On October 16, 2023, the U.S. Securities and Exchange Commission (SEC) Division of Examinations (EXAMS or Division) issued its annual examination priorities, which, for the first time, was published at the start of the SEC’s fiscal year to “better inform investors and registrants of key risks, trends, and examination topics” the Division intends to focus on in the coming year.1
The October 16 publication of the priorities represents the earliest publication to date in the 10-year history of the publication of examination priorities, which will help registrants better prepare for upcoming exams. EXAMS acknowledged that the short time period since publication of the 2023 priorities, only eight months ago2, means that “several initiatives and focus areas from last year remain” priorities for 2024. Against that backdrop, the Division focused on the need to demonstrate compliance with all of its new regulations, and we note that many of the areas of examination priorities also align with areas in which additional or amended regulations have been proposed or may be under consideration.
The priorities for the upcoming year underscore that investment advisers are fiduciaries and, therefore, EXAMS will focus on the identification and disclosure of conflicts of interest. Broker-dealers are especially reminded of their obligations under Regulation Best Interest (Reg BI). While EXAMS has focused for several years on duties owed to clients and investors, the fact that next year’s priorities lead with a discussion of EXAMS’ focus on duties owed to clients and investors suggests that registrants should expect even greater focus on this aspect of an examination. Further, as demonstrated by recent enforcement actions for marketing rule and custody rule violations, the SEC staff is providing little, if any, “grace period” for the implementation of new rules; that is, rather than giving registrants an opportunity to correct deficiencies, the SEC is proceeding (at least in some cases) directly to enforcement.3 For both investment advisers and broker-dealers, the Division is also focused on complex, costly, and illiquid products, such as derivatives, leveraged exchange traded funds (ETFs), variable annuities, and nontraded real estate investment trusts (REITs).
In addition, the Division highlighted its general focus on crypto assets and new technology, the need for security, resilience, and systems integrity for registrants and markets, and anti-money-laundering (AML) for broker-dealers and other financial institutions, specifically including compliance with Office of Foreign Asset Control (OFAC) sanctions (including for advisers). Notably missing from the specifically identified risk areas were environmental, social, and governance (ESG)–related issues.
This Sidley Update provides a summary of upcoming examination priorities and perennial issues registrants can anticipate in this year’s examinations. Based on the full scope of EXAMS priorities, registrants should note the following themes for 2024:
i) The Division’s core priorities remain the same as in prior years.
ii) Registrants should be ready to show how they have implemented compliance controls for new rules.
iii) ESG remains a challenging area to both regulate and examine, with ESG not only slipping down, but off, the priority list (although registrants should continue to be mindful of the overlap between the Division’s priorities and ESG-related products and services).
Examining all advisers’ adherence to their duty of care and duty of loyalty obligations remains a key priority. Specifically, EXAMS will focus on
- investment advice provided to clients with regard to products, investment strategies, and account types, particularly with respect to complex products (e.g., derivatives and ETFs), high-cost and illiquid products (e.g., variable annuities and nontraded REITs), and unconventional strategies
- processes for determining that investment advice is in the client’s best interest, including how advisers address conflicts of interest
- advisers’ economic incentives, including with respect to recommendations, revenue sharing, and conflicts of interest for advisers that are dually registered as broker-dealers; use of affiliated firms to perform client services; and having financial professionals service both brokerage and advisory clients
- adequacy of conflicts-of-interest disclosure
The Division remains focused on advisers’ compliance programs, including whether their policies and procedures reflect the various aspects of the advisers’ business, compensation structure, services, client base, and operations and address applicable current market risks.
The Division identifies other particular areas of examination focus:
- marketing practice assessments such as whether advisers have adopted and implemented reasonably designed written policies and procedures to prevent violations of the marketing rule4, Form ADV disclosures, and substantiation of processes and other required books and records
- compensation arrangements, with a focus on fiduciary obligations, alternative ways to maximize revenue, and fee breakpoint calculations
- valuation assessments regarding advisers’ recommendations to clients to invest in illiquid or difficult-to-value assets
- safeguarding assessments for advisers’ controls to protect clients’ material nonpublic information
- disclosure assessments to review the accuracy and completeness of regulatory filings, including Form CRS
As in prior years, the Division plans to prioritize examinations of advisers that have never been examined (NBEs), including those recently registered, and those that have not been examined in a number of years.
Private Fund Advisers
For private fund advisers, in addition to the topics above, EXAMS will prioritize specific topics, such as
- portfolio management risks when there is exposure to market volatility and higher interest rates
- adherence to contractual requirements regarding limited partnership advisory committees or similar structures
- accurate calculation and allocation of private fund fees and expenses
- due diligence practices, with a specific focus on private equity and venture capital fund advisers’ assessments of prospective portfolio companies
- conflicts disclosures with a specific attention to private funds managed side by side with registered investment companies and the use of affiliated service providers
- custody rule compliance including Form ADV reporting and timely completion of private fund audits
- policies and procedures for reporting on Form PF
Many of EXAMS’ priorities for registered advisers align with areas of recent rulemaking activity, including the Private Funds Rules5, Marketing Rule6, and Form PF amendments7.
