By Jennifer Dickinson, Senior Managing Director, U.S.
On February 7, 2023, the Securities and Exchange Commission (SEC)’s Division of Examinations (EXAMS) released its 2023 examination priorities. In many respects, they are similar to the 2022 priorities, but there are some new additions that investment advisers need to be aware of and understand.
The following is a summary of several key takeaways from this year’s exam priorities.
New investment adviser and investment company rules
The new Marketing Rule’s compliance date was November 4, 2022. Examiners will look at whether registered investment advisers have adopted and implemented written policies and procedures to comply with the new rule, focusing particularly on the following:
- Having a reasonable basis for believing that they can substantiate material statements of fact
- The additional requirements for presentation of performance
- Now that testimonials and endorsements are permitted, compliance with the disclosure requirements
- Disclosures associated with use of third-party ratings
Advisers should closely watch the SEC’s FAQ for updates as these exams progress, and make sure that they are nimble and ready to adapt their marketing materials to the SEC’s evolving expectations.
Form ADV Part 1, Item 5 has additional check-the-box questions around specific marketing activities, so firms should make sure that those responses are consistent with their actual marketing practices.
Two new rules for registered investment companies (RICs) also had compliance dates in 2022: the Derivatives Rule (Investment Company Act Rule 18f-4) and Fair Valuation Rule (Investment Company Act Rule 2a-5). Pursuant to the Derivatives Rule, RICs must adopt risk management programs with board oversight and comply with specific disclosure requirements. The Fair Valuation Rule establishes new requirements for determining fair value of a fund’s investments, board oversight, recordkeeping and reporting. In both cases, examiners will expect RICs to have established policies and procedures to comply with the rules and that disclosures are complete and accurate.
Advisers to private funds
After observing the size and growth of the private funds industry, EXAMS stated that it will continue to focus on private fund managers. Currently, more than 5,500 advisers manage around 50,000 private funds, comprising over $21 trillion in assets. Examiners’ areas of focus will include:
- Conflicts of interest
- Calculation and allocation of fees and expenses (in particular, calculation of post-commitment management fees and private equity funds’ valuation practices)
- Compliance with the new Marketing Rule, including performance advertising and compensated testimonials and endorsements
- Use of alternative data providers
- Compliance with the Custody Rule, including timely delivery of audited financial statements and selection of permissible audit firms
Examiners will also focus on private funds with specific risk characteristics, such as:
- Highly leveraged funds
- Private funds managed side-by-side with business development companies
- In the context of private equity funds, the use of affiliated service providers, and the adviser’s employees, to provide services to the funds and their portfolio companies
- Strategies that involve hard-to-value investments such as real estate (particularly commercial) and digital assets
- Funds that invest in or sponsor SPACs
- Adviser-led restructurings, including stapled secondaries and continuation vehicles
These priorities showcase the EXAMS team’s deepening industry knowledge and sophistication. Coupled with the SEC’s activist approach to private funds, we expect that examinations of private fund managers will intensify. Accordingly, firms should prioritize updating their policies and procedures and conducting regular, documented testing in key risk areas, especially fiduciary duty.
Retail investors and working families
Broker-dealers and investment advisers to retail clients are subject to strict standards of conduct to ensure that they act in those clients’ best interests. Specifically, examiners will focus on how firms are satisfying their obligations under Regulation Best Interest and the Advisers Act fiduciary standard to act in the best interests of retail clients, and not to place their own interests ahead of retail clients’. Firms that are dually registered, and those that use other affiliated financial services providers to advise clients, are of particular concern. Examiners will also focus on advice given to specific categories of investors (e.g. seniors and those saving for retirement).
