Skip to Content
Main Content

Investment Management Legal and Regulatory Update - July 2015

July 20, 2015
View as PDF

Industry Guidance

SEC Proposes Investment Company Reporting Modernization

The SEC proposed the following changes to modernize reporting and disclosure requirements for registered investment companies (funds):

  • rescind Form N-Q and adopt new Form N-PORT, which would require funds to report information regarding their monthly portfolio holdings;
  • amend Regulation S-X to require standardized and enhanced derivatives disclosures in financial statements;
  • adopt new Rule 30e-3, which would permit a fund to deliver shareholder reports by making the reports accessible on its website; and
  • rescind Form N-SAR and replace it with new Form N-CEN, which would require funds to report census-type information on an annual basis.

Funds currently report their complete portfolio holdings quarterly on Form N-Q (at the end of the first and third fiscal quarters) and Form N-CSR (at the end of the second and fourth fiscal quarters). The SEC proposes to rescind Form N-Q and adopt Form N-PORT, which would be filed by all investment companies, other than money market funds and small business investment companies, on a monthly basis. However, only the filing for every third month would be available to the public 60 days after the end of the fund’s fiscal quarter. The SEC believes this reporting schedule addresses the need for public disclosure while mitigating the potential for front-running and “copycatting.”

Funds would report the data in a structured extensible markup language (XML) format and would include additional information regarding fund portfolio holdings. This additional information consists of certain risk metrics providing measurements of a fund’s exposure to changes in interest rates, credit spread, and asset prices. Further, N-PORT will request information on securities lending, repurchase agreements, and reverse repurchase agreements, as well as information relating to counterparties to the transactions and over-the-counter derivative transactions. Finally, N-PORT requires information regarding market liquidity, pricing, and fund flows, so that the SEC may better understand liquidity pressures that are due to investor redemption activity.

Financial Statement Disclosure of Derivatives
Regulation S-X prescribes the form and content of financial statements required in registration statements and shareholder reports. It also establishes general requirements for portfolio holdings disclosures in fund financial statements. However, with the exception of options, there are no current standards for reporting derivative instrument information. The SEC proposes to add disclosures for derivatives in a fund’s financial statements that are similar to the proposed disclosures that would be required by Form N-PORT. Amendments to Regulation S-X would:

  • require new and standardized disclosures for holdings in open futures contracts, open forward foreign currency contracts, and open swap contracts;
  • require additional disclosures for holdings of purchased and written option contracts;
  • update disclosures for other investments (such as investments in and advances to affiliates) and reorganize the order in which some investments are presented;
  • amend the rules regarding the general form and content of financial statements to better house the new information;
  • require prominent placement in financial statements of disclosures regarding derivatives, rather than allowing such schedules to be embedded in the notes; and
  • require a new disclosure in the notes to the financial statements relating to securities lending activities.

Website Availability of Shareholder Reports
Rule 30e-3 would permit, but not require, a fund to make shareholder reports available online instead of mailing them to shareholders. Reliance on this rule would be subject to certain conditions relating to the availability of the shareholder reports, shareholder consent, notice to shareholders, and delivery of paper copies upon request by a shareholder.

To rely on the proposed rule, a fund’s current shareholder report, and any previous shareholder reports (within the last 244 days), would have to be available on the fund’s website along with a complete year of the fund’s portfolio holdings reports (N-PORTs).

Form N-CEN
Currently, funds report census-type information on Form N-SAR semi-annually. However, the SEC has found the utility of the information on Form N-SAR has become increasingly limited in light of new market developments, products, investment practices, and risks. Therefore, the SEC proposes to rescind Form N-SAR and replace it with Form N-CEN. The information funds would report on Form N-CEN would be similar to that reported on Form N-SAR. However, Form N-CEN would streamline and update the information to reflect current SEC needs and developments in the industry. Further, Form N-CEN would exclude, where possible, items that are reported on other forms or are otherwise available. Like Form N-PORT, reports on Form N-CEN would be structured in an XML format. Funds would file Form N-CEN annually within 60 days of the end of the fiscal year.

The SEC has requested comments on the proposed rules on or before August 11, 2015.

Sources: Investment Company Reporting Modernization, Release No. 33-9776 (May 20, 2015), available at:; SEC Proposes Rules to Modernize and Enhance Information Reported by Investment Companies and Investment Advisers, Press Release 2015-95 (May 20, 2015), available at:

Amendments to Form ADV and Investment Advisers Act Rules

Form ADV
The SEC proposes to amend Part 1A of Form ADV in four areas:

  • fill data gaps relating to separately managed accounts;
  • enhance current reporting requirements regarding identifying information and advisory business;
  • incorporate “umbrella registration” for private fund advisers; and
  • clarify technical and other amendments to existing items and instructions.

