On March 30, 2022, the Division of Examinations (the “Division”) of the Securities and Exchange Commission (the “SEC”) released its annual list of examination priorities for 2022. The Division identified five “significant focus areas,” that it believes pose “unique or emerging risks” to investors and the markets, as well as being areas where the seriousness and frequency of observations in past years demonstrate a need for continued vigilance. The Division also made clear that these five areas were not an exhaustive list and that it continues to monitor numerous other compliance and regulatory matters of registered investment advisers, registered investment companies, broker dealers, and other registrants.
Significant Examination Priorities
The five significant examination focus areas identified by the Division are:
Private Funds. The Division will focus on registered investment advisers (“RIAs”) who manage private funds. The Division estimates that more than 5,000 RIAs manage approximately $18 trillion in private fund assets with a 70% increase in such assets under management over the past five years. Examinations will review issues under the Advisers Act, including an adviser’s fiduciary duty and will specifically focus on:
(1) the calculation and allocation of fees and expenses, including the calculation of post-commitment period management fees and the impact of valuation practices at private equity funds;
(2) the potential preferential treatment of certain investors by RIAs to private funds that have experienced issues with liquidity, including imposing gates or suspensions on fund withdrawals;
(3) compliance with the Advisers Act Custody Rule, including the “audit exception” to the surprise examination requirement and related reporting and updating of Form ADV regarding the audit and auditors that serve as important gatekeepers for private fund investors;
(4) the adequacy of disclosure and compliance with any regulatory requirements for cross trades, principal transactions, or distressed sales; and,
(5) conflicts around liquidity, such as RIA-led fund restructurings, including stapled secondary transactions where new investors purchase the interests of existing investors while also agreeing to invest in a new fund.
The Division will also review private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations, focusing on conflicts and disclosures around these areas. Further, the Division will review the practices, controls, and investor reporting with respect to risk management and trading for private funds with indicia or signs of systemic importance.
ESG. The Division intends to continue its focus on environmental, social impact, and governance related advisory services (“ESG”) and investment products, including mutual funds, exchange-traded funds, and private fund offerings. Examinations are expected to focus on whether RIAs and registered funds are accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices designed to prevent violations of the federal securities laws in connection with their ESG-related disclosures, including review of their portfolio management processes and practices. The Division believes that ESG investing may carry additional risk due to:
(1) the lack of standardization in ESG investing terminology (e.g., strategies that are referred to as sustainable, socially responsible, impact investing, and environmental, social, and governance conscious, which incorporate ESG criteria);
(2) the variety of approaches to ESG investing (e.g., a portfolio may be labeled as ESG because of consideration of ESG factors alongside traditional financial, industry-related, and macroeconomic indicators, among others; other portfolios may use ESG factors as the driving or main consideration in selecting investments; or some portfolios engage in impact investing seeking to achieve measurable ESG impact goals); and
(3) the failure to effectively address legal and compliance issues with new lines of business and products.
The Division will also review whether the voting of client securities is in accordance with proxy voting policies and procedures, including whether the votes align with their ESG-related disclosures and mandates, and whether there are overstatements or misrepresentations of the ESG factors considered or incorporated into portfolio selection (e.g. greenwashing).
Retail Investors and Working Families. The Division will continue to address standards of conduct issues for broker-dealers and RIAs to ensure that retail investors and working families are receiving recommendations and advice in their best interests. Specifically, these examinations will focus on how registrants are satisfying their obligations under Regulation Best Interest and the Advisers Act fiduciary standard to act in the best interests of retail investors and not to place their own interests ahead of the interest of retail investors. Examinations will include assessments of practices regarding consideration of investment alternatives, management of conflicts of interest, trading, disclosures, account selection, and account conversions and rollovers.
In 2021, the Division referred numerous cases to the Enforcement Division in the following areas and can be expected to continue to do so in the current year:
(1) revenue sharing arrangements;
(2) recommending or holding more expensive classes of investment products when lower cost classes are available (e.g., RIAs that recommend no transaction fee mutual fund share classes that have 12b-1 fees in wrap fee accounts where the RIA may be responsible for paying transaction fees);
(3) recommending wrap fee accounts without assessing whether such accounts are in the best interests of clients, including the impact of the move to zero commissions on certain types of securities transactions by a number of broker-dealers;
(4) recommending proprietary products resulting in additional or higher fees; and,
(5) failure to prepare and deliver disclosures required by Regulation BI.
