Investment Industry Wire | January 2021– January 25, 2021

The pace and intricacies of regulatory change in the investment industry are, at times, nothing short of overwhelming. Yet, organizations in this space need to have a clear understanding of evolving regulations, their timing and overall impact.

To help you stay up to date, below is Cohen & Company’s quarterly recap of the latest regulatory developments.

Note: The following blog was written from a perspective of prior to January 20, 2021. President Biden’s chief of staff has asked all federal agencies to freeze all proposed and pending regulations until the appropriate people from the new administration review and approve them. As a result, some of the following information could change.

Securities & Exchange Commission (SEC)

Management Discussion and Analysis Changes
On November 19, 2020, the SEC yet again took a principles-based approach, adopting new amendments to Regulation S-K Item 301, 302 and 303 - Management Discussion & Analysis (MD&A) requirements. The SEC's goal is to simplify and enhance rules and highlight the importance of materiality when considering the information provided in this key communication to investors.

Under the new rule, some of the main provisions include:

  • Five Year Financial Data (Item 301): With the ready availability of data on EDGAR and trend information already required in MD&A, the SEC requires eliminating the five year table of selected financial data. However, the SEC encourages a registrant to provide material information and statistical data that the registrant believes will enhance a reader’s understanding of the registrant’s financial condition and results of operations.
  • Effects on Operations: SEC requires disclosures regarding material events and uncertainties known to management that are reasonably likely to cause current financial information to not indicative of future operating results or of future financial condition. This includes descriptions and amounts of matters that have had or may reasonably likely in the future have a material impact on reported operations.
  • Capital Resources: Registrants will need to provide material cash requirements, including commitments for capital expenditures, as of the latest fiscal period, the anticipated source of funds needed to satisfy such cash requirements and the general purpose of such requirements.
  • Off-Balance Sheet Disclosures: Due to changes in Generally Accepted Accounting Principles (GAAP), the SEC eliminates the current definition of off-balance sheet arrangements and related disclosure requirements. Rather, the requirement is now replaced with instructions to Item 303 to disclose discussion of off-balance sheet arrangements that have or are reasonably likely to have a material effect on a company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, cash requirements or capital resources. The SEC expects companies to incorporate their discussions of off-balance sheet arrangements into their broader discussions of liquidity and capital resources.
  • Critical Accounting Estimates: The SEC requires disclosure regarding critical accounting estimates, including changes in estimates and the sensitivity of the reported amounts to the underlying estimates. Companies must now provide qualitative and quantitative information necessary to understand the estimation uncertainty and the impact the critical accounting estimate may have on financial condition or results of operations, to the extent the information is material and reasonably available.

The amended rule will be effective February 10, 2021. Registrants will be required to apply the amended rules for their first fiscal year ending on or after August 9, 2021.

Impact: The SEC is taking one step forward in the modernization of MD&A disclosures to allow investors a view of the company from the management’s perspective.

Rule 2a-5 Good Faith Determinations of Fair Value
Originally proposed in April 2020, the SEC adopted Rule 2a-5 under the Investment Company Act of 1940 on December 3, 2020. The new rule does not establish material changes from what has been established throughout the industry as a best practice around valuation policies and procedures. Rather, the rule formalizes documentation, processing and reporting for determining fair value in good faith to achieve a board of director’s responsibilities. The new rule applies to all registered investment companies and BDCs, regardless of their investment objectives or strategies.

The new rule:

  • Formally permits boards, subject to board oversight, to designate other parties to perform certain fair value functions, including the actual day-to-day fair value determinations, i.e., valuation designee. If a valuation designed is identified by the board, the board still needs to fulfill the responsibility requirements for oversight and monitoring.
  • Defines when market quotations are “readily available,” the threshold for determining whether a fund must fair value a security. The SEC provided that a market quotation is readily available only when using a quoted price (unadjusted) in active markets for the identical instrument at that date. This definition is consistent with that of a level 1 input in the fair valued hierarchy outlined in U.S. GAAP.
  • Determines evaluated prices to not be considered readily available. Fair value must be used, regardless of whether or not the price was provided by third-party pricing services. In addition, broker-dealer "accommodation quotes" are not readily available market quotations.

The SEC also adopted Rule 31a-4, which provides expanded recordkeeping requirements for fair value determinations, including recordkeeping of designation of valuation designee. The board or its valuation designee must select, apply and test fair value methodologies and oversee and evaluate any third-party pricing services, where used.

The amended rules will be effective March 8, 2021. Registrants will be required to apply the amended rules for their first fiscal year ending on or after September 8, 2021.

Impact: The final rule modernizes 50-year-old valuation guidance by setting a consistent framework for fair value and standard practices across funds to help ensure fund boards are fulfilling their fiduciary responsibilities. Fund boards will find the added clarity helpful to be able to select valuation designees to aid in their review and determination of fair value in good faith — without significantly changing current market practice over portfolio valuation.

>> Read more on specific oversight responsibilities of a board if they were to select a valuation designee in “Half a Century Later, the SEC Modernizes its Fund Valuation Practices Framework”

Update to Fund-of-Funds Regulatory Framework
The SEC adopted new Rule 12d1-4 on October 7, 2020, providing consistency in the regulatory framework for registered funds that invest in other funds, i.e., fund-of-funds. The new framework replaces the current exemptive order process, which allowed variability from fund to fund.

The rule generally permits a fund to invest in another fund in excess of the limits imposed by Section 12(d)(1) of the 1940 Act without obtaining an exemptive order from the SEC. These limits include acquiring more than 3% of the outstanding voting securities of another fund; investing more than 5% of its total assets in any one registered fund; or investing more than 10% of its total assets in registered funds. The rule will apply provided that certain conditions, summarized below, are met. 

  • Limits on control and voting. The rule prohibits an acquiring fund from controlling another fund, except in certain limited circumstances. In addition, if the fund holds greater than a certain percentage in an acquired fund (25% of an open-ended fund and 10% of a closed-end fund), they must vote those shares in a prescribed manner to minimize the influence exercised over the acquired fund. 
  • Required evaluations and findings. Investment advisors of acquiring and acquired funds are required to make evaluations and conclude on the fund-of-funds arrangement, including whether there is a duplication of fees and the potential for undue influence.
  • Required fund-of-funds investment agreements. Funds that do not have the same investment advisor are required to enter into an agreement prior to the purchase of acquired fund shares in excess of the Section 12(d)(1) limits mentioned above. As such, acquisitions are subject to consent by the acquired fund.
  • Limits on complex structures. General prohibitions are imposed on three-tiered structures with certain listed exceptions.

The rule also includes disclosure provisions requiring acquiring funds to disclose whether they are relying upon Section 12(d)(1)(G) or on Rule 12d1-4 during the fund’s reporting period within Form N-CEN, which is filed annually. However, of note, the final rule does not include the 3% redemption limits over a 30-day period that were originally proposed. 

The provisions of Rule 12d1-4 do not extend to private funds and unregistered investment companies, such as foreign funds. 

The new rule was effective on January 19, 2021. The compliance date for the Form N-CEN amendments is January 19, 2022, which is also the date that Rule 12d1-2 will be rescinded, as well as the exemptive orders that grant relief from the investment limits of 12(d)(1).

Impact: Rule 12d1-4 will permit more and consistent fund of funds arrangements. However, it imposes a new set of conditions, including limits on control and voting of acquired funds’ shares, evaluations and findings by investment advisors, fund investment agreements and limits on most three-tier fund structures.

Regulatory Modernization Continues — Derivatives Rule for Registered Funds
Rule 18f-4 is a continuation of the SEC’s modernization plan, significantly altering the framework for derivatives used by registered investment companies (including mutual funds, ETFs, closed-end funds and business development companies). The new rule permits funds to invest in derivative transactions if they comply with certain conditions designed to protect investors.
Some of the requirements of this rule include:

  • Limitations on fund’s leverage risk. Limits have been included on the amount of leverage related risk based on a fund’s value-at-risk (VaR), an estimate of potential losses on an instrument or portfolio over a given period of time. The VaR-based limit replaces the current asset segregation requirements for purposes of limiting leverage risk. 
  • Derivatives risk management program. The rule includes a requirement to appoint a derivatives risk manager and to adopt a derivatives risk management program. The program must include risk guidelines, as well as stress testing, frequent backtesting, internal reporting and escalation, and program review elements.
  • Oversight and reporting. The derivatives risk management program should include periodic reporting to and oversight by the board of directors/trustees.
  • Record keeping. New reporting requirements have been added, and certain amendments to disclosure forms include information regarding a fund’s derivatives use and if a fund is out of compliance with the rule’s limit requirements for more than five days. Amended or modified Forms include N-Port, N-LIQUID and N-CEN.

Included within the rule is a limited derivative use exception that provides exemption from the derivatives risk management program requirements and the VaR-based limits. This exemption is available if the fund adopts and implements policies and procedures designed to manage the derivatives risks and limits its notional derivatives exposure (including the value of assets sold short) to either 10% of its net assets or to currency derivatives for hedging purposes.

The Commission also amended Rule 6c-11 under the Act (the SEC’s primary ETF rule) to allow leveraged or inverse ETFs to operate without obtaining an exemptive order, provided they comply with Rule 18f-4 as applicable. 

The new rule is effective on February 19, 2021.  The compliance date for the rule is August 19, 2022. 