Separately Managed Accounts
The SEC currently collects detailed information regarding pooled investment vehicles but little information specifically regarding separately managed accounts (SMAs). The SEC proposes to expand reporting for SMAs in Item 5 of Part 1A and Section 5 of Schedule D. Advisers would be required to report the approximate percentage of SMA regulatory assets under management (AUM) invested in ten broad asset categories, such as exchange-traded equity securities and U.S. government bonds. Although this information would be reported annually on Form ADV, larger advisers (with at least $10 billion in AUM attributable to SMAs) would include both mid-year and year-end data.

The SEC also proposes to require advisers with at least $150 million in AUM attributable to SMAs to report information on the use of borrowings and derivatives in those accounts. Advisers with less than $10 billion in AUM attributable to SMAs would be required to report the number of accounts that correspond to certain categories of gross notional exposure, as well as the weighted average amount of borrowings in those accounts. Advisers with at least $10 billion in AUM attributable to SMAs would have to report the above information, as well as the weighted average gross notional value of derivatives in each of six categories of derivatives.

Finally, the SEC proposes that advisers identify any custodians that account for at least ten percent of an adviser’s SMAs and the amount of the adviser’s AUM held at such custodian. The SEC believes this information would be helpful in allowing them to better identify advisers who use the same custodian in the event a concern about a particular custodian is raised.

Social Media and Other Identifying Information
The SEC proposes to require advisers to report their websites for social media platforms, such as Twitter, Facebook and LinkedIn, in addition to the adviser’s website address. The SEC seeks comments on whether they should ask advisers whether they permit employees to have social media accounts associated with the adviser’s business, and, if so, whether they should ask advisers to identify the number or percentage of employees that have those accounts. 

The SEC proposes advisers report whether their chief compliance officers (CCOs) are compensated or employed by someone other than the adviser, and, if so, report the name of that person. The SEC notes that its examination staff has observed “a wide spectrum of both quality and effectiveness of outsourced chief compliance officers and firms.” Identifying information for outsourced CCOs would allow the SEC to identify all advisers relying on a particular CCO or compliance firm. The SEC also proposes that advisers report their own proprietary assets within a range.

The SEC proposes to amend Item 5, which currently requires an adviser to provide approximate ranges for the number of advisory clients, the type of advisory clients and the AUM attributable to client types, to require an adviser to report the precise number of clients and AUM attributable to each category of clients. The SEC proposes to add a requirement that advisers report AUM of parallel managed accounts related to a fund advised by the adviser. The SEC is interested in this information to assess how an adviser manages conflicts of interest between parallel managed accounts and funds, and also to review any shifts in assets between parallel managed accounts and funds. Finally, the SEC proposes to collect information on the total amount of AUM attributable to acting as a sponsor and/or portfolio manager of a wrap fee program and any SEC file numbers and/or CRD numbers for that sponsor.

Umbrella Registration
For a variety of tax, legal and regulatory reasons, advisers to private funds may be organized as a group of related advisers that are separate legal entities but effectively operate as, and appear to investors to be, a single advisory business. Although the SEC previously provided guidance regarding umbrella registration, the SEC proposes to codify the concept of umbrella registration where a filing adviser and one or more relying advisers conduct a single private fund advisory business and where each relying adviser is controlled by or under common control with the filing adviser. The conditions for umbrella registration include:

  • the filing adviser and relying advisers advise only private funds and clients in SMAs that are “qualified clients” and are otherwise eligible to invest in the private funds and whose accounts pursue investment objectives and strategies that are substantially similar or otherwise related to those private funds;
  • the relying advisers are subject to the filing adviser’s supervision and control; and 
  • the filing adviser and relying advisers operate under a single code of ethics and written policies and procedures administered by a single CCO.

If these conditions and others are met, the filing adviser would file reports for the organization as a whole as well as individual schedules pertaining to the relying advisers. The SEC believes this information will help it better understand management of private funds, provide more reliable contact information, and assist in better understanding the relationship between relying advisers and filing advisers.

Clarifying Amendments
The SEC has proposed a set of amendments derived from questions advisers pose in completing Form ADV. These amendments would clarify the form and instructions to make the filing processes clearer and more efficient. These amendments would also remove outdated references to transition periods implemented after the Dodd-Frank Act.

Advisers Act Recordkeeping Rules  
Proposed amendments to Advisers Act Rule 204-2 would require advisers to maintain records of the calculation of performance information that is distributed to any person. Currently, advisers are required to maintain performance information that is distributed to 10 or more persons. The proposed amendments also would require advisers to maintain communications related to performance or rate of return of accounts and securities recommendations.

