By Les Abromovitz, Senior Director
On March 30, 2022, the SEC’s Division of Examinations (“Division”), formerly known as the Office of Compliance Inspections and Examinations, announced its priorities for the fiscal year 2022. The new publication represents the tenth time the SEC has published the Division’s examination priorities.
The Division publishes its priorities each year to provide insights regarding its approach to examinations and to highlight areas it believes pose potential risks to investors and the integrity of the U.S. capital markets. According to Richard R. Best, Acting Director of the Division of Examinations, “Our priorities cover a broad landscape of potential risks to investors that firms should consider as they review and strengthen their compliance programs.” In the SEC’s press release, Best observed that the Division’s priorities are tailored to focus on emerging risks, such as crypto-assets and expanding information security threats, as well as core issues such as protecting retail investors.
Since first sharing its top priorities in 2013, the Exam Priorities Letters have become more prominent over the years and are an important tool for the Division’s examination program. The publication of these examination priorities provides investors and registrants with transparency into those high-risk areas.
Although the areas identified are critical, the list is not comprehensive. The Division may identify new and exigent risks to investors and the marketplace as they arise.
Division identifies significant focus areas in 2022
Although the publication covers a number of other examination priorities, it is helpful to focus on the following five risk areas.
- Private funds;
- Environmental, social, and governance (“ESG”) investing;
- Protecting retail investors and working families;
- Information security and operational resiliency; and
- Emerging technologies and crypto-assets.
The Division takes a risk-based approach to examinations.
Private funds. The Division will focus on the more than 5,000 Registered Investment Advisors (“RIAs”) managing private funds. During the past five years, assets managed by advisors to private funds have increased by 70 percent.
Examiners will scrutinize whether private fund advisors have satisfied their fiduciary duty. They will evaluate risks by focusing on RIAs’ compliance programs, fees and expenses, custody, fund audits, valuation, conflicts of interest, disclosures of investment risks, and controls governing material nonpublic information (“MNPI”). Examiners will also review private fund advisors’ portfolio strategies and risk management, as well as their investment recommendations and allocations. They will focus on the advisors’ conflicts of interest and disclosures. As an example, these reviews will address private funds’ investments in Special Purpose Acquisition Companies (“SPACs”), particularly in situations where the private fund advisor is also the SPAC sponsor.
ESG investing. Examiners will remain focused on ESG-related advisory services and investment products. Generally, examinations will pay particular attention to whether RIAs and registered funds are accurately disclosing their ESG investing approaches. Examiners will evaluate whether firms have adopted and implemented policies, procedures, and practices that are intended to prevent violations of the federal securities laws. Examiners will also review the voting of client securities to see if they are consistent with proxy voting policies and procedures. Proxy votes should be aligned with the firm’s ESG-related disclosures and mandates.
In addition, there is a risk that firms will overstate or misrepresent the ESG factors considered, or incorporated into, their portfolio selection. Examiners will be on the lookout for performance advertising and marketing content containing “greenwashing,” which exaggerates a company’s commitment to, or achievement of, climate-related goals.
Protecting retail investors and working families. Examiners will be looking closely at broker-dealers’ and RIAs’ standard of conduct to ensure that retail investors and working families are receiving recommendations and advice that is in their best interests. They will explore many areas of concern, such as revenue sharing arrangements and recommending more expensive mutual fund share classes. Examiners will also focus on how firms are satisfying their obligations under Regulation Best Interest and the fiduciary duty owed pursuant to the Investment Advisers Act of 1940. Examiners will assess firms’ practices pertaining to their consideration of alternatives, management of conflicts of interest, trading and best execution, disclosures such as those offered in Form ADV and Form CRS, and account selection, as well as account conversions and rollovers. Of particular note is the Division’s reference to focusing on 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, and advisors’ 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.
For both RIAs and broker-dealers, examiners will focus on the effectiveness of compliance programs, testing, and training that is designed to ensure that retail investors and working families are receiving recommendations and advice consistent with their best interests.
Information security and operational resiliency. Examiners will review firms’ practices to prevent interruptions to critical services and to protect investor information, records, and assets. Examiners will determine whether firms:
- Have taken appropriate measures to safeguard customer and clients’ accounts and prevent intrusions;
- Oversee the work of vendors and service providers;
- Address malicious email activities, such as phishing or account intrusions;
- Respond to incidents, including those related to ransomware attacks;
- Identify and detect red flags related to identity theft; and
- Manage operational risk arising from a dispersed workforce.
Firms’ business continuity and disaster recovery plans will be under the microscope in 2022, especially with regard to the impact of climate risk and substantial disruptions to normal business operations.
Emerging technologies and crypto-assets. Examiners will be keeping a close watch on broker-dealers and RIAs that utilize emerging financial technologies since they create unique risks. The Division has observed a significant increase in the number of RIAs that provide automated digital investment advice to their clients, commonly referred to as “robo-advisors.” The Division is also concerned about the continued growth in the use of mobile apps by broker-dealers, as well as widespread offers, sales, and trading of crypto-assets.
When RIAs and broker-dealers claim to offer new products, services, or practices, examiners will evaluate whether there are operations and controls in place that are consistent with the disclosures made and the standard of conduct owed to investors. Examiners will decide if firms’ advice and recommendations, including those relying on algorithms, are consistent with investors’ investment strategies and the standard of conduct owed to them. Examiners will also look at whether the firm’s controls are appropriate for the unique risks associated with those practices.
When market participants are engaged with crypto-assets, examiners will review their custody arrangements for those assets. In addition, examiners will evaluate the offer, sale, recommendation, advice, and trading of those crypto-assets. They will assess whether firms have met their required standards of conduct when recommending such assets to or advising investors. In addition, the Division will conduct examinations of mutual funds and ETFs offering exposure to crypto-assets to evaluate their compliance, liquidity, and operational controls governing portfolio management and market risk.
While examination priorities change from year to year in response to newly-emerging threats, protecting investors and the capital markets is always at the heart of the SEC’s actions. The Division’s priorities are formulated based upon market and regulatory developments, examination findings, tips, and complaints. The Division also receives referrals and information from different offices at the SEC and FINRA, as well as other regulators across the globe. Although the Division will allocate significant resources to these priorities, examinations will morph in response to new or emerging risks, products and services, market events, and investor concerns.
These published priorities are not exhaustive and will not be stagnant. The SEC is likely to expand upon its priorities and concerns by issuing risk alerts. The SEC will also engage in industry and investor outreach to warn firms about emerging risks. While these priorities primarily drive the Division’s examinations, the scope of any exam is determined through a risk-based approach that incorporates an analysis of the firm’s history, operations, services, products offered, and other risk factors arising from its business model.
The Division’s publication is available at https://www.sec.gov/files/2022-exam-priorities.pdf.