On February 7, 2023, the SEC’s Division of Examinations (the “Division”) announced its 2023 examination priorities (“Examination Priorities”). The Division indicated that 2023 examinations will prioritize several significant focus areas that pose unique or emerging risks to investors or the markets, as well as examinations of core and perennial risk areas. Specifically, the Division will focus on: the new Marketing Rule; Registered Investment Advisers (“RIAs”) managing private funds; environment, social, and governance (“ESG”) issues; emerging technologies and crypto assets; information security and operational resiliency; standards of conduct; conflicts of interest; and Form CRS; and new Investment Company Act rules.
New Marketing Rule (Advisers Act Rule 206(4)-1). Calling the new Marketing Rule “a significant change to a core examination review area,” the Division stated it will focus on whether RIAs have adopted and implemented written policies and procedures reasonably designed to prevent violations by advisers and their supervised persons of the new rule. The Division will also review compliance with substantive provisions of the new Marketing Rule, including the requirement that RIAs have a reasonable basis for believing the RIA will be able to substantiate material statements of fact and requirements for performance advertising, testimonials, endorsements and third-party ratings.
Registered Investment Advisers that Manage Private Funds. The Division promised continued focus on RIAs to private funds, noting the significant portion of the RIA population represented by private fund managers. In this regard, exams will focus on: (i) conflicts of interest; (ii) calculation and allocation of fees and expenses, including post-investment 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; (iv) policies and practices regarding the use of alternative data and compliance with Advisers Act Section 204A, which requires investment advisers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material, non-public information; (v) and compliance with the Custody Rule, including timely delivery of audited financials and selection of permissible auditors.
The Division will also focus on RIAs to private funds with particular risk characteristics identified in the Examination Priorities, including: (i) highly-levered private funds; (ii) private funds managed side-by-side with BDCs; (iii) private equity funds that use affiliated companies and advisory personnel to provide services to their fund clients and portfolio companies; (iv) private funds that hold certain hard-to-value investments (e.g., crypto assets and real estate); (v) private funds investing in or sponsoring SPACs; and (vi) private funds involved in adviser-led restructurings, including stapled secondary transactions and continuation funds.
Furthermore, the Division remains focused on whether various aspects of RIAs’ operations and compliance practices have appropriately adopted and considered current markets factors, such as those that might impact valuation and the accuracy of RIA regulatory filings. During a typical examination, the Division will review the compliance programs and related disclosures of RIAs in one or more core areas, such as: (i) custody and safekeeping of client assets; (ii) valuation; (iii) portfolio management; and (iv) brokerage and execution.
Examinations will also often include reviews of conflicts of interest and compliance issues and the oversight and approval process related to RIA fees and expenses, including: (i) the calculation of fees; (ii) alternative ways that RIAs may try to maximize revenue, including revenue earned on clients’ bank deposit sweep programs; (iii) and excessive fees.
In addition to these core areas, examinations will review RIA policies and procedures for retaining and monitoring electronic communications and selecting and using third-party service providers.
Environmental, Social and Governance. Noting that RIAs and registered funds are competing for the rising investor demand for ESG-related investments and strategies that incorporate certain ESG criteria, and, thus are increasingly offering and evaluating investments that employ such strategies and investments, the Division promised continued focus on ESG-related advisory services, fund offerings and strategies incorporating ESG criteria, including whether funds are operating in accordance with their disclosures.
Emerging Technologies and Crypto-Assets. The Division noted that it continues to observe the proliferation of certain types of investments (e.g., crypto assets and their associated products and services) and emerging financial technology (e.g., broker-dealer mobile apps and RIAs choosing to provide automated digital investment advice to their clients). The Division will address these observations by conducting examinations of broker-dealers and RIAs offering new products and services or employing new practices, including technological and on-line solutions (e.g., on-line brokerage services, internet advisers, and automated investment tools and trading platforms, including RIAs referred to as “robo-advisers”).
Given the disruptions caused by recent financial distress among crypto asset market participants, the Division will also continue to focus on the offer, sale, recommendations of and advice regarding, and trading in crypto or crypto-related assets. In particular, whether such registrants: (i) met and followed their respective standards of care when making recommendations, referrals, or providing investment advice, to the extent required; and (ii) routinely reviewed, updated, and enhanced their compliance, disclosure, and risk management practices. The Division will also focus on new or never before examined registrants offering crypto or crypto-related assets.
In addition, examinations will also focus on broker-dealers and RIAs that employ digital engagement practices and the related tools and methods to assess whether: (i) recommendations were made or advice was provided (i.e., through social media marketing and social trading platforms); (ii) representations are fair and accurate; (iii) operations and controls in place are consistent with disclosures made to investors; (iv) any advice or recommendations are in the best interest of the investor taking into account the investor’s financial situation and investment objectives; and (v) risks associated with such practices are considered, including the impact these practices may have had on investors, such as seniors.
Information Security and Operational Resiliency. The Division will continue to review broker-dealers’ and RIAs’ practices to prevent interruptions to mission-critical services and to protect investor information, records and assets. In doing so, the Division will focus on firms’ policies and procedures, governance practices, response to cyber-related incidents and broker-dealers’ and RIAs’ compliance with Regulations S-P and S-ID, where applicable. The focus on these areas will include whether such policies and procedures are reasonably designed to safeguard customer records and information, including information residing on the registrants’ system and information residing with third-party service providers, and whether the location of such records has been properly disclosed to the SEC.
Regulation Best Interest and Form CRS. The Division will continue to prioritize examinations of broker-dealers and RIAs for compliance with their applicable standards of conduct. In this regard, broker-dealers and dually registered RIAs are an area of continued interest, as are affiliated firms with financial professionals who service both brokerage customers and advisory clients. These examinations will continue to focus on: (i) investment advice and recommendations regarding products, investment strategies, and account types; (ii) disclosures made to investors and whether such disclosures include all material facts relating to the conflicts of interest associated with the advice and recommendations; (iii) processes for making best interest evaluations, including those for reviewing reasonably available alternatives, evaluating costs and risks, and identifying and addressing conflicts of interest; (iv) factors considered in light of the investor’s investment profile, including investment goals and account characteristics; and (v) whether firms have customer or client agreements that purport to inappropriately waive or limit their standard of conduct, such as through hedge clauses.
Additionally, for RIAs, the Division will review whether conflicts of interest disclosures are sufficient that a client can provide informed consent to the conflict, whether express or implied.
The Division will also focus on compliance with Form CRS for broker-dealers and RIAs, specifically that firms (i) deliver Form CRS to retail investors, (ii) file Form CRS with the SEC and (iii) post Form CRS on their website (if any).
Registered Investment Companies. The Division will also continue to prioritize examinations of registered investment companies (“RICs”), such as mutual funds and ETFs, with a focus on compliance programs, governance practices, disclosures to investors and accurate reporting to the SEC.
The 2023 SEC examination priorities memo can be found here.
