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August 2022: New Crypto Bill

Crypto Bill Introduced by Members of the Senate Committee on Agriculture, Nutrition, and Forestry

Legislation was introduced on August 3 to give the Commodity Futures Trading Commission (CFTC) authority to regulate digital commodities. This is a bipartisan bill spearheaded by U.S. Senators Debbie Stabenow (D-MI), Chairwoman of the Senate Committee on Agriculture, Nutrition, and Forestry, and John Boozman (R-AR), Ranking Member. Among other things, the bill would require all digital asset platforms, referred to as “digital commodity platforms” in the bill, to register with the CFTC. The focus of the bill is to increase investor protection in the digital asset markets and have consistent oversight over digital asset platform and trading.

What does crypto have to do with the Committee on Agriculture, Nutrition, and Forestry? The CFTC is the agency responsible for regulating commodity markets. Commodities typically traded in these markets include traditional agricultural crops including wheat, corn, soybeans, and sugar as well as non-farm commodities like oil, gas, silver, gold, and financial instruments. The bill is implying that the majority of digital assets are commodities. From time to time, Congress reauthorizes the CFTC, which is the process used to update an agency’s authorities and recommended spending levels. Congress would need to approve the CFTC’s expanded authority to oversee certain digital assets as digital commodities.

Investor Protection: Investor protection is top of mind given recent activity in the digital asset space including the bankruptcies of crypto platforms Voyager and Celsius. The bill would subject these digital asset platforms to CFTC oversight, CFTC examinations, and require that the firm have adequate financial resources, disclose conflicts of interest, and abide by advertising standards which would include the disclosure of material risks. Additionally, the CFTC would be able to introduce rules related to margin and leverage. Hindsight is always 20/20 but it is reasonable to state that crypto platforms will have a higher level of investor protection under this bill compared to today’s requirements. Currently, crypto platforms are subject to AML requirements and various state requirements but are not held to the more burdensome requirements laid forth in this bill.

Risk Management: Digital commodity platforms are required under the bill to establish and maintain a program of risk analysis and oversight to identify and minimize sources of operational risk, including cybersecurity risk, through the development of appropriate controls and procedures, and automated systems. Digital commodity platforms would also be required to establish and maintain emergency procedures, backup facilities, and a plan for disaster recovery.

New Categories of CFTC Registration: Digital commodity platforms will need to register and identify as one of the following: digital commodity broker, digital commodity custodian, digital commodity dealer, digital commodity trading facility and similarly employees would have to register as associated persons of digital commodity brokers and digital commodity dealers.

Custody: Digital commodity platforms would be required to segregate customer funds and treat and deal with all customer property that is received by the digital commodity platform as belonging to the customer. Platforms would also be prohibited from commingling customer property. Customer property would be required to be separately accounted for and cannot be commingled with the assets of the digital commodity platform.

How does the SEC factor into this Bill? The bill recognizes that the other regulatory agencies such as the Securities and Exchange Commission (SEC) would have jurisdiction over such digital assets that function more like securities. The legislation also allows platforms and firms to dually register with both the CFTC and SEC.

How will the CFTC be funded to provide oversight? All digital commodity registered platforms would be required to provide the CFTC a user fee to cover the costs of registering digital commodity platforms, conduct oversight of digital commodity trades; and conduct education and outreach.

Aspect Advisors Commentary: We think another bipartisan bill focused on the oversight of the cryptocurrency market is positive and it shows that there is a meaningful effort being made to provide regulatory clarity to the cryptocurrency markets. This is preferable to a regulation by enforcement environment. However, we do believe that this legislation will also present challenges because a digital asset platform will likely have digital commodities, digital securities, and digital payments (i.e., stablecoins) all trading on the same platform. Therefore, the platform may end up being regulated by multiple regulatory agencies, which could increase the regulatory burden on firms. The other unknown factor is timing given that there is a long road ahead before this bill becomes law.

July 2022: SEC Rule Proposal - ESG Enhanced Disclosures

SEC Rule Proposal – Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices 

Investor interest in environmental, social, and governance (“ESG”) strategies has rapidly increased in recent years with significant inflows of capital to ESG-related services and investment products. Asset managers have responded to this demand by creating and marketing funds and strategies that consider ESG factors in their selection process. Unfortunately, there has been a lack of consistent, comparable, and reliable information among investment products and advisers that claim to consider one or more ESG factors. This lack of  information can create a risk that a fund or adviser’s actual consideration of ESG does not match investor expectations. The lack of specific disclosure requirements tailored to ESG investing creates the risk that funds and advisers marketing such strategies may exaggerate their ESG practices. With respect to environmental and sustainability factors, this practice often is referred to as “greenwashing.”  

Additionally, the absence of a common disclosure framework also makes it difficult for investors to find the disclosures and to determine whether a fund’s or adviser’s ESG marketing statements translate into concrete and specific measures taken to address ESG goals and portfolio allocation. It also makes it difficult for investors to understand how effectively the strategy is implemented over time, and can frustrate investors’ attempts to compare different ESG strategies across funds or advisers. The SEC is therefore proposing to amend rules and forms under both the Investment Advisers Act of 1940 and the Investment Company Act of 1940 to require registered investment advisers, exempt reporting advisers, registered investment companies, and business development companies, to provide additional information regarding their ESG investment practices.  

