going to propose standardization of environmental, social, and governance disclosures to investors and to the SEC. The vote happens at the SEC open meeting on May 25.

MATTERS TO BE CONSIDERED:

1. The Commission will consider whether to propose amendments to the rule under the Investment Company Act that addresses investment company names that are likely to mislead investors about an investment company’s investments and risks. The amendments the Commission will consider also include enhanced prospectus disclosure requirements for terminology used in investment company names, as well as public reporting regarding compliance with the new names-related requirements.
 

2. The Commission also will consider whether to propose amendments to rules and reporting forms for registered investment advisers, certain advisers exempt from registration, registered investment companies, and business development companies to provide standardized environmental, social, and governance (“ESG”) disclosure to investors and the Commission.

I assume the first item is to prohibit funds calling themselves “ESG funds” or “green” funds unless they meet some specific criteria.

The second is the new ESG Rule. What is it? It’s just a proposed rule so I would be guessing.

We could look to the proposed rule of Climate-Related Disclosures for Investors for public companies. That public company proposed rule is more focused on reporting greenhouse gas emissions and disclosure of climate-related risks. I don’t think its a great model for investment advisers and investment companies. I’m intrigued to find out what the SEC is trying to do with ESG.

Of course, this is yet another addition to a very busy regulatory agenda for the SEC.

Sources:

Two New Commissioners on Tap for the SEC

With one current vacancy and a second upcoming vacancy, the Securities and Exchange Commission needs some new blood. President Biden nominated two new commissioners to help the agency regain its full population.

Jaime Lizárraga has been nominated to fill a Democratic seat currently occupied by commissioner Allison Lee. She has stated that she is resigning, but will serve until her successor is in place. Lizárraga has worked for Speaker Pelosi for 14 years, and spent eight years before that on the House Financial Services Committee. He was the deputy director of legislative affairs at the SEC, briefly in the 1990s.

Mark Uyeda has been tapped to replace the vacancy created by former Republican commissioner Elad Roisman. Mr. Uyeda is a career attorney with the Securities and Exchange Commission. He is currently on detail from the SEC to the U.S. Senate Committee on Banking, Housing, and Urban Affairs, where he serves as Securities Counsel on the Committee’s Minority Staff.

Sources:

SEC Offers Up a Buffet of Private Fund Regulations

At its open meeting on February 9, the Securities and Exchange Commission offered up a buffet of proposed regulations of private funds. It’s really an all-you-can eat buffet with six proposed changes across a variety of areas.

The SEC wants private funds to send out quarterly statements to private fund investors. It doesn’t seem that the SEC would require them to be audited. It would have to provide a detailed accounting of all fees and expenses. It sounds like it would some form of standardized reporting. The quarterly reports would have to provide information on fund performance. For “liquid funds, the quarterly statement would provide annual net total returns since inception, average annual net total returns over prescribed time periods, and quarterly net total returns for the current calendar year. For “illiquid funds,” the statement would provide the gross and net internal rate of return and gross and net multiple of invested capital for the illiquid fund to capture performance from the fund’s inception through the end of the current calendar quarter. Not sure what is going to draw lines between “liquid” and “illiquid” funds.

The SEC is proposing that private funds have an annual audit. This seems odd to me. Private funds largely have to do this already under the Custody Rule. Not sure what this regulation would do beyond the Custody Rule, unless it will replace the Custody Rule for private funds.

Adviser-Led Secondaries Rule would require a fairness opinion in connection with an adviser led secondary transaction. This requirement would provide a check against an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors. Not sure how much this rule would help in already complex transactions

The preferential treatment rule would prohibit private fund advisers from providing preferential terms for redemptions and providing additional information about fund holdings.  The proposed rule would go further and prohibit private fund advisers from providing “other preferential treatment” unless disclosed to current and prospective investors. This proposed rule is designed to protect investors by prohibiting specific types of preferential treatment that have a material, negative effect on other investors. Is the SEC trying to kill side letters? This proposal could be a mess.

The prohibited activities rule is side table full of dishes cooked up by the SEC under the umbrella  that these practices are contrary to the public interest and the protection of investors

  • Charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees) and fees associated with an examination or investigation of the adviser;
  • Seeking reimbursement, indemnification, exculpation, or limitation of its liability for certain activity;
  • Reducing the amount of an adviser clawback by the amount of certain taxes;
  • Charging fees or expenses related to a portfolio investment on a non-pro rata basis; and
  • Borrowing or receiving an extension of credit from a private fund client.

The desert is that all registered investment advisers, not just private funds, have to document their annual review in writing.

Commissioner Peirce, as expected, was against the rule. She sees it as a diversion of resources by the SEC away from retail investor protection. Further she says that maybe the SEC needs to re-think whether there is any reason to keep private placements away from retail investors if the SEC is going to impose retail-like requirements on private investments.

