talking point - us.eversheds-sutherland.com · talking point. june 4, 2020. cynthia beyea, clifford...

© 2020 Eversheds Sutherland (US) LLPAll Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Eversheds Sutherland (US) LLP and the recipient. Eversheds Sutherland (US) LLP is part of a global legal practice, operating through various separate and distinct legal entities, under Eversheds Sutherland. For a full description of the structure and a list of offices, please visit www.eversheds-sutherland.com.

Asset Management Regulatory UpdateTalking point

June 4, 2020Cynthia Beyea, Clifford Kirsch, Michael Koffler, Susan Krawczyk, John Walsh and Lizet Steele

Eversheds Sutherland

Speakers

2

Clifford KirschNew York, NY+1 212 389 [email protected]

Michael KofflerNew York, NY+1 212 389 [email protected]

Susan KrawczykWashington DC+1 202 383 [email protected]

Cynthia BeyeaWashington DC+1 202 383 [email protected]

John WalshWashington DC+1 202 383 [email protected]

Lizet SteeleWashington DC+1 202 383 [email protected]


Agenda

─ The SEC’s proposed rule on fund valuation

─ The SEC’s request for comments on the fund names rule

─ The SEC’s proposed amendments to the adviser advertising and cash solicitation rules

─ The LIBOR transition

─ The upcoming June 30 compliance date for Regulation Best Interest and the Form CRS rules

3


The SEC’s proposed rule on fund valuation


What did the SEC do?

─ On April 21, it proposed a new rule under the Investment Company Act that would govern the valuation practices of fund boards• Proposed Rule 2a-5

─ Under the ICA, funds must value securities:• Using market values, when quotations are readily available• Otherwise using fair value as determined in good faith by the board• See Section 2(a)(41)

─ What is the regulatory issue?• To what extent can a board rely on others to assist its valuation process?• Currently governed by ASR 113 & 118 from 1969 & 1970

5


Why now?

─ SEC identified three relevant new developments:1. Congress passed the Sarbanes-Oxley Act

• Established the Public Company Accounting Oversight Board (PCAOB)• SEC adopted Rule 30a-3 to implement Sarbanes-Oxley for funds

2. SEC adopted Rule 38a-1• Requires compliance policies and procedures regarding valuation

3. Financial Accounting Standards Board (FASB) issued ASC 820• Defines fair value and establishes a framework for recognizing it under

GAAP

─ Bottom line: Valuation today is subject to higher levels of environmental control than it was 50 years ago

6


What must a board do?

─ Existing Law

─ SEC action against eight fund directors (2012)

─ Excessive delegation to adviser

─ “While it is understood that fund directors typically assign others the daily task of calculating the fair value of each security in a fund’s portfolio, at a minimum they must determine the method, understand the process, and continuously evaluate the appropriateness of the method used”

— SEC Enforcement Official

─ Current Proposal

─ Board may assign fair valuation to adviser

─ If the adviser:1. Provides quarterly reports2. Promptly reports problems3. Designates (by title) the responsible

advisory personnel and reasonably separates them from portfolio management

4. Keeps relevant records

7

Why is this relevant to other advisers?

─ Must assess and manage valuation risks

─ Must define methodologies• Must be consistent• Must specify inputs &

assumptions• Must specify methods for

future investments• Must monitor• Must be consistent with

ASC 820

─ Must test valuation methods periodically for appropriateness and accuracy

─ Must evaluate pricing services

─ Must establish criteria for pricing challenges

─ Must keep relevant records

8


Bottom line

─ The new rule is a process-driven, compliance-type approach to valuation:1. Risks faced2. Methods used3. Monitoring applied4. Oversight and escalation

─ You could see this as the Rule 38a-1 approach to valuation

─ Advisers Act Rule 206(4)-7 also requires compliance for valuation

─ NOTE: Comment period on the proposed rule closes on July 21, 2020

9


The SEC’s request for comments on the fund names rule


Background

─ Rule 35d-1 under the Investment Company Act of 1940

─ Adopted in 2001 as an investor protection measure

─ Requires a fund to invest at least 80% of its assets in the manner suggested by its name

