Client Alert
SEC Settles with ETF Investment Adviser for Causing 1940 Act Violations
share this page
The U.S. Securities and Exchange Commission (SEC) on July 27 announced settled charges against Simplify Asset Management Inc., an investment adviser to exchange-traded funds (ETFs), for causing certain violations of the Investment Company Act of 1940 (the 1940 Act) and rules under the 1940 Act related to affiliated transactions, leveraged investments, disclosures regarding the tax characterization of dividends distributed to shareholders, and fund compliance.[1] To resolve the matter, Simplify agreed to cease and desist from committing or causing further violations and to pay a civil penalty of $400,000.
Although the SEC has brought enforcement actions involving ETF managers before, this action is unique for its focus on Simplify’s causing violations of several disparate provisions of the 1940 Act by an affiliated trust and certain of Simplify’s advised funds. Perhaps most notably, it appears to be the SEC’s first enforcement action involving compliance with Rule 18f-4 under the 1940 Act.
Affiliated Transactions
First, the Order alleges that Simplify caused a trust to engage in two prohibited affiliated transactions in February and June 2023 with an ETF managed by Simplify by recommending and facilitating the trust’s transfer of shares of equity securities in exchange for shares of that ETF. Section 17(a)(1) of the 1940 Act prohibits “any affiliated person … of … a registered investment company … or any affiliated person of such a person … acting as principal” from “knowingly [] sell[ing] any security or other property to such registered company” subject to meeting certain conditions or obtaining exemptive relief from the SEC.[2]
In connection with the launch of the Simplify Propel Opportunities ETF (SURI), Simplify represented to the ETF’s board of trustees that SURI would be seeded by a trust through an in-kind transfer of securities. Simplify also represented that the trust was not an affiliate of SURI, but did not share the basis for that conclusion with the board. The Order states that the trust owned an approximately 25% fully diluted equity interest in Simplify and was therefore an affiliate of Simplify due to its ownership stake and a second-tier affiliate of the ETF because Simplify served as the ETF’s investment adviser. The trust subsequently engaged in the seed transaction with SURI, as well as an additional in-kind purchase of SURI shares that Simplify had also presented to the board. Both transactions provided the trust with certain tax benefits. The Order finds that the transactions violated Section 17(a)(1) and that Simplify caused the trust’s violations.
Leverage Thresholds
Second, the Order alleges that in April and May of 2024, Simplify caused the Simplify Macro Strategy ETF (FIG) to fail to comply with the conditions of Rule 18f-4 under the 1940 Act after FIG exceeded the rule’s permissible leverage-risk threshold. As a result, FIG was unable to rely on the rule’s exemption from the restrictions on borrowing “senior securities” in Section 18(f)(1) of the 1940 Act.
Among other things, Rule 18f-4 requires certain funds that use derivatives to implement a derivatives risk management program (DRMP) and comply with an outer limit on fund leverage risk based on a value-at-risk (VaR) test. VaR is an estimate of the potential losses, expressed as a percentage of the value of the portfolio’s assets, over a given time and at a specified confidence level. Funds must generally use the relative VaR test to determine compliance with the rule.
Under the relative VaR test, as applicable, the VaR of a fund’s portfolio must not exceed 200% of the VaR of a designated reference portfolio.[3] A fund must determine its compliance with its VaR test at least once each business day.[4] A fund that exceeds its VaR test “must come back into compliance promptly after such determination, in a manner that is in the best interests of the fund and its shareholders."[5]
If a fund remains out of compliance with its VaR test for five business days, its derivatives risk manager (DRM) must submit a written report to the fund’s board of trustees to explain how and by when the DRM reasonably expects the fund to come back into compliance.[6] Within 30 calendar days of the initial report, the DRM must submit a second written report to the board explaining how the fund returned to compliance or, if the fund remains out of compliance, updating the board regarding the fund’s progress toward compliance.[7] Finally, the DRM must analyze the circumstances that caused the fund to remain out of compliance for more than five business days and update any elements of the DRMP as appropriate to address those circumstances.[8]
During two separate time periods in April and May 2024, FIG exceeded its 200% VaR limit for five business days or more as a result of certain derivatives investments. FIG’s DRM did not notify FIG’s board of the VaR exceedances until August 8, 2024, however, and did not provide the board with the required written report until August 23, 2024. The written report also did not discuss the specific updates that were planned with respect to the DRMP to address the circumstances surrounding the exceedances.
In addition, Rule 18f-4(c)(7) and Rule 30b1-10 under the 1940 Act required FIG to report each exceedance to the SEC on Form N-RN within one business day of its occurrence, but FIG did not file Forms N-RN disclosing the exceedances until August 9, 2024. As a result, the Order finds that Simplify caused FIG to violate Section 18(f)(1) of the 1940 Act and Rule 30b1-10.
Distribution Source Disclosure
Third, the Order alleges that between July 2021 and June 2024, Simplify caused seven ETFs that it managed (Simplify ETFs) to fail to provide disclosure to investors that a portion of the dividends that were distributed to them constituted a return of capital rather than income, as required by Section 19(a) of the 1940 Act and Rule 19a-1 thereunder.