Proposed Rules – Investment Advisers 

The SEC is proposing to require ESG-related disclosures from registered investment advisers that utilize ESG factors as part of their advisory business. Requiring advisers to disclose with specificity their ESG investing approach would help clients understand the investing approach the adviser uses, as well as compare the variety of emerging approaches, such as employment of an inclusionary or exclusionary screen, focus on a specific impact, or engagement with issuers to achieve ESG goals.  

The SEC is proposing to add a new sub-Item 8.D to ADV Part 2A, which would require an adviser to provide a description of the ESG factor or factors it considers for each significant investment strategy or method of analysis for which the adviser considers any ESG factors. The SEC does not define “ESG” or similar terms, instead, proposing to require advisers to provide a description of the ESG factor or factors they consider, and disclose to clients how they incorporate these factors when providing investment advice, as well as when they recommend or select other investment advisers.  

The SEC is also proposing an amendment to Item 10.C of Part 2A to require an adviser to describe any relationship or arrangement, which is material to the adviser’s advisory business or to its clients, that the adviser or any of its management persons have with any related person that is an ESG consultant or other ESG service provider (for purposes of this release, a “related person ESG provider”). Related person ESG providers may include, for example, ESG index providers and ESG scoring providers. 

The SEC is also proposing to amend Item 17.A of Part 2A to require advisers that have specific voting policies or procedures that include one or more ESG considerations when voting client securities to include in their brochures a description of which ESG factors they consider and how they consider them. 

Wrap Fee Programs 

Advisers sponsoring wrap fee programs would be required to describe in Item 4 of their wrap fee brochures the services, including the types of portfolio management services, provided under each ESG program that they sponsor. 

ADV Part 1A & Form N-CEN 

The SEC is proposing to collect census-type information about advisers’ and funds’ uses of ESG factors, including their uses of ESG providers. This information would be reported in Form ADV Part 1A and Form N-CEN and would apply to registered advisers (both registered investment advisers and exempt reporting advisers), and registered funds, respectively. The SEC is also proposing additions to Item 5 of Part 1A, separately managed account reporting, to provide information about the advisory businesses with respect to SMA clients and proposed additions to Items 6 and 7 (other business activities and private fund reporting) to both advisers and exempt reporting advisers about their uses of ESG factors in managing their reported private funds. Additionally, the SEC is proposing to require advisers to disclose whether they conduct other business activities as ESG providers or have related persons that are ESG providers by amending Items 6 and 7 of Part 1A and Sections 6.A. and 7.A. of Schedule D.  

Fund Disclosures 

Related to registered (‘40 Act) funds, the SEC has proposed to require additional specific disclosure requirements regarding ESG strategies to investors in fund registration statements and the management discussion of fund performance in fund annual report. To address exaggerated claims about ESG strategies, the SEC is proposing minimum disclosure requirements for any fund that markets itself as an ESG-Focused Fund, and requiring streamlined disclosure for Integration Funds that consider ESG factors as one of many factors in investment selections.  

Specifically, the proposed rules would require that an Impact Fund summarize its progress on achieving its specific impact(s) in both qualitative and quantitative terms, and the key factors that materially affected the fund’s ability to achieve the impact(s), on an annual basis.  

There are also amendments to fund annual reports to require a fund for which proxy voting or other engagement with issuers is a significant means of implementing its strategy to disclose information regarding how it voted proxies relating to portfolio securities on particular ESG-related voting matters and information regarding its ESG engagement meetings.  

Finally, the SEC is proposing a requirement for ESG-Focused Funds that consider environmental factors. Specifically, the proposal would require disclosure of two greenhouse gas (“GHG”) emissions metrics for the portfolio in such funds’ annual reports. In addition to the ESG-specific disclosure, the Commission is proposing an amendment to Form N-CEN that would require all index funds, regardless of whether the fund tracks an ESG-related index, to report identifying information about the index. In addition the SEC is proposing to require UITs to provide investors with clear information about how portfolios are selected based on ESG factors. The proposed amendment would require any UIT with portfolio securities selected based on one or more ESG factors to explain how those factors were used to select the portfolio securities. 

Advertising & Marketing 

Current regulations seek to prevent false or misleading advertisements by advisers, including greenwashing, by prohibiting material misstatements and fraud. Advisers are prohibited from making false or misleading statements to existing or prospective investors in pooled investment vehicles (e.g., investors in a registered investment company or private fund). It generally would be materially misleading for an adviser to overstate in an advertisement the extent to which it utilizes or considers ESG factors in managing client portfolios. To address any concerns, the SEC proposal is reaffirming existing obligations under the compliance rules when advisers and funds incorporate ESG factors and compliance policies, and procedures should address the accuracy of ESG-disclosures made to clients, investors and regulators.  

Compliance Policies & Procedures 

Compliance policies and procedures should address the accuracy of ESG-disclosures and they should also address portfolio management processes to help ensure portfolios are managed consistently with the ESG-related investment objectives. If an adviser discloses to investors that it considers certain ESG factors as part of an integration strategy, the adviser’s compliance policies and procedures should be reasonably designed to ensure the adviser manages the portfolios consistently with how the strategy was described to investors, actually considering the ESG factors in the way it says it considers them. If a registered fund discloses to investors that it adheres to a particular global ESG framework, its policies and procedures should include controls that help to ensure client portfolios are managed in accordance with that framework. 