─ Names Rule does not apply to a name describing a fund’s investment objective, strategies, or policies

─ 80% policy must either be fundamental or require 60 days’ notice to change

11


Request for Comments

─ Published on March 2, 2020

─ Comments were due on May 5, 2020

─ SEC identified current challenges, posed specific questions and invited industry comment

─ As of May 31, 2020, 46 comment letters received

12


Current Challenges

─ Derivatives

─ Hybrid financial instruments

─ Index funds

─ Names that include a qualitative assessment (e.g., ESG)

─ Incentive to use a name as a differentiator

13


Examples of Questions Posed

─ How do funds select their names?

─ Is the Names Rule effective at preventing funds from using deceptive or misleading names?

─ Should the Names Rule be repealed? If so, why?

─ Is the 80% threshold appropriate?

─ How do funds determine if an investment is part of a particular industry?

─ Should the Names Rule apply specifically to investment strategies?

14


Industry Comments Received

─ Support for retaining the Names Rule and the 80% threshold

─ Support that the Names Rule should not be applied to investment strategies (e.g., ESG)

─ Support for a fund’s ability to select how it determines industry classification

─ Support for changes in the way the Names Rule applies to:• Index funds• Derivatives

15


The SEC’s proposed amendments to the adviser advertising and cash solicitation rules


Overview

─ On November 4, 2019, the SEC proposed to modernize the Advisers Act Advertising Rule and the Cash Solicitation Rule

─ The proposal seeks to update the existing frameworks to reflect advances in technology and methods of communication and evolution in industry practice

─ Advertisement• Any communication, disseminated by any means, by or on behalf of an investment

adviser, that (i) offers or promotes investment advisory services or (ii) seeks to obtain or retain advisory clients or investors in any pooled investment vehicle advised by the adviser

• Exclusions• Live oral communications that are not broadcast on radio, TV or the internet• Responses to unsolicited requests for specified information other than:

• A communication to a retail person that includes performance results• A communication that includes hypothetical performance

• Advertisements or sales literature about a RIC or BDC that is within the scope of Rule 156 or Rule 482

• Information required to be contained in a statutory or regulatory notice, filing, or other communication

17


Definitions

─ Hypothetical Performance• Performance results that were not actually achieved by any

portfolio of any client of the investment adviser, including:• Performance derived from representative model portfolios that are

managed contemporaneously alongside portfolios managed for actual clients

• Performance that is backtested by application of a strategy to market data from prior periods when the strategy was not actually used

• Targeted or projected performance returns with respect to any portfolio or to the investment services offered or promoted in the advertisement

─ Non-Retail Person • Qualified purchaser definition in Section 2(a)(51) of the ICA• Knowledgeable employee definition in Rule 3c-5 under the ICA

18


General Prohibitions

─ An advertisement may not:• Include an untrue statement of material fact or omit a material fact• Include a material claim or statement that is unsubstantiated• Include an untrue or misleading implication about, or be reasonably likely

to cause an untrue or misleading inference to be drawn concerning, a material fact relating to the adviser

• Discuss or imply any potential benefits without clear and prominent discussion of associated material risks or other limitations

• Refer to specific investment advice provided by the adviser that is not presented in a fair and balanced manner

• Include or exclude performance results, or present performance time periods, in a manner that is not fair and balanced

• Otherwise be materially misleading

19


Testimonials, Endorsements and Ratings

─ Testimonials and Endorsements• Proposal permits testimonials (client statements) and endorsements

(third-party statements) if the adviser (or testimonial or endorsement) prominently discloses:

• The testimonial was given by a client or investor/the endorsement was given by a non-client or non-investor, as applicable; and

• If applicable, cash or non-cash compensation was paid by the adviser in connection with obtaining the testimonial or endorsement

─ Third-Party Ratings• Proposal would permit third-party ratings if the adviser:

• Reasonably believes that any questionnaire/survey used in preparing the third-party rating makes it equally easy for a participant to provide favorable and unfavorable responses, and is not designed or prepared to produce any predetermined result; and