Information Security and Operational Resiliency. The Division will review broker-dealers’, RIAs’, and other registrants’ practices to prevent interruptions to mission-critical services and to protect investor information, records, and assets. Examinations will continue to review whether registrants have taken appropriate measures to:
(1) safeguard customer accounts and prevent account intrusions, including verifying an investor’s identity to prevent unauthorized account access;
(2) oversee vendors and service providers;
(3) address malicious email activities, such as phishing or account intrusions;
(4) respond to incidents, including those related to ransomware attacks;
(5) identify and detect red flags related to identity theft; and
(6) manage operational risk as a result of a dispersed workforce in a work-from-home environment.
In the context of these examinations, the Division will focus on, among other things, broker-dealers’ and RIAs’ compliance with Regulations S-P and S-ID, where applicable. In addition, the Division will again be reviewing registrants’ business continuity and disaster recovery plans, with particular focus on the impact of climate risk and substantial disruptions to normal business operations.
Emerging Technologies and Crypto-Assets. The Division will conduct examinations of broker-dealers and RIAs that are using emerging financial technologies to review whether the unique risks these activities present were considered by the firms when designing their regulatory compliance programs.
RIA and broker-dealer examinations will focus on firms that are, or claim to be, offering new products and services or employing new practices to assess whether:
(1) operations and controls in place are consistent with disclosures made, the standard of conduct owed to investors, and other regulatory obligations;
(2) advice and recommendations, including by algorithms, are consistent with investors’ investment strategies and the standard of conduct owed to such investors; and
(3) controls take into account the unique risks associated with such practices.
Examinations of market participants engaged with crypto-assets will continue to review the custody arrangements for such assets and will assess the offer, sale, recommendation, advice, and trading of crypto-assets. The Division is interested in whether such market participants:
(1) have met their respective standards of conduct when recommending to or advising investors with a focus on duty of care and the initial and ongoing understanding of the products (e.g., blockchain and crypto-asset feature analysis); and
(2) routinely review, update, and enhance their compliance practices (e.g., crypto-asset wallet reviews, custody practices, anti-money laundering reviews, and valuation procedures), risk disclosures, and operational resiliency practices (i.e., data integrity and business continuity plans).
Other Areas of Division Focus
In addition to the five areas of focus discussed above, the Division also will examine for any “heightened risk” at RIAs, such as the hiring of individuals with a disciplinary history. Further, the Division will review for errors in management fee calculations or adjustments, failure to implement breakpoints, and failure to refund prepaid fees.
The Division will also focus on broker dealer’s compliance issues, such as sales practices, microcap fraud, and anti-money laundering obligations. The Division will continue to examine broker dealer trading practices, conflicts arising from payment for order flow, and large trader reporting, among other matters. The Division will also examine national securities exchanges, security-based swap dealers, municipal advisors, and transfer agents. The Division also enumerated some of the other obligations that require examination and reporting as required by law, such as examination of clearing agencies and oversight of FINRA and the MSRB.
What is Missing from the Priorities List?
Given the extensive oversight of registered entities by the Division, it should not come as a surprise that certain types of securities market participants did not receive a mention in this Examination Priorities statement. Exempt Reporting Advisers (“ERAs”), such as investment advisers that provide advice only to venture funds, or advisers that advise only private funds with total assets under $150 million did not receive priority treatment by the Division. This should not be surprising or unexpected, as the SEC has made the determination in the rulemaking process that certain advisers merit less attention due to the nature or amount of the assets managed, among other things. However, it is worth pointing out that the SEC has brought a number of enforcement actions against ERAs over the past several years, which could have resulted from other sources, such as tips or referrals.
The Division, by way of this annual Examinations Priorities publication, is telling registrants key risk areas they need to address in order to become and remain fully compliant with the federal securities laws. The Division also publishes Risk Alerts highlighting new compliance and market risks and key observations from its examination program results. [i]Through these public statements, registrants can gauge what the Division is focused on, what they are finding in their exams, and what a registrant needs to do to close out an exam with a “no further comments” finding or a minor deficiency letter. Because all of these resources are available, registrants are both forewarned and appropriately fore-armed. Accordingly, registrants should review the identified 2022 examination priorities (and relevant Risk Alerts) and assess their operations and related compliance program activities in relevant priority areas.
[i] The Division of Examination’s FY21 Risk Alerts include:
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