On March 30, 2022, the Division of Examinations of the US Securities and Exchange Commission (the “Division” and “SEC,” respectively) announced its examination priorities for 2022.1 This year’s priorities specifically focus on: (i) private funds; (ii) environmental, social and governance (“ESG”) investing; (iii) standards of conduct, including Regulation Best Interest (“Reg BI”), fiduciary duty and Form CRS; (iv) information security and operational resiliency; and (v) emerging technologies and crypto-assets (collectively, the “Significant Focus Areas”).2
The following briefly summarizes the SEC’s Significant Focus Areas, highlights issues from the Investment Adviser and Investment Company Examination Program and the Broker-Dealer and Exchange Examination Program, and discusses other selected topics for 2022.3
I. Significant Focus Areas
- Private Funds – The Division will review issues under the Investment Advisers Act of 1940 (the “Advisers Act”), including fiduciary duties of investment advisers, and assess risks with a focus on, among other things, compliance programs, fund audits, valuation, conflicts of interest, disclosures of investment risks, and controls around material nonpublic information. The Division will continue to review: (1) the calculation and allocation of fees and expenses; (2) the potential preferential treatment of certain investors by registered investment advisers (“RIAs”) to private funds that have experienced issues with liquidity; (3) compliance with the Advisers Act Custody Rule 206(4)-2, including the “audit exception”; (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. Private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations will also be reviewed with a focus on conflicts and disclosures, including review of private fund investments in special purpose acquisition companies (“SPACs”) where the private fund adviser is also the SPAC sponsor. In addition, the Division will review the practices, controls, and investor reporting around risk management and trading for private funds with indicia of systemic importance, such as outsized counterparty exposure or gross notional exposure when compared to similarly situated firms.
- ESG Investing – The Division will continue its focus on ESG-related advisory services and investment products, including mutual funds, exchange-traded funds, and private fund offerings. Examinations will typically focus on whether RIAs and investment companies registered under the Investment Company Act of 1940 (“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.4 The Division will also review the voting of client securities in accordance with proxy voting policies and procedures, including whether the votes align with their ESG-related disclosures and mandates, and whether there are misrepresentations of the ESG factors considered or incorporated into portfolio selection (e.g., “greenwashing”), such as in their performance advertising and marketing.5
- Standards of Conduct – The Division will assess how broker-dealers and RIAs are satisfying their obligations under Reg BI and the fiduciary duty standard under the Advisers Act. 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 addition, the Division will review broker-dealers’ recommendations and sales practices related to SPACs, structured products, leveraged and inverse exchange traded products (“ETPs”), real estate investment trusts (“REITs”), private placements, annuities, municipal and other fixed income securities, and microcap securities. Examinations will also evaluate the compensation structures for financial professionals. RIA examinations will focus on: (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; and (4) recommending proprietary products resulting in additional or higher fees. For dually registered RIAs and broker-dealers and affiliated firms with financial professionals that service both brokerage customers and advisory clients, focus areas will be similar to those described above, but with a particular emphasis on potential conflicts of interest, such as: (1) the sale or recommendation of high fee products; (2) the sale or recommendation of proprietary products of the firms or their affiliates; (3) incentives for financial professionals to place their own or their firms’ interests ahead of customers (e.g., transactions that reduce costs to the adviser and increase expenses borne by the client); and (4) compensation structures that inappropriately influence investment recommendations.
- Information Security and Operational Resiliency – The Division will review whether firms have taken appropriate measures to safeguard customer accounts and prevent account intrusions; oversee vendors and service providers; address malicious email activities; respond to incidents; identify and detect red flags related to identity theft; and manage operational risk. In addition, business continuity and disaster recovery plans, with particular focus on the impact of climate risk and substantial disruptions to normal business operations, will be reviewed.
