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(Article from Registered Funds Regulatory Update, April 2023)

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The SEC’s Division of Examinations announced the following six enumerated priorities for 2023: (i) compliance with new investment adviser and investment company rules; (ii) RIAs to private funds; (iii) ESG; (iv) standards of conduct for broker-dealers and RIAs; (v) information security and operational resiliency; and (vi) crypto-assets and emerging financial technology. The following sets forth an overview of the Division’s 2023 examination priorities:

Compliance with New Investment Adviser and Investment Company Rules.

Advisers Act Rule 206(4)-1 (Marketing Rule). The Division will assess whether RIAs have adopted and implemented written policies and procedures that are reasonably designed to prevent violations by advisers and their supervised persons of the Marketing Rule. The Division will also review whether RIAs have complied with the substantive requirements of the Marketing Rule, including the requirement that RIAs have a reasonable basis for believing they will be able to substantiate material statements of fact and requirements for performance advertising, testimonials, endorsements, and third-party ratings.

Investment Company Act Rule 18f-4 (Derivatives Rule). For funds relying on the Derivatives Rule, the Division will, among other things: (i) assess whether funds have adopted and implemented policies and procedures reasonably designed to manage the funds’ derivatives risks and to prevent violations of the Derivatives Rule, and (ii) review for compliance with Rule 18f-4, including the adoption and implementation of a derivatives risk management program, board oversight, and whether disclosures concerning the fund’s use of derivatives are incomplete, inaccurate, or potentially misleading.

Investment Company Act Rule 2a-5 (Fair Valuation). The Division will: (i) assess funds’ and fund boards’ compliance with the new requirements for determining fair value, implementing board oversight duties, setting recordkeeping and reporting requirements, and permitting fund boards to designate valuation designees to perform fair value determinations subject to oversight by the board, and (ii) review whether adjustments have been made to valuation methodologies, compliance policies and procedures, governance practices, service provider oversight, and/or reporting and recordkeeping.

RIAs to Private Funds. The Division will continue to focus on fiduciary duties and will assess risks, including a focus on compliance programs, fees and expenses, custody, the new Marketing Rule, conflicts of interest, and the use of alternative data (i.e., data derived from beyond traditional financial statements, company filings, and press releases). The Division will also review private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations as well as disclosure relating to each of those areas. Additionally, the Division will focus on RIAs to private funds with specific risk characteristics, including: (i) highly leveraged private funds; (ii) private funds managed side-by-side with BDCs; (iii) private equity funds that use affiliated companies and advisory personnel to provide services to their fund clients and underlying portfolio companies; (iv) private funds that hold certain hard-to-value investments, such as crypto assets and real estate-related investments, with an emphasis on commercial real estate; (v) private funds that invest in SPACs; and (vi) private funds involved in adviser-led restructurings, including stapled secondary transactions and continuation funds.

Standards of Conduct: Regulation Best Interest, Fiduciary Duty and Form CRS. The Division will continue to focus on standards of conduct for broker-dealers and advisers, specifically related to compliance with Regulation Best Interest and the fiduciary standards of the Advisers Act to “ensure that retail investors and working families are receiving recommendations and advice in their best interests.” The Division’s examinations will assess practices regarding review of investment alternatives, management of conflicts of interest, and consideration of investment goals and account characteristics. The Division notes the following areas of assessment for its examinations:

• investment advice and recommendations with regard to products, investment strategies, and account types;
• disclosure made to investors and whether such disclosures include all material facts relating to the conflicts of interest associated with the advice and recommendations;
• processes for making best interest evaluations, including those for reviewing reasonably available alternatives, evaluating costs and risks, and identifying and addressing conflicts of interest; and
• factors considered in light of the investor’s investment profile, including investment goals and account characteristics.

In the case of RIAs, the Division will review whether conflicts of interest disclosure is sufficient such that a client can provide informed consent to the conflict, whether express or implied. For both broker-dealers and RIAs, the Division will seek to identify and understand the economic incentives (e.g., revenue sharing arrangements, commissions, or use of affiliate service providers) that a firm and its financial professionals have to recommend products, services, or account types. Examinations will review how firms are managing conflicts of interest, including mitigating or eliminating the conflicts of interest, when appropriate, and whether client agreements contain hedge clauses or other language that purport to limit the firm’s standard of conduct. Furthermore, the Division will review whether a firm has established written policies and procedures to identify such conflicts of interest and periodically reviewed and updated their policies and procedures, as appropriate.

Additionally, the Division will use its examinations of RIAs and broker-dealers to ensure compliance with Form CRS, which requires that firms (i) deliver their relationship summaries to new and prospective retail investors, as
well as to existing retail investors; (ii) file their relationship summary with the SEC; and (iii) post the current relationship summary on the firm’s public website, if the firm has one.

