SEC’s 2021 Exam Priorities: Continued Focus on Investment Advisors
By Joanna Conte, CPA, Partner, Assurance Services, Alternative Investment Group
The Securities and Exchange Commission’s (SEC) Division of Examinations (Division of Exams), formerly known as the Office of Compliance Inspections and Examinations, announced its 2021 examination priorities on March 3, 2021.1
This is the ninth year that the Division of Exams has published its exam priorities in a continuing effort to provide transparency about its activities. While additional priorities may be identified based on the Division’s ongoing findings and risk assessments, the advance announcement of exam priorities is intended to provide SEC-regulated entities insight into those areas that the agency believes warrant attention and constitute the most effective use of examination resources.
The Division of Exams noted that its work continues to be based on four “pillars”: promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy.
In addition, the Division established the Event and Emerging Risks Examination Team (EERT) in 2021, which will engage with registrants to identify new and exigent risks and will seek to ensure, through examinations and other forms of engagement and monitoring, that firms are positioned to address emerging threats.
The 2021 exam priorities have been organized around nine themes. The 2021 exam priorities are thematically similar to the 2020 exam priorities but reflect a more targeted focus on certain areas involving registered advisers.
This article will expand on the following exam priorities which are expected to have particular impact on investment advisers of private funds:
- Focus areas involving registered investment advisers and investment companies.
- Retail investors, including seniors and individuals saving for retirement.
- Information security and operational resiliency.
- Financial technology (FINTECH) and innovation, including digital assets.
- The London Inter-Bank Offered Rate (LIBOR) transition.
The Global Pandemic
In its announcement of the 2021 exam priorities, the Division of Exams acknowledged the global pandemic and its impact on the administration of the examination program as well as the financial services industry at large.
In response to the pandemic, the examination program shifted to correspondence examinations and incorporated a focus on operational challenges faced by registrants, including risks related to business continuity plans and cybersecurity threats. The Division of Exams issued a Risk Alert in August 2020 addressing COVID-19 compliance risks and considerations applicable to broker-dealers and investment advisers, as well as two additional Risk Alerts in 2020 focused on the specific cybersecurity risks associated with ransomware and client account credential compromise. The 2021 exam priorities indicate a continued focus on operational resiliency and information security.
The Division of Exams recognized that exchanges, clearing agencies, investment advisers, broker-dealers and other market participants were able to successfully adapt and meet the challenges resulting from the pandemic and expressed confidence that both firms and the Division will continue to operate in service of strong compliance and investor protection.
Exam Priority: Focus areas involving registered investment advisers and investment companies
Registered investment advisers (RIAs) are the target of the following examination priorities discussed in the Division of Exams announcement:
- RIA Compliance Programs. The Division of Exams noted that its interest will persist with respect to whether compliance programs of registered advisers are reasonably designed, implemented and maintained and that, in keeping with its risk-based approach, the examination program will incorporate a focus on RIAs that have never been examined and RIAs that have not been examined for several years. Areas of particular focus include:
- Advisers offering novel types or emerging investment strategies, including strategies that promote sustainable, socially responsible and ESG investing. The Division will review the consistency and adequacy of the disclosures RIAs provide to investors regarding these strategies and assess whether the firms’ processes and practices match their disclosures. The Division intends to review fund advertising to determine if it includes false or misleading statements as well as advisers’ proxy voting policies, procedures and voting records to assess whether they align with disclosures provided to investors.
- Advisers that are dually registered as, or affiliated with, broker-dealers, or have supervised persons who are registered representatives of unaffiliated broker-dealers.
- Registered Funds, Including Mutual Funds and Exchange Traded Funds. As retail investor exposure to these products increases, the Division of Exams has developed a heightened interest in monitoring industry practices and regulatory compliance. Interest areas include liquidity risk management, valuation issues, investments in market sectors that have experienced stress due to the pandemic, money market funds and registered funds that have not previously been examined or have not been examined in a number of years.
- Registered Investment Advisers to Private Funds. With respect to advisers to private funds, the examination priorities discuss the following areas of focus:
- Preferential treatment of certain investors by advisers to private funds that have experienced liquidity challenges; investment valuations and the resulting impact on management fees; disclosure and compliance issues with respect to cross trades, principal investments, or distressed sales; and conflicts of interest associated with adviser led fund restructurings, including secondary transactions in which new investors purchase the interests of existing investors while also agreeing to invest in a new fund.
- Advisers to private funds that have a higher concentration of structured products, such as collateralized loan obligations and mortgage backed securities, and whether default risk is adequately disclosed to investors.
- Advisers to private funds that hold portfolio companies in market sectors adversely impacted by the pandemic economy.
Exam Priority: Retail investors, including seniors and individuals saving for retirement
While this exam priority promotes a focus on Main Street investors, it also has applications to advisers of private investment funds.