The SEC has requested comments on the proposed rules on or before August 11, 2015.

Sources: Amendments to Form ADV and Investment Advisers Act Rules, Release No. IA-4081 (May 20, 2015), available at:; SEC Proposes Rules to Modernize and Enhance Information Reported by Investment Companies and Investment Advisers, Press Release 2015-95 (May 20, 2015), available at:

SEC Issues Cybersecurity Guidance for Funds and Advisers

The SEC’s Division of Investment Management published a guidance update emphasizing the importance of cybersecurity and discussing measures that funds and advisers should consider when addressing cybersecurity risks. In light of cyber attacks on a wide range of financial service firms, the SEC stressed the need for funds and advisers to protect the confidential and sensitive information of fund investors and advisory clients and encouraged funds and advisers to review their cybersecurity measures.

The guidance update highlighted several measures that funds and advisers may want to consider in addressing cybersecurity risk.  Funds and advisers should tailor their compliance program based on the nature and scope of their business.

The staff recommended that funds and advisers conduct a periodic assessment of:

  • the nature, sensitivity and location of information that the firm collects, processes and/or stores, and the technology systems it uses;
  • internal and external cybersecurity threats to and vulnerabilities of the firm’s information and technology systems;
  • security controls and processes currently in place;
  • the impact if the information or technology is compromised; and
  • the effectiveness of the firm’s governance structure for managing cybersecurity risk.


The staff urged funds and advisers to create a strategy that is designed to prevent, detect and respond to a cybersecurity threat, including:

  • controlling access to various systems and data via management of user credentials, authentication and authorization methods, firewalls and/or perimeter defenses, tiered access to sensitive information and network resources, network segregation and system hardening;
  • data encryption;
  • protecting against the loss or exfiltration of sensitive data by restricting the use of removable storage media and deploying software that monitors technology systems for unauthorized intrusion, the loss or exfiltration of sensitive data, or other unusual events;
  • data backup and retrieval; and
  • the development of an incident response plan.

The staff encouraged funds and advisers to implement their strategies through written policies and procedures, as well as training that will provide guidance to officers and employees concerning applicable threats and measures to prevent, detect and respond to such threats, and to monitor compliance with policies and procedures related to cybersecurity. Funds and advisers may also want to educate their investors and clients about how to reduce their exposure to cybersecurity threats concerning their accounts.

This guidance update further reflects the SEC’s continued focus on cybersecurity as a key compliance issue. See “OCIE Cybersecurity Initiative” in our May 2014 Data Privacy and Cybersecurity Flash, “SEC Announces 2015 Exam Priorities” in our January 2015 Update, and “Cybersecurity Examination Sweep Summary” in our April 2015 Update.

Source: Cybersecurity Guidance, Guidance Update No. 2015-02 (April 2015), available at:

Clarification of the SEC’s Recent Guidance Regarding Acceptance of Gifts or Entertainment by Fund Advisory Personnel 

As we reported in our April Update, the SEC’s Division of Investment Management issued guidance highlighting the conflict of interest that may exist when personnel of a fund’s investment adviser are offered gifts, favors or other forms of consideration from persons hoping to do business with the fund. The SEC noted, for example, that a portfolio manager accepting gifts or entertainment from a broker-dealer who executes or hopes to execute transactions on behalf of a mutual fund would violate Section 17(e) of the Investment Company Act.

The guidance raised concerns regarding whether Section 17(e) is to be read as a strict prohibition on the receipt by advisory personnel of any and all gifts and entertainment, or instead, whether a violation of Section 17(e) will be determined based on the facts and circumstances presented. The ICI recently published clarification of the SEC’s guidance based on its conversations with SEC staff, in which the staff noted that the guidance never expressed the view that Section 17(e) imposes a “zero tolerance” policy. Section 17 is designed to prevent conflicts of interest from affecting the judgement of advisers. In order for the SEC to prove a violation, it must show that some form of compensation was received in exchange for the purchase and sale of fund property.

Source: ICI Memorandum “Clarification of the SEC’s Recent Guidance on Gifts and Entertainment Paid to Advisory Personnel” (June 9, 2015).

Code of Ethics Exceptions for Accounts Over Which Reporting Persons Have No Influence or Control

An adviser must have a code of ethics that requires its access persons (e.g., officers and supervisory persons who have access to nonpublic information regarding securities transactions) to report their personal securities holdings and transactions. There is an exception, however, when an access person’s securities are held in accounts over which he or she “had no direct or indirect influence or control.” The SEC recently issued guidance regarding this exception, and the staff expressed its views in the context of advisory personnel’s trusts and third-party discretionary accounts.