• Makes certain disclosures (or if the third-party rating prominently discloses)

20


Performance Information

─ The proposed rule would prohibit including in any advertisement: • gross performance results unless it provides (or offers to provide promptly)

a schedule of fees and expenses deducted to calculate net performance• any statement that the calculation or presentation of performance results has

been approved or reviewed by the Commission• related performance unless it includes all related portfolios, provided that

related performance may exclude any related portfolios if: • the advertised performance results are no higher than if all related portfolios

had been included; and • the exclusion of any related portfolio does not alter the presentation of the time

periods prescribed by the rule• performance results of a subset of investments extracted from a portfolio,

unless it provides or offers to provide promptly the performance results of allinvestments in the portfolio

21


Hypothetical Performance

─ Proposal would prohibit including hypothetical performance in anyadvertisement unless the adviser: • Adopts and implements policies and procedures reasonably designed to

ensure that the performance is relevant to the financial situation and investment objectives of the recipient

• Recipient must have an objective for which hypothetical performance makes sense

• Recipient must have the financial and analytical resources to analyze the underlying assumptions and qualifications of the performance

• Discloses the criteria used and assumptions made in calculating the performance

• Provides (or, if recipient is a non-retail person, provides or offers to provide) the risks/limitations of the hypothetical performance

22


Performance Information in a Retail Advertisement

─ Advertisement targeted to a retail audience must:• Present net performance with equal prominence (calculated over the

same time period and using the same methodology); and • Generally require the presentation of performance results of a portfolio or

aggregation of related portfolios across 1-, 5- and 10-year periods

─ Net performance may reflect:• The deduction of a model fee when doing so would result in performance

figures that are no higher than if the actual fee had been deducted;• The deduction of a model fee that is equal to the highest fee charged to

the relevant audience of the advertisement; and • The exclusion of custodian fees

23


Advertising Rule: Pre-Use Review and Approval

─ The proposed rule would require advertisements to be reviewed and approved in writing by a designated employee before dissemination, except for advertisements that are:• communications disseminated only to a single person or household or to

a single investor in a pooled investment vehicle• live oral communications broadcast on radio, television, the internet or

any other similar medium

24


Solicitation Rule: Scope, Agreement and Oversight

─ Compensation. The rule would apply to both cash and non-cash (including directed brokerage, awards or other prizes, and free or discounted services) compensation arrangements

─ Extension to Private Fund Investors. The proposed rule would apply to the “solicitation” of current and prospective investors in private funds (i.e., classic brokerage activity)

─ Retain general requirement for written agreement, which must contain:• a description of the solicitation activities and compensation; • a requirement that the solicitor perform its solicitation activities in accordance with

the anti-fraud provisions of the Advisers Act; and • a provision that designates the solicitor or the adviser to provide the client (or

private fund investor), at the time of any solicitation activities (or if a mass communication, as soon as reasonably practicable thereafter) with a separate disclosure

─ The adviser must have a reasonable basis for believing the solicitor has complied with the written agreement

25


Disclosure Requirements

─ Modify the current solicitor disclosure to include additional information about a solicitor’s conflict of interest in making a referral• The separate disclosure must state:

• The adviser’s name;• The solicitor’s name;• A description of the adviser’s relationship with the solicitor; • The terms of any compensation arrangement, including a description of the

compensation (to be) provided to the solicitor;• A description of any potential material conflicts of interest on the part of the

solicitor resulting from the adviser’s relationship with the solicitor and/or the compensation arrangement; and

• The amount of any additional cost to the client (or private fund investor) as a result of the solicitation

─ Eliminate the current rule’s requirement that the adviser obtain from each client an acknowledgment of receipt of the disclosure

26


Disqualification

─ Proposal expands list of disciplinary events for which persons could be disqualified from acting as a solicitor, subject to an expanded exception

─ An adviser cannot compensate a solicitor, directly or indirectly, for any solicitation activity if the adviser knows, or, in the exercise of reasonable care, should have known, that the solicitor is an “ineligible solicitor”

