Risk & Reward

A Framework for the DOL’s New Proxy Voting Rule

The U.S. Department of Labor (DOL) has finalized a rulemaking that pertains to proxy voting and the exercise of other shareholder rights with respect to employee benefit plans subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The rule applies to plans directly, as well as to commingled investment funds that hold “plan assets.”2 Plan sponsors, investment advisers registered with the U.S. Securities and Exchange Commission (SEC), and other service providers that either exercise shareholder rights on behalf of plans or who appoint those who do should pay particular attention to this final rule.3

As with the DOL’s recent Financial Factors rulemaking, this rule’s genesis was probably the DOL’s concern over the striking growth of environmental, social & governance (ESG) investing. Engagement with a company’s board, for example, is a popular method used by managers to address ESG concerns. But both rules apply much more broadly, including to those managers and mandates that do not take ESG factors into account. Neither this rule nor the Financial Factors rule, is limited to ESG.

The exercise of shareholder rights, including proxy voting, has long been considered fiduciary conduct under ERISA. This rule retains that characterization and defines the scope of responsibilities. In doing so, the rule supersedes DOL Interpretive Bulletin 2016-01 and the relevant portions in DOL Field Assistance Bulletin 2018-01.

As discussed more fully below, fiduciaries of plans and plan asset vehicles will need to review their proxy voting policies and practices regarding their use of proxy advisors, especially when those advisors offer voting recommendations or their platforms pre-populate votes.4 With this rule, proxy advisory firms continue to face increased scrutiny from U.S. regulators, notably the SEC and DOL, over their practices and influence.

From a substantive standpoint, the rule compels fiduciaries to only exercise shareholder rights, including proxy voting, if they are undertaken solely in accordance with the economic interests of the plan and its participants and beneficiaries. This entails the fiduciary discerning some economic benefit to the plan, beyond the plan merely being a shareholder, resulting from the exercise of shareholder activities by the plan alone or together with other shareholders.5 Fiduciaries may consider the longer-term consequences and potential economic impacts from the exercise of such rights, even if they are not currently readily quantifiable, which should strengthen (or at least not hinder) proxy voting and engagement related to material ESG issues.6 Importantly, a discernible economic benefit to the plan must be initially identified to pass muster under the rule, even if the shareholder activity does not result in a direct or indirect cost to the plan.

In the DOL’s view, for example, a fiduciary may have to vote against a shareholder proposal that would result in the issuer incurring direct or indirect costs if such proposal did not also describe “a demonstrable expected economic return” to the issuer. On the other hand, “the costs incurred by a corporation to delay a shareholder meeting due to lack of a quorum is an example of a factor that can be appropriately considered as affecting the economic interest of the plan.”

The costs of proxy voting and other shareholder rights must also be considered, as they too affect the economic interest of the plan. These costs may include direct costs to the plan, such as expenditures for analyzing portfolio companies and the matters to be voted on, determining how the votes should be cast, and ultimately submitting proxy votes to be counted. Moreover, the DOL notes that “[i]f a plan can reduce the management or advisory fees it pays by reducing the number of proxies it votes on matters that have no economic consequence for the plan that also is a relevant cost consideration.”7 Indirect costs are also relevant. For example, the fiduciary should consider the opportunity costs of the exercise of shareholder rights, such as opportunity costs for the client resulting from restricting the use of securities for lending to preserve the right to vote.8

The rest of the rule is more process-oriented, which speaks to how fiduciaries can satisfy these substantive obligations in practice.

First, fiduciaries need to evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder rights. Here, fiduciaries should consider material information that is known by, available to, or reasonably should be known by the fiduciary. In this respect, the DOL pointed to the fact that, under recent SEC guidance, clients of proxy advisory firms may become aware of additional information from an issuer that is the subject of a voting recommendation, and that an ERISA fiduciary would be expected to consider the relevance of such additional information if material.

Second, fiduciaries must maintain records on proxy voting activities and other exercises of shareholder rights. For fiduciaries that are SEC-registered investment advisers, the DOL intends that these recordkeeping obligations would be applied in a manner that aligns to similar proxy voting recordkeeping obligations under the U.S. Investment Advisers Act of 1940, as amended (Advisers Act).

Third, and as applicable, fiduciaries must exercise prudence and diligence in the selection and monitoring of (i) investment managers charged with proxy voting and (ii) proxy advisory firms selected to advise or otherwise assist with exercises of shareholder rights, such as providing research and analysis, recommendations regarding proxy votes, administrative services with voting proxies, and recordkeeping and reporting services. The fiduciary should consider the qualifications of the service provider, the quality of services being offered, and the reasonableness of fees charged in light of the services provided. ERISA fiduciaries should also ensure that, when considering proxy recommendations, they are fully informed of the potential conflicts of interest of proxy advisory firms and the steps such firms have taken to address them (e.g., reviewing proxy advisor conflict of interest disclosures, etc.). Finally, fiduciaries should review the proxy voting policies and/or proxy voting guidelines and the implementing activities of the service provider; this requirement, however, does not require use of custom policies.

Fiduciaries may adopt proxy voting policies pursuant to a safe harbor and, if so, review them periodically for compliance with the rule (e.g., every two years). These policies may not preclude (i) submitting a proxy vote when the fiduciary prudently determines that the matter being voted upon is expected to have a material effect on the value of the investment or the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager) after taking into account the costs involved, or, conversely, (ii) refraining from voting when the fiduciary prudently determines that the matter being voted upon is not expected to have such a material effect after taking into account the costs involved. The rule specifically provides two safe harbors, either or both of which may be utilized when deciding whether to vote. The safe harbors are not the exclusive means to satisfy the rule or represent minimum requirements.

  1. Safe Harbor #1: A policy to limit voting resources to particular types of proposals that the fiduciary has prudently determined are substantially related to the issuer’s business activities or are expected to have a material effect on the value of the investment. The reference to the value of the investment rather than the plan’s total investment is intended to make clear that the evaluation could be at the investment manager level dealing with a pool of investor’s assets or at the aggregate plan level. The DOL expects that proposals relating to corporate events (e.g., mergers and acquisitions, dissolutions, conversions, or consolidations), buybacks, issuances of additional securities with dilutive effects on shareholders, or contested elections for directors, are the types of votes that would materially affect the investment.
  2. Safe Harbor #2: A policy of refraining from voting on proposals or particular types of proposals when the plan’s holding in a single issuer relative to the plan’s total investment assets is below a quantitative threshold that the fiduciary prudently determines, considering its percentage ownership of the issuer and other relevant factors, is sufficiently small that the matter being voted upon is not expected to have a material effect on the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager).

In response to concerns raised by some commenters, the safe harbors in the final rule are intended to be flexible enough to clearly enable fiduciaries to vote to establish a quorum of mutual fund shareholders or on other fund matters. On this point, the DOL noted that fiduciaries may also adopt voting policies that consider the detrimental effect on the plan’s investment due to the costs (direct and indirect) incurred related to delaying a shareholders’ meeting. The rule envisions fiduciaries having considerable flexibility in fashioning proxy voting policies and the opportunity to deviate from the policies in certain instances.

Proxy advisors remain top-of-mind for the DOL. The safe harbors are intended to provide fiduciaries the ability to operationalize the rule without having to seek recommendations on a vote-by-vote basis from proxy advisors. The rule prohibits fiduciaries from adopting a practice of following the recommendations of a proxy advisory firm without first determining that such firm or service provider’s proxy voting guidelines are consistent with the fiduciary’s obligations under the rule.9 As with the SEC, the DOL expects fiduciaries, under certain circumstances, to conduct a more particularized voting analysis than what may be conducted under the general guidelines. The DOL acknowledged that some plans rely on proxy advisory firms’ pre-population and automatic submission mechanisms for proxy votes but noted that adopting such a practice for all proxy votes effectively outsources their fiduciary decision-making authority.

The rule continues to recognize and account for the fact that an investment manager of a plan asset pooled investment vehicle may be subject to an investment policy statement that conflicts with the policy of another plan investor. In this case, compliance with ERISA requires the investment manager to reconcile, to the extent possible, the conflicting policies (assuming compliance with each policy would otherwise be consistent with ERISA). In the case of proxy voting, the investment manager generally must vote (or abstain from voting) the relevant proxies to reflect such policies in proportion to each plan’s economic interest in the investment vehicle. Investment managers of pooled funds, however, typically develop an investment policy statement and require participating plans to accept the investment manager’s proxy voting policy as a condition to subscribe, which remains permitted under the rule. The investment manager’s policies would need to comply with this rule, and the fiduciary responsible for the plan’s subscription in the fund would be obligated to assess whether the investment manager’s policies are consistent with this rule before subscribing in the fund.10

As noted above, the rule does not directly apply to investment vehicles that do not hold plan assets, such as mutual funds. The rule, for example, does not require ERISA fiduciaries to scrutinize a mutual fund’s voting practices in which the plan has an investment. The DOL does, however, contemplate that ERISA fiduciaries will consider the mutual fund’s voting policies as part of its overall consideration of the mutual fund as a prudent investment in accordance with the Financial Factors rule. Thus, fiduciaries should consider whether the investment fund’s voting policies are expected to have a material effect on the risk and/or return of an investment.

The rule’s compliance date is Jan. 15, 2021, subject to the following:

  • All fiduciaries should begin to review their proxy voting policies and practices in light of the new rule, especially plan investment committees and investment managers of separate accounts.
  • Fiduciaries that are investment advisers registered with the SEC must comply by Jan.15, 2021, with respect to the requirements to (i) evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder right and (ii) maintain records on proxy voting activities and other exercises of shareholder rights. The DOL intends that these requirements align with existing obligations under the Advisers Act, including Rules 204-2 and 206(4)-6 thereunder and the 2019 SEC Guidance and 2020 SEC Supplemental Guidance. Other types of fiduciaries have until Jan. 31, 2022, to comply with these requirements.
  • All fiduciaries shall have until Jan. 31, 2022, to comply with the requirements that they not adopt a practice of following the recommendations of a proxy advisory firm or other service provider without a determination that such firm or service provider’s proxy voting guidelines are consistent with the rule. Fiduciaries of pooled investment vehicles also have until that date to confirm the fund’s proxy voting policies with the rule.

1 The rule does not apply to the exercise of shareholder rights on behalf of non-ERISA plans, such as IRAs and governmental plans.

2 Investment companies registered under the U.S. Investment Company Act of 1940, as amended, do not hold plan assets and thus not subject to ERISA or this rule. Hedge funds and other commingled vehicles that fail to satisfy one of the exceptions set forth in the DOL’s plan assets regulation, on the other hand, are subject to ERISA and this rule. Similarly, bank-maintained collective investment trusts are subject to ERISA and this rule.

3 The rule does not apply to proxy voting that is passed through to participants and beneficiaries with accounts holding such securities in an individual account plan.

4 Firms that agree to act as “investment managers,” within the meaning of Section 3(38) of ERISA, should ensure the investment management agreement is clear on who has the responsibility to exercise shareholder rights on behalf of the plan. When the authority to manage plan assets has been delegated to an investment manager, the investment manager has exclusive authority to vote proxies or exercise other shareholder rights, except to the extent the plan, trust document, or investment management agreement expressly provides that the responsible named fiduciary has reserved to itself (or to another named fiduciary so authorized by the plan document) the right to direct a plan trustee regarding the exercise or management of some or all of such shareholder rights.

5 The proposed rule included a requirement that the fiduciary consider only factors that they prudently determine will affect the economic value of the plan’s investment based on a determination of risk and return over an appropriate investment horizon consistent with the plan’s investment objectives and the funding policy of the plan. The DOL eliminated this condition because of its potential compliance costs and that it may not be apparent that a particular vote will affect the plan’s investment return. A similar revision was made to the final Financial Factors rulemaking; thus, even the DOL admits fiduciaries need not be clairvoyant in evaluating how an investment decision, or the exercise of shareholder rights, on some basis (ESG or not) will materially affect the plan’s return in the future. Instead, fiduciaries should follow a thoughtful, prudent process in reaching the position that an investment, or the exercise of rights appurtenant to such investment, is in the economic interests of the plan.

6 As with the Financial Factors rulemaking, the DOL cautioned fiduciaries against taking too elastic an interpretation of economic benefits that could flow to the plan, by noting that “vague or speculative notions that proxy voting may promote a theoretical benefit to the global economy that might redound, outside the plan, to the benefit of plan participants would not be considered an economic interest under the final rule.”

7 The DOL also noted that it would “not be appropriate for plan fiduciaries, including appointed investment managers, to incur expenses to engage in direct negotiations with the board or management of publicly held companies with respect to which the plan is just one of many investors.” It is questionable whether this assertion is supported by the rule itself.

8 The DOL acknowledged that multiple investment managers may be responsible for managing a plan’s assets, and accordingly revised the rule to permit each investment manager to apply the rule to its specific mandate. The DOL noted, however, that “where the plan’s overall aggregate exposure to a single issuer is known, the relative size of an investment within a plan’s overall portfolio and the plan’s percentage ownership of the issuer, may still be relevant considerations in appropriate cases in deciding whether to vote or exercise other shareholder rights.”

9 The fiduciary selecting and using a proxy advisor, therefore, must review the proxy advisor’s voting guidelines against this rule in addition to separately determining whether a specific recommendation necessitates a particularized analysis. The review of the proxy advisor proxy voting guidelines should be addressed at the outset of the relationship with the proxy advisor and when the proxy advisor updates its guidelines (e.g., annually).

10 Uniform policies utilized by the investment manager across client accounts are still permissible under the rule, provided the policies comply with this rule.

DOL Finalizes Investment Advice Rulemaking

The U.S. Department of Labor (DOL) released last week a new class exemption that would provide relief to registered investment advisers, broker-dealers, banks and insurance companies for the receipt of compensation as a result of providing investment advice, including rollover advice, to ERISA-covered plans and individual retirement accounts (IRAs). Also included in this rulemaking package is new guidance from the DOL on its recent reinstatement of the traditional five-part test when one becomes an investment advice fiduciary.

Here we provide a brief overview of this significant rulemaking.