Compliance Dates 

The compliance date of the proposals would be one year following the effective date, which would be sixty days after the date of publication in the Federal Register: (i) the proposed disclosure requirements in prospectuses on Forms N-1A and N-2, (ii) the proposed disclosure requirements for UITs on Form N-8B2; (iii) the proposed regulatory reporting on Form N-CEN, and (iv) the proposed disclosure requirements and regulatory reporting on Form ADV Parts 1 and 2.  

The compliance date of any adoption of the proposed disclosures in the report to shareholders and filed on Form N-CSR would be 18 months following the effective date, which would be sixty days after the date of publication in the Federal Register. 

Comments are due on or before August 16, 2022 – Use the Commission’s internet comment form (https://www.sec.gov/rules/submitcomments.htm). 

July 2022: Current Look at Risk Management in Crypto

The past couple months have been a rough ride for crypto investors.  Valuations have come down across the board, and volatility has increased substantially.  While these market conditions have made it difficult for investors, the same conditions are testing the risk management framework of the exchanges, brokers, and issuers of digital assets.  In the absence of comprehensive regulation for digital assets, exchanges, issuers, and other service providers are left to develop risk management controls on their own.       

To illustrate these points, we have highlighted some recent news related to digital asset issuers and lenders. 

LUNA & UST – On May 9th, a large algorithmic stablecoin (UST) lost its peg to USD and dropped to a low of 26 cents.  The root cause of the lost peg was a handful of large wallets withdrawing UST cross-chain to take advantage of arbitrage opportunities. LUNA subsequently dropped over 90% as faith in UST was lost.  

Voyager – After suffering a $650 million loan default from a large hedge fund client, Voyager filed for bankruptcy protection on July 6th.   At the time of the statement Voyager claims to have assets of $110 million of liquid assets, and 1.6 billion in customer fiat and digital assets.  The bad loan was over 5 times the size of Voyager’s assets and almost 40% of all client assets at the time of the bankruptcy petition.   

Blockfi – After cutting staff and citing a “negative impact on growth” Blockfi has taken on more debt and agreed to be acquired for up to $240 million, less than 5% of its valuation in 2021.  As Blockfi is primarily a digital asset lending platform, it is also left on the hook when customers can’t make margin calls or default on loans.   

Celsius – The crypto lending firm paused withdrawals in early June due to “extreme market conditions”. Celsius has over 2 million users (about the population of Nebraska) and withdrawals are still currently halted on the platform. Celsius apparently has a $2 billion hole in its balance sheet. 

Vauld – Another crypto lender paused operations, including withdrawals, on July 4th and is exploring restructuring options due to “financial challenges”. 

What do these 5 stories have in common?  While it’s easy to say that the down market in digital assets is the culprit, that is not quite the whole story.  And while we don’t have all the details or any specifics around root causes, what we do have is a high-level belief that each of these firms has been affected by excessive credit and / or liquidity risk, a concept that is highly monitored and tested in traditional finance.  

None of the entities are regulated in the US to the same standards as those of a bank or other lending institution.  While they likely have risk management in place, there are no standards or regulatory agencies double checking their risk exposures and controls to ensure each entity can weather tough markets. 

In traditional finance, banks and broker dealers also have to deal with increases in bad debt and volatile client withdrawals.  2008 is a good example of bank and brokerage failures caused by the same market conditions.  Had these firms been subject to bank capital requirements, or broker dealer customer reserve requirements, these scenarios may not have happened, and even if they did, customer safeguards such as FDIC and SIPC may have served as a backstop against client loss.  

As it is now, these rules as written can’t apply.  Regulators do not currently know how to handle digital asset firms in this context.  And further, we don’t believe that digital asset providers should be subject to the same rules as traditional lenders and issuers.  We do however, believe that Client assets should be protected, whether digital assets, fiat, or securities.  We believe that there should be a focus on ensuring the concepts of customer asset protection that have been developed over many down markets are applied to all investors, including those that hold digital assets.    

Aspect Advisors can assist with your risk management requirements, whether it is testing your current controls or recommending and implementing a comprehensive risk management and compliance program. 

Please contact Jennifer Csaszar at [email protected] for more information. 

June 2022: Evolution of Money, Cryptocurrency Regulation

Aspect Advisors attended the June 8th Evolution of Money: Cryptocurrency Regulation event at the Washington Post in DC. The event occurred one day after the new bi-partisan crypto legislation bill was introduced by Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY).

The event started with remarks from the Chair of the Commodity Futures Trading Commission (CFTC), Rostin Behnan. Chair Behnan made it clear that he believes many cryptocurrencies are commodities rather than securities and therefore should be under CFTC jurisdiction. Chair Behnan was in support of the introduced crypto legislation because it would largely give CFTC jurisdiction over the crypto exchanges and intermediaries. The CFTC would be funded partly by a user fee paid by the crypto registered entities. It is Chair Behnan’s belief that consumer protection will increase significantly when the CFTC and other regulators have jurisdiction over the crypto markets. Chair Behnan discussed the need for risk disclosures as well as disclosure regarding environmental impact. Specifically, the Federal Energy Regulatory Commission (FERC) would be in charge of a disclosure framework for environmental impact.