>> Read “SEC Continues Modernization Efforts, Adopts Rule 18f-4 – Use of Derivatives”

Impact: The modifications to the regulatory regime provided by Rule 18f-4 are significant and clarify historically confusing and sometimes contradictory guidance. This comprehensive approach to regulating the use of derivatives by funds addresses concerns around investor protection, as well as levels the competitive landscape by requiring consistent limit calculations and reporting.

New Dear CFO Letters and Updates
In November 2019, the SEC’s Division of Investment Management undertook a process of updating previously issued Dear CFO Letters, letters historically issued by the Chief Accountant’s Office within the SEC Division of Investment Management to express views relative to specific accounting matters facing registered investment companies, business development companies and their independent public accountants. In October, a number of new Dear CFO Letters were issued, as well as updated and rescinded.

New Dear CFO letters include: 

  • 2020-01 Determining Commencement of Operations Date. This letter clarified the date that is viewed to be the date of commencement and highlights that it may differ from the performance calculation.  
  • 2020-02 Business Development Companies — Financial Statements in Initial Registration Statements. Within this item, the staff provided a position about the financial statement requirements in an initial registration statement for business development companies.
  • 2020-03 Combined Financial Statements for Compliance with Advisers Act Rule 206(4)-2. This matter provides guidance with regard to using combined financial statements when an advisor is relying on the annual audit exemption for Compliance with Advisers Act Rule 206(4)-2 for various pooled investment vehicles (PIVs).

Amended or modified Dear CFO Letters relate to:

  • 1998-04 Change in Independent Public Accountants. The modification provides additional views on how to report change in auditor (form N-3 now included for Reg S-K rules).
  • 2001-02 Senior Securities Table Disclosure. The addition to this topic provides clarity around differing ways to meet the requirement to provide an audit opinion over the senior securities table included either within a fund’s annual report or annual filing on form N-2 due to recent modifications to the form requirements.

Rescission of Dear CFO letters include:

  • 1998-01 Average Commission Rate Disclosure. This Dear CFO letter provided views regarding average commission rate disclosures in the prospectus of closed end funds, which has been rescinded to align to recently modified disclosure requirements.

While not authoritative guidance, Dear CFO Letter guidance is effective upon issuance and should be considered when addressing certain accounting, disclosure and auditing matters.

>> Read “SEC Refreshes Its “Dear CFO Letters” Practice”

Impact: The SEC Division of Investment Management continues to provide clarity around their expectations around these matters. The additional guidance was historically deemed very useful, and the revival of this practice is welcomed to assist in navigating the complexities within the regulatory requirements.

SEC and PCAOB Updates Independence Rules
The SEC has been working to more closely align the definition of independence with current day independence issues. Final amendments were adopted by the SEC on October 16, 2020, resulting in auditor independence requirements that more effectively focus on relationships and services that pose threats to an auditors’ objectivity and impartiality. 

The modifications addressed recurring fact patterns where relationships and services triggered technical rule violations under the current auditor independence rules without necessarily impairing the auditor’s objectivity and impartiality. The result is a focus on true threats, while avoiding potentially time consuming audit committee review of technical rule violations and similar nonsubstantive matters.

Two specific examples of the modifications include:

  • Modifications to loan or debtor-creditor relationship. Loan requirements were modified to include a new exception for student loans obtained from a financial institution under normal lending procedures, terms, etc. provided the loan was obtained by an individual or immediate family member for their educational expenses prior to becoming a covered person in the firm.
  • Amends the definition of an investment industry company complex. The SEC has made specific changes to the independence requirements with respect to the auditor of an investment company or an investment advisor or sponsor. The SEC has limited the definition of affiliates to exclude certain investment companies, advisors and sponsors not material to the controlling entity. This would, in some circumstances, prevent investment companies advised by related investment advisors from being included in the definition of “affiliate.”

In addition, the PCAOB modified their independence requirements outlined within Rule 3501 to align with the newly amended SEC Rule 2-01. Specifically, certain definitions were amended to conform to Rule 2-01, including “affiliate of the audit client,” “audit and professional engagement period” and “investment company complex.” 

The new rule is effective on June 9, 2021. Voluntary early compliance is permitted; however, auditors are not permitted to retroactively apply the final amendments to relationships and services in existence prior to the effective date or early compliance date if selected by an audit firm.

>> Read “SEC Modernizes Auditor Independence Rules”

Impact: The modifications provided in the new independence rules are designed to focus more on matters that are impactful in a client/auditor relationship. The amendments may also have qualitative implications, improving the overall audit process by expanding the pool of eligible auditors that were restricted by the previous rules.

Contact Lori Novak at, Keren Nass at or a member of your service team to discuss these topics further.

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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.