Here are the key takeaways:

  • Under the DOL’s five-part test, for advice to constitute “investment advice,” a financial institution or investment professional must (1) render advice to the plan as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing, or selling securities or other property; (2) on a regular basis; (3) pursuant to a mutual agreement, arrangement, or understanding with the plan, plan fiduciary, or IRA owner, that; (4) the advice will serve as a primary basis for investment decisions with respect to plan or IRA assets; and that (5) the advice will be individualized based on the particular needs of the plan or IRA. If a financial services firm becomes a fiduciary to a plan under this test, then the resulting compensation from that advice would trigger the prohibited transaction restrictions, necessitating an exemption. While there are currently existing exemptions that can be utilized, they cover discrete transactions, whereas the DOL’s new class exemption applies broadly, similar to how the DOL’s 2016 Best Interest Contract Exemption was designed to function (see below on status of that exemption).
  • The DOL indicates that advice to take a distribution of assets from a retirement plan is effectively advice to sell, withdraw, or transfer investment assets currently held in the plan, and, therefore, falls within the definition of fiduciary advice, assuming all five parts of the test are satisfied. DOL’s treatment of most rollover recommendations as investment advice is a departure from its historical position, but pairs well with its 2016 rulemaking and the Securities and Exchange Commission’s Regulation Best Interest. Note, however, that the DOL will not pursue claims for breach of fiduciary duty or prohibited transactions based on rollover recommendations made before the effective date of the new final exemption if the recommendations would not have been considered fiduciary communications under the reasoning of the DOL’s historical guidance (i.e., the Deseret Letter).
  • The new exemption requires the investment advice to meet the Impartial Conduct Standards, namely: a best interest standard; a reasonable compensation standard; and a requirement to make no materially misleading statements about recommended investment transactions and other relevant matters. The exemption includes disclosure requirements, conflict mitigation, and a compliance review. Prior to engaging in a rollover recommended, financial institutions must provide documentation of the specific reasons for the rollover recommendation to the retirement investor, including the reasons it satisfies the best interest standard. This exemption is partly based upon the temporary enforcement policy announced in Field Assistance Bulletin (FAB) 2018-02.
  • A financial institution’s reliance on the new exemption also requires it to establish, maintain and enforce policies and procedures designed to ensure that they comply with the Impartial Conduct Standards.
  • The exemption now includes a self-correction mechanism so that certain technical violations of the exemption’s conditions do not cause the total loss of exemptive relief.
  • The exemption does not cover advice arrangements that rely solely on robo-advice; however, the exemption would cover hybrid robo-advice, namely, advice generated by computer models coupled with interaction with an investment professional.
  • The DOL’s new rulemaking package removes 2016’s Best Interest Contract Exemption and the Class Exemption for Principal Transactions in Certain Assets Between Investment Advice Fiduciaries and Employee Benefit Plans and IRAs. Moreover, pre-existing prohibited transaction class exemptions that had been amended as part of the 2016 rulemaking (e.g., 75-1, 77-4, 80-83, 83-1, 84-24 and 86-128) have been reinstated and published on the DOL’s website in their original form.
  • The new exemption will be effective and available to financial institutions beginning 60 days after the date of publication in the Federal Register; however, FAB 2018-02 remains in place for a year to smooth the transition.

Please be on the lookout for our full analysis of this important development after the holidays.

Key Considerations: DOL’s New Final Regulation on ERISA’s Investment Duties (ESG-Related or Not)

The U.S. Department of Labor (DOL) finalized amendments to the investment duties of a fiduciary subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The rule amendments were aimed at ERISA fiduciaries that utilize products and strategies that incorporate environmental, social and/or governance (ESG) factors. Though the DOL opted not to let the final rule get bogged down in the ESG-lexicon quagmire by removing all express references to ‘ESG,’ the final rule clearly and directly applies to fiduciaries that consider ESG factors when investing on behalf of ERISA plans and funds that hold “plan assets.” Indeed, all ERISA fiduciaries that make investment decisions (including the selection of investment funds for participant-directed plan lineups), regardless of whether ESG is even implicated, should review this rule carefully.

The rule becomes effective 60 days after publication in the Federal Register. Plans have until April 30, 2022 to make any changes to their “qualified default investment alternatives” (QDIAs), within the meaning of 29 C.F.R. § 2250.404c-5, as a result of this rule. The rule contemplates a grandfathering mechanism, which will be highly fact-specific.2 The DOL further noted that it “will not pursue enforcement, and does not believe any private action would be viable, pertaining to any action taken or decision made with respect to an investment or investment course of action by a plan fiduciary prior to the effective date of the final rule to the extent that any such enforcement action would necessarily rely on citation to this final rule.”

The final rule builds upon the original investment duties regulation, which provided a safe harbor for fiduciaries in satisfying their duty of prudence under ERISA. The final rule, like the original, compels fiduciaries to give appropriate consideration to numerous factors regarding the composition of the plan portfolio as it relates to diversification, liquidity and current return of the portfolio relative to the anticipated cash flow needs of the plan, and the projected return of the portfolio relative to the funding objectives of the plan. Importantly for 3(38) investment managers, the final rule preserves the aspects of the original regulation that allowed investment managers to rely and act on information provided by the appointing fiduciary in fulfilling these duties with respect to the plan portfolio over which it has discretion.

The final rule withdraws DOL Interpretive Bulletin 2015-01 and supersedes “ESG Investment Considerations” in DOL Field Assistance Bulletin 2018-01.

This final rule does not address an ERISA fiduciary’s responsibilities with respect to proxy voting and the exercise of other shareholder rights. The DOL recently proposed a rule on this topic, though it has yet to move forward with the proposal. Until a final rule emerges, fiduciaries should continue to follow DOL Interpretive Bulletin 2016-01 and DOL Field Assistance Bulletin 2018-01.

Key Considerations

The final rule preserves the essence of the original investment duties regulation (and ERISA) by allowing ERISA fiduciaries considerable leeway in crafting investment portfolios. The DOL thus admitted that, as a general matter, there is total parity between investment strategies and products, whether ESG-related or not. In other words, an ERISA fiduciary may manage plan assets while taking into account ESG risks and opportunities without violating the rule.

The final rule presents five distinct issues worth considering (1) pecuniary factors; (2) comparing investment alternatives; (3) duty of loyalty; (4) special circumstances/non-pecuniary factors/tie-breakers, and (5) QDIAs.

Pecuniary Factors

Whether investing on behalf of an ERISA-covered defined benefit plan or selecting plan investment options for a participant-directed plan, the final rule compels fiduciaries to consider pecuniary factors only, absent special circumstances (discussed below), when evaluating the risk and return profiles of investments. The rule defines a “pecuniary factor” as one “that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and the funding policy….”3 The DOL expressly recognized that ESG factors may be pecuniary factors under the rule.4 The requirement that only pecuniary factors be considered is a legal requirement, not a safe harbor.

The final rule’s definition of pecuniary factors is forward-looking in nature, meaning a fiduciary need not know that a factor will materially affect risk/return at the time of the investment. Instead, the fiduciary must be prudent in coming to that conclusion based on the facts and circumstances. This change by the DOL should give comfort to fiduciaries who are closely tracking the emerging data of various ESG (and other) factors’ impact on investment performance. Fiduciaries should take note that the DOL has repeatedly cautioned fiduciaries against disproportionately weighting the materiality of a factor based on existing data.

The DOL opted to avoid defining the slippery concept of materiality. The DOL said in the preamble to the final rule that it “believes that fiduciaries and investment managers are generally familiar with that concept from its use in connection with both ERISA and the federal securities laws.” This seemingly allows the concept of pecuniary factors to evolve with market consensus on materiality and ultimately on how other regulators define materiality for these purposes. Yet, the DOL acknowledged that the following may be material, and thus, pecuniary factors under the rule: (1) an investment manager’s brand/reputation; (2) proprietary products; and (3) a fund or product’s legal regime that confers greater investor protection and/or improved disclosures.

As with any other evaluation of prospective investments, a fiduciary should first determine that it has sufficient skills and expertise to determine that the ESG (or any other) factor presents economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories (if not, the determination should be made by another fiduciary that has such expertise and skill).5 Moreover, the DOL apparently will look for risk controls in place commensurate with the complexity, nature and size of the investment activity (the implication is that fiduciaries that consider ESG factors should have rigorous controls in place to ensure that they are properly determining factors to be  pecuniary factors under the rule).

In the context of ERISA-covered participant-directed plans, the decision as to which funds populate the plan lineup is subject to ERISA’s fiduciary duties and this new rule, among others. In the preamble to the final rule, the DOL addressed whether a fiduciary could select an ESG investment fund, product or model portfolio based solely on participant request or because of the potential for increased contributions to the plan. In short, these types of considerations are not pecuniary factors and, therefore, the responsible fiduciary may not base its decision to include an ESG fund, product or model portfolio as a designated investment alternative without separately determining that the pecuniary reasons for such inclusion satisfy the rule. As discussed below, however, participant requests and the like may be “tie-breakers” in selecting between alternative investment options.

Comparing Investment Alternatives

Under the final rule, the fiduciary must compare investments or investment courses of action (e.g., selection of designated investment alternative for participant-directed plans) based on factors “that are expected to result in a material difference among reasonably available alternatives with respect to risk and/or return.” This comparison requirement is, therefore, not limitless. Thus, a fiduciary does not need to consider all factors that differentiate investment funds, only ones that are pecuniary. Moreover, fiduciaries are under no obligation to scour the market for the lowest cost investment opportunities, much less select the cheapest available investments.

The DOL further confirmed that the fiduciary need not expend considerable resources on searching for investment opportunities or considering an infinite number of investment alternatives. Instead, the fiduciary’s duty to evaluate alternative investment opportunities is limited to comparing alternatives that are reasonably available under the circumstances. This means that the rule “allow[s] for the possibility that the characteristics and purposes served by a given investment…may be sufficiently rare that a fiduciary could prudently determine, and document, that there were no other reasonably available alternatives for purposes of this comparison requirement.”

Duty of Loyalty

Fiduciaries are already well aware that ERISA imposes a duty of loyalty, in addition to the prudence requirements discussed above. The final rule incorporates this specific fiduciary duty by prohibiting fiduciaries from subordinating the interests of plan participants and beneficiaries in their retirement income to non-pecuniary goals. Though this may seem to be an example of form over function, the DOL opted not to include the duty of loyalty under the rule’s general safe harbor characterization, meaning fiduciaries will likely not only be conservative in satisfying the rule’s requirements but may also opt for even stronger controls/analysis/documentation than the rule technically requires to ensure they do not run afoul of the loyalty concerns the DOL has expressed in the context of ESG.

Special Circumstances/Non-Pecuniary Factors/Tie-Breakers

Prior DOL guidance provided that if, after an evaluation, alternative investments appear economically indistinguishable, a fiduciary may then, in effect, “break the tie” by relying on a non-pecuniary factor. Commenters argued that the proposal effectively required equivalence between investments. The DOL suggested that they did not mean for investment alternatives to have identical characteristics, just equivalent roles in the plan’s investment portfolio. Commenters argued that indistinguishability in liquid markets is all but impossible and are, in turn, never perfectly correlated.

Under the final rule, if a fiduciary is unable to determine which investment is in the best interests of the plan on the basis of pecuniary factors alone, the fiduciary may base the investment decision on non-pecuniary factors, provided the fiduciary documents the following: (1) why pecuniary factors were not sufficient to select the investment; (2) how the investment compares to the alternative investments; and (3) how the chosen non-pecuniary factors are consistent with the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan. This effectively prohibits ERISA fiduciaries from choosing investments with expected reduced returns or enhanced risks in order to secure non-pecuniary benefits.

The third condition is a hemmed-in version of the historical tie-breaker test. Simply, the DOL split the difference from the proposal, which all but eliminated the tie-breaker mechanism, and instead has allowed a tie-breaker but only on the basis of a pecuniary-light factor. Under the final rule, a fiduciary no longer appears able to select an investment fund based on the ethos of the plan sponsor (assuming the other conditions of the rule are met). Instead, the non-pecuniary factor must at least have some nexus to participants’ and beneficiaries’ retirement income or financial benefits. The DOL indicated that responding to participant demand in order to increase retirement plan savings may be consistent with the interests of the participants and interests in their retirement income or financial benefits under the plan. In contrast, selecting an investment option that “would bring greater personal accolades to the chief executive officer of the sponsoring employer, or solely on the basis of a fiduciary’s personal policy preferences, would not.”

The same standards apply to selecting investment funds, products and model portfolios for a participant-directed plan lineup. The DOL admonished fiduciaries to “carefully review the prospectus or other investment disclosures for statements regarding ESG investment policies and investment approaches.” In particular, the DOL stressed that fiduciaries should be “cautious in exercising their diligence obligations under ERISA when disclosures, whether in prospectuses or marketing materials, contain references to non-pecuniary factors or collateral benefits in a fund’s investment objectives or goals or its principal investment strategies.”

The DOL envisions that fiduciaries will evaluate fund prospectuses and other disclosures to determine if the fund uses an ESG or sustainability rating system of index. If the fund uses such a rating system or index, the fiduciary, as part of its due diligence, would need to consider whether the rating system or index “evaluates one or more factors that are not financially material to investments.” If so, the selection of the fund is a special circumstance, thereby requiring the fiduciary to satisfy the aforementioned heightened requirements.

On this point, the DOL indicated that a fiduciary would have to understand how the ratings are actually determined, such as the rating’s methodology, weighting, data sources, performance benchmarks and the underlying assumptions utilized. Moreover, “a fiduciary may not assume that combining [multiple factors] into a single rating, index or score creates an amalgamated factor that is itself pecuniary.”


On QDIAs, DOL stressed that the proposal was never intended to block investment funds, products or model portfolios that treat ESG factors as pecuniary in nature from being QDIAs. The final rule better captures this intent by only prohibiting those QDIAs whose investment objectives, goals or principal investment strategies include, consider or indicate, one or more non-pecuniary factors. Crucially, the tie-breaker mechanism is not available when selecting QDIAs. This means that a fund will no longer qualify as a QDIA if its investment objectives, goals or principal strategies include a non-pecuniary factor, even if including such fund as a QDIA is in response to participants’ request or otherwise increase the desirability of the plan to participants.

The DOL claimed fiduciaries can apply the rule to QDIAs easily and objectively. They indicated, for example, that a plan fiduciary can simply look at the investment fund’s prospectus to determine whether the fund is qualified or disqualified as a QDIA under the final rule. The DOL specifically pointed to Form N-1A to ascertain whether non-pecuniary considerations form a material part of a fund’s investment objectives or principal strategies. The DOL is under the impression that disclosures for other types of investment vehicles, such as collective investment trusts and insurance separate accounts, would provide sufficient information for these purposes.

As noted above, the DOL envisions fiduciaries evaluating fund prospectuses and other disclosures to determine if the fund uses an ESG or sustainability rating system of index. Again, if the fund uses such a rating system or index, the fiduciary, as part of its due diligence, would need to consider whether the rating system or index “evaluates one or more factors that are not financially material to investments.” If so, the fund would no longer qualify as a QDIA under the final rule.

Funds that use positive or negative screening may similarly result in their disqualification as a QDIA, if the screening involves non-pecuniary factors that effectively results in the exclusion of certain sectors or categories of investments, and such exclusions are reflected in the fund’s investment objectives or principal strategies. If these exclusions are not reflected in the investment alternative’s objectives or principal strategies, but they are otherwise disclosed, the fiduciary evaluating such fund is expected to undertake “an economic analysis of the economic consequences to the plan of such an exclusion and determining that such an exclusionary policy would not be economically harmful to the plan.”

The regulation does not apply to investment alternatives that are not designated investment alternatives under the plan (e.g., brokerage windows). However, DOL noted that the rule should not be construed as addressing the application of ERISA’s duties of prudence and loyalty to brokerage windows or other non-designated investment alternatives that grant participants and beneficiaries access to investments that are not designated investment alternatives, and suggests there may be future rulemaking to address this.

