Legal Alert

Investment Management Update

February 15, 2019

SEC Proposes New Fund of Funds Rule and Related Amendments

The Securities and Exchange Commission (SEC) has proposed a new rule and related amendments designed to streamline and enhance the regulatory framework for "fund of funds" arrangements. Rule 12d1-4 would permit registered funds to invest in other registered funds beyond the limits of Section 12(d)(1) of the Investment Company Act of 1940 (the 1940 Act) without the need for individual exemptive orders from the SEC. In addition, the SEC proposes to rescind Rule 12d1-2, as well as some exemptive orders permitting fund of funds arrangements, and to amend Rule 12d1-1. Finally, the SEC is proposing certain disclosure amendments to Form N-CEN. These proposals are described below.

Proposed Rule 12d1-4

This proposal would permit a registered investment company or business development company (collectively, the “acquiring funds”) to acquire the securities of any other registered investment company or business development company (collectively, the “acquired funds”) in excess of the limits in section 12(d)(1) of the 1940 Act, subject to the following conditions:

  • Control and Voting. The proposed Rule 12d1-4 would prohibit an acquiring fund from controlling an acquired fund. Control would be determined using the Section 2(a)(9) definition, including the rebuttable presumption of control. Thus, up to 25% of an acquired fund’s shares normally could be acquired by an acquiring fund. Further, the proposed Rule 12d1-4 would require an acquiring fund that holds more than 3% of an acquired fund’s outstanding voting securities to vote those securities in the manner prescribed by Section 12(d)(1)(E)(iii)(aa) in order to minimize the influence that an acquiring fund may exercise over an acquired fund. Notwithstanding the foregoing, an acquiring fund that is part of the same fund group as the acquired fund and an acquiring fund that has a sub-adviser that acts as adviser to the acquired fund would not be subject to such control and voting conditions.

  • Redemption Limits. To address concerns that an acquiring fund could threaten large-scale redemptions as a means to exert undue influence over an acquired fund, the proposed Rule 12d1-4 would prohibit an acquiring fund that acquires more than 3% of an acquired fund’s outstanding shares from redeeming more than 3% of the acquired fund’s total outstanding shares in any 30-day period.

  • Duplicative and Excessive Fees. The proposed Rule 12d1-4 includes conditions designed to prevent duplicative and excessive fees in fund of funds arrangements by requiring an evaluation of aggregate fees associated with the investment in the acquired fund and the complexity of the fund of funds arrangement.

  • Complex Structures. To limit funds’ ability to use fund of funds arrangements to create overly complex structures, proposed Rule 12d1-4 generally would prohibit funds from creating three-tier fund of funds structures, except in certain limited circumstances. An investment company intending to rely on the proposed Rule 12d1-4 must disclose in its registration statement if it is, or at times may be, an acquiring fund relying on the proposed Rule 12d1-4.

Rescission of Rule 12d1-2 and Certain Fund of Funds Exemptive Relief

Rule 12d1-2 permits funds that invest in funds within the same fund group to invest in unaffiliated funds and also direct investments in nonfund assets. In coordination with the proposed Rule 12d1-4, the SEC is proposing to rescind rule 12d1-2 and exemptive orders permitting fund of funds arrangements, with limited exceptions.

Proposed Amendments to Rule 12d1-1

The SEC is also proposing to amend Rule 12d1-1 to provide funds relying on Section 12(d)(1)(G) with continued flexibility to invest in money market funds outside of the same group of investment companies if they too rely on Section 12(d)(1)(G). The SEC believes that retaining this flexibility will help to ensure that funds in smaller complexes that do not have a money market fund as part of their fund complex may invest available cash in an unaffiliated money market fund.

Proposed Amendments to Form N-CEN

Currently, Item C.7 of Form N-CEN requires funds to report whether they relied on certain 1940 Act rules during the reporting period, including Rule 12d1-1. The proposed Form N-CEN amendments would require funds to report whether they relied on Rule 12d1-4 or the statutory exception in section 12(d)(1)(G) of the 1940 Act during the applicable reporting period.