Section 19(a) prohibits funds from making distributions or paying dividends from any source other than the fund’s accumulated undistributed net income or the fund’s net income “unless such payment is accompanied by a written statement which adequately discloses the source or sources of such payment.”[9] Rule 19a-1 prescribes the format and content requirements of the written statement that accompanies those payments.[10]
The SEC found that for several years, the Simplify ETFs made periodic distributions that were not from the net income of the ETFs, but that were instead a return of capital. Although the financial statements of the ETFs correctly reflected that the ETFs made distributions from return of capital at the end of the fiscal year, Simplify, on behalf of those funds, failed to provide the required contemporaneous notices to shareholders at the time of the distributions in violation of Section 19(a) and Rule 19a-1.
Policies and Procedures
Finally, the Order alleges that Simplify’s personnel played a significant role in adopting and implementing the policies and procedures of SURI, FIG and other Simplify ETFs, and that Simplify caused the funds to violate Rule 38a-1.
Among other things, 1940 Act Rule 6c-11 requires registered investment companies to establish policies and procedures tailored to the type of transactions they undertake with an authorized participant, including those governing the construction of baskets and the process that will be used for the acceptance of baskets. Such policies and procedures must include detailed parameters governing “custom baskets” — those with a non-representative selection of an ETF’s portfolio holdings — and the process for any revisions to, or deviations from, such parameters.
Until June 2026, SURI’s policies and procedures did not address the use of custom baskets that contained securities that were not held in SURI’s portfolio (like the one used in its June 2023 transaction with the trust affiliate of Simplify). Nor did SURI’s policies and procedures identify any process for deviating from the parameters related to custom baskets that they did contain. SURI incorrectly documented the custom basket used in the June 2023 transaction as a “rebalance” basket. In addition, SURI, FIG and the other Simplify ETFs engaged in similar transactions using custom baskets that deviated from those permitted in their policies and procedures while lacking any process for such deviations.
SURI and the other six Simplify ETFs also did not adopt or implement any policies and procedures concerning Section 19(a) of the 1940 Act and Rule 19a-1 notices to shareholders until August 2024.
Key Insights
Affiliated Transactions
While affiliated transactions have long been an area of regulatory interest for the SEC, the action reflects SEC focus on in-kind transfers of securities to ETFs, including in connection with initial seeding transactions. Fund managers should continue to carefully identify affiliates and second-tier affiliates of an ETF and to monitor transactions between the ETF and those affiliates to ensure that any such transactions are conducted pursuant to Section 17(a)(1) or relevant regulatory relief from the SEC or SEC staff. In particular, ETF managers should carefully review seeding arrangements when launching new ETFs.
Leverage Thresholds
This action appears to be the first to allege violations of Section 18(f)(1) after a failure to comply with Rule 18f-4 and, as a result, provides an important indication of the SEC’s expectations regarding the rule’s requirements. The Order demonstrates that identifying and monitoring a VaR exceedance is not, by itself, enough. The SEC believes fund complexes must also have effective escalation procedures and practices in place to ensure that reportable exceedances are timely reported to a fund’s board and the SEC, and that the circumstances surrounding the exceedance are analyzed and addressed through appropriate updates to the DRMP.
The action is particularly relevant to advisers of funds that employ derivatives-intensive, leveraged or hedging strategies, including single-stock leveraged and inverse ETFs and other funds whose derivatives positions may produce significant or rapidly changing leverage exposure. Such advisers should consider whether their escalation and reporting processes operate effectively in practice, including whether responsibilities are clearly allocated among the DRM, portfolio management, and legal and compliance personnel, and whether required board and SEC reporting can occur promptly upon a VaR exceedance. Boards may wish to confirm that a fund’s processes, both as written and in practice, are designed to bring sustained VaR exceedances promptly to the attention of the board with enough information to understand the cause and remediation of the issue and any resulting changes to the DRMP.
Distribution Source Disclosure
Income-producing and/or tax-managed strategies have increased in popularity. Fund managers should review tax disclosures in fund registration statements to ensure that the disclosures accurately reflect the various tax outcomes that may result from fund distributions. Additionally, because a fund calculates its actual taxable income and capital gains at the end of the fund’s tax year but delivers notices at the time that the fund’s distributions are made, fund managers should carefully monitor the fund’s distributions throughout the year and ensure that related notices adequately disclose the nature of those distributions.
Policies and Procedures
Although it continues to appear unlikely that the Atkins SEC will bring a standalone action for violations of Rule 38a-1 absent egregious circumstances, this action provides a recent example of the SEC’s continued interest in alleging violations of the rule alongside other substantive provisions of the federal securities laws, especially when an identified inadequacy in the policies and procedures arguably contributed to an alleged violation of one or more of those other substantive provisions.
[1] In re Simplify Asset Management, Investment Company Act Release No. 36269 (July 27, 2026) (Order).
[2] Section 17(a)(1), 1940 Act.
[3] Rule 18f-4(a).
[4] Rule 18f-4(c)(2)(ii).
[5] Id.
[6] Rule 18f-4(c)(2)(iii).
[7] Id.
[8] Id.
[9] Section 19(a), 1940 Act.
[10] Rule 19a-1.