Other Considerations

The DOL responded to concerns that the regulation may redirect or stall the development of ESG practices, particularly as the U.S. Securities and Exchange Commission (SEC) continues to monitor ESG developments. Commenters pointed to the SEC’s recent solicited public comment request on the “Names Rule” under the U.S. Investment Company Act of 1940, as amended. The DOL noted in the preamble to the final rule that it did not think it needed to delay a final rule until the SEC decides to take action on the Names Rule. The DOL also recognized that some financial regulators are looking at whether ESG risk presents systemic risk to the financial markets. The DOL responded, “if financial regulators adopt new rules or policies that affect financial market participants, that may create pecuniary or non-pecuniary considerations for plan fiduciaries apart from ERISA.” It isn’t entirely clear what the DOL meant by this. One interpretation is that other regulators’ interpretation of materiality can inform an ERISA fiduciary’s determination as to whether a particular factor is pecuniary or not under the final rule. Yet a contrary interpretation is that the DOL, by using the language “apart from ERISA,” intends to largely wall off the final rule from other regulators’ potentially increasing liberalization over what factors are material to investment return and risk.

The DOL likewise responded to commenters who raised concerns that this rulemaking would interfere with how other federal agencies were addressing ESG risks. For example, the DOL acknowledged that the State Department, Treasury Department, Commerce Department and Department of Homeland Security have taken positions on supply chain links to entities that engage in human rights abuses, including, for example, forced labor in China. Even though supply chain risk is an ESG factor, the DOL took the position that it sees no fundamental conflict between this final rule and positions regarding supply chain risk raised by other government agencies.

Somewhat relatedly, the DOL responded to a comment that the rule would conflict with the position it took regarding the federal Thrift Savings Plan (TSP), namely, to prohibit the plan from investing in Chinese equities. While noting that the TSP is not covered by Title I of ERISA, the DOL added that its “position with respect to investments in China was informed by consideration of specific matters relating to investment risk, including inadequate investor disclosures and legal protections, that are consistent with “pecuniary factors” as used in the final rule.” The DOL further added that “other concerns were raised because the Federal Government matches TSP contributions and investments in China might result in the Federal Government funding activities that are opposed to U.S. national security interest.” Its first explanation, namely that it found disclosures related to Chinese holdings insufficient and legal protections were insufficient, is noteworthy for all ERISA fiduciaries because the final rule states that sufficiency of disclosures and legal protections are pecuniary factors. Thus, a fiduciary may wish to exercise caution in how it evaluates and documents the pecuniary factors in deciding on an investment that has Chinese holdings in light of the DOL’s concern.

The DOL dismissed concerns that the final rule would conflict with international ESG rules and trends by dismissing the sheer relevance of such trends and non-U.S. rules. Specifically, the DOL stated, “international trends in the consideration of ESG factors or other actions of regulators in other countries are not an appropriate gauge for evaluating ERISA’s requirements as they apply to investments of ERISA-covered employee benefit plans.”

The final rule is not immune to rescission or change by Congress or the DOL under a future administration.

1 29 C.F.R. § 2550.404a-1.

2 In a footnote to the preamble of the final rule, the DOL stated, “[t]he Department notes that it may be that a fiduciary could prudently determine that the expected return balanced against the costs and risks of loss associated with divesting an investment made before the effective date of the rule are such that continuing to hold that investment would be appropriate even if the fiduciary as part of its monitoring process determined that the investment, or aspects of the decision-making process, does not comply with the final rule.”

3 The proposal’s language seemingly required that, before an ERISA fiduciary could treat an ESG or other factor as a pecuniary factor, the ESG or other factor would already have had to be determined by other investment professionals as being material to investment performance.

4 In the preamble to the final rule, the DOL noted, for example, that “a company’s improper disposal of hazardous waste would likely implicate business risks and opportunities, litigation exposure, and regulatory obligations” and that “[d]ysfunctional corporate governance can likewise present pecuniary risk that a qualified investment professional would appropriately consider on a fact-specific basis.”

5 The DOL indicated that it does not intend the term “generally accepted investment theories” to freeze the evolution of investment theory or practice, but rather “to establish a regulatory guardrail against situations in which plan investment fiduciaries might be inclined to use…policy-based metrics in their assessment of the pecuniary value of an investment or investment plan that are inherently biased toward inappropriate overestimations of the pecuniary value of policy-infused investment criteria.”

New DOL Rule Proposal Risks Chilling Proxy Voting and Shareholder Engagement

The U.S. Department of Labor (DOL) released its long-awaited proxy voting rule proposal on Aug. 31. If adopted without modification, fiduciaries of plans (e.g., investment managers) subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA), may shy away from voting proxies and participating in shareholder engagement on matters that do not demonstrably improve the value of the plan’s holding in the short-term. Thus, the exercise of shareholder rights on environmental, social and governance (ESG) issues, the benefits of which may be long-term in nature, may indeed be squeezed out of proxy voting policies of ERISA plan fiduciaries. Here are the key takeaways:

  • The DOL’s longstanding position is that the fiduciary act of managing plan assets includes decisions on the voting of proxies and other exercises of shareholder rights. Over the past few decades, the DOL has issued guidance on a fiduciary’s responsibilities regarding proxy voting and shareholder engagement. The DOL’s most recent guidance is Interpretive Bulletin (IB) 2016-01, as modified by Field Assistance Bulletin 2018-01. The guidance generally permitted fiduciaries to engage in these activities when the responsible fiduciary concluded that there is a reasonable expectation (by the plan alone or together with other shareholders) that such activity is likely to enhance the value of the plan’s investment in the issuer, after taking into account the costs involved.
  • The DOL has also long held that, while ERISA does not permit fiduciaries to subordinate the economic interests of participants and beneficiaries to unrelated objectives in voting proxies or in exercising other shareholder rights, a “reasonable expectation” that the plan is likely to enhance the value of the plan’s investment may be demonstrated where, as is typically the case, the plan’s investment is long-term in nature, or where a plan may not be able to easily divest of the particular holding. The DOL noted in IB 2016-01, for example, that the benefits of shareholder engagement may be difficult to quantify in the short-term but nevertheless can be realized in the long-term.
  • As with its ESG guidance, the DOL’s stance on proxy voting and other forms of shareholder rights have been a political football. Starting with the Clinton Administration in the mid-90s, each administration has taken slightly different approaches. Ultimately, the administrations have gone back and forth as to whether a weighing of the costs and benefits associated with proxy voting is necessary for each such vote or whether such an analysis is reserved for unusually expensive votes or engagements. In 2016, the DOL pointed out that proxy voting rarely entails a significant expenditure of plan assets, and because the value of the vote/engagement may be long-term in nature, there was rarely an issue where the costs outweighed the benefits. Moreover, because many plans’ investments track indices, it is often necessary to engage issuer boards rather than to divest the plan’s exposure in that company. And so, the DOL reasoned in IB 2016-01, the general rule was that proxy voting and shareholder engagement was permissible in most instances.
  • The new proposal provides that the responsible plan fiduciary must vote a proxy where the fiduciary prudently determined that the matter being voted upon would have an economic impact on the plan after taking costs into account. Conversely, the plan fiduciary must not vote any proxy unless the fiduciary determines that the matter being voted upon would have an economic impact on the plan after taking costs into account. This begs the following questions:
    • How much evidence must the fiduciary marshal to demonstrate that a particular vote would have an economic impact on the plan’s investment? While the proposal allows the fiduciary to determine the “appropriate investment horizon,” it raises the prospect that long-term benefits, which may not be readily quantifiable today, could be afforded less weight.
    • Does the benefit of engagement by a group of shareholders count? Prior DOL guidance recognized that benefits from the exercise of shareholder rights might arise from the plan by itself or in combination with other shareholders. Yet, the new proposal seems to ignore this prospect. The proposal instead focuses specifically on the plan’s holdings in the issuer relative to the plan’s portfolio (as well as the plan’s percentage ownership of the issuer) for purposes of calculating whether the plan will stand to economically benefit from the shareholder activity. Because the plan by itself is likely to have a relatively small ownership stake in any particular issuer, and the plan is required under ERISA to be well diversified, this language in the proposal could tilt a fiduciary away from voting.
    • What are the “costs”? The DOL has long understood that plans have rarely incurred the cost of proxy voting and shareholder engagement. Yet the DOL, in the preamble to the proposal, suggests that the costs may not be fully understood. Moreover, the proposal suggests that the costs the issuer incurs as a result of the voting and engagement are effectively costs to the plan (the idea being, apparently, that any cost to the company’s bottom line necessarily diminishes the value of the plan’s investment). Finally, the DOL suggests that opportunity costs are a relevant consideration, though it is unclear how a fiduciary could actually quantify this.
  • As noted above, successive administrations have largely fought over how often the ERISA fiduciary must undertake this cost-benefit analysis with respect to proxy voting and other shareholder rights. In 2008, the DOL envisioned the fiduciary undertaking the test rather routinely. Yet, the DOL changed its tune in 2016 to provide that the test would be a rare occurrence because, in most cases, the costs were negligible, and the benefits were assumed. Under the proposal, the DOL takes the position that the fiduciary must evaluate on a vote-by-vote basis whether the plan will receive some economic benefit as a result of the shareholder activity. The DOL, to its credit, recognized that a vote-by-vote analysis would be costly and onerous. Thus, the proposal introduces the concept of “permitted practices,” which, while not safe harbors, are examples of voting policies the DOL thinks the fiduciaries can efficiently rely upon to satisfy their compliance requirements under the proposal. The following are specific examples of such voting policies, though the DOL solicited feedback on whether other examples should be provided in a final rulemaking. The DOL stressed that these “permitted practices” are intended to be flexible and that fiduciaries are free to deviate from them if it’s prudent under the circumstances or otherwise tailor them to the plan (e.g., provide that the plan will vote in accordance with management’s recommendation for uncontested elections of directors, but devote resources when voting on buy-backs, dilutive issuances of securities, etc.). Ultimately, the policies must be “reasonably designed” to serve the plan’s economic interest.
    • Example A: A policy of voting proxies in accordance with the voting recommendations of management of the issuer on proposals that the fiduciary has prudently determined are unlikely to have a significant impact on the value of the plan’s investment, subject to any conditions determined by the fiduciary as requiring additional analysis because the matter being voted upon may present heightened management conflicts of interest or is likely to have a significant economic impact on the value of the plan’s investment.
    • Example B: A policy that voting resources will focus only on particular types of proposals that the fiduciary has prudently determined are substantially related to the corporation’s business activities or likely to have a significant impact on the value of the plan’s investment (e.g., mergers, dissolutions, buy-backs, etc.).
    • Example C: A policy of refraining from voting on proposals when the plan’s holding in a single issuer relative to the plan’s total investment assets is below a quantitative threshold that the fiduciary prudently determines, considering its percentage ownership of the issuer and other relevant factors, is “sufficiently small” that the outcome of the vote is unlikely to have a material impact on the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager). The DOL floated 5 percent as a potential threshold but specifically requested comments on it. As before, the DOL indicated that such policies would not preclude a fiduciary from voting in any particular case in which a fiduciary subsequently determines that the vote would have an economic impact on the plan.
  • The proposal requires that the fiduciary’s proxy voting policies be reviewed at least once every two years. Moreover, the responsible fiduciary must maintain records on proxy voting activities and other shareholder rights, including records that demonstrate the basis for particular proxy votes and exercises of shareholder rights.
  • The proposal requires that the fiduciary investigate the material facts that form the basis for any particular proxy voting/exercise of shareholder rights. The fiduciary may not adopt a practice of simply following the recommendations of a proxy advisory firm or other service provider without appropriate supervision and a determination that the service provider’s proxy voting guidelines are consistent with the economic interests of the plan and its participants and beneficiaries. A plan fiduciary using a proxy advisory firm is, therefore, responsible for understanding the conflicts of interest that could affect the proxy advisory firm’s recommendations.
  • The proposal preserves key aspects of prior DOL guidance related to proxy voting, specifically:
    • The fiduciary must be prudent in the selection and monitoring of persons selected to advise or otherwise assist with exercises of shareholder rights, such as research and analysis, recommendations regarding proxy votes, administrative services with voting proxies, and recordkeeping and reporting services. Here, the DOL explains that, as part of the duty to monitor, fiduciaries should require documentation of the rationale for proxy voting decisions so that fiduciaries can periodically monitor proxy voting decisions made by third parties.
    • A plan fiduciary must also assess and monitor an investment manager’s use of any proxy advisory firms, including any reviews by the manager of the advisory firm’s policies and procedures for identifying and addressing conflicts of interest.
    • Proxy voting decisions may be delegated to third-party investment managers.
    • Investment managers of pooled investment funds may require that, as a condition to subscription in the fund, plan investors adopt the manager’s voting policy.
  • The proposal has a 30-day comment period, meaning comments are due by early October.

Webcast Available Now – ESG Regulatory Lens – A Guide for Private Fund Managers

In this webcast, we:

  • Provide an overview of ESG and how the strategies apply to the various types of private fund managers.
  • Give an update on the regulatory climate and legal developments for ESG from the US to Europe and Asia.
  • Provide a framework for approaching the development of an ESG process, including where to access useful tools and resources.


Trysha Daskam, Director & Head of ESG Strategy, Silver Regulatory Associates

John P. Hamilton, Counsel, Stradley Ronon

George Michael Gerstein, Co-Chair, Fiduciary Governance, Stradley Ronon


OCIE issues risk alert re. COVID-19

OCIE issued a risk alert to share observations with broker-dealers and investment advisers (firms) based on OCIE’s ongoing COVID-19 outreach to registrants relating to the following six areas:

    1. (1) protection of investors’ assets – firms should consider additional steps to protect client assets (e.g. with regard to validating disbursements and protecting seniors);
    1. (2) supervision of personnel – firms should consider the impact of personnel working remotely as well as limitations on due diligence of other parties or new personnel;
    1. (3) practices relating to fees, expenses, and financial transactions – firms should consider the increased risk of misconduct due to increased financial pressures on firms and their personnel to compensate for lost revenue;
    1. (4) investment fraud – firms should consider the heightened risk of investment fraud through fraudulent offerings;
    1. (5) business continuity – firms should consider additional steps for protracted remote operations (e.g. security and support for infrastructure and personnel, succession planning); and
    1. (6) the protection of investor and other sensitive information – firms should consider the impact of remote operations on the protection of PII as well as heightened risks related to cybersecurity (e.g. heightened risk of fraudsters engaging in phishing scams).
Office Building

New SEC Proxy Regulations for Proxy Voting Advice Businesses and More Proxy Guidance for Investment Advisers

I. Introduction

At an open meeting on July 22, 2020, the Securities and Exchange Commission (SEC) voted 3-1 to adopt amendments to its proxy rules and to issue supplemental SEC guidance (Guidance) for investment advisers.1

The amendments to the proxy rules impose a number of new requirements on proxy voting advice businesses (PVABs). The Guidance discusses the proxy voting responsibilities of investment advisers when using a PVAB, and in particular, it focuses on adviser responsibilities when using the electronic voting platform of a PVAB.

