Compliance Roundup for April 5, 2024

Compliance Update for the week Ending April 5, 2024

For our clients and compliance colleagues, this weekly update will give you a quick look at the latest regulatory developments.  Enjoy!


Spring and T+1 are Coming: Are You Ready?

The SEC’s Division of Examinations (EXAMS) issued a risk alert entitled Shortening the Securities Transaction Settlement Cycle, highlighting the fact that the amendments under the Securities Exchange Act of 1934 (the “Exchange Act”) changing the settlement cycle for most broker-dealer transactions will be shortened from T+2 to T+1 on May 28, 2024. The risk alert lets broker-dealers and advisers know that EXAMS will be “engaging” with them through examination and outreach. It provides some details about the scope and content of this engagement. Significantly, EXAMS included a sample list of requests for information EXAMS may use to assess a firm’s readiness.

For investment advisers, the SEC amended the Advisers Act Recordkeeping Rule (Rule 204-2).  The changes require firms to maintain “each confirmation received, and any allocation and each affirmation sent or received, with a date and time stamp for each allocation and affirmation that indicates when the allocation and affirmation was sent or received” for orders subject to Exchange Act Rule 15c6-2(a). Copies can be retained electronically.  SEC-registered advisers should determine how they are going to maintain these records and update their recordkeeping policies and procedures accordingly. Moreover, EXAMS is concerned that some firms are lagging behind, stating “custodians and investment managers that manually affirm their transactions are providing affirmations at a significantly lower rate on trade date than prime brokers or investment managers that use central matching tools.”  For more details, please review the Risk Alert.

SEC Provides Guidance on Calculating Gross and Net IRR for Private Funds

The SEC updated its Marketing Compliance Frequently Asked Questions to clarify its expectation that private funds must present gross and net internal rates of return consistently. The staff states that the Marketing Rule (Advisers Act Rule 206(4)-1) “requires that any presentation of gross performance be accompanied by a presentation of net performance that has been calculated over the same time period and using the same type of return and methodology as the gross performance.”

The staff notes that certain private fund advisers have been showing their gross internal rate of return (“Gross IRR”) calculated from the time the investment is made without reflecting fund borrowing or subscription facilities. That Gross IRR is presented alongside the net internal rate of return (Net IRR) calculated to reflect the impact of fund borrowing.  The staff views this as violating the Marketing Rule since it results in IRR calculations “being made across different time periods (e.g., Gross IRR Calculations beginning when funds initially use their lines of credit to acquire investments, and Net IRR calculations beginning only once all capital commitment are called and their lines of credit are retired.).” For more details, check out the FAQs here.

SEC Updates Internet Adviser Exception

The SEC officially adopted amendments to Advisers Act Rule 203A-2(e) and Form ADV, allowing investment advisers who provide services exclusively through the Internet to register with the SEC without meeting the minimum assets under management threshold. (Check out our blog post, SEC Proposes Change to the Internet Adviser Exemption).  The rule was originally adopted in 2002 to relieve internet-based advisers from registering in multiple states.  Based on the Adopting Release, the SEC’s goal is to tighten up some loopholes in what was intended to be a very narrow exemption for firms that exclusively provide advice through an interactive website.  The amendments require an adviser relying on the exemption to have an “operational interactive website” for providing its advisory services on an ongoing basis. The amendments also eliminate the ‘de minimis’ exemption that allowed advisers to serve up to 14 non-internet clients in a 12-month period.  The SEC also amended Form ADV to require advisers relying on this exemption to represent on Schedule D that they have an operational interactive website.

The amendments will become effective 90 days after publication in the Federal Register. As noted in the SEC’s Fact Sheet, advisers relying on this exemption must comply with the updated rule by March 31, 2025. Advisers that cannot rely on the amended rule must either have another basis for SEC registration or register in one or more states and withdraw registration from the SEC.

SEC Expands the Definition of Broker

The SEC adopted two new rules, Rules 3a5-4 and 3a44-2 (the “Final Rules”), that may require hedge funds and proprietary trading firms that provide liquidity to other market participants to register as broker-dealers and become FINRA members. Under Section 3(a)(5) of the Exchange Act, a dealer includes “any person engaged in the business of buying and selling securities … for such person’s own account through a broker or otherwise” but excludes firms that buy or sell securities for their own account or as a fiduciary but not as a part of a regular business (emphasis added). This exclusion is typically referred to as the “trader” exception.  The Final Rules clarify what “part of a regular business” means and expand the definition of “dealer” and “government securities dealer.”  According to the Adopting Release, the Final Rules are required because of the “significant role of unregistered entities that act as liquidity providers.”

The rules provide no exclusions for investment advisers and private funds. Therefore, hedge funds that engage in high-frequency trading or significant trading activities may be affected. In the Adopting Release, the SEC analyzed prior Form PF reporting and speculated that about 12 private funds may fall within the rules’ parameters. However, the Commission made no promises as to the accuracy of this number.

The new rules include two tests for determining whether an entity that buys or sells securities as part of its “regular business” should be considered a broker: the “Trading Interest Factor” test and the “Primary Revenue Factor” test. See the SEC’s Fact Sheet for more details on how these tests apply.

For most investment advisers, these new rules have no effect.  The Adopting Release states that the new rules would not cover trading interests expressed by investment advisers as part of their fiduciary duty, such as placing orders or getting quotes on behalf of clients.

Don’t Make Promises You Can’t Keep: SEC Shuts Down “AI Washing”

With all the buzz about artificial intelligence (AI), it’s unsurprising that investment advisers have hopped on the bandwagon to use this technology in their investment processes.  However, a few firms got into trouble for claiming to use AI and machine learning to improve their investment performance. More specifically, the SEC settled charges against two investment advisers for ‘AI washing.’  In one case, the adviser touted its proprietary algorithms to make predictions across thousands of publicly traded companies up to two years in the future. Similarly, the second adviser claimed that its technology incorporated expert AI-driven forecasts.  Neither firm could provide evidence of their AI use and ended up paying $400,000 in civil penalties.

The lesson from these cases is not new – the SEC’s fraud standard under Section 206 of the Advisers Act is very strict. If you say it, you must prove it.

  • Recent Posts

  • Categories


  • Archives

Compliance Roundup for April 5, 2024