On February 7, 2023, the U.S. Securities and Exchange Commission (SEC) Division of Examinations (EXAMS or Division) issued its annual examination priorities. The Division highlighted new, notable, and significant focus areas for examination along with other perennial priorities. Compliance with new Advisers Act rules, including the marketing rule, and Investment Company Act rules, including the derivatives rule and fair valuation rule, top the list of significant focus areas. Consistent with previous exam priority announcements, private fund advisers; adviser standards of conduct; environmental, social, and governance (ESG)–related issues; and cyber and digital assets remain top priorities.1
This article provides a concise summary of upcoming examination priorities and perennial issues registrants can anticipate in the following year’s examinations.
EXAMS Mission and Mandate
In its “Message From the Leadership Team,” the Division emphasized the “four pillars” of its mission: promoting compliance, preventing fraud, monitoring risk, and informing policy. In pursuit of those objectives, the Division highlighted certain examination initiatives for specific market participants, including registered advisers (with a focus on both private fund advisers and advisers to registered funds) and investment companies, including mutual funds and exchange-traded funds (ETFs). The Division’s priorities reflect the targeted examination of “certain practices, products, and services that it believes present potentially heightened risks to investors or the integrity of the U.S. capital markets.” EXAMS prioritizes certain areas after a thorough risk-based assessment of information gathered from prior year examinations, enforcement actions, communications with other regulators (including representatives of state regulators), comments and tips from investors, regulated entities, and other industry participants as well as coordination with other internal divisions and offices of the SEC.
The Division also highlighted key metrics for fiscal year 2022, noting that it examined 15% of the registered investment adviser population and increased the number of in-person on-site examinations while continuing to use remote examinations where applicable.
New and Significant Focus Areas
The Division outlined its plans to prioritize several significant focus areas that pose unique or emerging risks.
Compliance with rules recently adopted under the Advisers Act and Investment Company Act
- Advisers Act Rule 206(4)-1 (Marketing Rule): The Division highlighted that the new Marketing Rule represents a significant change to a “core examination area” for registered investment advisers (RIAs). EXAMS will assess whether RIAs have complied with the substantive requirements of the Marketing Rule and that they have adopted and implemented written policies and procedures that are reasonably designed to prevent violations of the Marketing Rule. The Division discussed areas of focus for examination of RIA compliance with the Marketing Rule in its September 2022 Marketing Rule risk alert.2
- Investment Company Act Rule 18f-4 (Derivatives Rule): The Division will prioritize assessing whether registered investment companies (including mutual funds, ETFs, closed-end funds, and business development companies (BDCs) but excluding money market funds) have adopted and implemented policies and procedures reasonably designed to manage the fund’s derivatives risks and prevent violations of the Derivatives Rule under Investment Company Act Rule 38a-1. Focus areas include the adoption and implementation of derivatives risk management program, board oversight, and adequacy of fund’s derivatives disclosures.
- Investment Company Act Fair Valuation Rule 2a-5: Priorities included assessing funds’ and fund boards’ compliance with new requirements for determining fair value including implementing board oversight duties, recordkeeping, and reporting requirements and reviewing whether appropriate adjustments have been made to fund valuation methodologies, compliance policies and procedures, and governance practices.
RIAs to Private Funds
Advisers to private funds represent a significant portion of the total RIA population, totaling 35% of all RIAs with gross assets exceeding $21 trillion. Private funds have been a perennial focus area for examinations, and the Division highlights that it will continue to focus on RIAs to private funds with particular focus on the following areas:
i) conflicts of interest
ii) calculation and allocation of fees and expenses, including calculation of postcommitment period management fees and the impact of valuation practices at private equity funds
iii) compliance with the new Marketing Rule, including performance advertising and compensated testimonials and endorsements, such as solicitations
iv) policies and practices regarding the use of alternative data and avoiding the misuse of material nonpublic information in compliance with Advisers Act Section 204A
v) compliance with the Advisers Act Rule 206(4)-2 (Custody Rule), including timely delivery of audited financials and selection of permissible auditors
RIAs to private funds with specific risk characteristics will be a priority focus area for examination. Risk characteristics highlighted by the Division include private funds that
ii) are managed side-by-side with BDCs
iii) use affiliated companies and advisory personnel to provide services to their private equity fund clients and underlying portfolio companies
iv) hold certain hard-to-value investments, such as cryptoassets and real estate–connected investments, with an emphasis on commercial real estate
v) invest in or sponsor special purpose acquisition companies (SPACs)
vi) are involved in adviser-led restructurings, including stapled secondary transactions and continuation funds
Standards of Conduct: Regulation Best Interest, Fiduciary Duty, and Form CRS
- Regulation Best Interest and Fiduciary Duty: EXAMS will continue to prioritize compliance with relevant standards of conduct in its examinations of broker-dealers and RIAs. The Division noted particular interest in examinations of dually registered RIAs and affiliated firms that service both brokerage and advisory clients. Priority areas for examination continue to include
i) investment advice and recommendations regarding products, strategies, and account types
ii) investor disclosures and whether such disclosures include all material facts regarding conflicts of interest relating to advice and recommendations (for RIAs whether conflicts disclosure are sufficient for client to provide informed consent)
iii) processes for making best-interest evaluations
iv) factors considered based on client investment profile including investment goals and account characteristics
- Form CRS: Core examinations of broker-dealers and RIAs will continue to include compliance with Form CRS. The Division reemphasizes that rules require broker-dealers and RIAs to deliver their relationship summaries to new, prospective, and existing retail investors as well as file the relationship summary with the SEC and post it to the firm’s public website, if they have one.
ESG-related RIA advisory services and registered fund offerings continue to be a significant focus area for examination given the rising investor demand for investment strategies incorporating ESG investment criteria.
The Division will continue to examine whether
i) fund offerings are operating in a manner consistent with ESG-related disclosure
ii) ESG products are appropriately labeled
iii) recommendations of such products for any retail investors are made in the best interest of the investor
Information Security and Operational Resiliency
Cybersecurity remains a perennial priority focus area of examination for RIAs, broker-dealers, investment companies, municipal advisers, transfer agents, exchanges, and clearing agencies. EXAMS will focus on registrants’ policies and procedures, governance practices, and responses to cyber-related incidents as well as compliance with Regulations S-P and S-ID where applicable for broker-dealers and RIAs. Firm practices to prevent account intrusions and safeguard customer records and information, particularly in a remote work environment, will be a continuing focus area. Additional focus will be placed on registrants’ use of third-party vendors and the registrants’ visibility into the security and integrity of such vendor’s products and services. The Division will continue to assess operational resiliency planning of systemically significant registrants — including registrant efforts to consider and address any climate-related risks.
Cryptoassets and Emerging Financial Technology
With the continued growth of cryptoassets and their associated products and services, as well as emerging financial technology such as mobile apps and automated digital investment advice, the Division will prioritize examinations of broker-dealers and RIAs offering new products and services or using new practices including technological and online solutions for certain compliance functions, compliance, marketing, and servicing investor accounts (e.g., online brokerage services, internet advisers, and automated investment tools and trading platforms, including “robo-advisers”).
Examinations of RIAs that participate in the cryptoasset market, particularly those new to the cryptoassets market or those that have never been examined, will be a priority. The Division highlighted the recent market disruptions resulting from financial distress of certain cryptomarket participants and noted its continued monitoring of registrants that were affected or those that may be affected by such disruptions and will prioritize examination of those affected RIAs. Examinations of cryptomarket participants will focus on (1) standards of care when making recommendations or referrals or providing investment advice relating to crypto- or crypto-related assets and (2) enhancements to compliance, disclosure, and risk management practices relating to crypto-related assets.
Examinations will also focus on broker-dealers and RIAs that use digital engagement practices and the related tools and methods, such as through the use of social media marketing and social trading platforms, to assess whether
i) recommendations were made or advice was provided
ii) representations are fair and accurate
iii) operations and controls in place are consistent with previous disclosures
iv) any advice or recommendations are in the best interest of the investor
v) risks associated with such practices are considered, including the impact these practices may have on certain types of investors (e.g., seniors)
Investment Advisers and Investment Companies
Focus Areas for Examinations of RIAs
Consistent with previous years, the Division prioritizes examining those RIAs that have never been examined, including those that are newly registered, as well as those RIAs that have not been examined for a number of years. The focus of the Division’s examinations remains on compliance programs and related disclosures for core areas such as valuation, custody, portfolio management, brokerage, and execution. In addition to the core areas of focus, the Division highlighted review of RIA policies and procedures relating to selecting and using third-party service providers and the retention and monitoring of electronic communications.