Advisers should be aware of the following areas highlighted by the Division of Exams in the 2021 exam priorities:
- Standards of Conduct. The Division of Exams referred to several recently adopted SEC standards of conduct, including Regulation Best Interest, the Interpretation Regarding Standard of Conduct for Investment Advisers, and the Form CRS Relationship Summary. With respect to registered investment advisers, the Division noted that the Interpretation Regarding Standard of Conduct for Investment Advisers reestablished and expounded on certain elements of a registered adviser’s fiduciary duty with respect to its clients.
- Fraud, Sales Practices and Conflicts. This exam priority includes the disclosure of fees, expenses, and other charges paid by investors. It also includes disclosure of potential conflicts of interest. The aim is to arm investors with information required to make better informed decisions. The Division of Exams will evaluate whether registered investment advisers, as fiduciaries, have fulfilled their duties of care and loyalty. The Division is particularly focused on elimination, or at a minimum full disclosure, of conflicts of interest (including fee and compensation-based conflicts) which could incentivize an adviser to dispense investment advice that is not in a client’s best interest. Areas of particular focus include:
- Recent changes to the definition of “accredited investor” and how firms are complying when recommending and selling certain private offerings.
- Turnkey asset management platforms. Such platforms provide registered investment advisers with technology, investment research, portfolio management and other outsourcing services, and the Division plans to incorporate into its examinations a review of whether such fees and revenue sharing arrangements are sufficiently disclosed to investors.
- Retail-Targeted Investments. The Division of Exams disclosed that it will focus on certain investment products that present higher risk to investors. Higher risk may be the product of specific characteristics of those securities, market dynamics or an elevated concentration or placement with retail investors. These products include mutual funds and exchange traded funds, municipal securities and other fixed income securities and microcap securities. With respect to microcap securities, the Division announced that it will continue examinations of broker-dealers involved in selling stocks of microcap companies, which it defines as companies with a market capitalization of under $250 million. The Division noted that during the pandemic, several issuers of microcap securities made unsubstantiated claims regarding testing, treatments, and vaccines. The SEC suspended trading in certain microcap securities due to concerns about the sufficiency and veracity of information in the marketplace about the issuers. The Division remains focused on assessing whether registrants, including broker-dealers and transfer agents, are in compliance with their obligations in the offer, sale, and distribution of microcap securities.
Exam Priority: Information security and operational resiliency
The Division of Exams will continue to devote attention to operational resiliency and information security, including cybersecurity, in its exam program. Areas of particular focus include:
- Registrants’ response to heightened risks, resulting from the increase in remote operations in response to the pandemic, related to the following areas: endpoint security; data loss; remote access; use of third-party communication systems; and vendor management. The Division expressed a special interest in mechanisms for protection of clients’ personal financial information.
- Registrants’ business continuity and disaster recovery plans, with specific attention to whether such plans, particularly those of systemically important registrants, adequately address increasing physical and other pertinent risks associated with climate change.
Exam Priority: Financial technology (FINTECH) and innovation, including digital assets
In its discussion of this examination priority, the Division of Exams observed that firms are increasingly utilizing new data sources, often referred to as “alternative data,” and that this data has applications that may include influencing investment decision-making. The Division intends to focus on firms’ use of these data sets as well as newly developed financial technologies as they relate to the provision of services to investors.
With respect to digital assets, including cryptocurrency, Initial Coin Offerings (ICOs), secondary market trading, and Blockchain, the Division of Exams intends to concentrate attention on investment suitability, portfolio management and trading practices, safety of client funds and assets, pricing and valuation, effectiveness of compliance programs and controls, and supervision of employees’ outside business activities.
With respect to electronic investment advice, the Division of Exams plans to focus on registered advisers that generate investment recommendations through automated investment tools and platforms (so-called “robo-advisers”). The Division intends to assess whether registrants are operating in accordance with their representations and whether registrants are handling customer orders in accordance with customer instructions, and to evaluate compliance around trade recommendations made in mobile applications.
The Division of Exams acknowledged the growing utilization of technology to facilitate compliance with regulatory requirements (RegTech) and its intention to focus on the incorporation of RegTech into a firm’s compliance program.
Exam Priority: The London Inter-Bank Offered Rate (LIBOR) transition
The 2021 examination priorities include an assessment by the Division of Exams of a registrant’s readiness for the LIBOR transition, including its inventory of exposure to LIBOR, its preparations for the expected discontinuation of LIBOR, and the transition to an alternative reference rate, in connection with registrants’ own financial matters and those of its clients and customers.
The SEC is making a concerted effort to increase the transparency of its examination programs. The publication of exam priorities serves to equip registrants with information that can be used to achieve compliance with securities laws. Furthermore, the dissemination of the exam priorities increases the reach of the SEC’s exam program by enabling registrants not selected for examination to have access to the SEC’s priorities, focus areas and concerns, and to incorporate these insights into their compliance programs.
- All information cited in article is sourced from 2021 Examination Priorities published by the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations.