SEC Division of Examinations Announces 2023 Priorities

2023 SEC EXAMINATION PRIORITIES

On February 7, 2023, the United States Securities and Exchange Commission’s Division of Examination (“Examination Staff”) published its 2023 examination priorities (“Exam Priorities”).  The Exam Priorities is an excellent tool for compliance departments to consider as they look for ways to evaluate and improve their firm’s compliance programs, and prepare their firms for future examinations by Examination Staff of the SEC.  We welcome your comments and questions.

The Exam Priorities details areas where the Examination Staff will focus its examinations of investment advisers, broker-dealers and others this year.  The Examination Staff notes the development of this year’s Exam Priorities includes significant input from stakeholders within and outside of the SEC.  Additionally, this year, the Examination Staff reached out directly to representatives of state securities regulators and investor groups to gain additional feedback and viewpoints on critical investor protection issues to consider in developing this year’s Exam Priorities.  The Examination Staff articulates its mission as supported by “four pillars”: (1) promote compliance; (2) prevent fraud; (3) monitor risk; and (4) inform policy.  Each pillar ties into underlying interests of the examination program.

The Exam Priorities identify significant focus areas that pose unique or emerging risks to investors or the markets,or constitute core and perennial risk areas for the Examination Staff.  We summarize these areas below.

1. Notable New and Significant Focus Areas.

New Marketing Rule for Investment Advisers, Rule 206(4)-1.  The compliance date for the SEC’s new marketing rule applicable to investment advisers was November 2, 2022.  This new Marketing Rule is a significant change to a core examination review area for registered investment advisers.  The Examination Staff will assess whether investment advisers have adopted and implemented written policies and procedures reasonably designed to prevent violations of the new marketing rule.  The Examination Staff also will evaluate the rule’s requirement that investment advisers have a reasonable basis for believing they can substantiate material statements of fact and requirements for performance advertising, testimonials, endorsements and third-party ratings.  The Examination Staff will expect to see advisers have made appropriate updates to their policies and procedures following the November 2022 compliance date.

Investment Company Act Rule 18f-4 (Derivatives Rule).  The Exam Priorities state if a registered fund relies on the Derivatives Rule, the Exam Staff will, among other things: (1) assess whether adequate policies and procedures have been adopted by registered investment companies, including mutual funds (other than money market funds), exchange-traded funds (ETFs) and closed-end funds, as well as business development companies (BDCs) to manage the funds’ derivatives risks and to prevent violations of the Derivatives Rule.  The Examination Staff also will review for compliance with Rule 18f-4, including (a) the adoption and implementation of a derivatives risk management program, (b) board oversight, and (c) whether disclosures concerning the fund’s use of derivatives are incomplete, inaccurate or potentially misleading.

Investment Company Act Fair Valuation Rule 2a-5.  The Examination Staff will, among other things: (1) assess fund and fund board compliance with the new requirements for determining fair value, implementing board oversight duties, setting recordkeeping and reporting requirements, and permitting the funds’ board to designate valuation designees to perform fair value determinations subject to oversight by the board; and (2) review whether adjustments have been made to valuation methodologies, compliance policies and procedures, governance practices, service provider oversight, and/or reporting and recordkeeping.

Registered Investment Advisers to Private Funds 

Noting the continued growth of private fund assets (now more than $21 trillion) the Exam Staff will continue its focus on the following areas for private fund advisers: (1) conflicts of interest; (2) calculation and allocation of fees and expenses; (3) compliance with the new Marketing Rule, including performance advertising and compensated testimonials and endorsements, such as solicitations; (4) policies and practices regarding the use of alternative data and compliance with Advisers Act Section 204A; and (5) compliance with the Advisers Act Rule 206(4)-2 (Custody Rule), where applicable, including timely delivery of audited financials and selection of permissible auditors.  Note this last point was the subject of a sweep by the SEC’s Division of Enforcement last year, and Division Director Gurbir Grewal cautioned firms that sanctions may be more significant in future actions.

Additionally, the Examination Staff will focus on RIAs to private funds with specific risk characteristics.  The Exam Priorities provides the following list and where applicable, advisers should ensure they have corresponding policies and procedures.  (1) highly-leveraged private funds, (2) private funds managed side-by-side with BDCs, (3)  use affiliated companies and advisory personnel by private equity funds to provide fund clients and underlying portfolio companies with services, (4) private funds that hold certain hard-to-value investments, such as crypto assets and real estate-connected investments, with an emphasis on commercial real estate, (5) private funds that invest in or sponsor Special Purpose Acquisition Companies (SPACs), and (6) private funds involved in adviser-led restructurings, including stapled secondary transactions and continuation funds.