The comment period for the proposed rule and amendments will be 90 days after publication in the Federal Register.

by Joanna (Ying) Jiang

OCIE Priorities for 2019

The Office of Compliance Inspection and Examinations (OCIE), which manages the SEC's National Exam Program, has released its examination priorities report for 2019, including cybersecurity and cryptocurrency.

OCIE maintains approximately 1,000 staff members across 11 regional offices and supervises investment advisers, mutual and exchange-traded funds, and broker-dealers, among other regulatory responsibilities. OCIE completed more than 3,150 examinations in fiscal year 2018, a 10% increase over FY 2017, and examinations of investment companies alone rose by 45% year-over-year.

OCIE’s examination 2019 priorities stem from the agency's four pillars: (1) promoting compliance, (2) preventing fraud, (3) identifying and monitoring risk, and (4) informing policy. Each year, OCIE selects priorities to advance each pillar and addresses them through a combination of examinations, risk alerts, and outreach to investors and industry participants.

The examination priorities for 2019 include:

  • Matters of importance to retail investors, including seniors and those saving for retirement;
  • Compliance and risk in registrants responsible for critical market infrastructure;
  • Select areas and programs of Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB);
  • Digital Assets (such as cryptocurrencies, coins, and tokens);
  • Cybersecurity; and
  • Anti-Money Laundering.

Though OCIE views this list as non-exhaustive, it provides a fair preview of the Office’s areas of emphasis for the year ahead.

Matters of Importance to Retail Investors, Including Seniors and Those Saving for Retirement

OCIE plans to pursue examination of investment firms that provide products and services to retail investors, and in particular, to seniors and those saving for retirement. One area of interest within this examination priority is disclosure of fees and expenses. OCIE intends to review fees charged to advisory accounts, and select for examination firms with practices or business models that increase the risk of under-disclosure. Investment advisers should consider the adequacy of disclosures concerning wrap fee programs.

In addition, OCIE will review conflicts of interest for investment advisers and broker-dealers. This includes use of affiliated service providers and products, securities-backed non-purpose loans and lines of credit, and borrowing funds from clients. In each case, OCIE emphasizes the importance of disclosing possible conflicts.

OCIE further intends to review certain practices of broker-dealers and investment advisers. The office will review interactions of broker-dealers with senior investors to ensure prevention of financial exploitation. OCIE also recommends that investment advisers review the products and services provided to seniors and individuals saving for retirement for the presence of compliance programs, appropriate investment recommendations, and supervision of employees and representatives.

OCIE plans to continue examinations of mutual funds and exchange-traded funds, municipal advisers, broker-dealers that are entrusted with customer assets or that sell microcap securities, and, generally, investment advisers it has not recently examined.

Compliance and Risk in Registrants Responsible for Critical Market Infrastructure

OCIE identified several registrants responsible for critical market infrastructure it intends to prioritize in 2019. For one, OCIE will conduct annual examinations of clearing agencies the Financial Stability Oversight Council selected as systematically important, and for which the SEC is the supervisory agency. Examinations will focus on compliance with SEC standards and appropriate corrections based on prior examinations, among other areas that may be identified.

OCIE will also prioritize examination of entities subject to Regulation Systems Compliance and Integrity (SCI). Examinations will include review of policies and procedures required by Regulation SCI, controls related to governance procedures, internal audit programs, inventory management, and threat management capabilities.

Transfer agents also are a 2019 focus for OCIE, particularly those serving as paying agents for issuers, those developing blockchain technology, and those providing services to issuers of microcap securities, private offerings, crowdfunded securities, and digital assets. The office will review transfers, recordkeeping, safeguarding of assets, and the requirement that transfer agents file an annual report by an independent accountant regarding accounting controls.

Lastly, OCIE will also review national securities exchanges and their internal audit and surveillance programs and funding for regulatory programs.

