By Kevin Kirk
On March 30, 2022, the Securities and Exchange Commission’s (“SEC”) Division of Examinations (“Division”) released its 2022 Exam Priorities. The stated purpose for the Division in releasing these priorities is to promote compliance, prevent fraud, identify and monitor risk, and inform policy. The focus for the SEC in the coming year appears to be a continuance of the same items of focus from previous years. These priorities represent practices, products, and services which the Division has identified as areas of higher risk which could have a significant impact on investor protection. Firms whose businesses engage in any of these practices or offer any of the related products and services should be prepared if audited by the SEC.
In the release the Division provided some background regarding the significant growth seen within the private fund space. Per their estimation, more than 35% of RIAs manage private fund assets totaling more than $18 trillion, which represents a 70% increase in assets over the past five years. The sudden growth and complexities which surround these products has triggered this as a significant priority for the SEC and it appears to be a concern that will be on their radar for some time. RIAs who manage private funds can expect the SEC to focus on their practices related to the following:
- Fiduciary duty
- Compliance Program
- Fees and expenses assessed to the Fund
- Fund audits
- Conflicts of interest
- Disclosures and investment risks
- Controls related to Material Non-Public Information
Specifically, the SEC will most likely address 1) an advisors calculation of fees and expenses, including the treatment of post-commitment period management fees and the impact of the firm’s valuation practices; 2) Preferential treatment to certain investors and their ability to take withdrawals; 3) adherence to the Custody Rule, including the “audit exception” and reporting and updating of Form ADV in relation to the audit and auditors who perform such responsibilities; 4) adequacy of disclosures and compliance with regulatory requirements related to cross-trades, principal transactions, or distressed sales; and 5) conflicts associated with RIA led liquidity efforts, such as fund restructuring where new investors make a significant cash investment to create liquidity for existing investors. Additionally, the SEC will also be looking at any conflicts and disclosures related to an adviser’s portfolio strategies, risk management, investment recommendations and allocations.
Environmental, Social, and Governance (ESG)
Over the past year, the Division has expressed some real concerns related to advisory firms who have incorporated some version of ESG into their portfolio management process. ESG was one of the top priorities for the SEC last year and they continue to be very vocal with regards to firms utilizing ESG factors in their practices, having already released a risk alert on April, 9, 2021 (Risk Alert: The Division of Examinations’ Review of ESG Investing). Their main concerns are with firms who overstate or do not accurately disclose the role that ESG plays when evaluating investments or managing a particular strategy. These issues can lead to some firms providing false and misleading statements which could give investors the wrong impression about how involved ESG is used in the firm’s management of related assets. For example, firms may be omitting certain details in marketing materials about how they are utilizing ESG criteria and implying it plays a bigger role than what is actually occurring. This would be considered a violation of the antifraud provisions in the Advisers Act.
The SEC’s concerns are compounded by the lack standardization of terminology related to ESG investing, especially since it is still considered a novel concept. For example, common terms such as sustainable, socially responsible and ESG conscious investing are terms that can be vague and interpreted differently based on the circumstances and require additional explanation and disclosure. Other concerns expressed by the Division include specifics around how ESG is applied to the firm’s portfolio management process. For example, some firms may use ESG criteria as a risk assessment tool but does not specifically use it to limit or eliminate an investment from consideration. Additionally, the SEC will also be looking for failures in the way firms address legal and compliance issues in new lines of business and products involving ESG.
Firms who utilize ESG should expect an examination of their practices to include a review of any disclosures and policies and procedures to ensure they are accurate and sufficient to prevent any violation of securities laws, confirmation that client securities are voted in accordance with ESG-related disclosures and mandates, and for any overstatement and misrepresentation of ESG factors related to portfolio selection in any associated marketing and advertising materials.
Standards of Conduct: Regulation Best Interest, Fiduciary Duty, and Form CRS
Again, this year the Division will continue to focus on concerns surrounding Standards of Conduct related to advisers. The SEC will be placing a particular emphasis on determining if an adviser is fulfilling their fiduciary duty obligations to their clients. Most notably their obligations related to duty of care and duty of loyalty, which will include an adviser’s best execution obligation, disclosure of all financial conflicts of interest, and the objectiveness exercised in any advice provided to clients. Areas of specific focus will include: 1) revenue sharing arrangements; 2) recommendation of more expensive investments products when less expensive products are available (i.e., 12b-1 fees); 3) appropriateness of a client’s participation in wrap fee programs in light of many firms moving to zero commission pricing structures; and 4) recommendation of proprietary products which result in higher fees. The effectiveness of an adviser’s ability to provide informed consent to clients in their policies and procedures and related disclosures will be on their list as well.