Next, Senators Lummis and Gillibrand provided their thoughts on the introduced legislation. Lummis mentioned that the past few months of volatility and the LUNA/Terra stablecoin collapse shows that we are beyond ready for meaningful regulation in this space. Regarding stablecoins, Lummis stated that the legislation spells out a requirement that the stablecoin be backed by high quality liquid assets or be issued by a financial institution that is insured by the FDIC or NCUA. Senator Gillibrand stated they researched extensively the case law around the Howey Test to determine whether a cryptocurrency is a security. In the legislation, some refinements were made to the Howey test. Gillibrand shared that crypto is a democratization of finance and increases access to minorities and lowers remittance fees. Lummis and Gillibrand also discussed that energy consumption is an issue to watch; however, also noted that many firms are moving to carbon neutral crypto mining. Lummis and Gillibrand stated their legislation will need support from at least four committees in the Senate: the agricultural committee on commodities, banking committee on securities, finance committee regarding the taxation of cryptocurrency and the Intelligence committee regarding national security.

CEO of Grayscale, Michael Sonnenshein spoke on why he sees value in thoughtful regulation and the reason he thinks it is in the consumers best interest to have spot cryptocurrency ETFs available to them. Michael also believes the time is now for the SEC to allow them to convert their GBTC spot bitcoin trust to an ETF.

Lastly, there was a discussion from two industry policy experts. Dante Disparte at Circle, the issuer of the dollar backed stablecoin USDC shared that there actually is currently a decent state level regulatory framework for stablecoins. He further stated that there has been a flight to quality in the stablecoin markets after the LUNA/terra collapse and this has benefited Circle and USDC. Tomicah Tillemann at Haun Ventures shared that it was his view that the US needed to consolidate some of its regulatory agencies and really rethink how we approach crypto regulation. He shared some concern with trying to regulate it from multiple regulatory agencies.

Aspect Advisors believes this is a good first step at bipartisan legislation on the regulation of cryptocurrency. This is the beginning of the process for the legislation. Given the wide variety of stakeholders and number of Congressional Committees involved, it is expected to take some time for the legislative discussions and process to move forward. The industry will benefit from regulatory clarity, and we look forward to thoughtful regulation that does not materially hinder innovation.

May 2022: SEC Risk Alert – MNPI related Findings

The SEC recently released a short Risk Alert covering exam findings related to Material Non-Public Information. (“MNPI”) In short, advisers (Both registered and non-registered) are required to adopt policies and procedures to prevent the misuse of MNPI by the adviser and any person associated with the adviser. These procedures are normally included in the Adviser’s Compliance Manual required by Section 201A of the Advisers Act. Section 204A-1 also requires adopting a Code of Ethics that addresses MNPI risks for internal “Access Persons”.

The Risk Alert focuses on two key areas – Common deficiencies related to the MNPI policies and procedures, and common deficiencies related to Adviser’s Code of Ethics.

Material Non-Public Information

The SEC’s exam findings related to the Compliance Manual address shortcomings with “Alternative Data,” “Value-add Investors” and Expert Networks.” Each of these categories represent potential sources of inside information where procedures must be designed to identify each source, monitor for the receipt or use of inside information, and restrict use of the information.

While conceptually presenting the same risks to the firm, procedurally they are treated differently.

1. Alternative Data providers should be vetted through vendor due diligence, where the chance of inadvertent receipt of MNPI could be addressed. There may also be provisions in the vendor agreement that place constraints on the information to be received, or sections in the agreement that mitigate the risk. We would recommend procedures that require a thorough review of the vendor, address the risk of the inadvertent receipt of MNPI, and detail what to do with the information if received.

2. Value-Add Investors refers to clients or fund investors that may have access to MNPI (think corporate executives or financial professional investors). The SEC findings here relate to identification of these types of clients and recording the source of potential MNPI. For Advisers that have these types of clients, we recommend procedures for obtaining this information through account opening or onboarding. The information should be consolidated and treated as books and records, as it seems the SEC may ask for this during an exam.

3. Expert Networks refers to groups of financial professionals that provide specialized information and research services. While these relationships also present risk in receiving MNPI, The SEC requires more than identification and reporting. For advisors that use Expert Networks, the SEC requires procedures that cover:
a. Monitoring of the communications between the firm and the network;
b. Tracking / logging calls;
c. Reviewing notes; and,
d. Reviewing trading activity for access persons working with the expert network.

We recommend procedures that leverage other reviews currently being conducted. Email review can focus in on expert network communications, and personal trading reviews can focus on the companies or industries covered by the expert networks.

For all three items, the big picture is to have procedures for identifying them and addressing what to do if an access person received MNPI.

Code of Ethics

The second key area highlighted by the SEC includes common findings that we see as well. While the Adviser’s Act is generally principles-based and provides for latitude in adopting a compliance program that fits the Adviser, there are sections that are black and white regardless of the Adviser’s risk footprint. The Code of Ethics rule covering personal transaction reporting is one of those areas. Specifically:

1. Advisors must identify access persons;

2. Access persons must get pre-approval before investing in an IPO;

3. The Advisor must get current personal holdings of an access person within 10 days of being an access person;

4. Access person holdings and transactions must be reviewed and show evidence of such review; and,

5. Advisors must ensure the Code of Ethics is sent to access persons, and written acknowledgement is received and recorded.