II. Amendments to Proxy Rules

A quick summary of the rule amendments is highlighted in this chart:

A. Definition of Solicitation

Section 14(a) of the Exchange Act and the rules thereunder govern the solicitation and voting of the proxies of issuers. The amendment to Rule 14a-1(l)(1)(iii) confirms that Proxy Voting Advice generally constitutes a “solicitation.” Under this amendment, a “solicitation” involves persons that make voting recommendations to shareholders and who market their expertise separately from other forms of investment advice and sell such advice for a fee. The amendment excludes persons who furnish reports only in response to an unprompted request from the definition of solicitation.2

Institutional Shareholder Services, one of the main PVABs, had filed a lawsuit challenging the SEC’s interpretation that proxy advice constitutes a solicitation. It is unclear whether that litigation, which was stayed pending the final rule, will move forward.3

B. The Exemptions

As noted above, PVAB’s may rely on exemptions from the definition of solicitation (in either Rule 14a-2(b)(1) or (b)(3)4(exemptions)), provided that they meet certain conditions.5

a. Conflicts of Interest Disclosures

Disclosure Requirement. New Rule 14a-2(b)(9)(i) requires as a condition to reliance on the exemptions that a PVAB disclose in detail to clients material conflicts of interest so that PVAB clients can fully understand the nature and scope of such an interest, transaction or relationship. PVAB clients must also be provided with any policies and procedures used to identify, and steps taken to address any such material conflicts. These disclosures will have to be provided either in the PVAB’s reports or in an electronic medium, such as a client voting platform. The Release notes that these disclosures should be readily accessible to clients and facilitate their ability to consider such disclosures together with the report at the time they make their voting decisions.

b.  Notice to Issuers and Safe Harbor

Notice Requirement. New subparagraph A to Rule 14a-2(b)(9)(ii) requires as a condition to reliance on the exemptions that a PVAB adopt and publicly disclose written policies and procedures reasonably designed to ensure that issuers have a report made available to them at or prior to the time when such report is disseminated to the PVAB’s clients. Provided that this initial notice is given to issuers, PVABs are under no obligation to provide issuers with additional opportunities to review the report, including if the report is later revised or updated in light of subsequent events. This condition does not apply to voting advice: (1) that is based on a “custom policy,” i.e., a policy proprietary to the client; and (2) regarding certain mergers and acquisitions and contested matters.6

Safe Harbor. New Rule 14a-2(b)(9)(iii) provides a non-exclusive safe harbor that a PVAB will be deemed to satisfy the notice requirement if it has written policies and procedures that are reasonably designed to provide issuers with a copy of its report, at no charge, no later than the time it is disseminated to the PVAB’s client.7

c. Mechanism to Become Aware of Issuer’s Response and Safe Harbor

Mechanism to Become Aware of Issuer’s Response. New subparagraph B to Rule 14a-2(b)(9)(ii) requires a PVAB, as a condition to relying on the exemptions, to adopt and publicly disclose policies and procedures reasonably designed to ensure it provides clients with a mechanism by which they can reasonably be expected to become aware of any written responses by an issuer to a report, in a timely manner before the shareholder meeting or other action.

Safe Harbor. A non-exclusive safe harbor is available if the PVAB provides electronic notice on its electronic client platform (or through email or other electronic means) that the issuer has filed, or has informed the PVAB that it intends to file, additional soliciting materials (and includes an active hyperlink to those materials on EDGAR when available). The PVAB must provide a hyperlink to materials even if it believes the information is non-material or false or misleading.8

C. Amendments to the Anti-Fraud Provision

Largely consistent with the proposal, the SEC amended Rule 14a-9, the anti-fraud provision for proxy solicitations, to add examples of what may be misleading within the meaning of the rule. The amendment provides that “the failure to disclose material information regarding proxy voting advice, such as the proxy voting advice business’s methodology, sources of information, or conflicts of interest” could, depending on the particular facts and circumstances, be misleading within the meaning of the rule. In response to comments that the examples would heighten legal uncertainty and litigation risk, the Release emphasizes that the examples do not change the rule’s scope or application or make “mere differences of opinion” actionable, and the rule is still grounded in materiality.9

III. Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers

The Guidance addresses an investment adviser’s fiduciary duty and obligations under Rule 206(4)-6 under the Investment Advisers Act of 1940 as it relates to the adviser’s use of a PVAB to exercise of voting authority on behalf of its clients and supplements prior guidance issued by the SEC last year.10 The Guidance reiterates that an investment adviser should have policies and procedures in place that are reasonably designed to ensure that it exercises voting authority in the best interests of its clients.11

This Guidance focuses on an adviser’s use of PVABs’ pre-populated and automated voting services, which some advisers use to more efficiently address the thousands of votes they may make during a short proxy season. While the final rule amendments no longer require a PVAB to provide an issuer the ability to review a report prior to the PVAB client receiving it, and the SEC did not pursue imposing a “speed bump” on automated voting,12 the Guidance puts the onus on advisers to create and maintain policies and procedures that address any issuer response to a report. The Guidance also suggests advisers should disclose details regarding its use of automated voting and get client consent to such practices. The Guidance recommends the following:

  • Issuer’s Additional Soliciting Materials. Investment advisers follow policies and procedures that address situations where the adviser becomes aware of an issuer that has filed or intends to file additional soliciting material after the investment adviser has received the PVAB’s voting recommendation but before the proxy voting submission deadline.
  • Review of Proxy Advisory Firm Agreement. An investment adviser that uses a PVAB’s pre-populated and automated voting services should review its agreement with the PVAB to ensure that any non-public information possessed by the PVAB relating to the proxy vote of the investment adviser is not used in a manner that would not be in the best interests of the adviser’s client. This includes information on aggregated voting intentions of the investment adviser’s clients.
  • Informed Consent. An investment adviser wishing to use a PVAB’s automated voting service should obtain informed consent from its client prior to doing so.13 In particular, the investment adviser should disclose (1) the extent of its use of automated voting services and under what circumstances it uses such services; and (2) how its policies and procedures address the use of automated voting in cases where it becomes aware before the submission deadline for proxies to be voted at the shareholder meeting that an issuer intends to file or has filed additional soliciting materials with the SEC regarding a matter to be voted on. The Guidance recommends that an adviser’s policies and procedures address these disclosures.

IV. Conclusion

While the final amendments to the proxy rules are less prescriptive than the proposal, it is likely that PVABs will need to make some adjustments to their current practices, which may result in increased cost to clients and potential delays during the short proxy voting season. As Commissioner Allison Lee stated in her remarks opposing the adoption of the amendments, “The final rules will still add significant complexity and cost into a system that just isn’t broken” and “are still designed to, and will, increase issuer involvement in what is supposed to be independent advice from proxy advisory firms.”14It will be interesting to follow whether, as has been suggested, PVAB advice becomes less independent (i.e., if PVABs bow to issuer pressure due to concerns about threatened litigation). It is unclear whether the proposed amendments to the shareholder submission/resubmission thresholds, which were not addressed in the Release, will be finalized.15

The Guidance constitutes the latest SEC foray into fiduciary duty of advisers. Advisers will have to balance competing concerns and consider a cost-benefit approach to the review of policies and procedures and disclosure. The Guidance was not subject to notice and comment, is quite prescriptive and suggests an unusual level of detail with regard to policies and procedures and disclosure to clients.16 The SEC’s ability to enforce the Guidance, therefore, is not clear. It is also unclear whether the SEC will attempt to second guess an adviser’s good faith efforts to conform to the Guidance and best interest determinations required therein.

1 Exemptions from the Proxy Rules for Proxy Voting Advice, Release No. 34-89372 (July 22, 2020) (“Release”); Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Adviser, Release No. IA-5547 (July 22, 2020) (“Guidance”); Amendments to Exemptions from the Proxy Rules for Proxy Voting Advice, Release No. 34-87457 (Nov. 5, 2019) (“Proposal”); Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release Nos. IA-5325; IC-33605 (Aug. 21, 2019) (“Prior Guidance”). See also, Commissioners’ statements: Jay Clayton, Chairman, SEC, Proxy Voting – Reaffirming and Modernizing the Core Principles of Fiduciary Duty and Transparency to Provide for Better Alignment of Interest Between Main Street Investors and the Market Professionals Who Invest and Vote on Their Behalf (July 22, 2020); Hester M. Peirce, Commissioner, SEC, Statement at Open Meeting on Exemptions from the Proxy Rules for Proxy Voting Advice and Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers (July 22, 2020); Elad L. Roisman, Commissioner, SEC, Open Meeting to Adopt Amendments to the Proxy Solicitation Rules (July 22, 2020).

2 The final rule clarifies that the SEC does not intend this definition to cover investment advisers, and presumably broker-dealers, that provide reports as part of their advisory services: “[The rule] is not intended to include communications made in the normal course of business by other professionals to their clients that may relate to proxy voting. Instead, the amendment is intended to apply to entities that market their reports as a service that is separate from other forms of investment advice to clients or prospective clients and sell such advice for a fee.” Release, supra note 1, at 35 n.124. It is understood that investment advisers and broker-dealers routinely vote proxies for their clients, both with and without their clients’ explicit voting instructions.

3 The Release includes wording designed to preserve other portions of the rule should litigation be successful. See Release, supra note 1, at 136; Institutional S’holder Servs. Inc. v. SEC, No. 1:19-cv-03275 (D.D.C. Oct. 31, 2019).

4 Rule 14a-2(b)(1) exempts solicitations by persons who do not seek the power to act as proxy for a shareholder and do not have a substantial interest in the subject matter of the communication beyond their interest as a shareholder. Rule 14a-2(b)(3) exempts reports furnished by an adviser to any other person with whom the adviser has a business relationship.

5PVABs are not required to comply with the Rule 14a-2(b)(9) conditions until December 1, 2021. However, this transition period does not apply to the amendments to the definition of solicitation and the anti-fraud provisions.

6 Commenters, including investment advisers, had argued that advice based on custom policies should not be required to be provided to issuers because those custom policies are formulated by and tailored to a particular client and based on proprietary and often confidential information.

7 These policies and procedures can contain conditions requiring that such issuers have filed their definitive proxy statement at least 40 days before the shareholder meeting and expressly acknowledged that they will only use the report for their internal purposes and/or in connection with the solicitation, and the report will not be published or otherwise shared except with the issuer’s employees or advisers.

8 The Release did clarify that inclusion of a hyperlink would not, by itself, make the PVAB liable for the content of the issuer’s hyperlinked statement.

9 See Release, supra note 1 at p.132.

10 See Guidance, supra note 1; Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release Nos. IA-5325; IC-33605 (Aug. 21, 2019) (“Prior Guidance”); see also Risk&Reward Client Alert, SEC Adopts Guidance on Proxy Advisory Firms and Proxy Rules (Aug. 29, 2019) (discussing the Prior Guidance).

11 Consistent with the terminology in the Release, the Guidance also uses the term PVAB rather than “proxy advisory firm,” which was previously used in the Prior Guidance.

12 As discussed in our prior client alert, the SEC requested comments on whether PVABs should be required to disable the automatic submission of votes unless a client clicks on the hyperlink and/or accesses the issuer’s response or otherwise confirms any pre-populated voting choices before the PVAB submits the votes to be counted. Risk&Reward Client Alert, New SEC Proposal May Complicate Proxy Voting & Engagement by Advisers (Nov. 19, 2019).

13 Informed consent requires that the adviser make full and fair disclosure such that the client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent. See Guidance, supra note 1.

14 Allison Herren Lee, Commissioner, SEC, Paying More For Less: Higher Costs for Shareholders, Less Accountability for Management (July 22, 2020).

15 It appears that this aspect of the rulemaking has been a point of contention in the SEC’s 2021 budget appropriation with Democrats seeking to prohibit the use of funds to finalize rulemaking under Rule 14a-8. See House Committee on Rules, H.R. 7617 – Defense, Commerce, Justice, Science and Energy and Water Development, Financial Services and General Government, Homeland Security, Labor, Health and Human Services, Education, Transportation, Housing, and Urban Development Appropriations Act 2021.

16 In this respect, it can be argued that the Guidance is subject to similar criticism as the recently proposed valuation rule. See Hester M. Peirce, Commissioner, SEC, Statement on Good Faith Determinations of Fair Value under the Investment Company Act of 1940 Proposal (April 21, 2020) (questioning whether the benefits of the proposed rule “may be diminished significantly by an overly prescriptive approach to ensuring adequate board administration of the fair valuation process.”)

DOL’s New Fiduciary Investment Advice Package Presents Significant Compliance Risk

The U.S. Department of Labor (DOL) announced last week a series of actions regarding the provision of “investment advice” under the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA) and the U.S. Internal Revenue Code of 1986, as amended (the Code). Investment advisers, broker-dealers, banks, insurance companies and other financial services firms, which interface with ERISA-covered plans and IRAs, should especially take note. The provision of “investment advice” to ERISA-covered plans and IRAs triggers a need to comply with stringent fiduciary duties and a complex web of prohibited transaction rules (depending on the nature of the advice recipient).

This is part of a long continuum of federal and state efforts to more comprehensively regulate communications between financial services firms, especially broker-dealers, and retail investors, such as plan participants and IRA owners. The 2010s were largely dominated by DOL efforts, including two separate proposals, the latter of which culminated in the controversial 2016 Conflicts of Interest rulemaking, largely known as “the Fiduciary Rule.” Since then, the U.S. Securities and Exchange Commission (SEC) published Regulation Best Interest, which went into effect last week, and numerous states have sought to create uniform standards of care between broker-dealers and advisers. Both the 2016 DOL Fiduciary Rule and Regulation Best Interest, took aim at investment advice regarding rollovers.

To further complicate matters, the U.S. Court of Appeals for the Fifth Circuit in 2018 vacated the DOL’s Fiduciary Rule, sowing both relief and confusion in the industry. During this time, the DOL granted some temporary relief and appeared to let the SEC take the lead on regulating broker-dealer practices, which would be in keeping with the court’s decision. The DOL further signaled that any DOL investment advice rulemaking would align with Regulation Best Interest.

The DOL’s series of actions last week include reinstating the DOL’s longstanding 1975 regulation on investment advice fiduciary status, removal of the 2016 Fiduciary Rule (and its accompanying class exemptions),1 and the proposal of a new (and nimble) class exemption that would enable certain types of investment advice fiduciaries to receive a wide range of fees and other compensation without engaging in non-exempt prohibited transactions.

The comment period for the proposed class exemption closes on Aug. 6, 2020. Firms may wish to evaluate whether they will seek to rely on this new class exemption or instead rely on one or more other (narrower) exemptions that may be available.

Status as an Investment Advice Fiduciary

One is an investment advice fiduciary under ERISA and the Code to the extent he or she provides investment advice for a fee or other consideration (direct or indirect) with respect to monies or other property of the plan (or has any responsibility or authority to do so). Under the newly reinstated 5-part test, a communication constitutes fiduciary investment advice if a financial institution or investment professional who is not otherwise a fiduciary:

  1. Renders advice to the plan as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing, or selling securities or other property,
  2. On a regular basis,
  3. Pursuant to a mutual agreement, arrangement, or understanding with the plan, plan fiduciary or IRA owner, that
  4. The advice will serve as a primary basis for investment decisions with respect to plan or IRA assets, and that
  5. The advice will be individualized based on the particular needs of the plan or IRA.