─ Ineligible solicitor:• A person who is subject to a disqualifying Commission action or a

disqualifying event• Any employee, officer or director of an ineligible solicitor • If the ineligible solicitor is a

• Partnership, then all general partners• LLC managed by elected managers, then all elected managers

• Any person directly or indirectly controlling or controlled by the ineligible solicitor and any person described above with respect to such person

27


Exemptions

─ Impersonal investment advice (but not exempt from disqualification provisions)

─ Partners, officers, directors or employees and certain affiliates (but not exempt from disqualification provisions)• If the solicitor is one of the adviser’s partners, officers, directors,

or employees, or is a person that controls, is controlled by, or is under common control with the adviser, or is a partner, officer, director or employee of such a person, provided:

• The affiliation is readily apparent to or is disclosed to the client (or private fund investor) at the time of solicitation

• The adviser documents such solicitor’s status at the time the adviser enters into the solicitation arrangement

28


Exemptions

─ De minimis compensation• If the solicitor has performed solicitation activities for the adviser during the

preceding 12 month and the adviser’s compensation to the solicitor for those solicitation activities is $100 or less (or equivalent value in non-cash compensation)

─ Nonprofit programs• An adviser can participate in such programs without triggering the rule if:

• The adviser has a reasonable basis for believing that:• The solicitor is a nonprofit program;• Participating advisers compensate the solicitor only for the costs reasonably incurred in operating

the program; and • The solicitor provides clients a list of at least two advisers based on non-qualitative criteria (e.g.,

type of advisory services provided, geographic proximity, lack of disciplinary history, etc.); and • The solicitor or adviser prominently discloses to the client, at the time of solicitation:

• The criteria for inclusion on the list of advisers; and • That the advisers reimburse the solicitor for the costs reasonably incurred in operating the

program

29


The LIBOR transition


Items to consider when transitioning away from LIBORLIBOR Transition

─ Potential for contract default or frustration due to differences in rates• Spread adjustment methodology and term adjustment aim to minimize, to the extent possible, a value

transfer

─ Lack of forward-looking term rates for LIBOR fallback rates• E.g., SOFR for USD LIBOR, which is based on actual transactions referencing overnight rates on treasury

repos

─ Implementation of the compounded setting in arrears approach• The industry has proposed to use a lookback to solve for the fact that an overnight rate is not known until

the end of a payment period

─ Continued effectiveness of hedges

─ Capital impacts

─ Accounting and tax issues in relation to the transition to an alternative risk-free rate and the transition of legacy contracts

─ Securities, commodities, banking, insurance and consumer protection law ramifications

─ Avoidance of disputes, including litigation

31


Actions by regulatorsSOFR Transition Timeline and Progress

─ Staff of the Securities and Exchange Commission (SEC) published guidance that encourages market participants, including public companies, investment advisers, investment companies and broker-dealers, to commence or carry on the following two action items in connection with the LIBOR transition: 1. appropriate disclosures of material exposure to LIBOR and 2. the type of activities that market participants should engage in to manage such risk

─ Accordingly, many public companies have addressed the potential impact of the LIBOR cessation and transition in their recent SEC filings, including 10-Ks and 10-Qs

─ On December 30, 2019, the SEC published a public statement on the role of audit committees in financial reporting and key reminders regarding oversight responsibilities, which included the following statement on LIBOR: • “We encourage audit committees to understand management’s plan to identify and address the

risks associated with reference rate reform, and specifically, the impact on accounting and financial reporting and any related issues associated with financial products and contracts that reference LIBOR”

32


Actions by regulatorsSOFR Transition Timeline and Progress

─ CFTC Market Risk Advisory Committee (MRAC)• Publication of a standard set of disclosures that market participants may use (on a voluntary basis) with all

clients and counterparties with whom they continue to transact derivatives referencing LIBOR and other IBORs─ New York Department of Financial Services requested that Regulated Institutions submit LIBOR transitions

plans by March 23, 2020, to assure that their boards of directors (or equivalent governing authorities) and senior management: • understand and have assessed the risks associated with the LIBOR cessation;• have developed appropriate plans to manage such risks; and • have initiated actions to facilitate the transition