The staff believes that blind trusts can be established such that an access person would have no direct or indirect influence or control. A blind trust is typically a legal arrangement in which a trustee manages funds for the benefit of somebody who has no knowledge of the specific management actions taken by the trustee and no right to intervene in the trustee’s management.

Advisers have asserted that certain types of trusts and discretionary accounts are akin to a blind trust in terms of an access person’s influence or control. The staff believes that the fact that an access person provides a trustee with management authority over a trust for which he or she is grantor or beneficiary, or provides a third-party manager discretionary investment authority over his or her personal account, by itself, is insufficient for an adviser to reasonably believe that the access person had no direct or indirect influence or control over the trust or account for purposes of relying on the reporting exception. However, the staff believes that the adviser may be able to implement additional controls to establish a reasonable belief that an access person had no direct or indirect influence or control over the trust or account and could accordingly rely on the exception. Advisers may consider, for example:

  • obtaining information about a trustee or third-party manager’s relationship to the access person (i.e., independent professional versus friend or relative; unaffiliated versus affiliated firm);
  • obtaining periodic certifications by access persons and their trustees or discretionary third-party managers regarding the access persons’ influence or control over trusts or accounts;
  • providing access persons with the exact wording of the reporting exception and a clear definition of “no direct or indirect influence or control” that the adviser consistently applies to all access persons; and
  • on a sample basis, requesting reports on holdings and/or transactions made in the trust or discretionary account to identify transactions that would have been prohibited pursuant to the adviser’s code of ethics, absent reliance on the reporting exception.

With respect to the periodic certifications, the staff believes that general certifications are insufficient and recommended that advisers consider obtaining specific certifications from the access person by asking such questions as:

  • “Did you suggest that the trustee or third-party discretionary manager make any particular purchases or sales of securities for account X during time period Y?”
  • “Did you direct the trustee or third-party discretionary manager to make any particular purchases or sales of securities for account X during time period Y?”
  • “Did you consult with the trustee or third-party discretionary manager as to the particular allocation of investments to be made in account X during time period Y?”

In light of this new guidance, advisers should review their codes and compliance practices with respect to trusts and third-party discretionary accounts.

Source: Personal Securities Transactions Reports by Registered Investment Advisers: Securities Held in Accounts over which Reporting Persons Had No Influence or Control, IM Guidance Update No. 2015-03 (June 2015), available at

SEC Releases Money Market Fund Reform FAQs

The Division of Investment Management released a set of 53 frequently asked questions (FAQ) relating to the money market reforms adopted in July 2014. The money market fund FAQ covers a wide range of topics including compliance dates, advertising, and the use of amortized cost. The staff stated that it plans to continue to update the FAQ as necessary with the responses to additional questions.

Source: 2014 Money Market Fund Reform Frequently Asked Question (April 22, 2015), available at:

SEC Publishes FAQ Regarding Valuation Guidance

The SEC released a two-question FAQ related to the valuation guidance for all funds that was included in the money market funds release. The release stated that the board “may want to consider the inputs, methods, models, and assumptions” used by a pricing service to determine its evaluated prices and reminded boards that they have a non-delegable responsibility to determine if an evaluated price is a fair value of the security. The language led some to worry that the SEC staff expected boards to delve into the inner workings of pricing services.

The FAQ states that the release “was not intended to change the general nature of the board’s responsibility to oversee the process of determining whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value for a fund’s portfolio security or limit a board’s ability to appropriately appoint others to assist in its duties.” The FAQ clarified that boards may delegate “specific responsibilities intended to assist it in implementing the fund’s valuation policies and procedures, including its due diligence of pricing services.”

Source: Valuation Guidance Frequently Asked Questions (April 22, 2015), available at

ReTIRE Initiative

The Office of Compliance Inspections and Examinations (OCIE) is launching a multi-year Retirement-Targeted Industry Reviews and Examinations (ReTIRE) Initiative to examine advisers and broker-dealers that provide services or sell investment products to retail investors. Examination focus areas will include assessing whether representatives have a reasonable basis for recommendations, confirming that conflicts of interest are disclosed, reviewing supervision and compliance controls, and reviewing sales and marketing material.

