Each year, the U.S. Securities and Exchange Commission’s (SEC) Division of Examinations (Division) prioritizes the 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. Through its examination process, the Division seeks to promote compliance, prevent fraud, identify and monitor risk and inform policy. These annual examinations are designed to support the SEC’s mission to protect investors, facilitate capital formation and maintain fair, orderly and efficient markets.
The Division indicated that it would focus on four significant areas in addition to its examination of core and perennial risk areas. The following does not capture the entirety of the issues that the Division’s examinations will address but instead highlights areas where the Division has specifically identified a need for vigilance. In addition to its annual examinations, the Division will also continue to address important topics though “Risk Alerts” as well as industry and investor outreach.
I. Significant Focus Areas:
1. Private Funds. In the past five years, there has been a 70% increase in the assets managed by advisers to private funds. Given the size, complexity and growth of this market, the Division will continue its focus on Registered Investment Advisers (RIAs). The Division will review:
a. Fees and expenses, including the calculation of post-commitment period management fees and the impact of valuation practices at private equity funds, as discussed in greater detail in a Fall 2021 Risk Alert on Investment Advisers’ Fee Calculations;
b. 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;
c. 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 gate-keepers for private fund investors;
d. The adequacy of disclosure and compliance with any regulatory requirements for cross trades, principal transactions or distressed sales;
e. 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; and
f. Disclosures regarding RIAs’ portfolio strategies, risk management and investment recommendations and allocations, including investments and advising of Special Purpose Acquisition Companies (SPACs).
2. Environmental, Social and Governance (ESG) Investing. The Division expressed concern that RIAs’ ESG investment strategies or criteria could involve materially false and misleading statements or omissions given the lack of standardization in ESG investment terminology and approaches, and failures to effectively address legal and compliance issues with new business lines and products. The Division will review whether RIAs and registered funds are:
a. Accurately disclosing their ESG investment approaches;
b. Adopting and implementing 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;
c. Voting client securities in accordance with proxy voting policies and procedures and whether the votes align with their ESG-related disclosures and mandates; and/or
d. Overstating or misrepresenting the ESG factors considered or incorporated into portfolio selection (e.g., greenwashing), such as in their performance advertising and marketing.
3. Standards of Conduct: Regulation Best Interest, Fiduciary Duty and Form CRS. The Division will continue to address standards of conduct issues for broker-dealers, and will prioritize:
a. Broker-dealer examinations:
(1) Recommendations and sales practices related to SPACs, structured products, leveraged and inverse exchange-traded products, Real Estate Investment Trusts (REITs), private placements, annuities, municipal and other fixed-income securities and microcap securities as well as compensation structures.
b. RIA examinations:
(1) Fiduciary duties in regard to revenue sharing arrangements, recommendations of expensive classes of investment products when lower-cost classes are available, wrap fee accounts and proprietary products resulting in additional or higher fees.
(2) Such reviews also will include an assessment of the adequacy of RIAs’ compliance policies and procedures and disclosures to enable investors to provide informed consent.
c. Dually registered RIA and broker-dealers:
(1) Conflicts of interest in regard to the sale or recommendation of high fee products or proprietary products of the firms or their affiliates, incentives for financial professionals to place their own or their firm’s interests ahead of customers/clients, and compensation structures that inappropriately influence investment recommendations.
4. Information Security and Operational Resiliency. The Division stated that vigilant protection of data is critical to the operation of the financial markets. Therefore, the Division will review whether firms have taken appropriate measures to:
a. Safeguard customer accounts and prevent account intrusions;
b. Oversee vendors and service providers;
c. Address malicious email activities, such as phishing or account intrusion;
d. Respond to incidents, including those related to ransomware attacks;
e. Identify and detect red flags related to identity theft; and
f. 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.
Additionally, the Division will 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 has observed a significant increase in the number of RIAs choosing to provide automated digital investment advisers to their clients, often referred to as “robo-advisers” (see Polsinelli’s Investment Management and Funds team’s summary of the SEC’s robo-adviser Risk Alert here). The Division will conduct examinations of broker-dealers and RIAs that are using developing financial technologies to review whether the unique risks these activities present were considered by firms when designing their regulatory compliance programs.
II. Investment Adviser and Investment Company Examination Program
The Division also noted that it would review compliance procedures for RIAs that employ individuals with prior disciplinary histories, RIAs that have transitioned from the broker-dealer business model, and RIAs that have multiple branch offices.
III. Broker-Dealer and Exchange Examination Program
1. In regard to microcap securities, focus areas for the Division will include:
a. Transfer agent handling of microcap distributions and share transfers;
b. Broker-dealer sales practices and their consistency with Regulation BI; and
c. Broker-dealer compliance with certain regulatory requirements, including the location requirement of Regulation SHO, penny stock disclosure rules and the obligation to monitor for and report suspicious activity and other anti-money laundering (AML) obligations.
2. The Division’s focus on products and services will also include the sale of over-the-counter securities and whether broker-dealers recommending these securities are meeting their obligations under Regulation BI.
3. Among other areas, the Division intends to review best execution obligations in a zero-commission environment, operations of certain alternative trading systems for compliance with Regulation ATS and whether national securities exchanges are meeting their obligations under federal securities laws.
In addition to the areas listed above, the Division will also:
- Perform risk-based examinations of SEC-registered clearing agencies;
- Review the policies and procedures of critical market infrastructure entities pursuant to Regulation SCI;
- Make recommendations to improve FINRA oversight;
- Evaluate municipal securities broker-dealers’ compliance with the Municipal Securities Rulemaking Board;
- Engage with registrants to assess exposure to LIBOR and their transition to an alternative reference rate; and
- Ensure Compliance with Anti-Money Laundering Obligations.