─ Other regulators have issued specific guidance to regulated entities:• The Federal Housing Finance Agency issued a Supervisory Letter to the Federal Home Loan Banks limiting their

ability to enter into new financial instruments that reference LIBOR• Fannie Mae and Freddie Mac will require: (i) new language for single-family ARM instruments closed on or after

June 1, 2020; (ii) that all LIBOR-based single-family and multifamily ARMs have loan application dates on or before September 30, 2020; and (iii) that any acquisitions of single-family and multifamily LIBOR ARMs occur before December 31, 2020

• The UK Financial Conduct Authority’s “Dear CEO” letter is another example• The UK Financial Conduct Authority announced that the COVID-19 pandemic will not cause a delay of the

transition away from LIBOR

33


New York Law SolutionARRC New York Solution

─ The ARRC released a draft legislative proposal and report that aims to provide legal certainty with respect to the LIBOR transition for legacy instruments governed by New York law, including with respect to derivatives agreements

─ The proposed statute would • (1) require parties to use the Recommended Replacement Benchmark if no LIBOR fallback has been

provided or if such LIBOR fallback is the last quoted LIBOR or a LIBOR poll, survey or any other means of coming up with a LIBOR-referencing rate and

• (2) encourage the selection of the Recommended Replacement Benchmark if an instrument provides a party with discretion to determine the fallback rate

• Instruments with provisions that require that the parties use another non-LIBOR based rate, e.g., Fed Funds or Prime, would not be affected by the proposed statute

─ The proposed statute defines the Recommended Replacement Benchmark as the rate, including any adjustment spread and/or conforming changes thereto, selected or recommended by the Federal Reserve Board, the Federal Reserve Bank of New York, or the Alternative Reference Rates Committee

─ Potential issues: scope, conflicts, constitutional challenges and timing

34


Transition Planning

― Asset managers will need to ensure clients are ready to transition well before LIBOR ceases to be published:• Determining direct and indirect exposure (and sources of such exposure) to LIBOR, including in

financial instruments and contracts that mature after 2021, by developing an inventory of financial instruments impacted by LIBOR;

• Identifying and evaluating the scope of existing financial instruments and contracts that may be affected, and the extent to which those financial instruments and contracts already contain appropriate fallback language or would require amendment, either through bilateral negotiation or using industry-wide tools, such as protocols;

• Evaluating and monitoring the impacts across businesses and the risks inherent in the transition, including financial risks and nonfinancial risks;

• Enhancements to infrastructure (for example, models and systems) to prepare for a smooth transition to alternative reference rates;

• Governance, risk management, legal, operational, systems and operations, and other aspects of planning for the transition, including reporting, capital, accounting and tax;

• Active participation in working group and responding to industry consultations, including of the International Swaps and Derivatives Association (ISDA) and the Loan Syndications and Trading Association (LSTA); and

• Client education and outreach

35


Derivatives documentationWhat is being done?

─ ISDA is in the process of amending its 2006 Definitions to include new triggers and fallbacks for USD LIBOR and other IBORs• Triggers require permanent cessation of LIBOR as evidenced by a public statement by or on behalf of the

benchmark administrator or regulator of the administrator• ISDA has recently announced to also include a pre-cessation trigger

• The fallback Adjusted SOFR applies in arrears and on a compounded basis• The spread methodology will be based on a historical five-year median with a two-banking-day backward-shift

adjustment for operational and payment purposes

• The amendments will apply on a going-forward basis to transactions that incorporate the 2006 Definitions• Via an ISDA Protocol, parties may also amend documentation, including Schedules and CSAs, for legacy trades

that use either the 2006, 2000 or 1991 ISDA Definitions, the 1998 Euro Definitions, or that reference a relevant IBOR