As this section of the rule is so prescriptive, most Code of Ethics include all these provisions. The findings indicate that Advisers are simply not following the procedures, which is always an easy finding for SEC examiners.

These are common deficiencies we see as well. As consultants, we advise clients to focus on the higher risk areas, and in many cases, the risk of insider trading or front-running is low. This section of the risk alert serves as a good reminder that there are clear responsibilities that all Advisers have regardless of risk.

The last section of the Risk Alert provides considerations in crafting the Code of Ethics, namely the use of restricted lists, and allocation procedures between an access person and a client or fund. We agree that most Advisers should have procedures addressing these items.

For Advisers that have Expert Networks, Alternative Data providers, or Value-Added Clients, we would suggest procedures for identifying and restricting employee trading in securities should MNPI be received. These procedures would be needed in the event of inadvertent receipt of MNPI.

We would also suggest a policy governing access person transaction allocations, which can be very simple to craft and provides clear guidelines for personal trading of access persons.

April 2022: SEC Exam Priorities for 2022

The SEC just recently announced its 2022 Exam priorities.  We have reviewed them, compared them with 2021, and included some trends we have seen over the past year.

Published annually, (albeit a bit late this year) The SEC Exam Priorities outlines the SEC examination focus for the coming year.  Largely followed by compliance professionals, the publication gives investment advisors & broker dealers a view of what the SEC is concerned with when conducting examinations over the coming year.   There is also an outlook for changes in the publication year-over-year.  This relative view gives a broader trend of where the SEC is looking to focus its examinations for the years to come.   

One of the key metrics that caught our eye was in the Registered Investment Adviser (“RIA”) segment.  The SEC has been transparent about the growth of new RIAs.  In 2022, they made a clear statement that RIA growth is likely to far outpace SEC staffing increase.  The rolling 5-year rate changed from a 15.8% to a 20.8% increase in RIAs, from last year.  Not only is the annual growth in RIAs large, but it is also speeding up.  The SEC made clear that the percentage of RIAs that get examined each year going forward will likely decrease.

We have seen evidence of, (and expect more) shorter, targeted exams.  The information requests we have seen are much more concise and tend to focus on a handful of key areas where RIAs have the greatest risk.  Given the substantial growth of RIAs, this strategy makes sense, as the SEC is trying to keep pace with growth yet ensure the exam priorities are achieved. 

In this light, we are breaking out the topics we view as distinct enhancements over the 2021 Exam Priorities.  Our goal is to highlight updated key areas for firms to focus their efforts for the coming year.

Digital Assets & Emerging Technologies

In 2021, the SEC broke out the following topics for firms engaging in digital asset services: (1) whether investments are in the best interests of investors; (2) portfolio management and trading practices; (3) safety of client funds and assets; (4) pricing and valuation; (5) effectiveness of compliance programs and controls; and, (6) supervision of representatives outside business activities.

In 2022, the SEC seems to have narrowed its focus on firms offering digital asset services, namely digital asset robo-advisors.  The Examination Priorities mentions an uptick in these firms, something we have seen on the consulting side as well. We can expect the SEC to focus their examination efforts on Firms that conduct this type of business.  The examinations will likely focus on the items outlined in the 2021 Exam Priorities letter, specifically:

  1. Digital asset recommendations;
  2. Compliance programs items covering:
    1. wallet reviews;
    2. custody;
    3. anti money laundering; and,
    4. valuation.      
  3. Risk disclosures
  4. Operational resiliency plans

While many of these concepts were presented in last year’s Exam Priorities Letter, we can see an obvious focus in what type of firms the SEC is interested in and what they will be looking for.  

Private Funds

Much of the RIA growth discussed above came to private fund managers. This segment makes up 35% of the RIA population and makes up about 16% of RIA AUM.  The key figure here is the growth – Private fund assets have increased by 70% over the past five years.  This growth has spurred not just a focus on examinations but new regulations as well. The SEC specifically highlighted the following areas that they intend to focus on:

  • Fees and Expenses
  • Preferential treatment of certain clients when liquidity is limited.
  • Custody rule, specifically the exception to the surprise audit requirement.
  • Disclosure & compliance with cross trades, principal transactions or distressed sales.
  • Conflicts related to liquidity, RIA-led fund restructuring.
  • Portfolio strategies, risk management, recommendations, and conflict disclosure, particularly for funds that sponsor and/ or invest in SPACs.

Environmental, Social, & Governance (“ESG”)

As with digital assets, this priority was mentioned briefly in the 2021 exam priorities but received much more detail in 2022.  The focus in 2022 targets disclosure around ESG, noting the lack of standardization or clarity in ESG classifications.  We expect the heightened review of all ESG related disclosures, proxy voting procedures that align with management mandates, and any advertising that mentions ESG strategies or products.

Regulation Best Interest

As a newer rule, last year was the announcement of the SEC’s intention to focus on Regulation Best Interest compliance.  Last year, the guidance mainly targeted the treatment of retail investors, naming several retail investor groups and addressing rollovers and other strategies involving saving for retirement.  Mutual Funds, ETFs, Municipal Securities, and Microcap securities were highlighted as products the SEC was most concerned with.

