On February 7, 2023, the SEC’s Division of Examinations announced its 2023 examination priorities. These examination priorities are published annually to provide insights into the SEC’s risk-based approach. The publication also identifies areas that present potential risks to investors and the integrity of the U.S. capital markets. These examination priorities are intended to support the Division’s mission, which is to promote compliance, prevent fraud, monitor risk, and inform policy.
In a press release, SEC Chair Gary Gensler stated, “Our priorities reflect the changing landscape and associated risks in the securities market and are the product of a risk-based approach to examination selection that balances our resources across a diverse registrant base.” According to the press release, the SEC will emphasize compliance with new rules that apply to Registered Investment Advisers (RIAs) and investment companies.
As was the case in previous years, the SEC will focus on emerging risks, as well as rules designed to protect retail investors. The SEC’s goal is to enhance investor protection using high-quality examinations that address the latest industry trends and emerging risks that pose a threat to investors and the markets. The SEC’s examination priorities release highlighted a number of areas.
New Investment Adviser and Investment Company Rules – It is no surprise that the Division will focus on Rule 206(4)-1 under the Investment Advisers Act, more commonly known as the new Marketing Rule. Examiners will look at whether RIAs have adopted and implemented written policies and procedures that are reasonably designed to prevent violations of the rule by the firm and their supervised persons.
During examinations, the Division will review whether RIAs have complied with the substantive requirements of the Marketing Rule. In particular, examiners will make certain that firms have a reasonable basis for believing they will be able to substantiate material statements of fact. They will also make sure that RIAs fully comply with the Marketing Rule when advertising performance, testimonials, endorsements and third-party ratings.
RIAs to Private Funds – Today, more than 5,500 RIAs manage approximately 50,000 private funds with gross assets that exceed $21 trillion. According to the Division’s priorities release, RIAs to private funds represent more than 35 percent of all investment advisory firms.
Examinations will address key issues arising from the Investment Advisers Act, such as fiduciary duty, compliance programs, fees and expenses, custody, the Marketing Rule, conflicts of interest, and the use of alternative data. Examiners will review private fund advisers’ conflicts of interest and disclosures related to portfolio strategies. Furthermore, they will analyze risk management, as well as investment recommendations and allocations.
In addition, examiners will focus on RIAs to private funds possessing specific risk characteristics such as:
- Highly leveraged private funds;
- Private funds that are managed side-by-side with business development companies;
- Private equity funds that use affiliated companies and advisory personnel to provide services to their fund clients and underlying portfolio companies;
- Private funds that hold certain hard-to-value investments, such as crypto assets;
- Private funds that invest in or sponsor Special Purpose Acquisition Companies (SPACs); and
- Private funds involved in restructurings spearheaded by RIAs.
Retail Investors and Working Families – To protect retail investors and working families, examiners will prioritize the examination of broker-dealers and RIAs for compliance with applicable standards of conduct. The Division is especially concerned about dually-registered RIAs and affiliated firms with financial professionals who service both brokerage customers and advisory clients. The Division wants to ensure that retail investors and working families are receiving recommendations and advice that is in their best interests.
Specifically, examiners will focus on how firms are satisfying their obligations under Regulation Best Interest and the Investment Advisers Act fiduciary standard. Examiners will assess RIAs’ practices for reviewing investment alternatives and managing conflicts of interest. They will scrutinize whether firms’ advice and recommendations were made after fully considering their clients’ investment goals and account characteristics. In addition, examiners will review whether firms’ conflicts of interest disclosures are sufficient, so that a client can provide informed consent to the disclosed conflict. According to the priorities release, all broker-dealers and RIAs have at least some conflicts of interest in their relationships with retail investors. Examiners will also investigate whether an RIA inappropriately waived or limited their standard of conduct using a hedge clause.
Environmental, Social, and Governance (ESG) – The Division will continue to focus on ESG-related advisory services and fund offerings, such as determining whether they are operating in a manner that is consistent with their disclosures. In addition, the Division will evaluate whether ESG products are labeled properly and whether recommendations to retail investors are made in their best interests.
Information Security and Operational Resiliency – The Division views the current risk environment as elevated due to market events, geopolitical concerns, and the proliferation of cybersecurity attacks. The Division will review broker-dealers’, RIAs’, and other registrants’ efforts to prevent interruptions to mission-critical services. Examinations of broker-dealers and RIAs will also analyze the cybersecurity issues connected to the use of third-party vendors.
Examiners will focus on firms’ policies and procedures, governance practices, and response to cyber-related incidents, such as ransomware attacks, as well as broker-dealers’ and RIAs’ compliance with Regulations S-P and S-ID. Policies and procedures must be reasonably designed to safeguard customers’ records, assets, and information.
Emerging Technologies and Crypto-Assets – The Division will conduct examinations of broker-dealers and RIAs that are using emerging financial technologies, such as broker-dealers’ mobile apps and firms that provide automated digital advice to their clients. Examiners are particularly wary of firms that advise, recommend or trade in crypto or crypto-related assets. Examiners will be looking at whether the firm met and adhered to its standard of care when making recommendations, referrals, or providing investment advice. Not surprisingly, examiners will be reviewing firms’ compliance, disclosure, and risk management practices.
The Division’s priorities are not exhaustive and may change during the year. Although the Division allocates significant resources to the examination issues described in the priorities release, it will also devote resources to new or emerging risks, products and services, market events, and investor concerns. As those threats arise, examinations will pay more attention to them.
In addition to addressing the Division’s priorities, RIAs should take note of risk alerts published from time to time by the SEC. These risk alerts can help RIAs strengthen their compliance programs and bolster their policies and procedures.
The Division’s publication is available at https://www.sec.gov/files/2023-exam-priorities.pdf.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.