Fiscal Year 2021 Highlights
The SEC highlighted some key metrics from the prior fiscal year. In FY 2021, the Division completed 3,040 examinations, which represent a 3% increase from the prior year, and is on par with prepandemic fiscal year 2019. The Division examined approximately 16% of registered investment advisers (RIAs). Approximately 70% (specifically, 2,100) of all examinations resulted in deficiency letters, and approximately 6% (specifically 190) resulted in referrals to the Division of Enforcement for investigation.
Importance of Compliance Programs
The Division highlighted the importance of registrants’ improving and promoting compliance at the firms, including compliance engagement across business lines; knowledgeable chief compliance officers; commitment to compliance by firms’ principals; and resiliency of compliance programs to withstand changes in market conditions, investor demand, key personnel, services, and lines of business.
Private Fund, ESG Investing, Retail Investors, Cybersecurity, Fintech, and Digital Assets
The Division highlighted these topics as top priorities and indicated that examinations on these topics will focus on the following issues:
- Private Funds: Priorities echo many of the areas of focus in the SEC’s recent proposal relating to private funds2 as well as the recent comprehensive proposal with respect to special purpose acquisition companies (SPACs).3 Priorities include advisers’ exercise of their fiduciary duty; calculation and allocation of fees and expenses, including the calculation of post-commitment period management fees and the impact of valuation practices; custody and fund audits; valuation; conflicts of interest; controls around material nonpublic information; preferential treatment of certain investors around liquidity; disclosure and compliance around cross-trades, principal transactions, or distressed sales; conflicts around liquidity, including fund-adviser-led restructurings and stapled secondary transactions; investments in SPACs; risk management and trading for private funds with indicia of systemic importance; and conflicts and disclosures related to private fund investment in SPACs and advisers acting as SPAC sponsors.
- ESG Investing: registered funds, private offerings, and RIAs’ ESG disclosures concerning ESG investing approaches; adoption and implementation of policies, procedures, and practices in connection with such disclosures; voting client securities in accordance with proxy voting policies and procedures; and greenwashing.
- Retail Investors: how registrants are satisfying their obligations under Regulation Best Interest (Regulation BI) and the Advisers Act fiduciary standard to act in the best interests of retail investors; assessments of practices regarding consideration of investment alternatives, and management of conflicts of interest, trading, disclosures, account selection, and account conversions and rollovers. Broker-dealer examinations will review firms’ recommendations related to SPACs, structured and other enumerated products. RIA examinations will focus on revenue sharing arrangements, share class selection, and recommendations of wrap fee accounts and proprietary products.
- Information Security and Operational Resiliency: whether firms have taken appropriate measures to safeguard customer accounts and prevent account intrusions, oversee vendors and service providers, address malicious email activities, respond to incidents, identify and detect red flags related to identity theft, manage operational risk as a result of a dispersed workforce; and registrants’ business continuity and disaster recovery plans, including with respect to the impact of climate risk and substantial disruptions to normal business operations.
- Emerging Technologies and Crypto-Assets: priorities are consistent with the Division’s recent focus on robo-advisers4 and crypto assets.5 Priorities include risks associated with firms’ use of emerging financial technologies and whether their compliance programs consider and address those risks; firms offerings new products and services or employing new practices (e.g., fractional shares, “finfluencers,” or digital engagement practices); and whether operations and controls in place are consistent with disclosures made and advice and recommendations are consistent with investors’ investment strategies; custody arrangements for crypto-assets; and the offer, sale, recommendation, advice, and trading of crypto-assets.
Investment Advisers and Investment Companies
The Division’s focus in this space is largely on perennial issues. RIA examinations will focus on marketing practices; custody; valuation; advisory fee calculations; portfolio management; brokerage and execution; conflicts of interest and related disclosures; whether compliance programs focus on investment advice and the standard of conduct, oversight of service providers, and compliance resources; whether compliance programs have addressed heightened risks, including employing individuals with disciplinary history; shift from broker-dealer business model to advised accounts; and operating from multiple branch offices.
Examination of registered funds will focus on disclosures; accuracy of reporting to the SEC; compliance with the new rules and exemptive orders; liquidity risk certain fund practices, including advisory fee waivers and trading practice of portfolio managers that may be designed to inflate fund performance. The Division will prioritize certain types of registered funds including exchange-traded funds, money market funds, and business development companies. The Division’s focus also will include mutual funds that invest in private funds, advisory fee waivers, and trading activities of portfolio managers that may be designed to inflate fund performance.