Examiners will focus on:
- Investment advice regarding specific products, strategies and account types
- Whether disclosures include all material facts relating to any conflicts of interest
- Processes around best interest evaluations, including identifying reasonably available alternatives, costs and risks and conflicts of interest
- Factors firms considered regarding clients’ investment profiles, such as investment goals and account characteristics
- With respect to investment advisers, examiners will review conflicts of interest disclosures to determine whether they are sufficient to enable a client to provide informed consent
Recommendations regarding the following are of particular interest:
- Complex products, such as derivatives and leveraged ETFs and ETNs
- High cost and illiquid products, like variable annuities and non-traded REITs
- Proprietary products
- Unconventional strategies that claim to manage rising interest rates
- Microcap securities
- Account types, such as retirement account rollovers and 529 plans
Noting that all broker-dealers and investment advisers have conflicts of interest, the exam priorities state that examiners will need to understand the economic incentives that a firm and its employees have to recommend products, services or account types. Specifically, EXAMS observed that revenue sharing, commissions, markdowns and markups, particularly involving affiliates, may work to clients’ detriment. Examiners will expect firms to have adopted written policies and procedures that are regularly reviewed and updated, as well as tailored to the firm’s business.
Finally, examiners will scrutinize client agreements for language that purports to waive or limit the applicable standard of conduct and assess compliance with Form CRS requirements.
Given the strength of the environmental, social and governance (ESG) trend, and intense competition for investors in these strategies, EXAMS will continue to focus on ESG-related advisory services and fund offerings, including whether:
- Funds are operating in the manner described their disclosures
- ESG products are appropriately labeled
- Recommendations of ESG products to retail investors are made in their best interests
Firms that manage ESG strategies or market ESG funds should carefully revisit their disclosures and make sure that their portfolio management process are designed to support those objectives. In addition, firms should take care to document their suitability analysis if they are advising retail clients.
Information security and operational resiliency
Given that cybersecurity risks are currently high due to market events, geopolitical conditions and an uptick in cyberattacks (particularly ransomware), EXAMS continues to focus on firms’ ability to prevent disruptions to critical services and protect client information, records and assets. In this focus area, examiners will review firms’ policies and procedures, governance structure, incident response and compliance with applicable regulations. In particular, the EXAMS staff is focused on:
- Practices to prevent account intrusions and protect client information, while recognizing that many firms continue to operate remotely
- Use of third-party service providers and whether firms have transparency into the security and integrity of the provider’s products and services
- Unauthorized use of third-party providers, especially when departing employees attempt to move client information to another firm
- Operational resiliency planning and efforts to address climate-related risks
The SEC continues to solidify its expectations regarding cybersecurity and operational resiliency. It is no longer sufficient for firms to just cover their bases in these areas. We encourage firms to engage specialist providers to build robust cybersecurity and business continuity/disaster recovery programs that are tailored to their specific needs and risks. It is also important to regularly conduct tests to ensure that employees know what to do in the event of a cyber incident, disaster or other disruption.
Emerging technologies and crypto assets
Like the industry, the SEC is also watching trends and market upheaval in technology spaces. In particular, EXAMS will focus on broker-dealers and investment advisers that are deploying financial technologies or new practices, such as solutions addressing compliance, marketing and client servicing. This priority is two-pronged. In connection with digital assets, examinations will focus on the offer, sale or recommendation of, or advice on trading in these or related assets. EXAMS will prioritize new or never before examined registrants offering digital asset strategies. Examiners will expect firms to:
- Adhere to standards of care when making recommendations, referrals or providing investment advice
- Routinely review, update and enhance their compliance, disclosure and risk management practices
In addition, this priority focuses on firms that use technology to engage with clients and whether:
- Investment recommendations or advice were provided (e.g. via social media or a social trading platform)
- Representations were fair and accurate
- Operations and controls are consistent with disclosures
- Advice or recommendations are in the best interests of clients, considering their financial circumstances and objectives
- Risks associated with these practices, including particular impacts on subsets of investors, such as seniors
New technologies, products and ways to serve clients are compelling. In the midst of this innovation, firms should not lose sight of their obligations to act in clients’ best interests. Rather, these obligations require firms to consider their resources (internal and external), expertise, capacity and budget when engaging with new technologies.
2022 was an eventful year in our industry both in terms of rulemaking and enforcement. This year will surely bring more excitement, and hopefully clarity, as exams in these areas progress. Though not stated in the exam priorities, firms should assume that examiners will focus on recordkeeping of electronic communications, and be prepared to demonstrate compliance.