Source: Retirement-Targeted Industry Reviews and Examinations Initiative, National Exam Program Risk Alert by the Office of Compliance Inspections and Examinations, Volume IV, Issue 6 (June 22, 2015), available at

FINRA Interpretative Letter Regarding Providing Related Performance Information to Institutional Investors

FINRA published an interpretative letter in which it did not object to Hartford Funds Distributors’ proposed use of “related performance information” for mutual funds (typically funds with no or only limited performance history) in marketing materials distributed to financial intermediaries, provided the following conditions are satisfied:

  • related performance information may be provided only if it is actual performance of all separate or private accounts or funds that have substantially similar investment policies, objectives, and strategies, and are currently managed or were previously managed by the same adviser or sub-adviser that manages the mutual fund that is the subject of an institutional communication;
  • materials with related performance information may only be distributed to persons who qualify as “institutional investors” under FINRA Rule 2210(a)(4), such as broker-dealers, investment advisers,  banks, insurance companies, governmental entities, and certain employee benefit and qualified plans;
  • any institutional communication with related performance information will be clearly labeled “for use with institutions only, not for use with retail investors;”
  • the presentation of related performance information will disclose performance information that is net of fees and expenses of accounts, or net of a model fee that is the highest fee charged to any account managed in the strategy;
  • gross performance information may also be provided with certain disclosures;
  • related performance information will be for a period of at least one year and since the inception of the investment strategy, and be current as of the most recently ended calendar quarter;
  • related performance information will be clearly labeled as such and contain clear disclosure of the applicable dates for the performance;
  • for a mutual fund in existence for more than one year, its actual performance will be displayed more prominently than the related performance information; and
  • the institutional communication will disclose any material differences between the funds or accounts for which related performance information is provided and the mutual fund that is the subject of the institutional communication.

Subject to the above conditions, mutual fund marketers now may use related performance information when marketing mutual funds to institutional investors. This is particularly important in cases where an investment adviser has been employing an investment strategy that will be used for a new mutual fund that lacks its own performance history.

Source: Interpretive Letter to Edward P. Macdonald, Hartford Funds Distributors, LLC (May 12, 2015), available at

Litigation and SEC Enforcement Actions

SEC Charges Investment Adviser and Mutual Fund Board Members with Failures in 15(c) Advisory Contract Approval Process 

The SEC charged a mutual fund adviser, its principal, and three mutual fund board members with failing to satisfy their statutory obligations in connection with the evaluation and approval of mutual fund advisory contracts.

Commonwealth Capital Management (CCM) was charged with violating Section 15(c) of the Investment Company Act for allegedly providing incomplete or inaccurate information to two mutual fund boards, and the firm’s majority owner John Pasco III was charged with causing the violations. Without admitting or denying the findings, CCM and Pasco agreed to jointly and severally pay a $50,000 penalty, and the trustees each agreed to pay $3,250 penalties.

Pasco, who formerly held a variety of positions at the SEC, formed CCM and an affiliated administrator, Commonwealth Shareholder Services (CSS), as a turnkey investment company platform for advisers that want to manage small to mid-size mutual funds without having to administer the day-to-day operations of a fund, including the management of corporate governance and regulatory compliance. CCM acted as the investment adviser to various mutual funds within World Funds Trust (WFT) and World Funds Inc. (WFI). An SEC investigation found that as part of the 15(c) process, the WFT board of trustees, with the assistance of independent counsel, requested that CCM provide certain information regarding advisory fees paid by comparable funds as well as information about the nature and quality of the firm’s services. There was no documentary evidence that CCM provided, or that the trustees evaluated, fees paid by comparable funds. Although during the relevant period the WFT Funds did not pay any advisory fees, the SEC held that the trustees were obligated to evaluate CCM’s services as compared to the fees provided for in the advisory contracts.  Also, CCM allegedly provided incomplete responses about the nature and quality of services it provided versus services provided by the funds’ sub-adviser and CSS, and the trustees allegedly did not request or receive additional materials. According to the SEC, the trustees approved the advisory contracts without having all of the information they requested as reasonably necessary to evaluate the contracts. “As the first line of defense in protecting mutual fund shareholders, board members must be vigilant,” said Andrew J. Ceresney, Director of the SEC Enforcement Division. “These trustees failed to fully discharge their fund governance responsibilities on behalf of fund shareholders.”

Julie M. Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, added, “The advisory fee typically is the largest expense reducing investor returns. The WFT trustees fell short as the shareholders’ watchdog by essentially rubber-stamping the adviser’s contract and related fee.”