Broker-Dealer and Exchange Examination Program
Microcap, Municipal, Fixed Income, and Over-the-Counter Securities. The Division continues to prioritize examinations of broker-dealers for compliance in the offer, sale, and distribution of microcap securities, focusing on transfer agent handling of microcap distributions and share transfers, sales practices and consistency with Regulation BI, and compliance with regulatory requirements, including penny stock disclosure rules and certain anti-money-laundering (AML) obligations.
Examination of broker-dealers, underwriters, and municipal advisors also will focus on timely and accurate municipal issuer disclosure. Examination of broker-dealer trading activity in fixed-income securities will focus on sales practices; best execution obligations; fairness of pricing, markups, markdowns, and commissions; and confirmation disclosure requirements. The Division’s focus on products and services also will include whether broker-dealers recommending the sale of over-the-counter securities are complying with Regulation BI and Exchange Act Rule 15c2-11.
Broker-Dealer Operations. The Division highlighted the responsibility of broker-dealers who hold customer cash and securities to comply with the Customer Protection Rule and Net Capital Rule, with a focus on adequacy of internal processes, procedures, and controls; compliance with requirements for borrowing fully paid and excess margin securities from customers; and funding and liquidity risk management practices, with an eye toward the management of stress events.
Examinations of broker-dealer trading practices will focus on compliance with best execution obligations; Exchange Act Rule 606 order routing disclosure rules; large trader reporting obligations; and compliance with Regulation SHO. For alternative trading systems, the Division will pay particular attention to the consistency of disclosures provided in Form ATS-N, as provided within Regulation ATS.
Security-Based Swap Dealers (SBSDs). The Division’s initial examinations of newly registered SBSDs (i.e., registered by the October 6, 2021, compliance date) will focus on policies and procedures related to compliance with the security-based swap rules generally, including trade acknowledgement and verification, recordkeeping and reporting, and risk management requirements.
Municipal Advisers. Examination of municipal advisors will focus on whether they have met their fiduciary duty and conflict disclosure obligations to municipal entity clients, as well as registration, professional qualification, continuing education, and supervision requirements.
Transfer Agents. The Division will examinate transfer agents who have not previously been examined and those that service microcap or municipal bond issuers, use novel technologies such as blockchain or online crowdfunding portal applications, or engage in significant paying agent activity. The examination will focus on the transfer agent’s core functions, including the timely turnaround of items and transfers, recordkeeping and record retention, safeguarding of funds and securities, and filing obligations with the SEC.
Clearance and Settlement Examination Program
As required by Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Division will conduct at least one risk-based examination of each clearing agency designated as systemically important and for which the SEC serves as the supervisory agency, focusing on core risks, processes, controls, the nature of operations, and financial and operational risk. EXAMS will also conduct risk-based examinations of registered clearing agencies that have not been designated as systemically important. Both categories will be examined for compliance with the SEC Standards for Covered Clearing Agencies.
For SEC-registered clearing agencies, the Division will examine whether the risk-management frameworks comply with the Exchange Act, the adequacy and timeliness of their remediation of prior deficiencies, and other risk areas including margin, counterparty credit risk, disclosure framework, governance, recovery and wind-down, default management, liquidity risk management, and project management.
Regulation Systems Compliance and Integrity (SCI)
Examination of SCI entities will focus on the use of third-party network infrastructure services to support critical functions and the policies and procedures put into place regarding a return-to or continued hybridization of the workplace caused by the COVID-19 pandemic. The Division will also focus on whether the policies and procedures relating to incident responses as well as identification and mitigation of software supply chain risks are reasonably designed.
1 “2022 Examination Priorities,” available here.
2 “Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews,” available here. For a discussion of the SEC’s private fund proposals, see Sidley Investment Funds Update “SEC Proposes Significant Changes for Advisers and Private Funds,” available here.
3 Special Purpose Acquisition Companies, Shell Companies, and Projections, available here. See also Sidley Investment Funds Update, Expansive New SEC Rule Proposals Seek to Rewrite the SPAC Playbook, available here.
4 See Observations from Examinations of Advisers that Provide Electronic Investment Advice, available here. See also Sidley Investment Funds Update, SEC Identifies Deficiencies From its Electronic Investment Advice Initiative, available here.
5 See The Division of Examinations’ Continued Focus on Digital Asset Securities, available here. See also Sidley Investment Funds Update, SEC’s Division of Examinations Publishes Risk Alert and Compliance Guidance for Digital Asset Securities Activities, available here.
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