- Emerging Technologies and Crypto-Assets – Examinations will focus on firms that are offering new products and services or employing new practices such as fractional shares, “Finfluencers,” or digital engagement practices. The Division will assess whether: (1) operations and controls in place are consistent with disclosures made and 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.6 For market participants engaged with crypto-assets, the Division will review the custody arrangements, offer, sale, recommendation, advice, and trading of crypto-assets. In particular, the Division will review whether the participants (1) have met their respective standards of conduct and duty of care when advising investors 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. In addition, the Division will conduct examinations of mutual funds and exchange-traded funds (“ETFs”) offering exposure to crypto-assets to assess, among other things, compliance, liquidity, and operational controls around portfolio management and market risk. Practice Point: The private fund industry and ESG continue to be major focus areas of the SEC. More recently, the SEC has proposed new rules specifically applicable to private fund advisers, which include (among other things) proposed prohibitions with respect to certain private fund practices that the SEC believes are contrary to the public interest and the protection of investors as well as proposed audit and quarterly reporting requirements.7 In addition, a separate rulemaking proposal focuses on certain amendments to Form PF.8 On the topic of information security, the SEC recently proposed a new rule with respect to cybersecurity practices and related policies and procedures that would be applicable to RIAs and registered funds.9
II. Investment Adviser and Investment Company Examination Program
- Registered Investment Advisers – The Division will review whether compliance programs of RIAs address: (1) investment advice is in each client’s best interest; (2) oversight of service providers is adequate; and (3) sufficient resources exist to perform compliance duties. The Division will also review whether RIAs are implementing appropriate compliance and controls handling material non-public information, to the extent that firms are using alternative or non-traditional data as part of their business and investment decision-making processes. Furthermore, disclosures and issues related to fees and expenses remain focus areas of the Division as in prior years. In particular, its staff will concentrate on issues associated with: (1) advisory fee calculation errors, including, but not limited to, failure to adjust management fees in accordance with investor agreements; (2) inaccurate calculations of tiered fees, including failure to provide breakpoints and aggregate household accounts; and (3) failures to refund prepaid fees for terminated accounts or pro-rated fees for onboarding clients.
- Registered Funds, Including Mutual Funds and ETFs – In reviewing registered funds, the Division will focus on their compliance programs, which include disclosures to investors, accuracy of reporting to the SEC, compliance with the new rules and exemptive orders (including ETF rules and exemptive orders for non-transparent, actively managed ETFs, and custom baskets). As part of its review of registered funds’ liquidity risk management programs, the Division will consider whether such programs are reasonably designed to assess and manage the funds’ liquidity risk and review the implementation of required liquidity classifications, including firms’ oversight of third-party service providers. Similar to prior years, the Division will prioritize examinations of mutual funds or ETFs that have not previously been examined or have not been examined in a number of years. Certain types of registered funds, portfolio investments, and fund practices will be prioritized, including money market funds (reviewed for compliance with applicable requirements, including stress-testing, website disclosures, and board oversight) and business development companies (review of their valuation practices, marketing activities, and conflicts of interest with underlying portfolio companies). With respect to portfolio investments, the Division will focus on examinations of mutual funds investing in private funds to assess risk disclosure and valuation issues. Certain fund practices such as advisory fee waivers and trading activities of portfolio managers that may be designed to inflate fund performance will also be reviewed. Practice Point: Similar to last year, many of the above highlights are perennial areas seen in prior years, including those covering advisory fee calculations, disclosures to investors and the compliance program as a whole, including enhancements and revisions in response to new rules. As was the case in the Significant Focus Areas, the Investment Company Examination Program will also focus on private funds, specifically with respect to mutual fund investments in private funds.
III. Broker-Dealer and Exchange Examination Program
- Microcap, Municipal, Fixed Income, and Over-The-Counter (“OTC”) Securities – The Division will focus on broker-dealers’ compliance with their obligations in the offer, sale and distribution of microcap securities,10 including transfer agent handling of distributions and share transfers, and broker-dealers’ sales practices in light of Reg BI and compliance with certain regulatory requirements, including the locate requirement of Regulation SHO, penny stock disclosure rules, and anti-money laundering obligations. With respect to municipal securities, examinations will focus on whether broker-dealers, underwriters, and municipal advisors are meeting their respective obligations, as applicable, with respect to municipal issuer disclosure. With respect to trading in fixed-income securities, examinations will focus on broker-dealers’ sales practices, best execution obligations, fairness of pricing, mark-ups and mark-downs, and commissions, and confirmation disclosure requirements. The Division will also review the sale of OTC securities and whether broker-dealers recommending these securities are meeting their obligations under Reg BI and revised SEC Rule 15c2-11.