This year, the SEC provided similar guidance on what types of firms, products, and strategies they intend to focus on. Here again, we see a focus on the type of account being recommended (brokerage, advisory, wrap, rollover, etc) In comparing to last year, there seems to be a greater broker-dealer focus on SPACs, structured and other complex products, REITs, and Private Investments.  On the advisory side, the SEC specially calls out revenue sharing practices, share class recommendations, wrap account recommendations (specifically calling out the industry trend to zero commission charges), and proprietary product recommendations. 

The biggest enhancement under the Regulation BI priority is the focus on dual registrants (or affiliates that act in both capacities) In 2022, this topic was broken out and addressed separately, highlighting the focus on recommendations of high-fee and / or proprietary products and conflicts related to financial advisor sales incentives.  This guidance to us seems exceeding clear what the SEC is looking for.  

In general, we see a trend of the SEC being more specific in their guidance, as they are being more targeted in their exams.  We feel that this will likely continue, and the value of the Exam Priorities guidance will continue to grow for RIA and broker-dealer market participants.

The analysis above only represents the areas we have chosen to highlight.  Please see the complete 2022 Examination Priorities for a full assessment of the SECs focus for 2022.

March 2022: Cheat sheet on the SEC Proposed Cybersecurity Compliance, Reporting and Disclosure Rules

On February 9, 2022, the Securities and Exchange Commission voted 3–1 in proposing new cybersecurity rules for the investment industry. The new Proposed Rules come on the tail end of a growing anxiety from increasing cybersecurity threats on a national and global scale regarding infrastructure and within the capital markets.

The Proposed Rules would increase the substance, complexity, frequency and sophistication of the work product and deliverables required to demonstrate a model cybersecurity program. However, as these new requirements have long been mandated as part of the current regulatory landscape, the Proposed Rules are merely a formalization and natural evolution. Whether in the form of SEC enforcement actions, regulatory examinations, cyber sweeps, ODD reviews, or investor expectations, these requirements remain as absolute core cybersecurity controls that both RIAS and Registered Funds must implement and demonstrate.

Here’s what firms need to know:
The Proposed Rules apply to both registered investment advisers (Advisers) and certain investment companies (Funds). The new requirements will formalize and substantially increase the cybersecurity requirements on both Advisors and Funds in three (3) principal ways:

Cybersecurity Policies & Procedures

  • Develop and maintain a formal Cybersecurity Program
  • Address user security controls, monitoring of systems and data set, threat and vulnerability protections and incident response capabilities
  • Internal or outsourced administration by qualified individuals with appropriate knowledge and access
  • Significant five (5) year recordkeeping requirement

Reporting Significant Cybersecurity Incidents

  • Obligation to report “significant cybersecurity incidents” to SEC
  • Forty-eight (48) hour reporting window for each incident
  • Continuing reporting obligation if new material information is discovered for each incident
  • Reports will be confidential

Disclosing Cybersecurity Risks & Incidents

  • Advisers and Funds will have to make clear, direct cybersecurity risks disclosures to investors
  • Advisers: Form ADV Part 2A will be amended to include new Item 20, “Cybersecurity Incidents and Disclosures”
  • Funds: Registration Statements
  • Disclosure obligations are continuing for both Advisors and Funds
  • Disclosures will include assessing and addressing cyber risks that could materially affect services

March 2022: IA/BD Compliance Update

Hosts Justin Schleifer,
President & Co-Founder
Aspect Advisors
Bart Mallon,
Co-Managing Partner
Cole-Frieman & Mallon

 

Aspect Advisors and C-F&M 2022 IA/BD Compliance Update

We wanted to take this opportunity to thank everyone who attended and participated in our 2022 compliance update hosted by Justin Schleifer, Co-Founder, President (Aspect Advisors), and Bart Mallon, Co-Managing Partner (Cole-Frieman & Mallon). Our discussion on March 3 touched on many essential topics for financial industry professionals to keep top of mind for the upcoming year.

Some high points included:

Compliance Calendar.

  • Imminent Deadlines & Filings
    • ADV and CRS – March 31
    • Form PF – April 30 (annual filers)
  • Rule Implementation Dates
    • SEC Advertising Rule – November 2022
    • Proposed Private Fund Disclosures – Q2 2023
    • Proposed Cybersecurity Rules – Q2 2023
  • Periodic Tasks
    • Annual review of policies and procedures
    • Business continuity test/review
    • Cybersecurity test
    • Customer/account reviews
    • Employee training
    • Code of ethics surveillance

SEC Marketing Rule Implementation. The new SEC Marketing rules will replace the existing regime of no-action letters and establish clear rules for fund managers. These rules will not fundamentally change the spirit of the current regime and instead clarify specifics on today’s issues such as social media use, blog posts, testimonials, and others. The new rules are not expected to impact the investment management industry significantly. Still, fund managers will need to update policies and procedures and review current advertising materials to ensure compliance with the new rules.

Proposed Private Fund Disclosure Rules. The SEC has proposed new rules for private fund disclosures that seek to improve transparency for types of information that investors receive to aid them in making informed decisions. As it stands, the proposals could profoundly impact private fund operations and the relationship between managers and investors regarding investments. The effects would be felt by large fund managers who receive institutional investments. The institutional investor has the leverage to ask managers for preferential rights and other forms of favorable treatment. The SEC is reviewing proposals, and experts believe that some version of the rules will likely be implemented in 2023.

