After its fiscal year-end frenzy in September, the SEC relaxed slightly, with no new rule-making and fewer enforcement actions. So, I took a break last month and combined the October and November Roundups. You’re welcome. Things have perked up this month with EXAMS’ release of its 2025 priorities and publication of a new FAQ on Form PF’s compliance deadlines. The SEC also settled with two advisers on “greenwashing” charges, presumably resulting from EXAMS promise in its 2020 Exam Priorities to review “the accuracy and adequacy of disclosures provided by RIAs offering clients new types or emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate environmental, social, and governance (ESG) criteria.” I also could not resist including two cases from September. The first case includes a textbook example of the issues raised when cross-trading illiquid fixed-income securities. The second case provides a rare example of the SEC pursuing a firm for failing to register because of operational overlap.  Enjoy!       

2025 Examination Priorities

The SEC’s Division of Enforcement (EXAMS) released its 2025 Examination Priorities with its usual list of focus areas. Like 2024, EXAMS will be looking at how investment advisers meet their duty of care and loyalty, economic incentives, and client disclosures.

 The top hits for investment advisers include:

• Adherence to Fiduciary Standards of Conduct. EXAMS will “focus on recommendations related to (1) high-cost products; (2) unconventional instruments; (3) illiquid and difficult-to-value assets; and (4) assets sensitive to higher interest rates or changing market conditions, including commercial real estate.”  EXAMS will also be looking at advisers affiliated with broker-dealers, examining the suitability of recommendations for advisory accounts, disclosures about whether the adviser is acting as a fiduciary, the account selection process, and best execution.
• Effectiveness of Advisers’ Compliance Programs. Like prior years, EXAMS will be looking at how advisers that outsource investment management are meeting their fiduciary obligations, how firms are disclosing other sources of revenue, and the appropriateness and accuracy of fee calculation, “such as those associated with select clients negotiating lower fees when similar services are provided to other clients at a higher fee rate.”  
• Private Fund Advisers. EXAMS plans to review whether such advisers manage assets consistent with disclosures, accurately calculate fees and make appropriate offsets, disclose conflicts and risks, and comply with recently adopted SEC rules, including amendments to From PF and the Marketing Rule.
• Never Examined Advisers, Recently Registered Advisers, and Advisers Not Recently Examined. Newly registered firms should prepare for an initial exam. Those who have not had the pleasure of an examination ever, or at least in recent years, should prepare.

Keep in mind, however, that EXAMS regional offices often have their own agendas and may focus on other areas.

The SEC also promises to review risks applicable to multiple market participants, including how firms prepare for operational disruptions caused by cybersecurity attacks, weather-related events and geopolitical concerns. Compliance with May 2024 amendments to Regulation S-P, which require adopting policies and procedures for data breaches, incident response and service provider oversight, will also be on the SEC’s radar, although the compliance dates remain far in the future. Use of artificial intelligence will also be subject to scrutiny to ensure the accuracy of firm representations, the appropriateness of algorithm-produced advice and the adequacy of controls.  Firms offering crypto-asset-related services may also see additional examination questions. 

These priorities have not significantly changed since last year.  For those concerned that an exam is in their future, the best preparation is to maintain a compliance program tailored to your firm’s business and ensure you have the records to prove it.

Wondering When to Start Using Amended Form PF? SEC has the Answers

The SEC’s Division of Investment Management published additional “Form PF Frequently Asked Questions” to address the March 12, 2025 compliance date for the amendments adopted on February 8, 2024. The FAQs walk through different scenarios to answer when private fund advisers need to use the amended form.  Hint: Generally, any filings made after March 12, 2025, must be on the amended Form PF.

SEC Continues Long-Term Hunt for “Greenwashing”

Whenever an investment strategy is wildly successful at attracting new investors, the SEC takes notice. For example, the SEC’s Division of Examinations (“EXAMS”) 2020 Examination Priorities included a focus on ESG investment strategies. The results of this focus are now becoming public through the publication of settlement actions.

The splashiest case involved an investment adviser who paid a $17.5 million civil penalty for exaggerating the percentage of its AUM selected using ESG considerations. The SEC highlighted the fact that the firm included passive exchange-traded funds, which track indexes, in its total of “ESG integrated” assets. The firm also failed to produce a written policy or formal framework to define what “ESG integration” meant for the firm.