Thus, if a financial institution or investment professional triggers all five conditions and receives a fee or other compensation (direct or indirect), it is an investment advice fiduciary under ERISA and the Code. As noted above, this status would trigger fiduciary obligations and the need to carefully structure the advice and attendant transactions so as to avoid non-exempt prohibited transactions.

Last week’s decision to reinstate the traditional 5-part test is important, but perhaps even more noteworthy are the DOL’s insights on how it would now interpret the test. For example, the DOL indicated that the first prong would encompass advice to a retirement investor as to whether to take a distribution from a plan or whether to roll out of a plan and into an IRA. This is a notable departure from the DOL’s previous position (DOL Advisory Opinion 2005-23A) that advice regarding rollovers were generally not considered investment advice. The first prong also appears to pick up advice on account type (e.g., commission-based or fee-based) and on advice as to persons the retirement investor may hire as an investment advice provider or asset manager.

The second prong would also be interpreted quite broadly. For example, this prong appears to be met if the advice communication at issue is part of an “ongoing relationship or an anticipated ongoing relationship that an individual enjoys with his or her advice provider.” For example, if an investment professional already has a relationship with a plan participant pursuant to which he or she provides investment advice, advice on whether to roll assets out of the plan is part of that ongoing relationship, and, therefore, the roll over advice communication meets the “regular basis” requirement. Even if the investment professional lacks an existing advice relationship, advice to roll assets out of a plan and into IRA, in anticipation of an ongoing advice relationship, will similarly meet this prong. A third-party solicitor, for example, which is paid by a financial institution (that has or may have an ongoing fiduciary investment advice relationship with the recipient), bears greater risk that a recommendation they render will be treated as investment advice under the proposal.

The avoidance of triggering the third prong was often addressed through contractual representations and disclaimers. Yet even here, the DOL cautioned that this approach is not dispositive in establishing that both parties agreed investment advice was being provided.

Moreover, the 2020 proposal clarifies that prong (iv) of the test does not depend on whether the advice serves as the primary basis for the investment decision, but whether it serves as a primary basis. On this point, the DOL stated that financial service professionals who make recommendations pursuant to a best interest standard, including as required under Regulation Best Interest, or other requirements to provide individualized advice, will satisfy this prong, meaning, the parties would reasonably understand that the advice in question will serve as at least a primary basis for the investment decision.

It is worth pointing out that a requirement of a financial services firm to provide individualized advice, or to act in the investor’s best interest, under other federal law (e.g., Regulation Best Interest) or state law may also work to establish that such firm is an investment advice fiduciary to a retirement investor for purposes of ERISA and the Code.

Some communications are unlikely to constitute investment advice, however. One-time sales transactions, and bank networking arrangements are two examples the DOL highlighted. But unlike the 2016 rule, there do not appear any express safe harbors for marketing the fiduciary’s own services or investment advice rendered to sophisticated financial professionals as part of arm’s-length transactions. Commenters may wish to seek more explicit protection for these types of communications, including, but not limited to, greater consistency with Regulation Best Interest.

New Class Exemption

The proposed class exemption would generally be available to registered investment advisers, broker-dealers, banks and insurance companies (Financial Institutions), their individual employees, agents, representatives and independent contractors (Investment Professionals), as well as their affiliates and related entities, who receive a wide range of fees and other compensation (e.g., 12b-1 fees, commissions, third-party payments, etc.) as a result of providing investment advice to retirement investors (i.e., ERISA plan participants, beneficiaries and fiduciaries, as well as IRA owners and fiduciaries), including rollover investment advice. For example, this exemption could be handy for an RIA that provides investment advice that causes itself to start earning a fixed fee or a management fee. Another potential prohibited transaction for which this exemption would provide relief is where an RIA gives investment advice to a Retirement Investor that causes its affiliated broker-dealer to earn commissions for executing those transactions.

The exemption would also cover riskless2 and certain other principal transactions between the Financial Institution and retirement investor. As proposed, a covered principal transaction is defined differently depending on whether the retirement investor is the purchaser or seller. For sales to a retirement investor, the principal transaction would have to involve: (i) a US dollar denominated debt security issued by a US corporation and offered pursuant to a registration statement under the ’33 Act; (ii) a US Treasury Security; (iii) a debt security issued or guaranteed by a US federal government agent other than the Treasury Department; (iv) a debt security issued or guaranteed by a government-sponsored enterprise; (v) a municipal security; (vi) a certificate of deposit; (vii) an interest in a unit investment trust; or (vi) any other investment permitted to be sold by an investment advice fiduciary to a retirement investor under an individual exemption granted by the DOL. If the recommendation is with respect to a debt security, the recommendation must be made pursuant to written policies and procedures adopted by the Financial Institution that are reasonably designed to ensure that the security, at the time of the recommendation, has no greater than moderate credit risk and sufficient liquidity that it could be sold at or near carrying value within a reasonably short period of time. For purchases from a retirement investor, the principal transaction may cover any type of securities or investment property.

Before describing the conditions to the proposed exemption, it is important to first highlight where the exemption would not be available:

A. Where the Financial Institution, Investment Professional or any affiliate is the employer of employees covered by an ERISA-covered retirement plan investor or is a named fiduciary or plan administrator to such plan, or was selected to provide investment advice to the plan by a fiduciary not “independent” of the Financial Institution, Investment Professional or their affiliates.3 Employers can continue to recover their direct expenses when providing investment advice to their plans.

B. The transaction is a result of robo investment advice generated solely by an interactive website in which computer software-based models or applications provide investment advice based on personal information each investor supplies through the website, without any personal interaction with an Investment Professional. Sections 408(b)(14) and 408(g) of ERISA may provide relief in these instances.

C. The transaction involves the Investment Professional acting in a fiduciary capacity other than providing investment advice (g., the Investment Professional has discretionary control over the retirement investor’s assets).

The following are the conditions to the exemption:

  1. The Financial Institution and Investment Professional complies with the Impartial Conduct Standards. The Impartial Conduct Standards have the following core components:
    1. The investment advice is, at the time it is provided, in the “best interest” of the retirement investor. This is to be interpreted and applied in a manner consistent with Regulation Best Interest and the SEC’s interpretive release regarding the conduct standard of registered investment advisers. The “best interest” requirement would permit Financial Institutions and Investment Professionals to provide investment advice despite having a financial or other interest in the transaction, provided they do not place their interests ahead of the retirement investor’s. Investment advice on proprietary products, and advice that generates third-party payments, could be consistent with this “best interest” requirement. As with Regulation Best Interest, the “best interest” requirement does not necessarily create a monitoring obligation; however, the DOL indicated that certain investments may be so complex or risky that they may necessitate monitoring by the Financial Institution.
    2. The compensation received (directly or indirectly) by the Financial Institution, Investment Professional, their affiliates and related entities for their services does not exceed reasonable compensation within the meaning of Section 408(b)(2) of ERISA. Whether compensation is “reasonable” is fact-specific, but some factors that may inform the analysis include the market price for the services, the scope of monitoring duties (if any), and the complexity of the product.
    3. As required by the federal securities laws, the Financial Institution and Investment Professional seek to obtain “best execution” of the investment transaction reasonably available under the circumstances.
    4. At the time they are made, statements by the Financial Institution and Investment Professional about the recommended transaction “and other relevant matters” (e.g., fees and compensation, material conflicts of interest, etc.) are not materially misleading. The DOL would consider it “materially misleading” for the Financial Institution or Investment Professional to include any indemnification or exculpation clauses that are prohibited by applicable law, including Section 410 of ERISA.
  2. Prior to engaging in the transaction covered by the exemption, the Financial Institution provides the following information in one or a combination of written documents, all written in Plain English:
    1. A written acknowledgment that the Financial Institution and its Investment Professionals are fiduciaries under ERISA and the Code (as applicable) with respect to any fiduciary investment advice to retirement investors. Please note that, notwithstanding this requirement, the exemption is not intended to expand the retirement investor’s ability to enforce their rights in court or create any new legal claims, in stark contrast to the 2016 Best Interest Contract Exemption.
    2. A written description of the services to be provided. This description does not have to be tailored to the specific retirement investor. It is unclear if Form CRS would suffice for broker-dealers and investment advisers.
    3. A written description of the Financial Institution’s and Investment Professional’s material conflicts of interest that is both accurate and not misleading in all material respects.
  3. Policies & Procedures
    1. The Financial Institution establishes, maintains and enforces written policies and procedures prudently designed to ensure compliance with the Impartial Conduct Standards with respect the investment advice and related transactions.
    2. The policies and procedures mitigate “conflicts of interest” (the meaning of this is designed to be consistent with Regulation Best Interest) to the extent the policies and procedures, as well as incentive practices, when viewed as a whole, are prudently designed to avoid a misalignment of interests.
      1. For example, the policies and procedures would likely need to protect retirement investors from making excessive trades or investing in illiquid or risky products.
      2. Recommending a fee-based account to an investor with low trading activity would also be an impermissible practice.
      3. The policies and procedures would need to specifically address and mitigate the conflicts that arise from advice regarding proprietary products or from a limited menu of products.
      4. The policies and procedures would also have to address and mitigate the conflicts arising out of transaction-based compensation. The compensation structures with respect to which the DOL has concerns include thresholds that disproportionately increase compensation through incremental increases in sales. In the wake of the 2016 DOL fiduciary rule, various firms revised their compensation grids to avoid this situation, so the DOL’s concerns in this proposal should not be a surprise or be too onerous to address. Moreover:
        1. Differential compensation across investment products, or within product categories, also raise concerns, as do incentives that favor proprietary products. One possible approach to addressing these conflicts is by basing compensation on neutral factors or by levelizing the compensation across fund families.
        2. Sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of certain investments within a limited period of time appear to be per se impermissible.
        3. Supervision would be especially important for monitoring recommendations that are near compensation thresholds, or involve products that pay off more compensation, for advice regarding proprietary products, and for rollover advice.
        4. Depending on the facts, it may be necessary to limit the type of products that may be recommended to retirement investors.
    3. The Financial Institution internally documents the specific reasons that any recommendation to roll over assets from a plan to another plan or IRA, from an IRA to a plan, from an IRA to another IRA, or from one type of account to another (e.g., a commission-based account to a fee-based account), is the “best interest” of the retirement investor. This analysis would include consideration of the alternatives to the rollover, including leaving the assets in the participant’s current employer’s plan and selecting different investment options, the fees and expenses associated with both the plan and the IRA, whether the employer pays for some or all of the plan’s administrative expenses, and the different levels of services and investments available under the plan and IRA. The Financial Institution and Investment Professional could secure the plan-specific information if it is readily available or by requesting it from the participant. If the participant refuses to provide the information, “even after a full explanation of its significance,” the Investment Professional could provide a reasonable estimate of estimated expenses, returns, etc. It is somewhat unclear the extent to which the foregoing analysis needs to be shared with the retirement investor.
  4. The Financial Institution conducts at least an annual retrospective review that is reasonably designed to detect and prevent violations of the Impartial Conduct Standards and related policies and procedures. The review would have to be certified by the Chief Executive Officer or equivalent. The DOL indicated that this review process is based on FINRA’s rules governing how broker-dealers supervise associated persons. The review would have to be completed within six months following the end of the reviewed period and would have to be retained for six years. It appears that only the DOL and other federal and state regulators (including SROs) would be privy to this report, though commenters may wish to seek confirmation on this point.
  5. Neither the Financial Institution nor Investment Professional has been convicted of any crime described in Section 411 of ERISA arising out of the provision of investment advice, absent special permission from the DOL.
  6. The Financial Institutions maintains all the records demonstrating compliance with the exemption for six years, and makes available such information to the DOL, a plan fiduciary, a plan sponsor or any participant, unless such information constitutes a trade secret or is privileged, etc., in which case the Financial Institution would have to provide a written notice of such determination to the requester within 30 days of the request.

The comment period for this proposed class exemption closes on Aug. 6, 2020.

 The DOL also reinstated Interpretive Bulletin 96-1 regarding the types of communications with plan participants that amount to investment education (rather than advice).

 2 A riskless principal transaction is a transaction in which a Financial Institution, after having received an order from a retirement investor to buy or sell an investment product, purchases or sells the same investment product for the Financial Institution’s own account to offset the contemporaneous transaction with the retirement investor.

The DOL would view a party as “independent” of the Financial Institution and Investment Professional if: (i) the person was not the Financial Institution, Investment Professional or an affiliate, (ii) the person did not have a relationship to, or an interest in, the Financial Institution, Investment Professional or any affiliate that might affect the exercise of the person’s best judgment in connection with transactions covered by the exemption, and (iii) the party does not receive and is not projected to receive within the current federal income tax year, compensation or other consideration for his or her own account from the Financial Institution, Investment Professional or an affiliate in excess of 2% of the person’s annual revenues based upon its prior income tax year.

1940 Act Issues to Consider During the Pandemic – Part 11

Stradley’s Coronavirus Task Force will be updating this high-level overview of coronavirus disease 2019 (COVID-19) related issues for registered investment companies and fund managers as developments warrant.