The Division will prioritize examinations of registered investment companies, including mutual funds and ETFs. Such examinations routinely include assessing compliance programs and fund governance practices, disclosures, and accuracy of reporting as well as company valuation practices.
EXAMS identified certain focus areas, including
- reviewing fees and expenses, including whether companies have adopted effective written compliance policies and review of the boards’ approval of advisory contract and registered investment company fees, and with a particular focus on
- charging different advisory fees to different share classes
- identical strategies offered by the same sponsor through different distribution channels but with differing fee structures
- high advisory fees relative to peers
- high registered investment company fees and expenses, particularly those of registered investment companies with weaker performance relative to their peers
- derivatives risk management assessments and related policies and procedures
EXAMS also plans to review for compliance with the terms of exemptive order conditions and issues associated with market volatility. As with the adviser examinations, the Division plans to prioritize examinations of investment companies that have never been examined and those that have not been examined in a number of years.
Reg BI and Form CRS8
The Division remains focused on Reg BI. EXAMS identified areas of particular interest as
- recommendations with regard to products, investment strategies, and account types
- disclosures made to investors regarding conflicts of interest
- conflict mitigation practices
- processes for reviewing reasonably available alternatives
- factors considered in light of the investor’s investment profile, including investment goals and account characteristics
EXAMS will also focus on
- certain recommended products, including those discussed above for investment advisers, as well as other complex, high-cost, illiquid, proprietary, or microcap securities
- evaluation of written compliance policies and procedures
- firms’ conflicts of interest, account allocation practices, and account selection practices
- the content of a broker-dealer’s relationship summary, including the relationships and services that it offers to retail customers, fees and costs, conflicts of interest, and disciplinary history disclosures
- whether broker-dealers have met their obligations to file Form CRS with the SEC and deliver it to retail customers
The Division also plans to focus on dual registrants, examining such firms’ conflicts of interest, account allocation practices, and account selection practices as well as assessment of supervision of branch office locations.
Broker-Dealer Financial Responsibility Rules and Trading Practices
EXAMS will focus on broker-dealer compliance with the SEC’s Net Capital Rule (Rule 15c3-1) and its Customer Protection Rule (Rule 15c3-3) as well as related internal processes, procedures, and controls. Areas of focus include
- fully paid securities lending programs (presumably with customers and thus subject to Rule 15c3-3(b)(3)), a topic that the SEC staff raised with the industry in an October 2020 letter9
- accounting for types of liabilities such as rewards or points programs
- risk management controls to assess whether firms have sufficient liquidity to manage stress events
The Division will cover broker-dealer equity and fixed-income trading practices. In particular, EXAMS will review compliance with Regulation SHO, Regulation ATS10, and Exchange Act Rule 15c2-1111. With respect to wholesale market makers, examinations may include quote generation, order routing and execution, market data integration, regulatory controls, and risk management.
As required by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Division will conduct at least one annual 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 an assessment of financial and operational risk. The Division will also conduct risk-based examinations of registered clearing agencies that have not been designated as systemically important. Both categories of registered clearing agencies will be examined for compliance with the SEC’s Standards for Covered Clearing Agencies.
Other Market Participants
The Division will continue to focus examinations of municipal advisors on whether they have met their fiduciary duty obligations to municipal entity clients. In the second half of the year, the Division will also focus compliance with new MSRB Rule G-42, which becomes effective on March 1, 2024, and establishes the core standards of conduct for solicitor municipal advisors. The Division will continue to focus on conflicts of interest disclosure and relationship documentation, registration, professional qualification, continuing education, recordkeeping, and supervision requirements.
Security-Based Swap Dealers (SBSDs)
The Division will continue to focus examinations on whether SBSDs have implemented policies and procedures related to compliance with security-based swap rules generally and whether SBSDs are meeting their reporting obligations under Regulation SBSR. EXAMS will also focus on compliance with applicable capital, margin, and segregation requirements as well as relevant conditions in SEC orders governing substituted compliance and presumably could encompass FINRA margin rules relating to security-based swaps.
Examinations of transfer agents will continue to focus on processing of items and transfers, recordkeeping and record retention, safeguarding of funds and securities, and filings with the SEC. Transfer agents that use emerging technology to perform core functions and those that service certain types of issuers, including microcap and crypto assets, will remain a focus for the Division.
Risks Areas Affecting All Market Participants
Information Security and Operational Resiliency
Cybersecurity remains a perennial priority focus area affecting multiple market participants, including broker-dealers and investment advisers. EXAMS will focus on registrants’ policies and procedures, internal controls, oversight of third-party vendors (where applicable), governance practices, responses to cyber-related incidents, and training. EXAMS will look at firms’ practices to prevent account intrusions and to safeguard customer records and information, particularly with respect to multiple branch offices, as well as practices to promote cybersecurity. The Division will continue to assess how registrants identify and address risks to essential business operations with respect to third-party products and services, other cybersecurity issues associated with the use of third-party vendors, and unauthorized use of third-party vendors.Finally, the Division will assess registrant preparations associated with recently adopted rule changes to shorten the standard settlement cycle for most broker-dealer transactions from two business days after the trade to one business day. The compliance date is May 28, 2024.
