On October 16, 2023, Registered Investment Advisers (RIAs) and other regulated firms received sooner-than-expected guidance from the SEC when the Commission published its 2024 examination priorities. The SEC previously announced its 2023 examination priorities on February 7, 2023.
The SEC’s 2024 priorities focus on emerging risks to investors and the capital markets, as well as core and perennial risk areas. According to Richard R. Best, the Director of the Division of Examinations, “Continuing to make our examination priorities public increases transparency into the examination program and encourages firms to focus their compliance and surveillance efforts on areas of potentially heightened risk to retail investors.” Best was also quoted as saying, “We hope that aligning the publication of our examination priorities with the beginning of the SEC’s fiscal year will provide earlier insight to registrants, investors, and the marketplace of adjustments in our areas of focus year to year.”
As always, it is important to note that the SEC’s priorities will not be the entire focus of an RIA’s examination. The SEC’s press release observed, “The scope of any examination includes analysis of an entity’s history, operations, services, products offered, and other risk factors.”
Adherence to the fiduciary standard is always an SEC priority
Investment advisers owe a duty of care and loyalty to their clients. To determine if advisers are adhering to the fiduciary standard, the Division will focus on investment advice given to clients relating to products, investment strategies, and account types. In particular, examiners will be looking at:
- Complex products, such as derivatives, structured notes, and leveraged exchange-traded funds (ETFs);
- Costly and illiquid products, such as variable annuities and non-traded real estate investment trusts (REITs); and
- Unconventional strategies, such as those that supposedly address rising interest rates.
As always, examiners will seek to protect older investors and those who are saving for retirement.
Fiduciaries must provide investment advice that is in their clients’ best interest, which includes those processes for:
- Making initial and ongoing suitability determinations;
- Seeking best execution;
- Evaluating costs and risks; and
- Identifying and addressing conflicts of interest.
These evaluations will also look at factors, such as clients’ investment profiles, as well as their investment goals and account characteristics. Examinations will review how RIAs address conflicts of interest, including mitigating or eliminating the conflicts of interest if necessary. They will also review how RIAs allocate investments where investors have more than one account, be it a wrap fee program, a commission-based arrangement, or a fee-based account.
Examiners will always scrutinize the economic incentives that an RIA and its financial professionals may receive to recommend products, services, or account types. Economic incentives may exist, such as revenue sharing, markups, or other incentivizing revenue arrangements. Examiners will be looking closely at advisers that are dually registered as broker-dealers or use affiliated firms to perform client services. Examiners will be keeping a close watch on firms that employ financial professionals servicing both brokerage customers and advisory clients. The SEC has brought numerous enforcement actions when firms recommended certain mutual fund share classes or types of accounts when lower cost options were available. In addition, examiners are wary of investment advice related to proprietary products and affiliated service providers that result in additional or higher fees for investors.
As part of their review, examiners will look at an RIA’s disclosures made to investors and whether they include all material facts relating to conflicts of interest. Without full disclosure, clients are not capable of giving informed consent to a conflict of interest.
SEC examiners conduct:
- Compensation arrangement assessments that focus on matters, such as revenue earned on clients’ bank deposit sweep programs and fee breakpoint calculation processes, particularly when fee billing systems are not automated;
- Valuation assessments regarding advisers’ recommendations to clients to invest in illiquid or difficult-to-value assets, such as commercial real estate or private placements;
- Safeguarding assessments for RIAs’ controls to protect clients’ material non-public information, particularly when multiple advisers share office locations, have significant turnover of investment adviser representatives, or use expert networks; and
- Disclosure assessments to review the accuracy and completeness of regulatory filings, including Form CRS, with a particular emphasis on inadequate or misleading disclosures and registration eligibility.
Examiners remain focused on RIAs’ compliance programs
Not surprisingly, the Division of Examinations views RIAs’ compliance programs as a high priority. The Division expects RIAs’ policies and procedures to reflect the firm’s business model, including its compensation structure, services, client base, and operations. Those policies and procedures should address any current market risks to the extent they apply.