Chair Gensler along with Commissioner Lee and Crenshaw were all in favor of the proposed rule. They all piled on the idea that private funds are a large and growing segment of the investment industry. Of course if investors were unhappy with private funds they would not be investing in private funds and they would not be a large and growing segment of the investment industry.

Sources:

More Compliance Changes for Private Fund Managers

On Wednesday February 9 the SEC has a full agenda for its meeting and fund managers should pay attention. Here are the matters to be considered:

  1. The Commission will consider whether to propose rules and amendments under the Investment Advisers Act of 1940 (“Advisers Act”) for private fund advisers and whether to propose amendments to the compliance rule under the Advisers Act.
  2. The Commission will consider whether to propose new rules to address cybersecurity risk management for investment advisers and investment companies as well as related amendments to certain rules regarding adviser and fund disclosures under the Investment Advisers Act of 1940 and the Investment Company Act of 1940.
  3. The Commission will consider whether to propose rules and rule amendments under the Securities Exchange Act of 1934 to shorten the standard settlement cycle for most securities transactions.  The proposed rules and rule amendments would be applicable to broker-dealers and certain clearing agencies.  The Commission also will consider whether to propose rule amendments under the Investment Advisers Act of 1940 to require investment advisers to maintain certain related records.
  4. The Commission will consider whether to propose amendments to its whistleblower rules.

For the first item, I don’t have any insight into what is cooking in the SEC’s regulatory kitchen. Whatever is in the oven is coming out hot and for private fund managers. I’m going to guess its related to fees and fee disclosure. I think the Chair Gensler’s November 10 speech at the Institutional Limited Partners Association Summit may give us some insight.

I wonder whether fund investors have enough transparency with respect to these fees. I wonder whether limited partners have the consistent, comparable information they need to make informed investment decisions.
…
That’s why I have asked the staff to consider what recommendations they could make to bring greater transparency to fee arrangements.

I’m going to guess that the SEC is going to propose some kind of standard fee disclosure table for private funds like there is in registered funds.

As for item 2 on cybersecurity, I think we can look at Chair Gensler’s January 24 speech at the Northwestern Pritzker School of Law’s Annual Securities Regulation Institute.

Next, I’d like to discuss the broader group of financial sector registrants, like investment companies, investment advisers, and broker-dealers, beyond those covered by Reg SCI.

As I mentioned earlier, this group has to comply with various rules that may implicate their cybersecurity practices, such as books-and-records, compliance, and business continuity regulations. Building upon that, I’ve asked staff to make recommendations for the Commission’s consideration around how to strengthen financial sector registrants’ cybersecurity hygiene and incident reporting, taking into consideration guidance issued by CISA [Cybersecurity and Infrastructure Security Agency] and others.

I’m guessing we will see an expansion of cybersecurity requirements and reporting of cyber incidents to clients and investors.

We’ll have to tune it find out.

Sources:

Changes to Form PF

It’s been a decade since the SEC and FSOC pushed Form PF on to private funds. The SEC has decided it wants more data and has proposed an amendment to Form PF.  

The big change is next day reporting for key events by Large Hedge Fund Advisers and Private Equity Funds 

For large Hedge Funds: 

  • certain extraordinary investment losses 
  • significant margin and counterparty default events,  
  • material changes in prime broker relationships,  
  • changes in unencumbered cash,  
  • operations events, and  
  • events associated with withdrawals and redemptions 

For Private Equity Funds: 

  • execution of adviser-led secondary transactions,  
  • implementation of general partner or limited partner clawbacks,  
  • removal of a fund’s general partner,  
  • termination of a fund’s investment period, or  
  • termination of a fund. 

The purpose is provide more timely information to the SEC and FSOC and presumably signal distress in the markets quicker than the current delayed reporting. 

Commissioner Pierce opposed the changes. She does not think it will actually provide useful information for FSOC. She thinks it’s just a grab by the SEC to enhance enforcement activity and twist the form into micro-management by the SEC. In particular, the one-day period is an incredibly short term for a firm that will likely be focused on trying to resolve issues rather than regulatory reporting.  

Chair Gensler raised the specter of Long Term Capital Management in 1998. He used this as the boogeyman for why the SEC needs such intensive and quick reporting. 

Net assets managed by private funds rose to $11.7 trillion in the first quarter of last year from $5.3 trillion in 2013, SEC data show. There were 6,910 private equity funds with $1.60 trillion in gross assets in first quarter of 2013 and 15,584 funds with $4.71 trillion in gross assets in the fourth quarter of 2020. 

The proposal would reduce the threshold that triggers reporting as a large private-equity adviser to $1.5 billion from $2 billion in assets under management. That would pull approximately 75% of private equity funds into the reporting regime. 

The Form PF still has that clunky definition of a “hedge fund” that leaves fund managers with subscription credit facilities wondering if they might considered a hedge fund.

Sources: