Asset Management Regulatory Update

MARKETING RULE COMPLIANCE RISK ALERT AND ENFORCEMENT

On April 17, 2024, the Division of Examinations (the "Division") of the Securities Exchange Commission (the "SEC") issued a Risk Alert regarding the Staff of the Division (the "Staff") observations preliminary observations from examinations investment advisers' compliance with amended Rule 206(4)-1 (the "Marketing Rule") under the Investment Advisers Act of 1940 ("Advisers Act"). The Risk Alert paid particular attention to the Marketing Rule's seven principles-based general prohibitions for all advertisements (the "General Prohibitions").

The Staff provided details on the following critical deficiencies related to the application of the Marketing Rule's General Prohibitions:

• The Staff observed advertisements that included statements of material fact that appeared untrue or could not be substantiated. The Staff highlighted, among other examples, advertisements: (1) referencing specific investment mandates of the advisers in advertisements when there were no such mandates (e.g., ESG); (2) claiming that investment processes were validated by professional institutions when they were not; and (3) misrepresenting the advisers' client base, such as describing the adviser as a "private fund adviser" when the firm did not advise any private funds.
• The Staff observed advertisements that omitted material facts necessary to make the statements not misleading in light of the circumstances under which they were made. The Staff highlighted, among other examples, advertisements that: (1) recommended certain investments (e.g., on podcasts or websites) without disclosing the conflicts of interest attributed to the compensation paid to or received by the advisers for such recommendations; (2) represented performance information that did not provide adequate disclosure regarding the share classes included in the performance returns; (3) claimed that the advisers achieved above average performance results without clarifying that the advisers did not yet have clients or performance track records; and (4) included third-party ratings that (i) implied that the Adviser was the sole top recipient of certain awards when the awards went to multiple recipients or the adviser was not the top recipient and (ii) failed to disclose that the adviser or that adviser personnel nominated fellow employees for awards.
• The Staff observed advertisements that included only the most profitable investments or specifically excluded certain investments without providing sufficient information and context to evaluate the rationale, such as investments that were written off as losses or were lower-performing investments.

The Staff's observations also focused on adviser compliance with the Marketing Rule–related aspects of Form ADV, Advisers Act Rule 206(4)-7 (the "Compliance Rule"), and Advisers Act Rule 204-2 (the "Books and Records Rule").

• The Staff observed advisers using outdated language in their Form ADVs referencing provisions of the prior Cash Solicitation Rule (Advisers Act Rule 206(4)-3), inaccurately indicating that no referral arrangements existed, and omitting material terms and compensation of referral arrangements on Form ADV, Part 2A, Item 14.
• While the Staff noted that many advisers had adopted compliance policies and procedures that included processes to comply with the Marketing Rule, there were observed instances where advisers' policies and procedures were not reasonably designed or implemented to address compliance with the Marketing Rule, which resulted in gaps for preventing violations of the Marketing Rule, highlighting policies and procedures that: (1) failed to address applicable marketing channels utilized by the advisers, such as websites and social media and (2) were updated to reflect the Marketing Rule but were not implemented (e.g., policies that required net of fees performance to be included with any performance advertisement but practices of including only gross performance in advertisements).
• The Staff observed Marketing Rule-related Books and Records Rule deficiencies, noting that advisers did not maintain copies of information posted to social media and did not maintain documentation to substantiate claims included in advertisements.

The Risk Alert follows shortly after the SEC announced a second set of settled enforcement cases against five registered investment advisers, after previously announcing a set of settled enforcement cases against nine advisory firms in September 2023. The SEC's recent settlement orders alleged that the five firms advertised hypothetical performance to the general public on their websites (i) without adopting and implementing policies and procedures reasonably designed to ensure that the hypothetical performance was relevant to the likely financial situation and investment objectives of each advertisement's intended audience, (ii) without ensuring that the hypothetical performance was not misleading or misrepresentative, and (iii) without substantiating the performance figures presented in their advertisements.

PRIVATE FUND ADVISER RULES VACATED BY FIFTH CIRCUIT

On June 5, the U.S. Court of Appeals for the Fifth Circuit (the "Fifth Circuit") vacated the entirety of the private fund rules (the "Private Fund Rules") adopted by the SEC in August 2023 (please see our prior alerts for a description of the Private Fund Rules' provisions) holding that in adopting the Private Funds Rules the SEC exceeded the statutory authority of section 211(h) and section 206(4) of the Investment Advisers Act of 1940 (the "Advisers Act").

While, the SEC has not yet indicated whether it will appeal the decision (among its other options, the SEC can file a petition for certiorari seeking review before the U.S. Supreme Court within 90 days) private fund advisers should still prepare for the possibility that certain aspects of the Private Fund Rules will surface as investor requests in negotiations, in future SEC examination and enforcement activities, and in industry best practices.