ESG Investing. The Division will continue its focus on ESG-related advisory services and fund offerings, including whether the funds are operating in the manner set forth in their disclosure. In addition, the Division will assess whether ESG products are appropriately labeled and whether recommendations of such products for retail investors are made in investors’ best interests. The Division recognizes that RIAs and registered funds are competing for the rising investor demand for ESG-related investment strategies and are increasingly offering and evaluating investments that employ such strategies.

Information Security and Operational Resiliency. The Division will review broker-dealer and RIA practices to prevent interruptions to mission critical services and to protect investor information, records, and assets. In particular, the Division’s exams will focus on safeguarding customer records and information (including those stored via third-party service providers), governance practices, responses to cyber-related incidents, and broker-dealer and RIA compliance with Regulations S-P and S-ID, where applicable. The Division notes that “[t]he current risk environment related to cybersecurity is considered elevated given the larger market events, geopolitical concerns, and the proliferation of cybersecurity attacks, particularly ransomware attacks.” In addition, the Division will continue to assess the operational resiliency planning of systemically significant registrants, such as their efforts to address climate-related risks.

Crypto-Assets and Emerging Financial Technology. Given the disruptions caused by recent financial distress among crypto asset market participants, examinations of registrants will also focus on the offer, sale, recommendation of, or advice regarding trading in crypto or crypto-related assets and include whether the firm (i) met and followed their respective standards of care when making recommendations, referrals, or providing investment advice, and (ii) routinely reviewed, updated, and enhanced their compliance, disclosure, and risk management practices. The Division also will conduct examinations of broker-dealers and RIAs that are using emerging financial technologies (e.g., broker-dealer mobile apps, automated “robo adviser” investment tools, and trading platforms) to meet compliance and marketing demands and to service investor accounts. Examinations of broker-dealers and RIAs will also focus on firms that employ digital engagement practices and the related tools and methods to assess whether: (i) recommendations were made or advice was provided (e.g., through the use of social media marketing and social trading platforms); (ii) representations were fair and accurate; (iii) operations and controls in place were consistent with disclosure made to investors; (iv) any advice or recommendations were in the best interests of the investor taking into account the investor’s financial situation and investment objectives; and (v) risks associated with such practices were considered, including the impact these practices may have on certain investors, such as seniors.

Investment Advisers and Investment Company Examination Programs.

Registered Investment Advisers. The Division will continue to review the compliance programs of advisers, including whether the various aspects of RIA operations and compliance practices have appropriately adopted and considered current market factors, such as those that might impact the valuation and accuracy of RIA regulatory filings. Typically, examinations of RIAs involve review of compliance programs and related disclosures in one or more core areas, such as custody and safekeeping of client assets, valuation, portfolio management, and brokerage and execution. The Division’s reviews of RIAs also often include a review for conflicts, compliance issues, and the oversight and approval process related to RIA fees and expenses, including: (i) the calculation of fees; (ii) alternative ways that RIAs may try to maximize revenue, including revenue earned on clients’ bank deposit sweep programs; and (iii) excessive fees. Additionally, 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 advisers and registered funds that have never been examined, including recently registered firms, and those that have not been examined for a number of years.

Registered Investment Companies. The Division will focus on the fiduciary obligations of RIAs to registered investment companies, particularly with respect to their receipt of compensation for services or other material payments made by such registered investment companies and other sources. As part of its review of registered fund compliance programs and governance practices, the Division will continue to evaluate board processes for assessing and approving advisory and other fund fees, particularly for funds with weaker performance relative to their peers. In addition, the Division will assess the effectiveness of fund derivatives risk management programs and liquidity risk management programs, as applicable.

The Division will also focus on funds with specific characteristics, such as: (i) turnkey funds, to review their operations and assess effectiveness of their compliance programs; (ii) mutual funds that converted to ETFs to assess governance and disclosure associated with the conversion (partly to ensure that 12b-1 fees charged to investors of mutual funds do not benefit shareholders of ETF clones); (iii) non-transparent ETFs to assess compliance with the conditions and other material terms of their exemptive relief; (iv) loan-focused funds, such as leveraged loan funds and funds focused on collateralized loan obligations for liquidity concerns and to review whether the funds have been significantly impacted by, and have adapted to, elevated interest rates; and (v) medium- and small-fund complexes that have experienced excessive staff attrition to focus on whether such attrition has affected fund controls and operations. The Division will also monitor the proliferation of volatility-linked and single-stock ETFs and may review such fund disclosures, marketing, conflicts, and compliance with portfolio management disclosure, among other things. As with RIA examinations, the Division will prioritize
registered investment companies that have never been examined, including recently registered investment companies, and those that have not been examined in a number of years.

2023 Examination Priorities, Division of Examinations, SEC (Feb. 7, 2023), available at: https://www.sec.gov/files/2023-exam-priorities.pdf.