  • Market Closures and Market Restrictions: A list of securities market closures and market restrictions is available here(Updated 6/22/2020)
  • In-Person Board Meetings: The Securities and Exchange Commission has provided exemptive relief in orders under the Investment Company Act of 1940 (1940 Act Orders) to allow fund boards to meet telephonically or by video conference to consider and vote on matters that would otherwise require an in-person vote.1 The relief applies whenever reliance upon it is necessary or appropriate due to circumstances related to current or potential effects of COVID-19. The SEC has issued an order (1940 Act Extension Order) that extends relief from the in-person board meeting requirement, which previously was scheduled to expire on Aug.15, to a date to be specified in a public notice from SEC staff, which will be a date at least two weeks from the date of the notice and no earlier than Dec. 31, 2020.2 (Updated 6/22/2020)
  • SEC Filings: The 1940 Act Orders and orders under the Investment Advisers Act of 1940 provide relief from the timeliness requirements of certain filings under the 1940 Act and the Advisers Act.3 The 1940 Act Orders provide relief from the timeliness requirements of Form N-CEN, Form N-PORT, and Form N-23C-2 when a fund is unable to meet a deadline due to circumstances related to current or potential effects of COVID-19. The relief for Forms N-CEN and N-PORT applies to filing obligations for which the original due date is on or after March 13 but on or prior to June 30, 2020, while the relief for Form N-23C-2 extends to Aug. 15, 2020. The Advisers Act Orders provide timeliness relief for Form ADV and Form PF filings and for Form ADV Part 2 client delivery obligations for 45 days from the original due date, when the original due date is on or after March 13 but on or prior to June 30, 2020. The SEC previously posted staff guidance that Form ADV does not have to be updated to reflect temporary teleworking locations.4 The SEC has also provided relief from timeliness requirements for certain filings under the Securities Exchange Act of 1934.5 Note that filings not covered by the orders continue to be required on a timely basis, including filings on Form N-LIQUID, Form N-CR, and Form N-MFP, although it is possible that the SEC will consider issues with these forms on an individualized basis. The SEC provided information on contacting the staff with issues, including issues with these filings, in press releases announcing the actions.The SEC announced in the 1940 Act Extension Order that the relief from 1940 Act filings requirements provided in the 1940 Act Orders will not be further extended. (Updated 6/22/2020)
  • Delivery of Prospectuses and Shareholder Reports: The 1940 Act Orders also provide relief from the obligations to timely transmit annual and semiannual reports to shareholders and to file them with the SEC. The relief applies when the original due date is on or after March 13 but on or prior to June 30, 2020, and the fund is unable to prepare or transmit the report due to circumstances related to current or potential effects of COVID-19. In addition, the SEC announced that it would not provide a basis for an SEC enforcement action if a fund does not timely deliver a current prospectus because of circumstances related to COVID-19 when delivery was originally required during this period. The position is not available to an initial purchase by the investor of the fund’s shares.The SEC announced in the 1940 Act Extension Order that this relief will not be further extended. (Updated 6/22/2020)
  • Term Asset-Backed Securities Loan Facility: The Federal Reserve Bank of New York has established the Term Asset-Backed Securities Loan Facility (TALF), which provides non-recourse funding to eligible borrowers owning eligible collateral in the form of AAA-rated asset-backed securities backed by newly and recently originated consumer and small business loans.A TALF borrower must have significant operations in and a majority of its employees based in the United States. The New York Fed has provided guidance that, for a borrower organized as an investment fund, this test will be applied to the borrower’s investment manager.8 The facility initially will make up to $100 billion of loans available, and each loan provided under the facility will have a maturity of three years. Unless the program is extended, no new credit extensions will be made after Sept. 30, 2020. The SEC staff in 2009 provided no-action guidance to allow registered funds to participate in a similar facility established in 2008.9 The SEC staff has confirmed that the 2009 guidance is also applicable to the current facility, and it has provided guidance that a fund or business development company may participate in TALF indirectly through a private fund.10 The initial TALF subscription date was June 17, 2020, and the New York Fed has announced that approximately $252 million in TALF loans were requested on that date.11 (Updated 6/22/2020)
  • Money Market Mutual Funds:
    • Liquidity Facility: The Federal Reserve Board has announced a Money Market Mutual Fund Liquidity Facility (MMLF) that is intended to assist money market funds in meeting demands for redemptions.12 Under the MMLF, the Federal Reserve Bank of Boston will lend to depository institutions and bank holding companies, taking as collateral assets purchased by the borrower from prime money market funds (i) concurrently with the borrowing or (ii) or on or after March 18, but before the opening of the facility. The facility is similar to the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility that operated from late 2008 to early 2010 but will purchase a broader range of assets. The Federal Reserve Board expanded the facility to cover certain assets purchased from tax-exempt municipal money market funds.13 The Federal Reserve Board has announced that the facility opened March 23, and full documentation and additional guidance are available.14  As of May 31, 2020, the total outstanding amount of the loans under the facility was approximately $32.5 billion (down from $39.4 billion as of May 14 and $51.1 billion as of April 14).15 (Updated 6/22/2020)
    • Form N-CR: Several money market funds filed on Form N-CR in March to report financial support, and one money market fund filed on Form N-CR in March to report downward deviations of its shadow price by more than ¼ of 1%. An amended report is required to be filed within four business days of the provision of financial support or downward deviation that describes the reason for the support and terms of the support or the reason for the deviation, as applicable. (Updated 3/23/2020)
    • Purchases by Affiliated Banks: The Federal Reserve Board has issued a template exemptive letter allowing banks to purchase assets from affiliated money market funds, subject to certain conditions, including that the assets must be investment grade and purchased at fair market value.16 In addition, the SEC staff has granted no-action relief to permit certain bank affiliates of money market funds to purchase securities from the funds in accordance with the Federal Reserve Board guidance, but otherwise pursuant to rule 17a-9, subject to certain conditions.17 The SEC no-action letter does not affect the ability of other money market fund affiliates to purchase assets from the fund in accordance with rule 17a-9. (Updated 3/23/2020)
    • Guaranty: The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which was enacted into law on March 27, suspends the existing prohibition on the use of the Exchange Stabilization Fund for the establishment of any guaranty programs for the money market fund industry.18 Any such guarantee shall be limited to a guarantee of the total value of a shareholder’s account in a participating fund as of the close of business on the day before the announcement of the guarantee and terminate not later than Dec. 31, 2020. This provision allows the Department of the Treasury to establish a Money Market Funds Guaranty Program but does not require it to do so. (Updated 3/31/2020)


  • Transfer Agents and Fingerprinting Requirements: The SEC has provided a broad exemption from requirements applicable to transfer agents except for the safeguarding requirement.19 The exemption also applies to broker-dealers and other persons who are subject to a fingerprinting requirement. Transfer agents and other persons relying on the relief must provide notice to the SEC. The SEC encourages transfer agents and the issuers for whom they act to inform affected security holders. The SEC has extended the period covered by the exemption to June 30; it originally was due to expire May 31.20 (Updated 6/1/2020)
  • Exchange-Traded Funds:
    • The New York Fed has established the Secondary Market Corporate Credit Facility (SMCCF), which purchases in the secondary market corporate bonds issued by U.S. companies and shares of U.S.-listed ETFs whose investment objective is to provide broad exposure to the market for U.S. corporate bonds.21 The New York Fed has retained BlackRock Financial Markets Advisory as a third-party vendor to serve as the investment manager for this facility.22 The SMCCF will cease making such purchases no later than Sept. 30, 2020, unless extended. The Federal Reserve Board announced on April 9 that the SMCCF had been expanded and, together with the Primary Market Corporate Credit Facility, will have a combined size of up to $750 billion.23 The SMCCF may purchase any U.S.-listed ETF whose investment objective is to provide broad exposure to the market for U.S. corporate bonds, although the preponderance of ETF holdings will be ETFs whose primary investment objective is exposure to U.S. investment-grade corporate bonds. The SMCCF will not purchase shares of an ETF if it then would own more than 20% of the ETF’s shares.  The facility began making purchases on May 12, 2020, and is transacting initially with primary dealers that deal directly with the New York Fed.  As of May 19, the SMCCF had made purchases of approximately $1.307 billion, all in ETFs, and it had an additional $287 million of purchases that had not yet reached settlement.24 (Updated 6/1/2020)
    • For an ETF that invests in foreign markets that close, the ETF may wish to consider whether to invest in alternative instruments, such as ADRs, in order to achieve the desired exposure to the foreign securities. In circumstances where there is no ability to make additional investments in appropriate alternative instruments, an ETF may wish to stop accepting creation unit purchases. The SEC previously has noted that ETFs generally may suspend the issuance of creation units only for a limited time and only due to extraordinary circumstances, such as when the markets on which the ETF’s portfolio holdings are traded are closed for a limited period of time.25 ETF issuers should be aware that any decision to suspend creations could have an impact on the arbitrage efficiency of the ETF and could lead to greater deviations between the market price of the ETF shares and the NAV of the shares. Like other open-end funds, ETFs cannot suspend redemptions unless the New York Stock Exchange is closed or there is appropriate guidance from the SEC. ETFs are permitted to charge transaction fees of up to 2% on redemptions. Such fees are designed to offset the costs of redemptions to the ETF. Some fixed-income ETFs that deliver cash redemptions instead of in-kind redemptions reportedly have increased their transaction fees on redemptions in light of increased transaction costs in the bond market. (Updated 3/23/2020)
  • Paycheck Protection Program:The Paycheck Protection Program authorizes forgivable loans to small businesses to pay their employees during the COVID-19 crisis.26 Borrowers submitting a PPP application must certify that current economic uncertainty makes this loan request necessary to support the ongoing operations of the applicant. The Small Business Administration, which implements the program, has announced that any borrower that, together with its affiliates, received PPP loans with an original principal amount of less than $2 million will be deemed to have made the required certification in good faith. Hedge funds and private equity funds are not eligible for PPP loans, but their portfolio companies may be able to qualify.27 The SEC staff has provided guidance that an advisory firm that receives a PPP loan may be required to disclose the loan and its financial condition to clients.28 (New 5/15/2020)
  • Division of Investment Management Statement: The SEC’s Division of Investment Management has issued a statement emphasizing the ongoing importance of updating and delivering the required information to fund investors in a timely manner, even during this period of operational challenge.29 The statement reminds funds of the obligation to update prospectuses and deliver them to new investors,30 and it encourages funds to consider whether disclosures should be revised based on how COVID-19-related events may affect the fund and its investors. (New 4/20/2020)
  • Closed-End Funds: A closed-end fund is required to suspend its offering of shares until it amends its prospectus if the fund’s net asset value declines more than 10% from the NAV as of the effective date of the registration statement. The SEC staff has released guidance allowing the use of a prospectus supplement, with notice to the SEC staff, rather than an amendment to the registration statement.31 (New 4/20/2020)
  • Shareholder Meetings: The SEC staff has provided guidance to both operating companies and funds that is intended to provide regulatory flexibility to companies seeking to change the date and location of shareholder meetings and to use new technologies, such as “virtual” shareholder meetings that avoid the need for in-person shareholder attendance, while at the same time ensuring that shareholders and other market participants are informed of any changes.32 The guidance notes that the ability to conduct a “virtual” meeting is governed by state law, where permitted, and the issuer’s governing documents. Note that companies seeking to conduct a virtual meeting may, under state law, need to have an appropriate process for shareholders to vote at the meeting. The guidance has been revised to extend to special meetings as well as annual meetings and to provide further guidance on notice requirements. (Updated 4/20/2020)
  • Business Development Companies: The SEC has provided limited and conditional exemptive relief for business development companies that provides additional flexibility to BDCs to issue and sell senior securities.33 In addition, for BDCs with an SEC order permitting co-investment transactions with certain affiliates, the SEC relief allows the BDC to participate in certain follow-on investments with regulated funds and affiliated funds. The relief is available until Dec. 31, 2020. (New 4/13/2020)
  • Regulation BI/Form CRS: SEC Chairman Jay Clayton has announced that the SEC believes that the June 30, 2020, compliance date for Regulation Best Interest and other requirements, including the requirement to file and begin delivering Form CRS, remains appropriate.34 To the extent that a firm is unable to make certain filings or meet other requirements because of disruptions caused by COVID-19, including as a result of efforts to comply with national, state or local health and safety directives and guidance, the firm should engage with the SEC. The SEC’s Office of Compliance Inspections and Examinations has issued two Risk Alerts that provide broker-dealers and investment advisers with advance information about the expected scope and content of the initial examinations for compliance with Regulation BI and Form CRS,35 and FINRA has provided guidance on best practices in preparing for Regulation BI.36 The SEC staff has announced that it is now accepting filings on Form CRS.37 (Updated 4/13/2020)
  • Paper Submissions: Although most SEC filings are now made electronically via EDGAR, there are still some submissions that normally must be submitted in paper form.
    • The SEC’s Division of Trading and Markets has announced relief for certain submissions that are required to be filed in paper format with a manual signature and for related notarization requirements.38 The affected filings include audited annual reports submitted by broker-dealers. Filers should contact Division staff to discuss the appropriate process for filing. The staff statement covers submissions for the period from and including March 16, 2020, to June 30, 2020. (New 4/7/2020)
    • The SEC’s Division of Corporation Finance has announced that notices of proposed sales of securities on Form 144 may be filed via email and, subject to certain conditions, may have a typed form of signature rather than a manual signature.39 (New 4/13/2020)
    • The SEC’s Division of Investment Management has announced that requests for hearing applications on notices of applications for exemptive orders under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 must be submitted by email.40 (New 4/13/2020)
  • Accounting Issues: SEC Chief Accountant Sagar Teotia has announced that the SEC’s Office of the Chief Accountant recognizes that the accounting and financial reporting implications of COVID-19 may require companies to make significant judgments and estimates in a number of accounting areas, including fair value and impairment considerations.41 The OCA has consistently not objected to well-reasoned judgments that entities have made, and it will continue to apply this perspective. The OCA remains available for consultation and encourages stakeholders to contact it with questions they encounter as a result of COVID-19. (New 4/7/2020)
  • Affiliated Purchases of Debt Securities: The SEC staff has issued no-action relief to affiliates of open-end funds, other than exchange-traded funds and money market funds, to allow them to purchase debt securities from the funds.42 The relief is subject to conditions, including that the price must be the security’s fair market value per Section 2(a)(41) of the 1940 Act, provided that this price is not materially different from the value indicated by a reliable third-party pricing service, and that the fund must publicly disclose the purchase on its website and inform the staff. In addition, if the purchaser thereafter sells the security for a higher price, it must promptly pay the difference to the fund, unless the purchaser is a bank or bank affiliate and this condition would conflict with Sections 23A and 23B of the Federal Reserve Act. The relief will be in effect until further notice from the staff. (New 3/31/2020)
  • SEC Lending and Borrowing Relief: The SEC has issued an order providing additional flexibility for open-end funds (other than money market funds) and insurance company separate accounts registered as unit investment trusts to obtain short-term funding.43 The relief is available until a notice terminating it is issued, which will be at least two weeks from the date of the notice and no earlier than June 30, 2020. Prior to relying on any of the relief, the fund would have to notify SEC staff. In addition, interfund lending requires notification on a fund’s public website.
    • Fund affiliates may lend money to the fund on a collateralized basis, provided the board makes determinations that the borrowing is in the best interest of the fund and its shareholders and that it will be for the purposes of satisfying shareholder redemptions.
    • For fund families with an SEC order permitting an interfund lending and borrowing facility, a lending fund may lend up to 25% of its current net assets and the term may be for any period that does not extend beyond the expiration of the relief, notwithstanding the terms of the order, provided, among other conditions, that the board reasonably determines that the maximum term for interfund loans is appropriate. (Recent orders typically limit lending funds to 15% of current net assets and the term to seven days.)
    • For fund families without an interfund lending order, funds may lend and borrow in accordance with the terms of any such order issued within the past twelve months, with the same modifications.44
    • Funds are not required to seek shareholder approval if lending under the relief would violate a fundamental policy, provided that the board reasonably determines that the lending or borrowing is in the best interests of the fund and its shareholders. (New 3/27/2020)
  • OCIE Statement: The SEC’s Office of Compliance Inspections and Examinations has issued a statement that it has moved to conduct examinations off-site through correspondence unless it is absolutely necessary to be on-site, and that it will work with registrants to ensure that its work can be conducted in a manner consistent with maintaining normal operations and with necessary or appropriate health and safety measures.45 OCIE also stated that reliance on regulatory relief would not be a risk factor utilized in determining whether OCIE commences an examination, and it encourages registrants to utilize available regulatory relief as needed. (New 3/27/2020)
  • Signatures on EDGAR Filings: The SEC staff has issued a statement on the manual signature and record requirements for documents filed electronically with the SEC.46 The staff will not recommend enforcement action if a signatory retains a document adopting the signature and provides the document to the filer for retention, with the time and date executed, and the filer establishes and maintains policies and procedures governing this process. (New 3/27/2020)
  • FINRA Guidance: FINRA has issued guidance that provides temporary relief and guidance with respect to a number of requirements, including filings that would otherwise be required for temporary relocations and the timing of FOCUS reports and certain other filings.47 The guidance will be available until FINRA publishes a Regulatory Notice announcing a termination date. (New 3/27/2020)
  • Blue Sky Guidance: A number of state and provincial securities regulators have published guidance that provides relief or other COVID-19-related updates. The North American Securities Administrators Association has established a resource page to collect these updates.48 (Updated 3/27/2020)
  • State and Local Closures: Many states, counties and cities have announced business closures in connection with “shelter-in-place” public health efforts to slow the spread of COVID-19. Some of the orders may contain broad exceptions for the financial services industry, while others may not. Beyond the direct impact on firms in those localities, review the location of service providers and the terms of these orders carefully to determine whether necessary support functions will remain available. FINRA has posted a resource page with links to state “shelter-in-place” and “stay-at-home” orders.49 (Updated 3/27/2020)
  • Tax Implications for Funds with Institutional Shareholders: For institutional funds with few shareholders, beware that the fund could fall into personal holding company status if at any time during the last half of the taxable year more than 50% in value of the fund’s shares are owned, directly or indirectly, by or for not more than 5 “individuals.” For purposes of this rule, employee pension trusts, private foundations, trusts forming part of a plan providing for the payment of supplemental unemployment compensation benefits, and a trust, a portion of which is permanently set aside or to be used exclusively for charitable purposes, are considered individuals. (New 3/23/2020)
  • CPO NFA Filings: The CFTC staff has provided no-action relief to commodity pool operators that extends certain filing deadlines.50 With respect to Form CPO-PQR filings under CFTC Regulation 4.27, Small and Mid-Sized CPOs had until May 15, 2020, to submit their annual filings for 2019, while Large CPOs have until July 15, 2020, to submit their filings for Q1 2020. For pool annual reports under CFTC Regulations 4.7(b)(3) or 4.22(c) that were due on or before April 30, 2020, the deadline for filing and distributing the report, which must include certified financial statements, was extended until 45 days after the due date specified in the regulations. For monthly or quarterly reports to pool participants under CFTC Regulation 4.7(b)(2) or 4.22(b) for all reporting periods ending on or before April 30, 2020, the deadline for distribution to participants was extended to 45 days after the end of the reporting period (instead of 30 days as stated in the regulations). The National Futures Association has issued similar relief for CPO Members and has provided Commodity Trading Advisor Members with similar relief for NFA Form PR filings.51 (Updated 3/23/2020)
  • Liquidity Risk Management: Current developments raise a number of issues for the management of funds’ liquidity risk:
    • Assessment, management, and periodic review of liquidity risk: Funds should review fund liquidity risk in light of current and reasonably expected market events and redemption patterns and may need to consider appropriate mitigating steps for strengthening the fund’s ability to meet redemptions, including readying borrowing and other liquidity facilities. Some fund managers may wish to consider use of the relief provided by the SEC and its staff for affiliated transactions.
    • Classification of portfolio investments: Rule 22e-4 requires funds to review their portfolio investments’ liquidity classifications more frequently than monthly if changes in relevant market, trading, and investment-specific considerations are reasonably expected to materially affect classifications. Such reviews should focus especially on holdings that could be considered illiquid investments as a result of these developments or that could fall out of highly liquid investment status. An important consideration will be a review of the reasonably anticipated trading sizes in light of redemption expectations. Funds should be alert to the possibility that vendor classifications may be based on historical rather than current data.
    • Highly liquid investment minimum: For funds that currently hold primarily highly liquid assets, and therefore are not required to have an HLIM, the program administrator may need to examine whether the fund can still qualify for that status. For HLIM funds, the HLIM may need to be reviewed under the required factors in light of current market and redemption developments and, if a shortfall is reasonably anticipated, a shortfall response plan should be developed, which must include a plan for reporting shortfalls to the fund’s board.
    • Illiquid investments: During this period of extreme market volatility, the fund should monitor closely whether there is a need to reclassify holdings as illiquid investments. Funds should be prepared to file Form N-LIQUID if the fund’s illiquid assets exceed 15% of its net assets. The program administrator should have guidance designed to prevent purchases that would violate the prohibition on acquiring illiquid investments when over the 15% limit. We do not yet know if the SEC will provide guidance relieving funds from filing Form N-LIQUID in the event of foreign or other market closings that are beyond the scope of existing guidance on extended foreign holidays.
    • Redemptions in kind: Funds may wish to consider whether redemptions in kind would be an appropriate tool for large redemption requests, including whether operational logistics are in place to accommodate any such redemption requests. (Updated 3/19/2020)
  • MiFID II Reporting: Under the MiFID II delegated regulation, investment firms providing the service of portfolio management and subject to MiFID II must inform the client where the overall value of the portfolio, as evaluated at the beginning of each reporting period, depreciates by 10% and thereafter at multiples of 10%, no later than the end of the business day in which the threshold is exceeded or, in a case where the threshold is exceeded on a non-business day, the close of the next business day.52 (New 3/19/2020)
  • Fund Boards: Fund directors should stay up to speed on current market events so they can properly apply their business judgment as necessary from a governance standpoint. In many cases, fund boards are receiving periodic status reports or attending status updates from fund advisers. Examples of areas for directors to consider include, for funds, fund flows, liquidity levels, valuation, and performance; and for fund advisers, status of operations under business continuity plans, market assessments, and the assessment of critical fund service providers. Board reporting from fund advisers is particularly important during times of market stress. To strike an appropriate balance between staying apprised and being efficient and respectful of fund advisory personnel time, boards may seek to channel questions or communications through independent counsel or the board chair/lead independent director. (New 3/19/2020)
  • Business Continuity Plans: Business continuity at the current time is key. In most cases, those plans already are in effect. Consideration should be given to contingency planning in the event that fund managers, transfer agents, pricing services, or other service providers are unable to provide services because of employee absences. Funds and fund managers should make and communicate revisions to their plans as they adjust to the developing environment.
  • Valuation: Funds should examine whether they are able to obtain valid prices for their investments, especially in markets that may be closed or have limited availability. Experience from the 2008 financial crisis shows that vendor reassurances as to the quality of their pricing information may provide false comfort, so vendor prices should be checked for reliability. At this time, we do not expect the SEC to provide relief from the daily pricing requirement.
  • Redemptions: Under Section 22(e) of the 1940 Act, open-end funds generally may not suspend the right of redemption unless the New York Stock Exchange is closed, or the SEC provides guidance that daily redemptions are not required because trading is restricted or an emergency exists. At this point, funds should assume that they must continue to provide daily redemptions. Funds should review any borrowing arrangements that may need to be utilized. We are closely monitoring for any relevant guidance from the SEC or its staff on this topic.
  • Cybersecurity: Firms are at increased risk of cyberattacks, particularly with the use of remote offices and telework. Anxious employees may be more vulnerable to email phishing attacks. Employees should be reminded of the continued need for vigilance.