According to the SEC’s order, CCM also omitted, or provided inaccurate, information requested by independent directors in the WFI series of mutual funds. CCM used a standard industry database (Lipper) to provide fee information for share classes that were comparable in size to WFI Fund’s class A shares and that had an investment strategy that was comparable to the WFI Fund. To avoid claims of “cherry-picking” funds, CCM did not edit the tables to delete share classes of funds that were not directly comparable to the WFI Fund, and therefore, according to the SEC, the chart contained “numerous inapt comparisons.” The SEC noted that the chart for WFI, an actively managed fund, included (i) fund share classes with different distribution fee structures; (ii) assets at a share-class level rather than total-fund level; (iii) different types of funds (including an unmanaged index fund and an index-based ETF); and (iv) funds with different fee structures (including funds with a combined advisory and administration fee). Furthermore, the SEC found that certain information in the chart was missing or incomplete. The SEC also found inaccuracies in two additional charts comparing the WFI Fund’s expense ratio and advisory fee to those of selected funds from the chart. The SEC found that CCM failed to provide certain information about profitability (e.g., two years of financial statements) and the correct dollar amount of fees waived under an expense limitation agreement. In addition, CCM mistakenly believed and incorrectly informed the WFI independent directors that the fund had appropriate breakpoints when, in fact, the proposed breakpoints were omitted from the advisory contract.

The SEC’s order finds that CCM and the three trustees violated Section 15(c) of the Investment Company Act, and Pasco caused CCM’s violations. The order also finds that CSS was contractually responsible for preparing the shareholder reports on behalf of the WFI funds, and failed to include required information concerning the 15(c) process in one fund’s 2010 shareholder report in violation of the Investment Company Act.

Sources: SEC Charges Investment Adviser and Mutual Fund Board Members With Failures in Advisory Contract Approval Process, SEC Press Release 2015-124 (June 17, 2015), available at; In the Matter of Commonwealth Capital Management, LLC, Commonwealth Shareholder Services, Inc., John Pasco, III, J. Gordon McKinley, III, Robert R. Burke and Franklin A. Trice, III, Investment Company Act Release No. 31678 (June 17, 2015), available at

SEC: Companies Cannot Stifle Whistleblowers in Confidentiality Agreement

The SEC settled its first enforcement action against a company for using improperly restrictive language in confidentiality statements in violation of the whistleblower protections afforded under Rule 21F-17 of the Securities Exchange Act. KBR, Inc. required its employees to sign confidentiality statements when they raised internal compliance concerns or when they served as witnesses in internal investigation interviews. These statements were included as an enclosure to the KBR Code of Business Conduct Investigation Procedures manual, and included disclosure that employees could be subject to discipline or termination for disclosing the content of internal investigations to outside authorities without prior approval from the company’s legal department. Since the subject matter of some of the interviews involved potential securities law violations, the SEC found the presence of restrictive language in KBR’s employee confidentiality statements to directly undermine the purpose of Rule 21F-17. The Rule was adopted under the Dodd-Frank Act in 2011 to prohibit companies from taking any action to discourage whistleblowers from reporting possible securities law violations to the SEC.  

Although the SEC did not find instances in which KBR actually prevented its employees from disclosing information to the SEC, the Commission nevertheless deemed the statements improper because they could have precluded KBR’s employees from reporting their concerns. Without admitting or denying the findings, KBR agreed to pay a $130,000 fine to settle the charges. Additionally, KBR voluntarily revised its confidentiality statement to clarify that its employees are not required to obtain approval from the company’s legal department before reporting possible violations of federal law to any governmental agency.

The SEC’s commitment to whistleblower protections is also evidenced by a recent sweep exam initiative. The SEC’s Boston Regional Office has sent examination letters to various investment advisers asking for copies of their employment and severance agreements. Although the sweep is currently limited to advisers under the jurisdiction of the Boston Regional Office, it has the potential to become a national initiative.  

A lesson from the SEC’s enforcement action against KBR is that investment advisers and other employers should carefully review their existing confidentiality agreements and other employment-related documents, as well as any specific whistleblower policies and procedures. The presence of a blanket prohibition on disclosing information to an outside party may be enough to trigger regulatory scrutiny. SEC Enforcement Director Andrew Ceresney recommends that all companies review their confidentiality statements and other employee agreements to ensure that they do not contain overly restrictive language. Similarly, Chief of the SEC’s Office of the Whistleblower Sean McKessy advises employers who use confidentiality agreements to “review and amend existing and historical agreements that in word or effect stop their employees from reporting potential violations to the SEC.” Firms should also review their internal reporting procedures and internal investigation practices to ensure that such procedures do not hinder whistleblowing.

Sources: SEC: Companies Cannot Stifle Whistleblowers in Confidentiality Agreements (Agency Announces First Whistleblower Protection Case Involving Restrictive Language), SEC Press Release 2015-54 (April 1, 2015), available at; In the Matter of KBR, Inc., SEC Release No. 74619 (April 1, 2015), available at; Sweep Exam Probes How Advisers Handle Whistleblowers, IAWatch (June 25, 2015).