- Broker-Dealer Operations – Examinations of broker-dealers that hold customer cash and securities will continue to focus on compliance with the SEC’s Customer Protection Rule (SEC Rule 15c3-3) and Net Capital Rule (SEC Rule 15c3-1). Specifically, the Division will review the adequacy of internal processes, procedures and controls, and compliance with requirements for borrowing fully paid and excess margin securities from customers. The Division will also assess broker-dealers’ funding and liquidity risk management practices. With respect to firms’ trading practices, examinations will focus on compliance with best execution obligations in a zero commission environment, and SEC Rule 606 order routing disclosure rules. The Division will also focus on potential conflicts of interest in order routing, including conflicts arising from payment for order flow (such as wholesaler payments or exchange rebates), and the possible effects of such conflicts on order routing decisions and best execution obligations. In addition, examinations will focus on large trader reporting and compliance with Regulation SHO (e.g., rules regarding aggregation units and locate requirements). Examinations will further focus on the operations of certain alternative trading systems with Regulation ATS, with a focus on consistency with their disclosures on Form ATS-N. Finally, the Division will focus on firms that are engaged in activities that appear to require broker-dealer registration and those that may be involved in the illegal distribution of unregistered securities.
- Security-Based Swap Dealers (“SBSDs”) – With respect to these new registrants, the Division will focus on the policies and procedures related to compliance with the security-based swap rules generally, including trade acknowledgement and verification, recordkeeping and reporting,11 and risk management.
- Municipal Advisors – The Division will focus on municipal advisors’ fiduciary duty and conflict disclosure obligations to municipal entity clients, as well as their registration, professional qualification, continuing education and supervisory obligations.
- Transfer Agents – The Division will examine transfer agents’ core functions, including the timeliness of transfers, recordkeeping and record retention, safeguarding of funds and securities, and filing obligations with the SEC. The Division will focus on transfer agents who have not been examined previously in addition to transfer agents that service microcap or municipal bond issuers, engage in significant paying agent activity, or use novel technologies (e.g., blockchain or online crowdfunding portal applications). Practice Point: This will be the first year that the Division will examine compliance with amended SEC Rule 15c2-11, which became effective in September 2021.12 The SEC subsequently issued no-action relief under the amended rule for broker-dealers that publish or submit quotations in a quotation medium for fixed income securities, subject to certain phase-in requirements, in order to allow for an orderly and good faith transition into compliance with amended Rule 15c2-11.13
IV. Selected Topics
- LIBOR Transition – As was the case in the 2021 priorities, the Division will continue to engage with registrants through examinations and outreach efforts to assess their exposure to LIBOR and their transition to an alternative reference rate, in connection with registrants’ own financial operations, the exposures of their clients and customers, and their own obligations when recommending LIBOR-linked instruments.14
- Anti-Money Laundering Programs – The Division will continue to review for compliance with applicable anti-money laundering requirements, including evaluating whether broker-dealers and registered funds have adequate policies and procedures in place that are reasonably designed to identify suspicious activity and illegal money-laundering activities. Practice Point: RIAs should continue updating existing LIBOR and alternative reference rate-related risks in their Form ADVs as well as those in the prospectuses of sponsored registered funds and private placement memoranda of sponsored private funds.15
V. Concluding Thoughts
Firms should consider addressing topics applicable to their business as part of their overall risk and compliance management process. Of course, as was the case in prior years, the 2022 priorities do not represent an exhaustive list of the areas on which the Division will focus. Accordingly, firms should thoroughly evaluate their compliance programs and make enhancements as warranted, particularly in light of the nature and extent of the SEC regulatory and enforcement activity as of late.