Proposed Cybersecurity Rules. In recent years, there has been a push from the SEC and other financial regulators to improve cybersecurity, so it comes as no surprise that the SEC has formally proposed a set of rules to govern the matter. Like other policy and procedure requirements, many of the new rules lack specifics, meaning that individual firms will need to determine what they view as necessary to include to maintain compliance.

NFTs. From the past six months, everyone’s favorite buzzword has grown in prominence within the investment management industry following the launch of NFT-exclusive private investment funds. Like other digital assets, the primary concerns for managers are custody and the general compliance of the assets. NFTs have also raised novel valuation questions as experts seek ways to appraise the assets in ways beyond their trading price.

DAOs. The emergence of DAOs as legal entities has raised two critical items to follow in 2022. First, DAOs have sought to create real-world investment products, raising questions about how private fund managers can allow a DAO to invest in the fund. Second, DOAs have inquired about launching their private investment fund products, which presents unique legal and compliance challenges that need to be tackled.

Offshore Exchanges. A popular question from fund managers in the digital asset space regards opening accounts at offshore exchanges legally. To date, there is no easy answer, and attempts to do so must be conducted carefully on a client-by-client basis. There will be instances where opening an offshore exchange account is impossible or cost-prohibitive.

BlockFi’s Settlement. The SEC succeeded in sending shockwaves through the digital asset space after it agreed to a $100 million settlement with BlockFi over BlockFi’s interest product. BlockFi has decided to work with the SEC to register the product. Still, experts are unsure of how this will be done and wonder if this settlement will affect the desire of other market participants to develop new products. Furthermore, this settlement reflects the SEC’s troubling pattern of regulating by enforcement instead of publishing new rules and guidance. It also shines a light on how the SEC views these products as securities and could be the first step in considering specific lending-focused smart contracts to be securities.

Crypto Best Practices. There are essential best practices that fund managers in the digital asset space need to be aware of, especially managers experienced in traditional asset classes:

  1. It is essential to conduct and document diligence on counterparties and vendors. Vendors in the digital asset space are often new and unproven, in contrast to the established vendors of traditional asset classes.
  2. Fund managers must have a reasonable basis for custody providers and custody solutions. Nonetheless, while the SEC views custody of digital assets as being out of the ordinary, they have primarily been receptive to new solutions.
  3. Be aware of the potential to receive MNPI.

Unlike traditional asset classes, there are fewer mechanisms for publishing company information to make it public. It is essential that employees understand the meaning of MNPI and how it impacts their business.

Big Predictions for 2022. Justin predicts that the SEC will bring another significant enforcement action that matches the BlockFi action in scale. The agency wants to further apply traditional securities law to digital assets, which means we could see another large settlement or a case fought in public court to set a precedence within the industry. Bart predicts increased activity from DAOs and potentially a significant breakthrough with DAOs in the next six months.

Regards,

Justin Schleifer & Bart Mallon

February 2022: SEC Proposed Private Fund Rules

The SEC has turned its attention to more carefully regulating advisers to private funds, as made clear by new rule proposals released last week. While the proposals are currently in the comment period, it seems likely that most, if not all, of the provisions of the proposed rules will be implemented.

There are three primary facets to the new rules:

  1. Preparation and distribution of statements (with required content) to fund investors.
  2. Requiring audits of all private fund vehicles.
  3. Addressing disparity of investor terms (e.g. side-letters).

The pervasive theme to these proposed mandates is increased transparency to fund investors.

Statements would be required to include a more complete description of adviser compensation, fund fees and expenses, and any fee offsets/rebates/waivers in addition to more specific performance reporting requirements. The SEC has included a provision that allows for this information to be presented differently depending on whether the private fund is liquid (e.g. open-end, hedge) or illiquid (e.g. closed-end, PE/VC), so that investors can more easily compare data from one fund to another. The current proposal is for statements to be provided quarterly, within 45 days of the end of each quarter.

Under the custody rule, most private funds currently undergo an annual audit. However, there are some vehicles that may have used alternative methods in the past. The proposed rules would supersede the custody rule in this context and would require all private funds to undergo an annual financial audit. This could potentially pose a financial burden to some vehicles that hadn’t previously had an audit performed, so it remains to be seen the if the SEC provides some relief for certain fund types (e.g. SPVs).

It is common for fund managers to have special investment terms for founding and/or large investors as an enticement for those investors to participate in the fund. The SEC is concerned that term adjustments involving transparency and/or liquidity preferences for certain investors could be detrimental to the interests of other investors in the fund. Under the proposed rules, managers may be prohibited from certain activities and/or required to disclose certain side-letter terms to the investor base at large. We expect this proposal to be particularly unpopular and it remains to be seen whether it will end up in the final rule.

February 2022: BlockFi

BlockFi agreed to pay a $50 million penalty to the Securities and Exchange Commission (SEC) and an additional $50 million in fines to 32 states to settle similar charges. The fine is related to BlockFi Interest Accounts (BIAs) that lets clients accrue interest on holdings of Bitcoin and other cryptocurrencies. The SEC determined that the BIAs were unregistered securities. In response, BlockFi announced it intends to register under the Securities Act of 1933 the offer and sale of a new lending product.   

Specifically, BlockFi promised BIA investors a variable interest rate, in exchange for crypto assets loaned by the investors. Investors in the BIAs had a reasonable expectation of obtaining a future profit. The order further stated that BlockFi made misleading statements on its website regarding the level of risks of its BIA product.  