In another case, the SEC settled with an adviser (the “Adviser”) for failing to invest its ETFs in accordance with its investment policy. The Adviser marketed three ETFs as incorporating ESG factors and told the fund’s board of trustees and investors that the funds were not invested in fossil fuels and tobacco. In executing its investment strategy, the Adviser used outside vendors to identify companies involved in fossil fuels and tobacco sales. However, these vendors did not screen out all the companies involved in the prohibited activities. Surprisingly, the Adviser was aware of these gaps but did not inform its mutual fund board or revise its marketing materials. Ultimately, the funds held securities of companies involved in fossil-fuel-related activities and sold tobacco. The Adviser was required to pay a $4 million civil penalty.

The lessons learned from these cases include:

• Clearly define what “ESG” factors your firm considers part of its investment process. For example, in the first case discussed above, the firm failed to have consistent policies and procedures for defining “ESG Integration.” This ultimately led to the firm including passively managed funds in the total ESG-integrated assets.
• Develop a process to ensure the accuracy of the ESG process and its disclosure. Consider detailed investment policies and procedures regarding ESG investing, including specific documentation supporting each stage of the process.
• Understand data provided by outside vendors. Firms must assess the quality of the ESG data provided by understanding the source of the information, how it is collected, and how often the data is updated. Firms should also understand the vendor’s methodology and consider whether an ESG rating is consistent with the firm’s own knowledge and opinion of the company.  Check out the CFA Institute’s Guidance for Integrating ESG Information into Equity Analysis and Research Reports for more guidance.
• Ensure your firm has implemented internal controls to monitor client-mandated investment prohibitions. As noted in EXAMS’ Risk Alert: The Division of Examinations’ Review of ESG Investing, firms need to understand client directives and implement systems to “consistently and reasonably track and update clients’ negative screens leading to the risk that prohibited securities could be included in client portfolios.” For example, if a client does not want to invest in tobacco industries, then the investment guidelines should include specific language as to what that means. For example, could the adviser invest in a company that receives a small amount of its revenue from tobacco sales?  Or is it just tobacco growers and distributors?  

For more guidance on implementing an ESG investment approach, firms should review the SEC’s risk alert from 2021, which highlights some policies, procedures and practices that the SEC liked. The CFA Institute has also provided guidance on integrating ESG information into investment analysis, available here.   

SEC Charges Adviser $70 Million for Pricing Short Cuts and Cross Trading Violations

 Valuation of portfolio assets is always a hot button for the SEC, especially where the adviser is responsible for fair valuing the assets. In one of the many cases reported at the end of September, the SEC settled charges against an investment adviser for overvaluing certain illiquid mortgage obligations (CMOs), requiring payment of a $70 million penalty plus disgorgement. At issue was the adviser’s pricing for certain illiquid, small-sized positions called “odd lots.” Generally, odd lot bonds trade at a discount to larger, round-lot positions because they are more difficult to trade. In this case, however, the adviser used a pricing vendor’s valuation for all CMOs, even though the vendor’s pricing was based solely on round-lot positions. The SEC found that this practice overvalued some of the bonds, resulting in false and misleading disclosures, breaches of the Advisers Act and Investment Company Act Compliance Program Rules, and violations of the cross-trading rules under the Investment Company Act.  

Interestingly, the Adviser performed an internal pricing analysis in August 2018, presumably in response to an SEC settlement where an adviser was cited for overvaluing bonds by using vendor-supplied round-lot pricing for odd-lot positions. The analysis estimated that the firm’s odd lot positions traded at discounts to pricing vendor marks ranging from 3% to 28%, with the discount proportionally higher as the lot size decreased. Apparently, this analysis did not convince the adviser’s pricing committee to discontinue using the pricing vendor marks. The SEC only says that the committee decided it was “industry practice” to continue.

This valuation practice affected the Adviser’s separately managed accounts, private funds and mutual funds by inflating their performance and resulting in unlawful cross-trading. Without going into all the details, the adviser engaged in cross-trading some of the CMOs among client accounts, using the pricing vendor’s marks, violating both the firm’s internal policies and Rule 17a-7 of the Investment Company Act.  Rule 17a-7 requires that cross-trades be executed at the “independent current market price,” defined, in this case, as “the average of the highest current independent bid and lowest current independent offer determined on the basis of reasonable inquiry.”     

In a surprising twist, a portfolio manager for the Adviser’s two mutual funds learned about some proposed cross trades and rang the alarm bell. Consequently, in September 2018, the Adviser’s executive committee heard about the issue and decided to discontinue purchasing odd lot positions. The committee did not, however, implement policies and procedures to fair value existing odd lot positions or disclose the liquidity risks of the existing odd lot positions in client accounts.     