Standards of Conduct: Regulation BI (Reg BI) and the Fiduciary Duty

The Examination Staff will continue to prioritize examinations of broker-dealers and investment advisers for compliance with their applicable standard of conduct.  As in past years, the Examination Staff will continue to focus on: (1) investment advice and recommendations with regard to products, investment strategies, and account types; (2) disclosures made to investors and whether such disclosures include all material facts relating to the conflicts of interest associated with the advice and recommendations; (3) processes for making best interest evaluations, including those for reviewing reasonably available alternatives, evaluating costs and risks, and identifying and addressing conflicts of interest; and (4) factors considered in light of the investor’s investment profile, including investment goals and account characteristics.  Also, in the case of investment advisers, examiners will review whether the conflicts of interest disclosures are sufficient such that a client can provide informed consent to the conflict, whether express or implied.  Note, the Exam Priorities also identified broker-dealers and dually registered investment advisers as an area of continued interest for the Examination Staff, as are affiliated firms with financial professionals who service both brokerage customers and advisory clients.  Special policies and procedures are appropriate and expected for such firms.

As we await the final version of the proposed Private Funds Proposed Reforms, the Exam Priorities notes examinations will review whether firms have customer or client agreements that purport to inappropriately waive or limit their standard of conduct, such as through the use of hedge clauses.

The Examination Staff also prioritize review for compliance with Form CRS.  SEC rules require firms to deliver relationship summaries to new and prospective retail investors, as well as to existing retail investors.  Firms also must file their relationship summary with the SEC and post the current relationship summary on the firm’s public website.

Environmental, Social, and Governance (ESG) Investing.  The Exam Priorities notes the industry competition for a piece of the rising investor demand for ESG-related investments and strategies that incorporate certain ESG criteria.  In response, the Examination Staff observes many advisers are increasingly offering and evaluating investments that employ such strategies and investments.  Examination Staff will continue its focus on ESG-related advisory services and fund offerings, including whether the funds are operating in the manner set forth in their disclosures.  In addition, Examination Staff will assess whether ESG products are appropriately labeled and whether recommendations of such products for retail investors are made in investors’ best interest.  Note, this also has been an area for recent SEC enforcement activity, and we anticipate additional cases which may come through referral by the Examination Staff.

2. INFORMATION SECURITY AND OPERATIONAL RESILIENCY

The Exam Priorities note the current risk environment related to cybersecurity is considered elevated given the larger market events, geopolitical concerns, and the proliferation of cybersecurity attacks, particularly ransomware attacks.  Cybersecurity remains a perennial focus area for the Examination Staff in its inspections of registrants, including investment advisers, broker-dealers, investment companies, municipal advisors, transfer agents, exchanges and clearing agencies.

The Examination Staff will review policies and procedures, governance practices, and a firm’s response to cyber-related incidents, including those related to ransomware attacks.  Compliance with Regulations S-P and S-ID, by broker-dealers and investment advisers also will be evaluated.  The Examination Staff recently published a risk alert on Regulation S-ID.  The Examination Staff’s focus on policies and procedures will include a review as to whether such procedures are reasonably designed to safeguard customer records and information.

The Examination Staff also will continue to look at firms’ practices to prevent account intrusions and safeguard customer records and information, including personally identifiable information, while recognizing that personnel may continue to access information in a remote environment.  Cybersecurity issues associated with the use of third-party vendors also will be evaluated.  This includes steps firms take to oversee the security and integrity of third-party products and services.  The Examination Staff notes its focus will also include reviewing whether there has been an unauthorized use of third-party providers, particularly for transition assistance when departing personnel of an investment adviser attempt to migrate client information to another firm.

Examination Staff also will continue to assess systemically significant registrants’ operational resiliency planning.  Note this specifically includes efforts to consider and/or address climate-related risk.

3. CRYPTO ASSETS AND EMERGING FINANCIAL TECHNOLOGY

The Exam Priorities notes in light of the disruptions caused by recent financial distress among crypto asset market participants, the Examination Staff will continue to monitor and, when appropriate, conduct examinations of potentially impacted or affected firms.  Examinations will focus on the offer, sale, or recommendation of, advice regarding and trading in crypto or crypto-related assets.  Specifically, the Examination Staff will assess whether such market participants involved with crypto or crypto-related assets: (1) meet and follow their respective standards of care when making recommendations, referrals, or providing investment advice; and (2) routinely review, update, and enhance their compliance, disclosure, and risk management practices, respectively.  In addition, the Examination Staff will focus on new or never before examined registrants offering crypto or crypto-related assets.

Examinations also will focus on firms that employ digital engagement practices (such as behavioral prompts, or game-like features) and related tools and methods.  This is to assess whether: (1) recommendations are made or advice is provided (e.g., through the use of social media marketing and social trading platforms); (2) representations are fair and accurate; (3) operations and controls in place are consistent with disclosures made to investors; (4) any advice or recommendations are in the best interest of the investor taking into account the investor’s financial situation and investment objectives; and (5) risks associated with such practices are considered, including the impact these practices may have on certain investors (e.g., seniors).

4. INVESTMENT ADVISERS AND INVESTMENT COMPANIES

 Focus Areas for Investment Advisers.  The Exam Priorities note during a typical examination, compliance programs and related disclosures of advisers in one or more core areas, such as custody and safekeeping of client assets, valuation, portfolio management, and brokerage and execution are evaluated.  Examinations also often include a review for conflicts, compliance issues and the oversight and approval process related to adviser fees and expenses, including: (1) the calculation of fees; (2) alternative ways advisers may try to maximize revenue, including revenue earned on clients’ bank deposit sweep programs; and (3) excessive fees.  In addition to reviewing these core areas, examinations will review advisers’ policies and procedures for retaining and monitoring electronic communications and selecting and using third-party service providers.