Crypto Assets and Emerging Financial Technology
The Division highlighted continued volatility and activity in crypto asset markets and indicated that it will monitor and conduct examinations of registrants focusing on the offer, sale, recommendation of, advice regarding, trading in, and other activities in crypto or related products. EXAMS will specifically review whether registrants (1) meet and follow their respective standards of conduct when recommending or advising customers and clients regarding crypto assets and (2) routinely review, update, and enhance their compliance practices, risk disclosures, and operational resiliency practices, as required, which could encompass review of a firm’s custody agreement for compliance with Rule 15c3-3. The Division will also assess technological risks associated with the use of blockchain and distributed ledger technology, including the design of related compliance policies and procedures and associated risk disclosures.
Given the proliferation of emerging financial technologies, the Division will focus on broker-dealers and advisers offering new products and services or using new practices, particularly technological and online solutions aimed at compliance and marketing. In particular, the Division will focus on automated investment tools, artificial intelligence, and trading algorithms or platforms along with associated risks.
Regulation Systems Compliance and Integrity (SCI)
The Division will continue to evaluate policies and procedures of SCI entities, including whether the policies and procedures of SCI entities are reasonably designed to secure the SCI systems, including the physical security of the systems housed in data centers.
The Division highlighted the need for broker-dealers and certain registered investment companies to continue their efforts to have reasonably tailored AML programming that identify customers and conduct ongoing monitoring to identify and report suspicious transactions. Essentially, the Division reminds financial institutions of some common areas of AML programming. For example, annual AML testing is one area of focus. Financial institutions should consider assessing whether the individuals conducting their annual testing are sufficiently qualified and that those individuals address the appropriate scope for testing.
The Division also reminded financial institutions of the need to review their AML programs to assess whether they are reasonably tailored to address the risks attendant with their customers and business. A risk assessment by the financial institution will assist in understanding whether it has adequate AML coverage to identify and report suspicious activity. Financial institutions should look at their business and customer base that includes a lens of what risks the regulator may perceive to ensure that there is adequate AML programming coverage.
In addition, customer identification programs (CIP), as well as customer due diligence programs (CDD) addressing beneficial ownership requirements of certain legal entities, remain a key priority. Financial institutions should assess the adequacy of both their CIP and CDD programs to understand whether gaps exist. Finally, the Division broadly states financial institutions should meet their suspicious activity report (SAR) filing obligations. While the report provides little insight into what issues the examination staff may focus on relative to SAR filings, financial institutions may consider looking across their platforms to make sure that personnel are aware of what must be reported as suspicious. Ongoing tailored training to employees and registered personnel may be helpful in making sure suspicious activity is being reviewed and reported as required under the SAR rule for the financial institution.
Finally, the Division indicated that it will expand its focus on OFAC monitoring and compliance to include not only broker-dealers but also investment advisers.
1 U.S. Securities and Exchange Commission 2024 Examination Priorities, available at https://www.sec.gov/files/2024-exam-priorities.pdf.
2 For additional information about the 2023 examination priorities, see the following Sidley Update: SEC Division of Exams Announces 2023 Examination Priorities.
3 For additional information, see the following Sidley Updates: SEC Marketing Rule Enforcement: Charges Against Nine Registered Investment Advisers Over Hypothetical Performance Advertising and 2023 Fiscal Year in Review: SEC Enforcement Actions Against Investment Advisers to Private Funds, Registered Funds, and Retail Clients.
5 For additional information, see the following Sidley Update: U.S. SEC Adopts Significant Changes for Advisers and Private Funds.
6 For additional information, see the following Sidley Update: SEC Adopts New Investment Adviser Marketing Rule.
7 For additional information, see the following Sidley Updates: SEC Adopts Significant Form PF Amendments and SEC Adopts New Rule Amendments for Money Market Funds and Form PF Reporting Requirements for Large Liquidity Fund Advisers.
8 For additional information, see the following Sidley Updates: SEC Adopts Regulation Best Interest and Form CRS; Issues Investment Advisers Act Interpretations, SEC Publishes Bulletin on Conflicts of Interest for Broker-Dealers and Investment Advisers, and SEC Publishes Additional Interpretive Guidance on Reg BI and Investment Adviser Standard of Care.
9 For additional information, see the following Sidley Update: SEC Issues Compliance Deadline, Guidance on Permitted Collateral Arrangements for Fully Paid and Excess Margin Securities Lending.
10 For additional information, see the following Sidley Update: SEC Adopts New Disclosure Regime for NMS Stock ATSs.
11 For additional information, see the following Sidley Update: SEC Adopts Amendments to Enhance Retail Investor Protections, Modernize Rule Governing Quotations for Over-the-Counter Securities.
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