Please do not hesitate to reach out to your Stradley Ronon contact, or to any member of Stradley’s Coronavirus Task Force, with any questions and concerns you may have during this period. You can reach Sara Crovitz at 202.507.6414 or scrovitz@stradley.com, or John Baker at 202.419.8413 or jbaker@stradley.com.

1 For the 1940 Act Orders, see Release No. IC-33824 (Mar. 25, 2020), https://www.sec.gov/rules/other/2020/ic-33824.pdf; Release No. IC-33817 (Mar. 13, 2020), https://www.sec.gov/rules/other/2020/ic-33817.pdf.  The various forms of relief provided in the 1940 Act Orders, which are further discussed below, are subject to conditions that are set out in the orders, such as subsequent ratification of votes, notice to the SEC of filing delays, and website disclosure of issues with the delivery of shareholder reports and prospectuses.

Release No. IC-33897 (June 19, 2020), https://www.sec.gov/rules/exorders/2020/ic-33897.pdf.

3 For the Advisers Act Orders, see IA-5469 (Mar. 25, 2020), https://www.sec.gov/rules/other/2020/ia-5469.pdf; Release No. IA-5463 (Mar. 13, 2020), https://www.sec.gov/rules/other/2020/ia-5463.pdf.

4 Using IARD, Form ADV: Item 1.F, https://www.sec.gov/divisions/investment/iard/iardfaq.shtml#item1f.

5 Release No. 34-88465(Mar. 25, 2020), https://www.sec.gov/rules/exorders/2020/34-88465.pdf; Release No. 34-88318 (Mar. 4, 2020), https://www.sec.gov/rules/other/2020/34-88318.pdf.

6 Press Release 2020-73, SEC Extends Conditional Exemptions from Reporting and Proxy Delivery Requirements for Public Companies, Funds, and Investment Advisers Affected by Coronavirus Disease 2019 (COVID-19) (Mar. 25, 2020), https://www.sec.gov/news/press-release/2020-73; Press Release 2020-63, SEC Takes Targeted Action to Assist Funds and Advisers, Permits Virtual Board Meetings and Provides Conditional Relief from Certain Filing Procedures (Mar. 13, 2020), https://www.sec.gov/news/press-release/2020-63.

7 Policy Tools:  Term Asset-Backed Securities Loan Facility, https://www.federalreserve.gov/monetarypolicy/talf.htm.

8 FAQs:  Term Asset-Backed Securities Loan Facility (June 15, 2020), https://www.newyorkfed.org/markets/term-asset-backed-securities-loan-facility/term-asset-backed-securities-loan-facility-faq.

9 Franklin Templeton Investments, SEC No-Action Letter (June 19, 2009), https://www.sec.gov/divisions/investment/noaction/2009/franklintempleton061909.htm.  Stradley Ronon acted as counsel for this no-action request.

10 Investment Company Institute, SEC No-Action Letter (May 27, 2020), https://www.sec.gov/investment/ici-sifma-052720.  The guidance on participating through a special purpose vehicle makes generally available to funds and BDCs a 2009 no-action position that originally was available only to the requesting party.  See T. Rowe Price Associates, SEC No-Action Letter (Oct. 8, 2009), https://www.sec.gov/divisions/investment/noaction/2009/troweprice100809.htm.

11 Term Asset-Backed Securities Loan Facility Rates, https://www.newyorkfed.org/markets/term-asset-backed-securities-loan-facility/term-asset-backed-securities-loan-facility-rates.

12 Press Release, Federal Reserve Board broadens program of support for the flow of credit to households and businesses by establishing a Money Market Mutual Fund Liquidity Facility (MMLF) (Mar. 18, 2020), https://www.federalreserve.gov/newsevents/pressreleases/monetary20200318a.htm.

13 Press Release, Federal Reserve Board expands its program of support for flow of credit to the economy by taking steps to enhance liquidity and functioning of crucial state and municipal money markets (Mar. 20, 2020) https://www.federalreserve.gov/newsevents/pressreleases/monetary20200320b.htm.

14 Policy Tools: Money Market Mutual Fund Liquidity Facility, https://www.federalreserve.gov/monetarypolicy/mmlf.htm.

15 Periodic Report: Update on Outstanding Lending Facilities Authorized by the Board under Section 13(3) of the Federal Reserve Act (June 9, 2020), https://www.federalreserve.gov/publications/files/pdcf-cpff-mmlf-pplf-6-10-2020.pdfsee also Periodic Report: Update on Outstanding Lending Facilities  Authorized by the Board under Section 13(3) of the Federal Reserve Act (May 23, 2020), https://www.federalreserve.gov/monetarypolicy/files/pdcf-cpff-mmlf-5-24-20.pdf; Periodic Report: Update on Outstanding Lending Facilities Authorized by the Board under Section 13(3) of the Federal Reserve Act (Apr. 23, 2020), https://www.federalreserve.gov/publications/files/pdcf-mmlf-and-cpff-4-24-20.pdf.

16 Money Market Mutual Funds Template Letter (Mar. 17, 2020), https://www.federalreserve.gov/supervisionreg/legalinterpretations/fedreserseactint20200317.pdf.

17 Investment Company Institute, SEC No-Action Letter (Mar. 19, 2020), https://www.sec.gov/investment/investment-company-institute-031920-17a.

18 H.R. 748, § 4015, 116th Cong. (2020), https://www.congress.gov/116/bills/hr748/BILLS-116hr748enr.pdf.

19 Release No. 34-88448 (Mar. 20, 2020), https://www.sec.gov/rules/exorders/2020/34-88448.pdf.

20 Release No. 34-88960 (May 27, 2020), https://www.sec.gov/rules/exorders/2020/34-88960.pdf.

21 Policy Tools: Secondary Market Corporate Credit Facility, https://www.federalreserve.gov/monetarypolicy/smccf.htm.

22 Secondary Market Corporate Credit Facility, https://www.newyorkfed.org/markets/secondary-market-corporate-credit-facility.

23 Press Release, Federal Reserve takes additional actions to provide up to $2.3 trillion in loans to support the economy (Apr. 8, 2020), https://www.federalreserve.gov/newsevents/pressreleases/monetary20200409a.htm.

24 Periodic Report: Update on Outstanding Lending Facilities  Authorized by the Board under Section 13(3) of the Federal Reserve Act (May 28, 2020), https://www.federalreserve.gov/publications/files/pmccf-smccf-talf-5-29-20.pdf.  The Federal Reserve Board is making publicly available detailed information on its transactions and holdings under the facility.  See SMCCF Transaction-specific Disclosures (May 29, 2020), https://www.federalreserve.gov/monetarypolicy/files/smccf-transition-specific-disclosures-5-29-20.xlsx.

25 Release Nos. 33-10695, IC-33646 (Sept. 25, 2019), 84 Fed. Reg. 57162, 57178 (Oct. 24, 2019), https://www.federalregister.gov/d/2019-21250.

26 Paycheck Protection Program, https://www.sba.gov/funding-programs/loans/coronavirus-relief-options/paycheck-protection-program.

27 Business Loan Program Temporary Changes; Paycheck Protection Program—Requirements—Promissory Notes, Authorizations, Affiliation, and Eligibility, 85 Fed. Reg. 23450, 23451 (Apr. 28, 2020), https://www.federalregister.gov/d/2020-09098.

28 Division of Investment Management Coronavirus (COVID-19) Response FAQs, Q&A II.4, https://www.sec.gov/investment/covid-19-response-faq.

29 SEC Division of Investment Management, Importance of Delivering Timely and Material Information to Investment Company Investors (Apr. 14, 2020), https://www.sec.gov/investment/delivering-timely-material-information.

30 As discussed above, the SEC has provided limited conditional relief from the obligation to timely deliver prospectuses to existing shareholders. See supra Delivery of Prospectuses and Shareholder Reports.

31 Division of Investment Management Coronavirus (COVID-19) Response FAQs, Q&A III.5, https://www.sec.gov/investment/covid-19-response-faq.

32 Staff Guidance for Conducting Annual Meetings in Light of COVID-19 Concerns (Apr. 7, 2020), https://www.sec.gov/ocr/staff-guidance-conducting-annual-meetings-light-covid-19-concerns.

33 Release No. IC-33837 (Apr. 8, 2020), https://www.sec.gov/rules/exorders/2020/ic-33837.pdf.

34 SEC Chairman Jay Clayton, Investors Remain Front of Mind at the SEC: Approach to Allocation of Resources, Oversight and Rulemaking; Implementation of Regulation Best Interest and Form CRS (Apr. 2, 2020), https://www.sec.gov/news/public-statement/statement-clayton-investors-rbi-form-crs.