Supreme Court Decision on 401(k) Fee Case

In our April Update, we advised you that the Supreme Court heard oral arguments in Tibble v. Edison, the first 401(k) excessive fee suit to reach the high court. Plaintiffs argued that Edison violated its fiduciary duty to plan participants by selecting higher fee retail-class mutual funds when identical institutional-class mutual funds were available with lower fees. The technical argument before the Supreme Court related to the statute of limitations for bringing claims under ERISA, specifically whether the plaintiffs could bring claims that Edison breached its fiduciary duty with respect to funds that were added to a 401(k) plan in 1999, more than six years before the case was filed. The Supreme Court held that the Ninth Circuit Court of Appeals erred by applying a statutory bar to a breach of fiduciary duty claim based on the initial selection of the funds without considering the contours of the alleged breach of fiduciary duty. The Court noted that ERISA’s fiduciary duty is derived from the law of trusts, which provides that a trustee has a continuing duty, separate and apart from the duty to exercise prudence in selecting investments at the outset, to monitor and remove imprudent investments. The Supreme Court remanded the case to the Ninth Circuit Court of Appeals to consider plaintiffs’ claims that Edison breached its duties within the relevant six-year statutory period under ERISA, recognizing the importance of analogous trust law.

Source: Tibble v. Edison, 575 U.S.__ (May 18, 2015); available at

SEC Charges CCO for Failing to Report Material Compliance Matter under Rule 38a-1

The SEC charged BlackRock Advisors LLC with breaching its fiduciary duty by failing to disclose a conflict of interest created by the outside business activity of a top-performing portfolio manager, and failing to adopt written compliance policies and procedures regarding outside business activities as required by Rule 206(4)-7 under the Advisers Act. The SEC also charged BlackRock’s former CCO for causing BlackRock’s compliance-related violation.

The SEC further charged BlackRock and the CCO for violating Rule 38a-1 under the Investment Company Act, which requires CCOs to provide annual written reports regarding material compliance matters. Without admitting or denying the findings, BlackRock agreed to settle the charges and pay a $12 million penalty, and the CCO agreed to pay a $60,000 penalty.

According to the SEC’s order, Daniel J. Rice III was managing energy-focused funds and SMAs at BlackRock when he founded Rice Energy, a family-owned and operated oil and natural gas company. Rice was the general partner of Rice Energy and personally invested approximately $50 million in the company. Rice Energy later formed a joint venture with a publicly traded coal company that eventually became the largest holding (9.4%) in the BlackRock Energy & Resources Portfolio managed by Rice. Following three Wall Street Journal articles in June 2012 detailing Rice’s connection to Rice Energy and his simultaneous role as an energy sector portfolio manager at BlackRock, Rice announced he would no longer manage BlackRock funds and he would leave BlackRock at the end of 2012. The SEC’s order finds that BlackRock knew and approved of Rice’s investment and involvement with Rice Energy as well as the joint venture, but failed to disclose this conflict of interest to either the boards of the BlackRock registered funds or its advisory clients.

The SEC found that BlackRock failed to adopt and implement written policies and procedures addressing how to assess outside activities of its employees for conflicts purposes, who was responsible for approving outside activity, and how to monitor employees with BlackRock-approved outside activities. The SEC found that the CCO knew and approved of numerous outside activities engaged in by BlackRock employees (including Rice), but he did not recommend written policies and procedures to assess and monitor those outside activities and to disclose conflicts of interest to the funds’ board and advisory clients. In January 2013, BlackRock finally adopted written policies and procedures addressing outside activities.

BlackRock had a private investment policy that required employees to receive BlackRock’s approval before making any private investments. The SEC found that Rice violated BlackRock’s policy by not obtaining pre-approval to form and fund Rice Energy and make loans to a Rice Energy subsidiary. The SEC further found that BlackRock and the CCO knew about Rice’s violations of the private investment policy, and knew or should have known that these violations were “material compliance matters” under Rule 38a-1 of the Investment Company Act and, therefore, were required to be reported to the boards of directors of the Rice-managed funds.

“This is the first SEC case to charge violations of Rule 38a-1 for failing to report a material compliance matter such as violations of the adviser’s policies and procedures to a fund board,” said Julie M. Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit. “BlackRock and [the CCO] caused the funds’ failure to report Rice’s violations of BlackRock’s private investment policy and denied the funds’ boards critical compliance information alerting them to Rice’s outside business interests.”

