SEC Marks Important Milestone with a Decade of EXAMS

Investment Management Update

Date: May 04, 2022

The Securities and Exchange Commission’s (SEC) Division of Examinations (EXAMS) recently marked an important milestone – a decade of publishing its examination priorities. EXAMS 2022 examination priorities reiterates its mission to promote and improve compliance, prevent fraud, monitor risk and inform policy. Although the examination schedule remains flexible, its priorities focus on:
  • Private Funds
  • ESG Investing
  • Standards of Conduct: Reg BI, Fiduciary Duty and Form CRS
  • Information Security and Operational Resiliency
  • Emerging Technologies and Crypto-Assets
  • Registered Investment Companies including Mutual Funds and ETFs and
  • Other focus areas relating to broker-dealers and exchanges.
Private Funds

In line with recent SEC rule proposals, EXAMS lists private funds as a significant area of focus. The Division noted that more than 5,000 SEC-registered investment advisers (RIAs), manage approximately $18 trillion in private fund assets deployed in a variety of investment strategies in various fund types, including significant investments from state and local pensions with working family beneficiaries.[1] In the past five years, there has been a 70% increase in the assets managed by advisers to private funds, this coupled with the complexity and size of RIAs and examination findings, has caused the Division to continue to prioritize its focus on RIAs of private funds.

Examinations of RIAs in this space will review issues including an adviser’s fiduciary duty and will assess risks, with a focus on compliance programs, fees and expenses, custody, fund audits, valuation, conflicts of interest, disclosure of investment risks and controls around material nonpublic information.[2]

Specifically, EXAMS will continue to review: (1) the calculation and allocation of fees and expenses, (including post-commitment period management fees and the impact of valuation practices); (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 custody rule, including the “audit exception” to the surprise examinations, Form ADV reporting and updating audits and auditor requirements; (4) the adequacy of disclosure and compliance regarding cross trades, principal transactions or distressed sales; and (5) conflicts involving liquidity, such as RIA-led fund restructurings, including stapled secondary transactions in which new investors purchase the interests of existing investors while also agreeing to invest in a new fund.

Additionally, EXAMS noted it will also review private fund advisers’:

  • Portfolio strategies,
  • Risk management policies,
  • Investment recommendations and allocations,
  • Practices, controls, investor reporting around risk management and trading and
  • Conflicts and disclosures around these areas.

With the increased focus of EXAMS and the SEC on RIAs to private funds, we suggest RIAs to private funds review their existing disclosures, practices and procedures for consistency with disclosed practices and procedures outlined in fund documents.

ESG Investing

On March 21, 2022, the SEC proposed new ESG-related rules for operating companies.[3] Though the proposed rules will not affect registered funds, we expect that the SEC will propose ESG-related rules for registered funds. The 2022 exam priorities highlight how RIAs and registered funds are increasingly offering and evaluating investments that employ ESG strategies, in part to meet investor demand for such strategies and investments. EXAMS noted that there is a risk that disclosures regarding portfolio management practices could involve materially false and misleading statements or omissions, which may be compounded by: (1) the lack of standardization in ESG investing terminology; (2) the variety of approaches to ESG investing; and (3) the failure to effectively address legal and compliance issues with new lines of business and products. To combat these issues, EXAMS will focus on whether RIAs and registered funds are:

  • accurately disclosing their ESG investing approaches and that they have adopted and implemented such policies, procedures and practices designed to prevent violations of federal securities laws and review of their portfolio management processes and practices;
  • voting client securities in accordance with proxy voting policies and procedures and whether the votes align with their ESG-related disclosures and mandates; and
  • overstating or misrepresenting the ESG factors considered or incorporated into portfolio selection, such as in their performance advertising and marketing materials.
Standards of Conduct: Reg BI, Fiduciary Duty and Form CRS

EXAMS will continue to address standards of conduct issues for broker-dealers and RIAs, focusing on satisfying obligations under Regulation Best Interest and the Investment Advisers Act of 1940 (Advisers Act) fiduciary standard to act in the best interests of retail investors and not to place their own interests ahead of retail investors’ interests. Examinations will include assessments of consideration of alternatives practices (e.g., with regard to potential risks, rewards and costs), management of conflicts of interests, trading, disclosures, account selection (e.g., brokerage, advisory or wrap fee accounts), account conversions and rollovers.

Focus areas for broker-dealer examinations will include a review of practices, policies and procedures concerning the evaluation of cost and the availability of reasonable alternatives relating to whether recommendations are in the investor’s best interest.

RIA examinations will focus on whether RIAs are providing investment advice consistent with its fiduciary duties, including the duties of loyalty and care.

Dually registered RIAs and broker-dealers must consider the examination focus areas discussed above but with particular emphasis on conflicts of interest with regard to account recommendations and the allocation of investments across different accounts.[4] Specifically, these examinations will delve into (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 firm’s interests ahead of customers/clients (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.[5]

Information Security and Operational Resiliency

With an increase in remote operations in response to the pandemic, EXAMS will focus on the review of RIA and broker-dealer information security controls and business continuity and disaster recovery plans.[6] EXAMS will focus on the impact of climate risk and substantial disruption to normal business operations. More specifically, the examinations will review whether firms have taken appropriate measures to:

  • safeguard customer accounts and prevent account intrusions, including verifying an investor’s identity to prevent unauthorized account access;
  • oversee vendors and service providers;
  • address malicious email activities, such as phishing or account intrusions; respond to incidents, including those related to ransomware attacks; and
  • manage operational risk resulting from dispersed employees in a work-from-home environment.