Focus Areas for Registered Investment Companies, Including Mutual Funds and ETFs
Examinations of registered funds will prioritize perennial focus areas including adequacy of compliance programs and governance practices, investor disclosures, and accuracy of reporting to the SEC.
The Division will also focus on the fiduciary obligations for advisers to registered investment companies with particular focus on the review of adviser compensation and material payments made by registered investment companies. The Division stated that it plans to continue to examine and evaluate boards’ processes for assessing and approving advisory and other fund fees. Finally, the Division noted that it plans to assess the effectiveness of funds’ derivatives risk management programs and liquidity risk management programs.
The Division will prioritize registered funds with certain characteristics
i) turnkey funds3
ii) mutual funds that converted to ETFs
iii) nontransparent ETFs
iv) loan-focused funds
v) medium and small fund complexes that have experienced excessive staff attrition
Consistent with RIA examinations, the Division prioritizes those registered investment companies that have never been examined or those that have not been examined for a number of years. Focus areas for these examinations include advisory contract approval process, fund code of ethics, consistency of corporate governance practices with disclosures, and effectiveness of fund compliance programs including the oversight of service providers.
Broker-Dealer and Exchange Examination Program
The Division intends to prioritize compliance and supervisory programs of broker-dealers including as they relate to electronic communications and recordkeeping. As they have done in previous years, the Division highlighted the responsibility of broker-dealers who hold customer cash and securities to safeguard those assets pursuant to the Customer Protection Rule and the Net Capital Rule. Examiners will focus on the adequacy of internal processes, procedures, and controls as well as assess the broker-dealer’s credit, market, and liquidity risk management controls in place for managing liquidity during stress events.
Examinations of trading practices for broker-dealers in both equity and fixed income securities will continue with focus on conflicts of interest in order routing and execution that may negatively affect retail investors and compliance with Regulation SHO. Compliance with Regulation ATS will remain a focus area for alternative trading systems with a focus on consistency of disclosures provided in Form ATS-N.
Issues specific to municipal and other fixed income securities including municipal securities dealer and underwriter compliance with issuer disclosure obligations and fairness of pricing will continue to be focus areas for examination. Compliance with penny stock disclosure rules and quotation publication restrictions of Securities Exchange Act Rule 15c2-11 as well as other issues specific to over-the-counter and microcap securities will continue to be priority focus areas for EXAMS. The Division will also pursue the identification of firms that may be involved in the illegal distribution of unregistered securities.
Securities- 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.
The Division will continue to focus examinations of municipal advisors on whether they have met their fiduciary duty obligations to municipal entity clients as well as compliance with MSRB Rule G-42. The Division will also continue to focus on conflicts of interest disclosure and relationship documentation, registration, professional qualification, and supervision requirements.
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 cryptoassets, will remain a focus for the Division.
Clearance and Settlement
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.
Regulation Systems Compliance and Integrity (SCI)
The Division will focus on evaluating policies and procedures of SCI entities relating to the development of software to keep systems current, security threats to SCI systems from network breaches, dependencies on third parties to operate SCI systems, and maintaining security and operational capabilities of external applications relied on by SCI systems including those residing in the cloud.
The current geopolitical environment including the imposition of additional international sanctions has placed increased importance on examination of broker-dealer and registered investment company AML programs and compliance with Office of Foreign Assets Control and Department of the Treasury–related sanctions. The Division will prioritize examination of firm customer identification and ongoing due diligence programs, suspicious activity report filing obligations, and testing of AML programs to ensure that policies and procedures are reasonably designed to identify suspicious activity and money-laundering activities.
London Interbank Offered Rate Transition (LIBOR)
The Division will continue to assess the preparation of broker-dealers and RIAs for the transition away from LIBOR with the discontinuation of LIBOR still scheduled for mid-year 2023.
1 See previous Sidley Update “SEC Announces 2022 Examination Priorities: Private Funds, ESG, Retail Cyber, and Digital Assets Top the List” for more information.
2 See previous Sidley Update “U.S. Adviser Marketing Rule: Compliance Deadline Approaching, Exams to Follow” for further discussion on the risk alert.
3 “Turnkey funds” refers to funds that use a turnkey service provider to organize, operate, and service the funds.
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