Information Security and Operational Resiliency
In 2022, we can expect the Division to continue their focus on the processes and capabilities of advisers to protect their client’s information from cyber related events and the effectiveness of their disaster recovery and continuity plans.
To accomplish this objective, the SEC will look to ensure that firms have taken the appropriate measures to protect customer accounts and prevent unauthorized access, including proper verification of anyone requesting access to such accounts. Also, they will be looking at the how firms oversee their vendors and service providers, address malicious email activities (i.e., phishing attacks), respond to breaches or incidents, identify and detect identity theft, and manage any associated risks related to their remote work environment.
A firm’s disaster recovery and continuity plan will also be a priority of the Division. Most notably there will be a particular focus on making sure they address climate change and other significantly impactful events which can cause extensive disruptions in a firm’s operations. This area has received even more attention after the recent business disruptions that we have all witnessed during the current COVID-19 pandemic. Also, the increasing concerns over the cause and effect related to climate change has made this a particular priority of the Division as well. Firms should expect any exam to include a review of their plan to make sure they are comprehensive and are being regularly reviewed to ensure their ongoing effectiveness.
Emerging Technologies and Crypto-Assets
Another of focus for the Division will be advisers who provide automated digital investment advice (i.e., robo-advisers) and those who recommend investments in crypto-assets (e.g., Bitcoin). The SEC will be looking at the compliance programs of advisers related to these emerging technological investment practices to determine if any deficiencies exist, including if the unique risks associated with these products are accounted for in their program. Advisers who recommended the use of crypto-assets, should expect the SEC to review any custody arrangements related to such assets and the firm’s practices associated with the offer, sale, recommendation, advice, and trading of them. The SEC, in particular, will look to ensure that firms have a thorough understanding of these products and are meeting their fiduciary duties to their clients. Also, SEC will be looking at a firm’s policies and procedures and related disclosure to ensure they are sufficiently being updated as the regulatory landscape associated with them evolves.
Additional Focus Areas
In the coming year, firms can expect the Division to continue its ongoing evaluations of compliance programs associated with both Registered Investment Advisers (“RICs”) and Registered Investment Companies (“RICs”), including mutual fund and ETFs. This includes evaluating aspects related to marketing practices, custody of client assets, valuation practices, portfolio management, brokerage and execution, conflicts of interest, and all disclosures related to these topics.
RIAs should anticipate an evaluation of their compliance program to make sure it addresses such items as investment advice in the client’s best interest, oversight of service providers, and employing sufficient resources to effectively execute the firm’s compliance responsibilities. Additionally, RIAs should expect attention to be paid to how they address heightened risks, disclosures, and issues related to fees and expenses. the SEC will especially be looking at a firm’s fee and expense practices to uncover any issues related to inaccurate fee calculations, failure to provide fee breakpoints and aggregate household assets, and failure to refund prepaid fees to terminated clients or pro-rate fees for new clients.
RICs can continue to expect an ongoing review of areas such as disclosures made to investors, accuracy of reporting to the SEC, and compliance with new rules and exemptive orders. Also, the SEC will have a particular focus on the implementation of liquidity classifications and the firm’s oversight of third-party service providers. The Division stated that certain funds including money market funds, business development companies, and mutual funds investing in private funds will be a priority. Certain fund practices employed by RICs, such as advisory fee waivers and trading activities of portfolio managers designed to inflate performance, will also be on their radar as well.
The SEC has outlined a very ambitious agenda for 2022 and appears ready to increase examination and enforcement efforts to meet their new goals. Although 2021 brought new leadership and priorities to the regulatory agency, 2022 could be a true inflection point for the agency. With the Marketing Rule going into effect in November and major SEC initiatives surrounding ESG, crypto assets, cybersecurity, and private fund advisers, investment advisers may feel like overwhelmed by the amount of regulatory change. If you would like an experienced partner to assist you in navigating this regulatory environment, the professionals at Key Bridge Compliance stand ready to assist you. Feel free to contact us at firstname.lastname@example.org