RIAs and broker-dealers should ensure their compliance with Regulations S-P and S-ID, where applicable.

Emerging Technologies and Crypto-Assets

EXAMS has noted a significant increase in the number of RIAs that provide automated digital investment advice to retail clients and continued growth in the use of mobile apps by broker-dealers and a rapid increase of the offer, sale and trading of crypto-assets.

Examinations of RIAs and broker-dealers using developing financial technologies will focus on firms that are, or claim to be, offering new products and services or employing new practices to assess whether sufficient operations and controls are consistent with disclosures made and the standard of conduct owed to investors; advice and recommendations are consistent with an investor’s investment strategy; and the controls consider the unique risks associated with such practices.

Custody agreements of market participants engaged with crypto-assets will continue to be reviewed. EXAMS will assess whether such market participants:

  • 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; and
  • routinely review, update and enhance their compliance practices, risk disclosures and operational resiliency practices.

Additionally, the Division will conduct examinations of mutual funds and ETFs offering exposure to crypto-assets to assess, among other things, compliance, liquidity and operational controls around portfolio management and market risk.

Managing compliance while incorporating the use of evolving and developing investment technologies and securities products can be cumbersome. We advise RIAs, broker-dealers and other market participants to ensure they are adhering to their policies and procedures as disclosed in fund documents and setting alerts to stay abreast of any new SEC releases or proposed regulations on the subject.

Registered Investment Companies, Including Mutual Funds and ETFs

EXAMS will continue its assessment of registered funds’ compliance programs and governance practices. This assessment will include a review of disclosures to investors, accuracy of reporting to the SEC and compliance with the new rules and exemptive orders. The Division goes on to list certain types of registered funds, portfolio investments and fund practices that will be prioritized, examples of which include money market funds, business development companies, mutual funds invested in private funds, advisory fee waivers and trading activities of portfolio managers.

Fintech and Innovation

Recognizing the rapid growth of and related risks presented by the digital asset market, including cryptocurrency, the Division is steady in its efforts to examine SEC-registered market participants engaged in such market. The Division’s examinations will assess:

  • investment suitability;
  • portfolio management and trading practices;
  • safety of client funds and assets;
  • pricing and valuation;
  • effectiveness of compliance programs and controls; and
  • supervision of employees’ outside business activities.

Additionally, examinations will focus on evaluating whether registrants are operating consistent with their representations, whether firms are handling customer orders in accordance with their instructions and review compliance around trade recommendations made in mobile applications.

Other Focus Areas Related to Broker-Dealers and Exchanges

In continuing its mission to deter microcap fraud, EXAMS will prioritize examinations of broker-dealers for compliance with obligations in the offer, sale and distribution of microcap securities (securities of companies with market capitalization under $250 million).

Broker-dealers that hold customer cash and securities have a responsibility to ensure that those assets are safeguarded in accordance with the Customer Protection Rule and the Net Capital Rule. Examinations of broker-dealers will continue to focus on compliance with these rules, including the adequacy of internal processes, procedures, controls and compliance with requirements for borrowing fully paid and excess margin securities from customers. EXAMS may also assess broker-dealer funding and liquidity risk management practices to assess whether firms have sufficient liquidity to manage stress events.[7]

As in previous years, the Division will prioritize the review of 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 to ensure investors are receiving the benefits of the federal securities laws.

Additionally, the Division will examine the national securities exchanges to assess whether they are meeting their obligations under the federal securities laws and will focus on exchange regulatory programs to detect and discipline violations and participation in National Market System (NMS) Plans. Examinations may also assess and compare any exchange advisory services offered to issuers regarding ESG initiatives.[8]

Outlook

Annually, EXAMS highlights the highest risks to investors and the markets. It is important to note that EXAMS priority list is not exhaustive. A firm’s leadership, including those in compliance, legal, risk and information security across the financial services industry should review the priorities and consider their firm’s operations and internal controls in these higher-risk areas to avoid potential compliance weaknesses or failures.

If you have any questions regarding the 2022 exam priorities, need assistance with updating your firm’s compliance policies and procedures, preparing for a regulatory exam, implementing the use of emerging technologies or offering or investing in crypto assets, please visit one of our many resources available on the Thompson Hine website or contact one of the authors.

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FOR MORE INFORMATION

For more information, please contact:

Marc B. Minor
614.469.3232
Marc.Minor@ThompsonHine.com

Tashia Love
614.469.3284
Latashia.Love@ThompsonHine.com

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[1] SEC Division of Examinations, 2022 Examinations Priorities, (March 30, 2022), https://www.sec.gov/files/2022-exam-priorities.pdf (hereinafter, “2022 Priorities”)

[2] Id. at 12.

[3] Press Release, SEC, SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors (Mar.21, 2022), available at https://www.sec.gov/news/press-release/2022-46.

[4] Id. at 14

[5] Id.

[6] SEC Division of Examinations, 2021 Examinations Priorities, (March 3, 2021) https://www.sec.gov/files/2021-exam-priorities.pdf

[7] Id. at 20

[8] Id.