 The big takeaways here are:

• Because valuation is part of an adviser’s fiduciary duty, firms must strictly follow the Advisers Act rules and internal policies and procedures. In this case, the pricing committee knew that using the pricing vendor’s marks resulted in an overvaluation of the bonds at issue. Perhaps the committee decided that using round-lot pricing was more cost-efficient than getting broker quotes or fair valuing the bonds; the difference in pricing was not significant, or the pricing was consistent with industry practice to justify continuing to use the pricing vendor’s marks. The settlement order does not give us these facts. The SEC, however, does not buy into any “reasonableness” arguments.
• Be extra careful when dealing with registered investment companies (i.e., mutual funds) since additional rules may apply. In this situation, the cross-trading activity included trades between separately managed accounts and registered investment companies. As noted above, mutual funds are only allowed to engage in cross-trades with affiliates of their adviser (which include other accounts managed by the same adviser) if the conditions of Investment Company Act Rule 17a-7 are met. The Adviser did not execute the trades at the “independent current market price” as required by the rule, and the mutual fund investors were harmed by paying higher prices for the bonds.   
• Cross-trading may benefit clients but carries risks for the adviser. As evidenced by this case, an adviser’s fiduciary duty dictates that the firm must prove
  • The cross-trade benefits both the buyer and the seller. Consider documenting approval by the portfolio managers for all accounts involved and the compliance department.
  • The cross-trade’s execution price reflects independent market prices. If market prices are unavailable, the firm’s fair valuation process must be strictly followed. Keep in mind that crossing illiquid securities is inherently riskier than crossing those with an easily ascertainable market value. Moreover, certain clients, such as registered investment companies and accounts subject to ERISA, are prohibited from cross-trading unless certain regulatory requirements are met.
• Involving a broker-dealer does not automatically mean the firm is not engaging in a cross-trade. Compliance departments can test for unapproved cross-trading activity by checking for trades on the same day, where a security is bought and sold through the same broker-dealer in the same lot size, and the adviser is on both sides of the transaction.   

For more insights into the valuation of illiquid bonds and the perils of cross-trading, check out these resources:

• Division of Examinations Risk Alert: Observations Regarding Fixed Income Principal and Cross Trades by Investment Advisers from An Examination Initiative
• Investment Advisers Act of 1940 Release No. 4577, December 1, 2016
• Investment Advisers Act of 1940 Release No. 3762, January 27, 2014

Adviser Found Guilty of Failing to Register in Rare Case of Operational Overlap

SEC registration as an investment adviser brings with it many legal and compliance obligations. So, it’s no surprise that some firms seek to set up separate entities to avoid regulatory burdens, including compliance with the Custody Rule (Advisers Act Rule 206(4)-2). The SEC, however, generally ignores legal structures, viewing investment advisers and their affiliates wholistically.

One firm learned this lesson the hard way. The adviser (the “Adviser”) completed the paperwork to register as an exempt reporting adviser back in 2018. The Adviser was affiliated with another SEC-registered investment adviser (the “Registered Adviser”) through common ownership. The firms also shared office space, IT systems, an email domain, a phone number and employees. The Adviser relied on Section 203(m) of the Advisers Act, which provides an exemption from SEC registration for advisers that provide advice solely to private funds with less than $150 million in assets under management.

Technically, the Adviser met the exemption’s requirements. However, Advisers Act Section 208(d) says it’s unlawful for someone to do something indirectly that they could not do directly under the Act. Back in 2011, when the exempt reporting adviser exemption was adopted, the SEC referred to section 208(d), giving advisers a heads up that they would be looking at the activities of an adviser’s affiliates when determining whether an adviser qualified for the exemption.  The SEC stated on page 125 of the release that “we would treat as a single adviser two or more affiliated advisers that are separately organized but operationally integrated, which could result in a requirement for one or both advisers to register.”

The facts that resulted in the settlement included:

• Overlapping ownership between the two advisers
• Common CCO for both firms
• Owners of both firms also acted as portfolio managers for the two advisers
• “Significant” personnel overlap between firms, including employees who provided investment advice
• Operational overlap between the firms, including sharing offices, email domain and phone number, and IT system.

The penalty imposed was rather small by SEC standards, only $45,000, presumably because the adviser took prompt remedial actions, including steps to recognize its operations and separate its advisory functions from its affiliate. The Adviser also agreed to engage an independent public accountant to perform a surprise examination to verify the funds’ assets.

The takeaway from this case is that reading the rule is not always enough. It is not easy to keep abreast of the SEC’s interpretations, especially when they are expressed on page 128 of a 208-page adopting release or require familiarity with more obscure SEC settlement orders (e.g., Advisers Act Release No. 3859, Advisers Act Release No. 3858, and Advisers Act Release No. 4733). Therefore, it’s important to get expert advice.

Photo by Priscilla Du Preez 🇨🇦 on Unsplash

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