By Jennifer Dickinson, Senior Managing Director, U.S.
On October 16, 2023, the U.S. SEC’s Division of Examinations (EXAMS) announced its 2024 examination priorities. With the new year now upon us, this article explores the areas applicable to registered investment advisers, including both private fund managers and firms that advise individual accounts.
ESG is absent – but don’t get comfortable
Notably absent from the priorities is environmental, social and governance (ESG) compliance, which was a priority for 2023. Firms that manage ESG strategies or consider ESG factors as part of their investment programs should not breathe a sigh of relief, however. Rather, they should expect EXAMS teams to scrutinize marketing materials and dig into portfolio management practices because these are perennial focus areas.
Any misleading ESG-specific content or failure to follow ESG policies as they relate to portfolio management will result in deficiencies, official priorities notwithstanding.
Operational resiliency and information security remain a priority for all
Operational resiliency and information security remain a priority for all types of firms. Specifically:
- Observing that risks remain elevated due to the proliferation of cyberattacks, hybrid work environments, severe weather-related events and geopolitical concerns, EXAMS teams will look at a firm’s practices to prevent interruptions to mission-critical services and to protect investor information, records and assets
- EXAMS teams will focus on registrants’:
- Policies and procedures, internal controls, oversight of third-party vendors, governance practices, and responses to cyber-related incidents, including those related to ransomware attacks
- Identity theft prevention programs and policies and procedures to protect customer records and information, particularly whether registrants adequately train staff on them
- Use of third-party products/services and how firms identify and address risks to essential business operations, including concentration risk associated with this use and the potential impact to the U.S. securities markets
- With respect to firms that have a main office and branch offices, EXAMS teams will continue to look at firms’ practices to prevent account intrusions and safeguard customer records and information in these dispersed environments
Specific priorities for investment advisers
Regarding investment advisers specifically, EXAMS teams will focus on the following:
- Investment advice on specific products and strategies:
- Complex products, such as derivatives and leveraged exchange-traded funds (ETFs)
- High cost and illiquid products, such as variable annuities and non-traded real estate investment trusts (REITs)
- Unconventional strategies, including those that purport to address rising interest rates
Firms that advise older investors and those saving for retirement should expect deeper scrutiny.
- Processes for determining that investment advice is provided in clients’ best interests, including:
- Making initial and ongoing suitability determinations
- Seeking best execution
- Evaluating costs and risks
- Identifying and addressing conflicts of interest
Examiners will also review the factors that advisers consider in light of clients’ investment profiles, such as investment goals and account characteristics, including any associated conflicts of interest. For example, allocating investments to clients that have more than one account (e.g. allocating between accounts that are adviser fee-based, brokerage commission-based and wrap fee, as well as between taxable and non-taxable accounts)
- Economic incentives that may be driving an adviser and its financial professionals to recommend particular products, services or account types, including the source and structure of compensation, revenue or other benefits. These incentives may exist when there is revenue sharing, mark-ups or other incentivizing revenue arrangements.
In particular, EXAMS teams will focus on conflicts of interest faced by dual registrants or advisers that use affiliated broker-dealers, including when financial professionals service both brokerage customers and advisory clients. These conflicts may arise with respect to advice:
- To purchase or hold onto certain types of investments or invest through certain types of accounts when lower-cost options are available
- Regarding proprietary products and affiliated service providers that result in additional or higher fees to clients
- Disclosures made to clients and whether they include all material facts relating to conflicts of interest associated with the investment advice. These disclosures should be sufficient to allow a client to provide informed consent to the conflict
Continued scrutiny of private fund managers
EXAMS teams will continue their focus on private fund managers’ operations, disclosures, conflicts of interest and compliance with the rules that are specific to these firms, namely:
- Portfolio management risks associated with recent market volatility and higher interest rates, such as poor performance, significant withdrawals, valuation issues and funds with more leverage or that invest in illiquid assets
- Adherence to contractual obligations regarding LPACs and similar boards/committees, including notification and consent requirements
- Accuracy of fee calculations and allocation of expenses (both fund-level and investment-level), including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and application of any offset provisions
- Assessing private equity and venture capital firms’ portfolio company due diligence practices for consistency with policies, procedures and disclosures
- Conflicts, controls and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers
- Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements
- Policies and procedures for reporting on Form PF; specifically, compliance with the new requirements to amend if certain events occur
Reaffirmed focus on advisers’ compliance programs overall
Finally, the 2024 priorities reaffirm EXAMS’ focus on advisers’ compliance programs more broadly, including:
- Marketing rule: Adoption of written policies and procedures; ADV disclosures; substantiation and recordkeeping; presentation of performance metrics, particularly use of hypothetical performance; and assessment of whether content is misleading
- Compensation: Revenue streams and fiduciary duty considerations and fee breakpoint calculation processes, particularly when billing processes are not automated
- Valuation: Recommendations to invest in illiquid or hard-to-value securities, such as commercial real estate or private placements
- Material non-public information: Controls in place particularly when multiple advisers share office space, have employee turnover or use expert networks
- Filings and disclosures: Accuracy and completeness; Form CRS and whether statements re inadequate or misleading; and registration eligibility
In addition to the stated priorities, advisers’ compliance game plan for 2024 should factor in the September 14, 2024 compliance date for the private fund reforms (if applicable), ongoing off-channel communications enforcement, and the SEC’s continuing sweep exams on the marketing rule.