SECURITIES AND EXCHANGE COMMISSION V. JARKESY

On June 27, 2024, the U.S. Supreme Court ("Supreme Court") issued its decision in Securities and Exchange Commission v. Jarkesy, ruling that when the SEC seeks civil penalties against a defendant for securities fraud, the Seventh Amendment entitles the defendant to a jury trial. Accordingly, the SEC may no longer pursue civil monetary penalties through administrative proceedings.

By way of background, the SEC may bring an enforcement action in one of two forums. It can file suit in federal court (an "Article III Court"), or it can adjudicate the matter "in-house" in an administrative enforcement action before an SEC-appointed Administrative Law Judge ("ALJ") or the Commissioners, whose decision is nevertheless ultimately subject to Article III judicial review. Unlike proceedings in Article III Courts where the defendant is entitled to a jury trial presided over by an Article III judge, and for which the Federal Rules of Evidence and Civil Procedure apply, administrative proceedings are not subject to the Federal Rules, and the ALJ or Commission serves as factfinder. However, administrative proceedings can, depending on the circumstances, be timelier and more cost-effective than Article III Court review (for both the government and defendants). The SEC's use of in-house administrative proceedings is a relatively recent practice, as before passing the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010, the SEC could only seek civil penalties in federal court.

George Jarkesy Jr. ("Jarkesy") established two hedge funds, with his firm Patriot28, LLC ("Patriot28"), as the investment adviser, managing $24 million in assets from over 100 investors. In 2011, the SEC investigated Jarkesy and Patriot28 and, according to the SEC's allegations, found that Jarkesy and Patriot28 misled investors and brokers by misrepresenting investment strategies, lying about the identity of the fund's auditor and prime broker, and overvaluing the funds' claimed value to collect larger management fees. In 2013, the SEC initiated an administrative enforcement action against Jarkesy and Patriot28, alleging various violations of Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), and Section 206 of the Advisers Act. In 2014, Jarkesy challenged the SEC's administrative proceedings in the U.S. District Court for the District of Columbia, citing constitutional infringements, but both the district court and the U.S. Court of Appeals for the D.C. Circuit denied the injunction, finding that the district court lacked jurisdiction. After an evidentiary hearing by an ALJ, Jarkesy was found guilty of securities fraud, and the SEC then ordered Jarkesy to pay a civil penalty of $300,000, with Patriot28 forced to disgorge $685,000 in ill-gotten gains. Jarkesy was also barred from various securities-related activities.

Jarkesy sought review of the ALJ's decision by the SEC. While that petition was pending, the U.S. Supreme Court decided Lucia v. SEC, holding that SEC ALJs were officers of the United States subject to the Appointments Clause and were improperly appointed. Jarkesy, however, had waived his right to a new hearing.

The SEC affirmed the ALJ's fraud findings, imposed penalties, and rejected Jarkesy's argument that it had utilized "unconstitutionally delegated legislative power" to pursue the case in an administrative proceeding rather than in an Article III court. It also rejected Jarkesy's argument that the proceedings violated his Seventh Amendment right to a jury trial.

He then filed a petition for review in the U.S. Court of Appeals for the Fifth Circuit, which reversed and remanded, finding that the SEC's administrative proceedings suffered from three significant constitutional defects: (1) that it deprived Jarkesy of his Seventh Amendment right to a jury trial; (2) that Congress "unconstitutionally delegated legislative power to the SEC by failing to provide it with an intelligible principle by which to exercise the delegated power"; and (3) that statutory removal restrictions on ALJs violated Article III. The SEC petitioned for certiorari, which the Supreme Court granted, and the Court heard oral argument on November 29, 2023.

In a 6-3 majority (the "Majority") opinion by Chief Justice Roberts, the Supreme Court decided the case solely on Seventh Amendment grounds, holding that the SEC's imposition of civil monetary penalties for securities fraud through administrative proceedings violated Jarkesy's right to a trial by jury for all "suits at common law." The Supreme Court did not take up other constitutional issues raised by the Fifth Circuit.

The Majority of the Supreme Court first reasoned that because claims for securities fraud violations (such as fraudulent and misleading statements) target the same conduct prohibited by common law fraud, such actions constitute a "suit at common law" to which the Seventh Amendment applies. Next, focusing on the SEC's desired remedy — civil penalties — the Majority reasoned further that because civil penalties are a punitive form of monetary relief traditionally awarded in courts of law, such penalties constitute a prototypical common-law legal remedy and, therefore, also implicate the Seventh Amendment. A defendant would, therefore, be entitled to a jury trial on action for securities fraud unless the "public rights" exception to Article III jurisdiction applied.

