The SEC’s Division of Examinations (“Division”) published an Alert, 2023 Examination Priorities, which detailed the significant focus areas that the SEC will prioritize during upcoming examinations. The four pillars of the Division’s Examinations policies include (1) promote compliance; (2) prevent fraud; (3) monitor risk; and (4) inform policy.
The Examination Priorities summarizes new and continuing focus areas, including an emphasis on the SEC’s “New Marketing Rule,” standards of conduct (specifically conflicts of interest and fiduciary duties), environmental, social and governance (ESG) investing, information security, and crypto investing with a focus on emerging technologies.
Private funds represent a significant portion of the Registered Investment Advisor (RIA) population. More than 5,500 RIAs manage approximately 50,000 private funds with gross assets exceeding $21 trillion. In the past five years, there has been an 80% increase in gross assets of private funds due to steady contributions through retirement plans. In response to the noted trend, the Division will continue to maintain its focus on private fund managers. The Division has detailed five specific focus areas:
In addition to the five specific focus areas stated above, the Division will focus on managers of private funds that have the following risk characteristics:
Each of the above factors and risk areas are consistent with recent concerns posted by the Division. Private fund managers should assess their risk profile and approaches to these issues and make efforts to get ahead of potential examination scrutiny. See below for more detail related to new focus areas and risks as listed.
One of the new changes detailed by the Division is the focus related to the New Marketing Rule which was announced through a Risk Alert in September 2022. Through the new ruling, the focus of the Division will be geared toward assessing whether RIAs have adopted and implemented written policies and procedures that are reasonably designed to prevent violations by the advisers and their supervised persons. The Division will further review whether the RIA has complied with the substantive requirements of the New Marketing Rule. These include the requirement that the RIA has 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. Please, see “New SEC risk alert modernizes investment adviser marketing rules” for a more in-depth assessment of this rule.
The Division has defined a few areas of focus related to RIA standards of conduct and Regulation Best Interest (Reg BI) Rule 15I-1. (See “SEC's new rule for broker dealers: Regulation Best Interest” for more details on this.) The Division determined that disclosures made to investors should include all material facts relating to the conflict of interest associated with any advice or recommendations received. The Division will also look at the process in place for making best interest evaluations and will consider the factors relevant to the evaluation. The Division provided a listing of recommendations for examinations, including complex products, such as derivatives and leveraged exchange-traded funds (ETFs), exchange-traded notes (ETNs), high cost and illiquid products, proprietary products, unconventional strategies that purport to address rising interest rates, and microcap securities.
Lastly, the Division notes that compliance with Form CRS will continue to be prioritized and included in the Division’s core examinations of RIAs and broker dealers. The SEC requires that firms deliver their relationship summaries to new and prospective retail investors, as well as existing investors. If the firm has a public website, this information should be published there as well.
ESG investing continues to be a priority for examinations in 2023. The Division details that RIAs and registered funds are competing for the rising investor demand for ESG-related investments and strategies that incorporate certain ESG criteria. In response, the Division is looking at ESG-related advisory services and fund offerings, including whether the funds are operating in the manner set forth in their disclosures. This focus will include whether ESG products are appropriately labeled and whether recommendations of such products for retail investors are made in the investor’s best interest. RIA managers should maintain supporting records for ESG-related claims.
The Division has a specific interest in advisers’ policies and procedures, governance, practices and responses to cyber-related incidents. This focus will include an assessment of whether safeguards are in place to protect customer records and information. Further, the Division will review the locations of these records to ensure that they have been appropriately disclosed to the SEC (as required). Other focuses include the prevention of account intrusions, the use of third-party vendors, and operational resiliency for systemically significant RIAs. The Division has continued to increase its focus on cybersecurity in examinations, specifically regarding notification to clientele when a security breach occurs.
The Division will continue to observe the proliferation of certain investment types, including crypto assets and their associated products and services, and emerging financial technologies. The Division notes that recent financial distress among crypto-asset market participants has created disruptions. The Division will continue to monitor and, when appropriate, conduct examinations of potentially impacted or affected registrants, in particular new or never examined registrants offering crypto-related assets. These examinations will assess whether the market participant:
The Division emphasized within its Examination Priorities that it will review RIA policies and procedures for retaining and monitoring electronic communications and selecting and using third party service providers. Based on this, private fund managers should review their electronic communication practices and assess the adequacy of policies in place.
The Examination Priorities highlights the key focus areas related to issues specific to private fund managers. Consistent with prior years, the Division prioritizes RIAs that have never been examined, including recently registered firms and those who have not received an examination for several years. Preparation for examination requires careful attention and review regarding the private fund’s compliance program and business practices. For the full Examination Priorities Report please see SEC 2023 Exam Priorities Report