35 OCIE, Risk Alert: Examinations that Focus on Compliance with Regulation Best Interest (Apr. 7, 2020),
https://www.sec.gov/files/Risk%20Alert-%20Regulation%20Best%20Interest%20Exams.pdf; OCIE, Risk Alert: Examinations that Focus on Compliance with Form CRS (Apr. 7, 2020), https://www.sec.gov/files/Risk%20Alert%20-%20Form%20CRS%20Exams.pdf.

36 FINRA Highlights Firm Practices from Regulation Best Interest Preparedness Reviews (Apr. 8, 2020), https://www.finra.org/rules-guidance/key-topics/regulation-best-interest/preparedness.

37 Frequently Asked Questions on Form CRS, https://www.sec.gov/investment/form-crs-faq#filing.

38 Division of Trading and Markets Staff Statement Regarding Requirements for Certain Paper Submissions in Light of COVID-19 Concerns (Apr. 2, 2020), https://www.sec.gov/tm/paper-submission-requirements-covid-19.

39 SEC Division of Corporation Finance, Statement Regarding Requirements for Form 144 Paper Filings in Light of COVID-19 Concerns (Apr. 10, 2020), https://www.sec.gov/corpfin/announcement/form-144-paper-filings-email-option.

40 IM Information Update IM-INFO-2020-03 (Apr. 8, 2020), https://www.sec.gov/files/im-info-2020-03.pdf.

41 SEC Chief Accountant Sagar Teotia, Statement on the Importance of High-Quality Financial Reporting in Light of the Significant Impacts of COVID-19 (Apr. 3, 2020), https://www.sec.gov/news/public-statement/statement-teotia-financial-reporting-covid-19-2020-04-03.

42 Investment Company Institute, SEC No-Action Letter (Mar. 26, 2020), https://www.sec.gov/investment/investment-company-institute-032620-17a.

43 Release No. IC-33821 (Mar. 23, 2020), https://www.sec.gov/rules/other/2020/ic-33821.pdf.

44 Recent interfund lending orders are available at https://www.sec.gov/rules/icreleases.shtml#interfundlending.

45 OCIE Statement on Operations and Exams – Health, Safety, Investor Protection and Continued Operations are our Priorities (Mar. 20, 2020), https://www.sec.gov/ocie/announcement/ocie-statement-operations-health-safety-investor-protection-and-continued.

46 Staff Statement Regarding Rule 302(b) of Regulation S-T in Light of COVID-19 Concerns (Mar. 24, 2020), https://www.sec.gov/corpfin/announcement/staff-statement-regarding-rule-302b-regulation-s-t-light-covid-19-concerns.

47 Frequently Asked Questions Related to Regulatory Relief Due to the Coronavirus Pandemic (Mar. 24, 2020), https://www.finra.org/rules-guidance/guidance/faqs/coronavirus. FINRA guidance, updates, and other information on COVID-19 are available at https://www.finra.org/rules-guidance/key-topics/covid-19. Other self-regulatory organizations are also providing relief and guidance. See, e.g., Cboe Regulatory Circular 20-021 (Mar. 25, 2020), http://cdn.cboe.com/resources/regulation/circulars/regulatory/RC20-021-Filing-Extensions-for-Annual-Reports-and-FOCUS-Reports.pdf; Cboe Regulatory Circular 20-022 (Mar. 25, 2020), http://cdn.cboe.com/resources/regulation/circulars/regulatory/RC20-022-Extension-of-Time-for-Certain-Filings-Currently-Due-April-1-2020.pdf.

48 Novel Coronavirus COVID-19 Updates, https://www.nasaa.org/industry-resources/covid-19-updates/.

49 State “Shelter-in-Place” and “Stay-at-Home” Orders, https://www.finra.org/rules-guidance/key-topics/covid-19/shelter-in-place.

50 Press Release No. 8136-20, CFTC Issues Third Wave of Relief to Market Participants in Response to COVID-19 (Mar. 20, 2020), https://www.cftc.gov/PressRoom/PressReleases/8136-20.

51 Notice to Members I-20-15 (Mar. 23, 2020), https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=5218.

52 European Commission Delegated Regulation art. 62, https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-2398-EN-F1-1.PDF.


Surviving Election Season: Refresher on Pay-to-Play Rules for Investment Advisers

Election season is already in full swing. As a result, investment advisers may wish to increase their attention to applicable pay-to-play compliance obligations, as further described herein.

I. Background on the Rule

In connection with political contributions, registered investment advisers, certain exempt reporting advisers and foreign private advisers (collectively referred to herein as “advisers”),1 as well as their “covered associates”2 (which is broadly defined), are subject to Rule 206(4)-5 of the Advisers Act, otherwise known as the “pay-to-play” rule. The purpose of the rule is to curtail “pay-to-play” practices by advisers seeking to manage the assets of state and local governments (e.g., public pension funds and investments by public universities) in return for political contributions. The SEC does not have to show any intent or quid pro quo to allege a violation of this anti-fraud rule. Penalties imposed by the SEC in connection with violations of the rule are severe even for foot-faults. Such penalties generally include disgorgement of any advisory fees received from such governmental entities, as well as the imposition by the SEC of civil monetary penalties (which are regularly in the hundreds of thousands of dollars).3

II. Prohibitions

     A. Ban on Fees Following Contributions

As a general matter, the rule prohibits advisers and their covered associates from making political “contributions”4 to any “official”5 of a “government entity”6 who was, at the time of the contribution, an incumbent, candidate or successful candidate for an elective office of a government entity if that office could influence the hiring of an investment adviser for such entity or have authority to appoint a person who could have such influence. If such a political contribution is made, the adviser is prohibited from receiving any compensation from advisory services to that government entity for two years thereafter – otherwise known as the “time-out” period. The adviser can still provide uncompensated advisory services to such entity during the time-out period, or provide uncompensated advisory services until the entity locates a replacement adviser. Note that an adviser to a “covered investment pool”7 in which a government entity invests or is solicited to invest shall be treated as though that adviser was providing or seeking to provide investment advisory services directly to the entity.

     B. Ban on Using Third Parties to Solicit Government Business

The rule further prohibits an adviser from providing payment8 to (or agreeing to pay), directly or indirectly, any person to solicit9 a government entity for advisory services on behalf of the adviser. However, such solicitation is not prohibited if the person is a (1) “regulated person”10 (such as a registered investment adviser, broker-dealer or municipal adviser) or an (2) executive officer, general partner, managing member, similar person or employee of the adviser. The rule also prohibits an adviser from coordinating or soliciting a person or PAC to: (1) contribute to an official of a government entity to which the adviser provides or seeks to provide advisory services or (2) make a payment to a political party of a state or locality in which the adviser provides or seeks to provide advisory services to a government entity.

     C. Catchall Ban

As a sort of catchall provision, the rule prohibits any acts done indirectly which, if done directly, would violate the rule. For example, the SEC staff has indicated that while a covered associate’s contribution to a PAC generally would not trigger the two-year time-out, if the contribution is earmarked or known to be provided for the benefit of a particular political official, it would implicate the catchall provision because the covered associate would be doing indirectly what it could not do directly.11

III. Exceptions and Exemptions from the Rule

     A. Exception for Certain New Covered Associates

Whereas the rule requires a two-year look-back for all covered associates who solicit clients, it only requires a six-month look-back for “new” covered associates who do not solicit clients. The “look-back” period will follow covered associates that change advisers, such that a prohibited contribution by a covered associate will result in a “time out” for the covered associate’s new firm for the remainder of the two-year or six-month period, depending on whether the covered associate solicits clients for the new firm. To prevent advisers from channeling contributions through departing covered persons, if a covered person makes a prohibited contribution and then leaves the employ of that adviser, the former adviser will also still be subject to the two-year time-out period, despite the departure of the covered associate who made the contribution.

     B. De Minimis Exception

The primary exception to the pay-to-play rule is the de minimis exception. The de minimis exception allows an adviser’s covered associate that is a natural person to contribute: (1) up to $350 to an official per election (with primary and general elections counting separately) if the covered associate is entitled to vote for the official at the time of the contribution; and (2) up to $150 to an official per election (with primary and general elections counting separately) if the covered associate is not entitled to vote for the official at the time of the contribution. Most firms implement pre-clearance requirements in connection with covered person political contributions in order to ensure compliance with this exception. Any contribution above such de minimis amounts, no matter how small, can trigger a violation of the rule.

     C. Returned Contribution Exception

If a covered associate makes a contribution that triggers the two-year time-out period solely because he or she was not entitled to vote for the official at the time of the contribution, the adviser can undo the contribution under very narrow circumstances. To be eligible for the returned contribution exception, the contribution had to be less than $350, the adviser must have discovered the contribution within four months of the date of such contribution, and the adviser must cause the contributor to re-collect the contribution within 60 days after the adviser discovers the contribution. However, an adviser can only rely on the returned contribution exception on limited occasions (for advisers with fewer than 50 employees, twice in a 12-month period; for advisers with more than 50 employees, three times in a 12-month period), and an adviser can never use the returned contribution exception for the same covered associate twice. Again, this exception is only applicable if the violation is discovered and remedied on a timely basis.

     D. Request for Exemptive Relief

In extremely narrow circumstances, the rule also allows an adviser to apply for an order exempting it from the two-year time­out requirement in the event of an inadvertent violation that falls outside of the exceptions set forth above. The SEC will grant orders only when, according to the SEC, the imposition of the time-out provision is unnecessary to achieve the rule’s intended purpose.12 Advisers applying for an order must do so through an application process that exposes the firm and the covered associate to public scrutiny.

IV. Recordkeeping Requirements

As part of their recordkeeping requirements under the pay-to-play rule, advisers must collect and maintain:

  • the names, titles and business and residence addresses of all covered associates;
  • all government entities to which the adviser provides or has provided investment advisory services, or which have been investors in any covered investment pool to which the adviser provides or has provided investment advisory services, in the last five years;
  • all direct and indirect contributions made by the adviser or its covered associates to an official of a government entity or direct or indirect payments made to a political party or PAC; and
  • the name and business address of each regulated person to which the adviser agrees to provide direct or indirect payment to solicit a government entity.

V. Summary

If an investment adviser would like to remain eligible to bid for government contracts, it should take affirmative steps to ensure that the firm and its covered persons do not violate the pay-to-play rule. Robust pay-to-play policies and procedures, as well as pre-clearance of political contributions, are recommended best practices for advisers that seek government clients. Re-education of adviser personnel and covered associates as to the requirements of the rule, especially in light of the upcoming election season, is also advised.13 An adviser should also consider pre-screening new covered person candidates for the applicability of the rule. Finally, it may be helpful to conduct periodic checks of campaign contribution databases, as well as require quarterly pay-to-play compliance reporting. The SEC may bring enforcement actions for even minor foot-fault violations of the rule. Such cases generally result in disgorgement and fines. Compliance with the relevant recordkeeping obligations is also important, as the SEC regularly reviews pay-to-play recordkeeping as part of adviser exams.

The rule applies to all investment advisers registered (or required to be registered) with the Securities and Exchange Commission (SEC), or unregistered in reliance on the exemption available under section 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act) (15 U.S.C. 80b-3(b)(3)), or that is an exempt reporting adviser, as defined in section 275.204-4(a) – which includes venture capital fund advisers and private fund advisers.

A “covered associate” broadly includes (1) a general partner, managing member, executive officer or other individual with a similar status or function; (2) any employee who solicits a governmental entity for the adviser (and any person who supervises, directly or indirectly, such an employee); or (3) a political action committee (PAC) controlled by the adviser or by any of its covered associates.

3 See e.g., In the Matter of Ancora Advisors LLC, SEC Administrative Proceeding File No. 3-18937 (Dec. 18. 2018), found here.

4 The definition of “contribution” is broad and encompasses any gift, subscription, loan, advance or deposit of money or anything of value made for (1) the purpose of influencing any election for federal, state or local office; (2) payment of debt incurred in connection with any such election; or (3) transition or inaugural expenses of the successful candidate for state or local office.

5 An “official” means any person (including any election committee for the person) who was, at the time of the contribution, an incumbent, candidate or successful candidate for elective office of a government entity, if the office: (1) is directly or indirectly responsible for, or can influence the outcome of, the hiring of an adviser by a government entity; or (2) has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity.

A “government entity” means any state or a political subdivision of a state, including: (1) any agency, authority or instrumentality of the state or a political subdivision, (2) a pool of assets sponsored or established by the state or political subdivision or any agency, authority or instrumentality thereof, including, but not limited to a “defined benefit plan” as defined in section 414(j) of the Internal Revenue Code (26 U.S.C. 414(j)), or a state general fund; (3) a plan or program of a government entity; and (4) officers, agents, or employees of the state or political subdivision or any agency, authority or instrumentality thereof, acting in their official capacity.

7 “Covered investment pool” means: (1) an investment company registered under the Investment Company Act of 1940 (Investment Company Act) that is an investment option of a plan or program of a government entity; or (2) any company that would be an investment company under section 3(a) of the Investment Company Act, but for the exclusion provided from that definition by either section 3(c)(1), 3(c)(7) or 3(c)(11) of that Act.

8  “Payment” means any gift, subscription, loan, advance, or deposit of money or anything of value.

9  “Solicit” means: (1) with respect to investment advisory services, to communicate, directly or indirectly, for the purpose of obtaining or retaining a client for, or referring a client to, an adviser; and (2) with respect to a contribution or payment, to communicate, directly or indirectly, for the purpose of obtaining or arranging a contribution or payment.

10 “Regulated person” means: (1) a registered investment adviser that has not (and whose covered persons have not) made, coordinated or solicited a contribution within the last two years that would violate the rule; (2) a broker-dealer that is a member of a registered national securities association, so long as such association’s rules prohibit members from engaging in distribution or solicitation activities after making political contributions and the SEC finds, by order, that such rules are at least substantially equivalent to the restrictions imposed on advisers under the rule; and (3) municipal advisors registered under section 15B of the Securities Exchange Act of 1933 and subject to pay to play rules adopted by the Municipal Securities Rulemaking Board (MSRB), provided that the MSRB rules: A) impose substantially equivalent or more stringent restrictions on municipal advisors than the pay to play rule imposes on investment advisers and B) are consistent with the objectives of the pay to play rule.

11 Staff Responses to Questions about the Pay to Play Rule.

12 The rule outlines a number of factors that the SEC will consider, including an assessment of the adviser’s compliance environment, the nature of the contribution and the covered associate’s intent in making the contribution. Since the rule’s adoption, the SEC has granted 16 exemptive orders. See e.g. In the Matter of D.B. Fitzpatrick & Co., Inc., Investment Advisers Act Release No. 5496 (May 5, 2020) (order), found here; D.B. Fitzpatrick & Co., Inc., Investment Advisers Act Release No. 5475 (Apr. 9, 2020) (notice of application), found here; In the Matter of D.B. Fitzpatrick & Co., Inc., File No. 803-253 (Apr. 9, 2020) (application), found here.

13 For example, even though the rule applies to advisers seeking to influence state and local entities and not federal entities, if a state office holder that has influence over the selection of investment advisers, which could include a sitting state governor, were to be nominated as a Vice Presidential running mate, contributions to that ticket could implicate the rule.

Nicole Kalajian
Aliza Dominey
Sara Crovitz