Broadly, the Supreme Court's "public rights" exception allows Congress to "assign the matter for decision to an agency without a jury, consistent with the Seventh Amendment." The Majority concluded that the "public rights" exception did not apply because the SEC's action was a "matter of private rather than public rights" based upon historical precedent (the anti-fraud provisions of the federal securities laws are modeled on historical common-law fraud claims), thereby making "adjudication by an Article III court . . . mandatory." The Majority rejected SEC's position that public rights are necessarily involved where a government agency brings suit under a statutory grant of authority, reasoning that the action did not fall within any of the distinctive areas involving governmental prerogatives where the Court's jurisprudence had concluded that a matter might be resolved outside of an Article III Court without a jury.

Accordingly, the Court concluded that Jarkesy and Patriot28 were entitled to a jury trial in an Article III Court.

Although it may appear relatively narrow in scope on its face, the legal and practical ramifications of the decision– will be significant for the SEC and other federal agencies that impose penalties through administrative proceedings. For any action that is akin to a "suit at common law" and where the remedy sought is one that traditionally "could only be enforced in court of law," the Jarkesy ruling strongly supports that the defendant has a right to a jury in an Article III Court.

SEC ADOPTS RULE AMENDMENTS TO REGULATION S-P TO ENHANCE PROTECTION OF CUSTOMER INFORMATION

On May 16, 2024, the SEC adopted amendments to Regulation S-P, which governs the treatment of consumers' nonpublic personal information by certain financial institutions. Regulation S-P requires (i) brokers, dealers, investment companies, and registered investment advisers to adopt written policies and procedures that address administrative, technical, and physical safeguards to protect customer records and information (the "safeguards rule") and (ii) the proper disclosure of consumer report information in a manner that protects against unauthorized access to or use of such information (the "Disposal Rule"). The Disposal Rule also applies to SEC-registered transfer agents.

The amendments to Regulation S-P (the "Amendments") define customer information for any covered institution (excluding transfer agents) as any record containing nonpublic personal information about a customer of a financial institution, whether in paper, electronic or other form, that is in the possession of a covered institution or that is handled or maintained by the covered institution or on its behalf. This information is "customer information" regardless of whether it pertains to individuals with whom the covered institution has a customer relationship or to the customers of other financial institutions where such information has been provided to the covered institution.For transfer agents, customer information is any record containing nonpublic personal information identified with any natural person, who is a securityholder of an issuer for which the transfer agent acts or has acted as transfer agent, that is handled or maintained by the transfer agent or on its behalf.

Pursuant to the Amendments, covered institutions will be required to develop, implement, and maintain written policies and procedures for an incident response program that is reasonably designed to detect, respond to, and recover from unauthorized access to or use of customer information. In particular, a covered institution's incident response program will be required to have written policies and procedures to assess the nature and scope of any incident that involves unauthorized access to or use of customer information and identify the systems and types of customer information that may have been accessed or used without authorization. The incident response program must also take appropriate steps to contain and control the incident to prevent further unauthorized access or use.

In addition, the Amendments require covered institutions to notify individuals whose sensitive customer information was, or is reasonably likely to have been, accessed or used without authorization. Covered institutions will be required to provide this notice as soon as practicable, but no later than 30 days after the institution becomes aware that unauthorized access or use has occurred or is reasonably likely to have occurred. Notice is not required where the institution determines that the customer information has not been, and is not reasonably likely to be, used in a manner that would result in substantial harm or inconvenience. The notice provided to affected individuals must include details regarding the incident, the breached data, and how the affected individual can respond to protect themself.

With respect to service providers used by covered institutions, covered institutions will be required to establish, maintain, and enforce written policies and procedures reasonably designed to require oversight, including through due diligence and monitoring of service providers, and ensuring that affected individuals receive any required notices.

The effective date of the Amendments is August 2, 2024. The compliance date for larger entities is December 3, 2025, while the compliance date for smaller entities is June 3, 2026. "Larger entities" means: (i) investment companies that, together with other investment companies in the same group of related investment companies, have net assets of $1 billion or more as of the end of the most recent fiscal year; (ii) registered investment advisers with $1.5 billion or more in assets under management; and (iii) all broker-dealers and transfer agents that are not small entities under the Securities Exchange Act for purposes of the Regulatory Flexibility Act.

SEC SPRING 2024 REGULATORY AGENDA

On July 8, 2024, the SEC released its Spring 2024 Regulatory Agenda (the "Regulatory Agenda"). The Regulatory Agenda includes fifteen rules in the proposed rule stage and nineteen rules in the final rule stage. Those in the final rule stage include rules with respect to enhanced disclosures by certain investment advisors and investment companies regarding ESG investment practices; cybersecurity risk management for investment advisers, registered investment companies and business development companies; outsourcing by investment advisers; and Regulation Best Execution.

Rules in the "proposed rule stage" include, among others, rules with respect to Regulation D and Form D improvements; safeguarding advisory client assets; open-end fund liquidity risk management programs; investment company fund fee disclosure and reform; and exchange-traded products.

UPCOMING CONFERENCES

*Host Organization Key: Mutual Fund Directors Forum ("MFDF"), Independent Directors Council ("IDC"), and Investment Company Institute ("ICI")

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