Focus Areas for Registered Investment Companies, Including Mutual Funds and ETFs.  Perennial focus areas include, an assessment of registered investment companies’ compliance programs and governance practices, disclosures to investors, and accuracy of reporting to the SEC.  The Exam Priorities note a focus on the fiduciary obligations of advisers to registered investment companies, particularly with respect to receipt of compensation for services, or other material payments made by such registered investment companies and other sources to the adviser.

As part of its review of registered investment companies’ compliance programs and governance practices, Examination Staff will continue to evaluate boards’ processes for assessing and approving advisory and other fund fees, particularly for funds with weaker performance relative to their peers.  Where applicable, Examination Staff also will assess the effectiveness of funds’ derivatives risk management programs and liquidity risk management programs.

The Examination Staff also focus on funds with specific characteristics, such as: (1) “turnkey funds,” to review their operations and assess effectiveness of their compliance programs; (2) mutual funds that converted to ETFs, to assess governance and disclosures associated with the conversion to an ETF; (3) non-transparent ETFs, to assess compliance with the conditions and other material terms of their exemptive relief; (4) loan-focused funds, such as leveraged loan funds and funds focused on collateralized loan obligations, for liquidity concerns and to review whether the funds have been significantly impacted by, and have adapted to, elevated interest rates; and (5) medium and small fund complexes that have experienced excessive staff attrition, to focus on whether such attrition has affected the funds’ controls and operations.  Examination Staff also will monitor the proliferation of volatility-linked and single-stock ETFs, and may review such funds’ disclosures, marketing, conflicts, and compliance with portfolio management disclosures.

5. BROKER-DEALER AND EXCHANGE EXAMINATION PROGRAM

 Broker-Dealers.  The Exam Priorities notes the Examination Staff’s intention to focus examinations on broker-dealer compliance and supervisory programs generally, including those for electronic communications related to firm business, as well as the recordkeeping for those electronic communications.  Examination Staff also will prioritize reviewing policies and procedures for broker-dealers holding customer cash and securities.  The Exam Priorities note such firms have a responsibility to ensure that those assets are safeguarded in accordance with the Customer Protection Rule and the Net Capital Rule.  The Examination Staff will expect policies and procedures that address such considerations.

Examination Staff will continue to examine broker-dealer trading practices in both equities and fixed income securities. Examinations will assess conflicts of interest in order routing and execution that may negatively affect retail investors.  Examinations also will focus on compliance with Regulation SHO, including the rules regarding aggregation units and locate requirements.  The Examination Staff also will examine the operations of alternative trading systems for compliance with Regulation ATS, including assessing consistency with their disclosures provided in Form ATS-N.

A continued focus on issues specific to municipal securities and other fixed income securities should be expected, such as fairness of pricing, compliance with confirmation disclosure requirements, and municipal securities dealer and municipal underwriter compliance with obligations related to municipal issuer disclosure.  In addition, the Examination Staff will continue to focus on issues specific to over-the-counter securities and microcap securities.

The Exam Priorities also address focus areas for National Securities Exchanges, Security-Based Swap Dealers, Municipal Advisors and Transfer Agents.

6. ANTI-MONEY LAUNDERING (AML)

 The Exam Priorities notes the Bank Secrecy Act requires financial institutions, including broker-dealers and certain registered investment companies, to establish AML programs tailored to address the risks associated with the firm’s location, size, and activities, including customers they serve, the type of products and services offered, and way those products and services are offered.  The Exam Priorities also notes the heightened importance of conducting examinations of AML programs of broker-dealers and certain registered investment companies due to the current geopolitical environment and the increased imposition of international sanctions.  Accordingly, Examination Staff will continue to prioritize examinations of broker-dealers and certain registered investment companies for compliance with their AML obligations in order to assess, among other things, whether firms have established appropriate customer identification programs and whether they are satisfying their Suspicious Activity Reporting (“SAR”) filing obligations, conducting ongoing due diligence on customers, complying with beneficial ownership requirements, and conducting robust and timely independent tests of their AML programs.

     7. THE LONDON INTERBANK OFFERED RATE (LIBOR) TRANSITION

The Exam Priorities notes the discontinuation of LIBOR could have a significant impact on the financial markets and may present a material risk for certain market participants, including the investment advisers, broker-dealers, investment companies, municipal advisors, transfer agents and clearing agencies overseen by the Examination Staff.   For those impacted by the change, examinations will assess preparedness for the transition away from LIBOR (currently scheduled for discontinuation in June 2023).

CONCLUSION

The Exam Priorities is packed with useful information for financial services firms to consider as a tool for evaluating the effectiveness of their own compliance programs.  In addition, it provides insight into areas of concern for the Exam Staff, which firms should expect to be reviewed during regulatory examinations.  This writing is intended as a summary of the Exam Priorities and we encourage firms to review the entire document, which may be found here.  Please contact us with any questions of if we may be helpful in testing your compliance program.