After a record-breaking year highlighted by US$6.4B in civil penalties, fines, interest, and disgorgements, the Securities and Exchange Commission has released its 2023 examination priorities. The penalties assessed were almost double the US$3.9B collected by the SEC in 2021. In terms of the primary targets of the SEC actions, the highest number of actions were against investment advisors and investment companies. The messages from the regulator are clear: they aim to change the behavior of RIAs through strict enforcement and sanctions, and registrants would be well advised to review their compliance procedures and operational practices well in advance of a routine or for-cause SEC examination.
Highlights and SEC Examination Priorities
While we recognize that compliance with all of the rules and requirements of the SEC and state regulatory authorities is critical, it’s useful to reflect on the current priorities of examiners in routine and for-cause reviews. In the SEC Release, the Commission highlighted a number of recently adopted rules under the Advisers Act of 1940 and the Investment Company Act of 1940.+
The Marketing Rule – The new Marketing Rule is a significant change affecting all registered advisors. The Division of Examinations will focus on the adoption and implementation of written policies and procedures designed to comply with the new Rule. Registrant’s procedures should address new standards for performance advertising, testimonials, endorsements, and third-party ratings.
Derivatives Rule – The Rule requires compliance from mutual funds, other investment companies, exchange-traded funds, and business development companies (BDCs) in assessing policies and procedures designed to manage the funds’ derivatives risk, board oversight, and the adequacy of disclosures.
Fair Valuation – The Division will assess a fund’s compliance with the new requirements for determining fair valuation including board oversight, recordkeeping and reporting requirements, the designation of valuation designees, valuation methodologies, policies and procedures, and service provider oversight.
RIAs to Private Funds – The Division will continue to focus on a private fund’s RIA for conflicts of interest, the calculation and allocation of fees and expenses, the Marketing Rule, compliance with the Custody Rule, and the selection of auditors and the timely delivery of audited financials.
Regulation Best Interest and Fiduciary Duty – The examination of broker/dealers and registered advisors will focus on advice and recommendations of products, investment strategies, and account types, disclosure of material facts, the process for making best-interest recommendations, reasonably-available alternatives, the evaluation of costs and risks, and facts consider in light of an investor’s profile. Form CRS delivery, monitoring, filing, and website posting will also continue to be a priority.
ESG Investing – The Division will focus on ESG-related advisory services and fund offerings, including whether or not the ESG products are operating in a manner set forth in their disclosures, if the products are appropriately labeled, and whether recommendations are made in the investors’ best interests.
Information Security and Operational Resiliency – The Division continues to review practices to prevent interruptions to mission-critical services and the protection of investor information, records, and assets. The focus will be on policies and procedures, governance practices, testing, and the response to cyber-related incidents such as ransom attacks, visibility into the security and integrity of third-party vendors, and compliance with Regulation S-P.
Crypto Assets and Emerging Technology – The division continues to observe the proliferation of crypto assets and emerging financial technology. The focus will include “robo-advisor” platforms, standards of care when making recommendations, disclosure and risk management practices, and advisors adopting crypto-related assets for sale to investors.
Anti-Money Laundering – Examinations will focus on policies and procedures designed to verify the identity of clients and beneficial owners, client due diligence, monitoring for suspicious activity, and the reporting of Suspicious Activity Reports (SARs). Given the current geopolitical environment and the increased imposition of international sanctions, registrants are well advised to review their AML policies and procedures, standards of care, and consider robust and timely independent testing of their AML compliance program.
During a typical examination, the Division reviews the compliance programs and related disclosures of RIAs in one or more core areas, such as custody and safekeeping of client assets, valuation, portfolio management, and brokerage and execution. Often examinations also include a review for conflicts, compliance issues, and the oversight and approval process related to the calculation of fees, alternative ways that RIAs may try to maximize revenue, and excessive fees. In addition to reviewing these core focus areas, examinations will review RIA policies and procedures for retaining and monitoring electronic communications and selecting and using third-party service providers. As in previous years, the Division prioritizes RIAs that have never been examined, including recently registered firms, and those that have not been examined for a number of years.
The writing is very much on the wall. The SEC broke the record for fines and enforcement actions in 2022 and could be aiming for another banner year in 2023. Independent testing to review the adequacy of a firm’s written policies and procedures in comparison to its day-to-day business practices is an important step in protecting a registrant from being a target of a future SEC action.