Select Areas and Programs of FINRA and MSRB

Included among OCIE’s examination priorities are particular matters related to FINRA and MSRB. For FINRA, the office will review its regulatory programs and the quality of examinations of its members. For MSRB, OCIE will focus on evaluating its policies, procedures, and controls.

Digital Assets (such as cryptocurrencies, coins, and tokens)

In light of the growth in the prominence of digital assets and the involvement of investment advisers and broker-dealers in trading them, OCIE will prioritize review of the offer and sale, trading, and management of such assets when they qualify as securities. See also our prior article here.


Cybersecurity continues to be a key issue for regulators, including OCIE. See also our prior article here. As a result, OCIE will prioritize cybersecurity reviews across its examination programs, focusing on issues such as information security governance, network storage, and policies and procedures concerning retail trading information security. Investment advisers with multiple branch offices are likely targets for reviews, including of governance and risk assessment, access rights and controls, and incident response, among other issues.

Anti-Money Laundering

Broker-dealers are required to establish anti-money laundering programs under the Bank Secrecy Act. OCIE will prioritize examination of broker-dealers for compliance with these obligations, such as establishing policies and procedures reasonably designed to prevent money laundering, along with ensuring they are making necessary filings and implementing and testing their programs.

by Paul D. Hallgren

FINRA Launches Amnesty Program for Potential Violations of Share Class Sales in 529 Plans

FINRA recently issued Regulatory Notice 19-04 to members, announcing an enforcement amnesty program for members who may have committed violations in connection with sales of shares of 529 plans. The amnesty program is called the 529 Share Class Initiative (the 529 Initiative).[1] Its purpose is to encourage broker-dealer member firms to self-report potential violations of share class sales in exchange for more lenient settlement terms. Firms must self-report and provide FINRA with a remediation plan on or before April 1, 2019.

529 plans are tax-advantaged municipal securities that plan participants can use to pay eligible educational expenses. The plans are named for Section 529 of the Internal Revenue Code, which governs the tax treatment of securities. Shares in 529 plans are commonly sold in different classes with different fee structures. “A” shares impose front-end sales charges with a lower annual fee, while “C” shares impose no front-end sales load, but impose a higher annual fee.  The share class appropriate for a client depends on the client’s expected investment horizon.

Interests in 529 plans are municipal securities and not subject to the prospectus delivery and registration requirements of the Securities Act of 1933. FINRA member firms sell shares in 529 plans under MSRB Rule G-27, which requires supervisory systems related to the offer and sale of municipal securities in compliance with securities laws.

In 2018, the Internal Revenue Code was amended to expand the use of 529 plans from college expenses to expenses for grades K-12, and subject to certain limitations. As 529 plan sales may increase due to this change, FINRA is concerned with ensuring that member firms sell the appropriate share class for a client’s investment horizon.

FINRA is encouraging member firms to review their supervisory systems governing 529 plan sales and self-report violations. Key areas of FINRA concern failure to:

  • train representatives in the costs and benefits of different share classes;
  • understand and assess different costs of share classes for individual transactions;
  • receive or review data reflecting 529 plan share classes sold; and
  • review share-class information including breakpoint discounts or sales charge waivers, when reviewing suitability of 529 plan recommendations.

Firms are encouraged to conduct customer-specific analyses and review client portfolios and investment horizons to determine if clients own the appropriate share class. FINRA notes that if a firm knows or should know that a client’s investment horizon is longer than six or seven years, a class C share is typically more expensive than an A share. This situation could indicate a potential violation.

To receive amnesty, member firms must report violations by April 1, 2019, for the years 2013-2018. The firm must submit detailed data on sales made under 529 plans and include an assessment of supervisory systems, and describe a proposed restitution and remediation program.  In exchange for self-reporting, member firms will be required to make restitution and receive a censure, but no FINRA fine.