• Ability of an Agent to adhere to the ISDA Protocol on behalf of a Client• On behalf of all Clients represented by such Agent;• On behalf of only those Clients represented by such Agent that such Agent specifically names or identifies; or• On behalf of all Clients represented by such Agent, excluding any Clients that such Agent specifically names or

identifies as excluded• In each case, the Agent can elect to apply the amendments in this Protocol to either:

1. Each document into which the Agent has entered on behalf of those Clients; or2. Documents into which the Agent did not enter on behalf of those Clients but which the Agent has the

authority from the relevant Client to amend

36


The upcoming June 30 compliance date for Regulation Best Interest and the Form CRS rules


Background on Regulation BI and Form CRS Rules

─ Regulation BI will apply to broker-dealers making recommendations to retail customers• Will impose best interest obligation on securities and investment

strategy recommendations, including account recommendations• Four component obligations must be met:

• Disclosure, Care, Conflict of Interest [management] and Compliance

─ Form CRS rules will apply to both broker-dealers and investment advisers providing services to retail investors• Will impose a requirement to deliver a standardized “relationship

summary” disclosure to retail investors• Page limit and information order restrictions• Retail customer and retail investor essentially the same• But different delivery trigger for relationship summary than Reg BI

disclosure

38


Impact on Asset Managers

─ If your funds or programs are ultimately marketed to retail customers/retail investors

─ Need to be aware of impact of Regulation BI and Form CRS rules on:• Wholesalers and wholesaling activities• Compensation arrangements with intermediaries• Fee and cost disclosure in offering documents• Marketing materials• Investor servicing

39


Wholesalers and Wholesaling Activities

─ Regulation BI will apply to a broker-dealer or associated person who makes a recommendation to a retail customer• Need not be the broker-dealer effecting the transaction

─ Considerations for wholesalers• Interaction with retail customers• Type of interaction• Substance of interaction

40


Compensation Arrangements

─ Regulation BI’s conflict of interest obligation will require broker-dealers to identify, disclose, mitigate and in certain circumstances eliminate conflicts of interest associated with recommendations• Focus on compensation arrangements

• Firm level • Rep level

• Focus on “material limitations” and proprietary products

─ Mitigation measures• Sales loads and GDC changes• Bases for determining revenue-sharing payments and marketing allowances• Training and education events• Wholesaler reimbursements, gifts, business entertainment

41


Offering Document Disclosures

─ Regulation BI will require broker-dealers to provide a disclosure to retail customers regarding the fees and costs associated with purchasing and holding a security that may be recommended• In scope: fund operating fees and expenses, sales loads, surrender

fees• Numerical information can be in ranges where specific information is

in a prospectus or offering document

─ Disclosure must also discuss material facts related to conflicts of interest associated with recommendations

─ Prospectuses and offering documents• Consider providing this disclosure even if not required

42


Marketing Materials

─ Regulation BI will prohibit the use of the term “adviser” to refer to an associated person of a broker-dealer who is not also a supervised person of an investment adviser• SEC suggests neutral term of “financial professional”

─ Regulation BI’s care obligation will require broker-dealers and their associated persons to consider potential risks, rewards and costs associated with a recommendation as well as “reasonably available alternatives”

─ Asset manager-supplied marketing materials• Consider changing “financial advisor” to “financial professional”• Consider whether marketing materials provide information

supportive of the “care” analysis required under Regulation BI• Consider product training materials

43


Investor Servicing

─ Form CRS rules will apply to broker-dealers:• Recommending account type, securities transaction or

investment strategy involving securities to a retail investor• Placing an order for a retail investor • Opening brokerage account for retail investor

─ Applicability to customary investor servicing?

44


Questions?

45

eversheds-sutherland.com© 2020 Eversheds Sutherland (US) LLPAll rights reserved.

Clifford KirschNew York, NY+1 212 389 [email protected]

Michael KofflerNew York, NY+1 212 389 [email protected]

Susan KrawczykWashington DC+1 202 383 [email protected]

Cynthia BeyeaWashington DC+1 202 383 [email protected]

John WalshWashington DC+1 202 383 [email protected]

Lizet SteeleWashington DC+1 202 383 [email protected]