SEC Commissioner Daniel M. Gallagher issued a public dissent, noting that this enforcement action illustrates “a Commission trend toward strict liability for CCOs… undoubtedly sending a troubling message that CCOs should not take ownership of their firm’s compliance policies and procedures, lest they be held accountable for conduct that, under 206(4)-7, is the responsibility of the adviser itself. Or worse, that CCOs should opt for less comprehensive policies and procedures with fewer specified compliance duties and responsibilities to avoid liability when the government plays Monday morning quarterback.” Commissioner Gallagher called for the SEC to consider amendments or staff guidance to “clarify the roles and responsibilities of compliance personnel under the rule so that these individuals are not improperly held accountable for the misconduct of others.” Gallagher, who has served as a commissioner for four years and whose term ends in June 2016, recently announced his intention to depart the SEC as soon as a successor can be confirmed. SEC Commissioner Luis A. Aguilar issued a public response to Gallagher, stating that “the Commission works to support CCOs who strive to do their jobs competently, diligently, and in good faith—and these CCOs should have nothing to fear from the SEC.” Aguilar, who has served as a commissioner for seven years, reached the end of his appointed term in June 2015. 

Sources: SEC Charges BlackRock Advisors With Failing to Disclose Conflict of Interest to Clients and Fund Boards, SEC Press Release 2015-71(April 20, 2015), available at; In the Matter of Blackrock Advisors, LLC and Bartholomew A. Battista, Investment Advisers Act Release No. 4065 (April 20, 2015), available at; Commissioner Daniel M. Gallagher, Statement of Recent SEC Settlements Charging Chief Compliance Officers with Violations of Investment Advisers Act Rule 206(4)-7 (June 18, 2015), available at; Commissioner Luis A. Aguilar, The Role of Chief Compliance Officers Must be Supported (June 29, 2015), available at

SEC Charges Deloitte & Touche with Violating Auditor Independence Rules

The SEC charged Deloitte & Touche LLP with violating auditor independence rules when its consulting affiliate maintained a business relationship with a trustee serving on the boards and audit committees of three funds it audited. Without admitting or denying the findings, Deloitte agreed to pay more than $1 million to settle the charges. The SEC also charged the trustee with causing related reporting violations by the funds, and charged the funds’ administrator with causing the funds to violate Rule 38a-1 under the Investment Company Act. They also agreed to settle the charges.

Auditor independence rules require outside auditors to remain independent from their clients to ensure there is not even the appearance of a firm compromising its objectivity and impartiality when auditing financial statements. According to the SEC’s order, Deloitte violated the rules with respect to the appearance of independence by failing to follow its own policies and conduct an independence consultation prior to entering into a new business relationship with the trustee. Deloitte failed to discover that the required initial independence consultation was not performed until nearly five years after the relationship had been established.

According to the SEC’s order, the trustee was required to complete annual trustee and officer (T&O) questionnaires, but he did not identify his business relationship with Deloitte Consulting in response to questions asking for his “principal occupations and other positions” or any “direct or material indirect business relationship” with Deloitte. The T&O questionnaires did not expressly cover business relationships with the auditor’s affiliates.

The SEC alleged that none of the funds adopted written policies and procedures reasonably designed to prevent auditor independence violations, or provided sufficient training to assist board members in the discharge of their responsibilities related to auditor independence.  The SEC held that the funds’ administrator, which had contractually agreed to assist the funds in discharging their responsibilities under Rule 38a-1 and furnished a CCO to each of the funds, was responsible for drafting inadequate policies and procedures governing auditor independence and the selection, retention and engagement of the auditor.

Sources: SEC Charges Deloitte & Touche with Violating Auditor Independence Rules, SEC Press Release 2015-137 (July 1, 2015), available at; In the Matter of Deloitte & Touche LLP, ALPS Fund Services, Inc. and Andrew Boynton, Investment Company Act Release No. 31703 (July 1, 2015), available at

Board Fires Fund’s Adviser

The board of trustees of Vertical Capital Income Fund, a closed-end interval fund that invests in residential mortgages, took the unusual move of terminating the investment advisory agreement with its adviser, Vertical Capital Asset Management, LLC (VCAM). According to a sticker to the Fund’s prospectus, “the Board determined, based on information provided by VCAM, that VCAM lacks sufficient resources to meet its obligations to the Fund, and failed to adequately monitor the actions of its affiliate Vertical Recovery Management (VRM) in its duties as the servicing agent of the mortgage notes held by the Fund.” The interested trustee/fund president/treasurer has agreed to monitor the Fund’s portfolio until an interim adviser is appointed by the board.

Source: Greg Saitz, Citing Inadequate Monitoring, Board Fires Fund’s Adviser, Board IQ (June 24, 2015).

The information contained herein is based on a summary of legal principles. It is not to be construed as legal advice. Individuals should consult with legal counsel before taking any action based on these principles to ensure their applicability in a given situation.

Recent News

Join Our Mailing List

Need to stay current on the latest news, trends and regulatory issues impacting your business? Subscribe today! We know your time is valuable, so we limit our communications to only the most pertinent info you need to stay informed.