FINRA warned that it will continue to focus on 529 plan sales. Firms that do not self-report will face stiffer sanctions if FINRA finds that the firm should have self-reported violations. FINRA also cautioned that the 529 Plan Initiative offers amnesty only to firms and not to individuals involved in sales violations.

by Jonathan B. Levy

SEC Increases Enforcement Attention on Robo-Advisers

The SEC’s Division of Enforcement has recently stepped up its enforcement activity against “robo-advisers”—investment advisers that operate an automated digital investment advisory program marketed to clients over the internet. The prevalence of robo-advisers has grown tremendously in the last few years.

Hedgeable, Inc.

In the matter of Hedgeable, Inc., the SEC charged a relatively small New York based robo-adviser with fraud, dissemination of false or misleading advertising, failing to maintain books and records, and failure of its compliance policies and procedures. Hedgeable admitted to the SEC's allegations and accepted the terms of an administrative order, including sanctions.

To try to recruit clients over the internet, Hedgeable created an index of robo-adviser performance based on competitor robo-advisers' advertised performance. Hedgeable compared the index performance to a Hedgeable composite that was supposed to reflect the performance of a typical Hedgeable client strategy. Hedgeable marketed its favorable composite performance against the “Robo-Index” it created. Both the composite and the index were materially misleading.

The Hedgeable composite was not reflective of Hedgeable’s clients and involved classic cherry-picking. The composite included only a small subset of clients during the comparison period.  Hedgeable used only 4% of its client accounts during the comparison period, ignoring 96% of its accounts.

The so-called “Robo-Index” created by Hedgeable to compare its performance against its competitors was not a real index derived from competitors’ actual trading models. Hedgeable calculated the Robo-Index based on its own analysis of publicly available information from competitors’ websites using estimates of the competitors’ trading models. Hedgeable made its own assumptions on when the competitors would have rebalanced their portfolios, without any basis in fact. Hedgeable touted its misleading superior performance in website advertising, widely disseminated fact sheets, and other disclosures.

An Index Must Be Genuine and a Composite Must Be Representative

If an adviser compares its performance to an index, the index must be an established index and not one created by the adviser. If an adviser creates a composite, the composite must accurately reflect client account strategies.

WealthFront, LLC

In the matter of Wealthfront Advisers, LLC f/k/a Wealthfront, Inc., the SEC’s Enforcement Division brought an enforcement action against a robo-adviser for making misleading statements concerning the tax advantages of the robo-adviser’s strategy. Wealthfront is a Silicon Valley based robo-adviser that has over $11 billion in assets under management. Wealthfront claimed that it developed a proprietary tax loss harvesting strategy that would allow clients to sell certain assets at losses to offset taxable income or gains on other transactions, which would reduce client tax liabilities. Wealthfront admitted to the SEC's allegations and accepted the terms of an administrative order, including sanctions. 

Wealthfront advertised that it monitored its client account activity to avoid the application of the “wash sale” rule of the Internal Revenue Code. Under the “wash sale” rule, a client cannot recognize a loss on sale of a security if the client trades the same or a substantially identical security within a 30-day period. Wealthfront did not in fact monitor client accounts for compliance with the wash sale rule, and a large percentage of accounts had wash sales negate the benefit of Wealthfront’s tax strategy.   

In addition to misleading advertising about its proprietary trading strategy, Wealthfront used its Twitter feed to republish posts by other Twitter users making positive statements about Wealthfront. These Twitter users were undisclosed Wealthfront employees, Wealthfront investors, and Wealthfront clients who would receive free services from Wealthfront if a client came to Wealthfront through a Twitter post. In so doing, Wealthfront violated the prohibition in the Adviser’s Act against the use of testimonials.

Finally, Wealthfront also violated Rule 206(4)-3, the “Cash Solicitation Rule.”  Wealthfront created an affiliate program in which it paid bloggers who successfully solicited new clients on behalf of Wealthfront.  The Cash Solicitation Rule requires advisers to enter into a written agreement with solicitors, and requires that the solicitor make certain disclosures to solicited clients.