The press release also included a statement by Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, putting other crypto lending platforms on notice and proclaiming that they should take immediate notice of this action and to come into compliance with the federal securities laws.  

We expect other digital asset exchanges and digital asset firms to follow BlockFi and register similar crypto interest-bearing accounts with the SEC. We also expect the SEC to continue their regulation by enforcement approach until formal guidance and securities laws specific to digital assets are enacted.  

SEC Enforcement Action: BlockFi Lending LLC (sec.gov) 

Upcoming Events

More events coming soon!

Past Events

May 12th, 2022

Rooftop Crypto Happy Hour in NYC

Hosts
Aspect Advisors
FalconX
Houlihan Capital

+ Coming to NYC for the AIMA Digital Asset Conference?  + Join us for a drink to connect with fund managers, allocators and institutional service providers.
+ Contact [email protected] for more details.

April 26th, 2022

Upping the Ante on Cybersecurity:
The SEC’s Proposed Rules Around Cybersecurity Risk Management

Hosts / Panel
John Araneo, Align Cybersecurity
Jim Smith, Aspect Advisors

Topics will include:
+ Introduction, background and reasons for the Proposed Rules
+ Discussion of cybersecurity as encompassing IT, security, and regulatory challenges
+ Current observations by the SEC
+ Recommended next steps for the investment management industry

March 3rd, 2022

2022 IA/BD Compliance Update

Host
Bart Mallon, Cole-Frieman & Mallon

Panel
Bart Mallon, Cole-Frieman & Mallon
Justin Schleifer, Aspect Advisors

Topics will include:
+ 2022 Compliance Calendar: ADV amendments + Annual filings
+ SEC Marketing Rule implementation
+ SEC Updates: Private Funds, Cybersecurity, and Digital Assets
+ Best Practices for Crypto Advisers
+ ODD trends for crypto RIAs

 

January 21st, 2021

2021 IA/BD Compliance Update

Host
Bart Mallon, Cole-Frieman & Mallon

Panel
Bart Mallon, Cole-Frieman & Mallon
Justin Schleifer, Aspect Advisors
Kathlyne Kiaie, Aspect Advisors

In January 2020, we hosted a presentation and networking event at the offices of Cole-Frieman & Mallon LLP together with Aspect Advisors, a regulatory compliance consulting firm. The event was very popular and well attended, so we’re bringing it back for 2021 as a webinar and we hope to see you there!

Topics will include:
+ 2020 compliance calendar (including Form ADV annual update)
+ Major issues from the SEC and courts in 2020
+ SEC focus on crypto / digital assets in 2021
+ Fintech regulations and best practices

September 2nd, 2020

Cryptocurrency and Digital Asset Forum: Trends in Legal, Tax, and Compliance

Host
Bart Mallon, Cole-Frieman & Mallon

Panel
Ryan David Williams, Ashbury Legal
Justin Schleifer, Aspect Advisors
Nick Cerasuolo, Blockchain Tax Partners

Join us to get your questions answered by an expert panel during a Live Discussion. Experience a unique collaborative event to explore the latest developments in the Cryptocurrency and Digital Asset sector. Suggested topics for this session include (but are in no way limited to):

+ Putting Crypto Investments to Work: Unlocking Full Potential Through Yield and Lending
+ DeFi Implications: Market-Making (Liquidity), Governance, and Custody
+ Evolving Landscape: Latest Products/Services, Regulations, and Enforcements

July 22nd, 2020
The Operational Due Diligence Process

Host
Winter Mead, Oper8r

Panelists
Brian Borton, Stepstone Group
Justin Schleifer, Aspect Advisors
Sean Park, First Republic Bank

Justin Schleifer will be a Panelist for a webinar hosted by Oper8r about the fundamentals of the operational due diligence process, including how LPs should think about the operations of their firms from a compliance and regulatory perspective. 

May 7th, 2020
REG BI: Are you Ready for June 30th?

Host
Bart Mallon, Co-Founder and Partner,
Cole-Frieman & Mallon LLP, Aspect Advisors LLC

Panelists
James Dombach, Murphy & McGonigle
Justin Schleifer, Aspect Advisors
Paul Merolla, Murphy & McGonigle

Join us for a complimentary one-hour webinar and get the advice you need to implement Regulation Best Interest with confidence! In this “beyond-the-basics” webinar, our discussion will take a deeper dive into how firms can implement Reg BI requirements.  Topics will include:

+ the SEC’s OCIE guidance regarding regulatory expectations
+ common questions we’ve been asked from a compliance / legal perspective
+ practical strategies for implementation
+ Q & A with participants

February 11th, 2020
Bitcoin Mining: The Current Environment

Hosts

Michael Fitzsimmons CAIA, Director, Capital Introduction Williams Trading
Bart Mallon, Co-Founder and Partner, Cole-Frieman & Mallon LLP, Aspect Advisors LLC

Panelists

Mathew D’Souza, Blockware Solutions
Thomas Ao, MCredit
Yida Gao, Struck Capital

VC firms have been investing in bitcoin mining and infrastructure to attain lower volatility exposure to the best performing asset class of the past decade. Come hear from the experts in both operating and financing mining businesses as they discuss the opportunities and challenges they face. This will be a lively discussion about an opaque, widely misunderstood area of the blockchain space.