Examiners will evaluate the effectiveness of RIAs’ annual review of their compliance program. An RIA’s policies and procedures should address the firm’s:
- Portfolio management processes;
- Disclosures made to investors and regulators;
- Proprietary trading by the RIA, as well as the personal trading activities of supervised advisory personnel;
- Safeguarding of clients’ assets from conversion or inappropriate use by advisory personnel;
- Creation of accurate and thorough books and records and maintenance of them in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
- Privacy safeguards for the protection of clients’ records and information, including cybersecurity procedures;
- Trading practices;
- Marketing of advisory services;
- Processes used to value clients’ holdings and charge fees based on those valuations; and
- Business continuity plans.
An RIA’s annual review should ensure that the firm’s policies and procedures will help advisers to fulfill their fiduciary obligations.
The Division’s priorities release noted that examiners will be focused on RIAs’ policies and procedures for:
- Selecting and using third-party and affiliated service providers;
- Overseeing branch offices when firms operate from numerous or geographically dispersed offices; and
- Obtaining informed consent from clients when RIAs implement material changes to their advisory agreements.
The Division will continue to prioritize examinations of RIAs that have never been examined, recently registered advisers, and those firms that have not been examined for a number of years.
Marketing practices will be under the microscope
Because the Marketing Rule is relatively new, the Division has made marketing practice assessments a high priority for RIAs, including advisers to private funds. Examiners will ascertain whether RIAs have:
- Adopted and implemented reasonably designed written policies and procedures to prevent violations of the Marketing Rule, as well as the Investment Advisers Act and its rules;
- Fully disclosed their marketing-related information on Form ADV; and
- Substantiated their processes and retained other required books and records.
Marketing practice reviews will also evaluate whether disseminated advertisements include any untrue statements of a material fact, are materially misleading, or are otherwise deceptive. If applicable, advertisements must comply with the Marketing Rule’s requirements for performance advertising, including hypothetical and predecessor performance. In addition, examiners will be reviewing RIAs’ use of third-party ratings, testimonials and endorsements.
Examination of investment advisers to private funds
Private fund advisers represent a significant portion of the SEC’s registered investment adviser population. The Division will continue to focus on advisers to private funds and will prioritize areas such as:
- The portfolio management risks that arise when there is exposure to recent market volatility and higher interest rates, including private funds experiencing poor performance, significant withdrawals and valuation problems, as well as private funds with more leverage and illiquid assets;
- Adherence to contractual requirements regarding limited partnership advisory committees or similar structures, such as advisory boards, including contractual notification and consent processes;
- Accurate calculation and allocation of private fund fees and expenses, including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and potential offsetting of those fees and expenses;
- Due diligence practices to ensure consistency with policies, procedures, and disclosures, such as evaluations of prospective portfolio companies;
- Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and the use of affiliated service providers;
- Compliance with the Investment Advisers Act requirements governing custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor, and the distribution of private fund audited financial statements; and
- Policies and procedures regarding Form PF filings.
Notably, the SEC’s 2024 examination priorities made no direct reference to environmental, social, and governance (ESG) investing. In 2021 through 2023, ESG investing issues were a priority.
The Division’s priorities are likely to evolve throughout the year. Although the Division allocates significant resources to the examination issues described in its priorities release, it will also shift focus to new or emerging risks, products and services, market events, and investor concerns. As those threats arise, examiners will shift gears and pay more attention to them.
Aside from focusing on 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 to strengthen their compliance programs and bolster their policies and procedures.
The SEC’s release makes note of other priorities, such as increased scrutiny of cryptocurrency broker-dealers and other firms dealing with crypto assets. Cybersecurity and artificial intelligence will also be a priority for examiners.
The SEC’s priorities release is available at https://www.sec.gov/files/2024-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.