Advertising Rules, the Cash Solicitor Rule and the Restrictions on Testimonials Apply to All Advisers—Robo-Advisers Included

The Wealthfront enforcement matter is a reminder that the SEC remains vigilant about misleading advertising and advisers must be careful in what they claim. It is also a reminder that advisers may not pay to solicit business unless they comply with the Cash Solicitation Rule.

These recent cases reflect increased SEC focus on robo-advisers, but also serve as reminders that the rules apply equally to brick-and-mortar and internet-based advisers.

by Jonathan B. Levy

SEC OCIE Issues Risk Alert on Instant Messaging and Books and Records; Reminds Advisers on Best Practices

OCIE recently issued a National Exam Program Risk Alert reporting on the agency’s observations from investment adviser examinations on electronic messaging. OCIE is concerned that adviser representatives are using electronic messaging to interact with clients and not maintaining electronic records as required by Rule 204-2 (the “Books and Records Rule”).

Rule 204-2(a)(7) requires advisers to make and keep original records of all written communications related to, among other things: (1) investment recommendations; (2) receipts, disbursement, or delivery of funds or securities; (3) placing or execution of orders to purchase or sell securities; or (4) the performance or rate of return on client accounts or securities recommendations. The Books and Records Rule also requires that advisers keep records of all advertising, investment newsletters, and bulletins.

OCIE examinations revealed that advisers are using electronic communications such as text/sms messaging, instant messaging, personal email, and personal or private messaging. These communications were often sent using third-party platforms, and some firms do not have appropriate systems to archive, supervise, and maintain books and records for electronic communication.

Best Practices for Private Electronic Messages

OCIE identified the following best practices to meet an adviser’s record-retention obligations under the Books and Records Rule with respect to electronic messaging:

Policies on Electronic Messaging:

  • Advisers should only permit electronic communications for business purposes that can be used in compliance with the Advisers Act.
  • Advisers should prohibit use of applications that can be readily misused, such as those that allow anonymous communications, allow for automatic destruction of messages, or prohibit third-party viewing or backup.
  • If an employee receives a message using a technology prohibited by the firm, the firm’s policy should require the employee to move the applicable message to a system that complies with the Books and Records Rule.
  • If an adviser permits use of personal devices, the adviser must adopt policies and procedures to capture messages on such devices.
  • Advisers that allow employees to use social media platforms, personal email, or personal websites for business purposes must adopt policies and procedure to ensure business communications are maintained through those avenues.
  • Employees should be informed that violations of the adviser’s policies and procedures for electronic messaging could result in discipline or even termination.

Training Employees on Electronic Messaging:

  • Advisers should institute training on compliance and obtain attestations of compliance with the policies from employees.
  • If advisers allow the use of social media for business purposes, advisers’ compliance professionals should monitor social media posts and websites and archive business communications to ensure compliance.

Supervision Responsibilities:

  • Advisers should regularly review social media sites to make sure employees are using social media in an approved manner.
  • Advisers’ compliance professionals should run regular internet searches or set automated alerts to capture when an adviser’s name or employee’s name appears on a website to identify if unauthorized activity is occurring online.
  • Advisers should adopt a reporting program to allow employees to confidentially report potential violations.
  • Advisers should require approval from adviser’s compliance and IT professionals before using firm servers on personal devices.
  • Cybersecurity applications should be required for personal devices. 

OCIE’s Risk Alert is a good reminder that advisers need to make sure that compliance programs continue to evolve with changes in technology and communications.

by Jonathan B. Levy

[1] The Share Class Initiative follows the SEC’s Division of Enforcement’s 2018 amnesty program for mutual fund share class sale violations. See

Copyright © 2019 by Ballard Spahr LLP.
(No claim to original U.S. government material.)

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the author and publisher.

This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.

Subscribe to Ballard Spahr Mailing Lists

Get the latest significant legal alerts, news, webinars, and insights that affect your industry.