SEC’s 2022 Exam Priorities: Investment Advisers Still in the Spotlight
By Joanna Conte, CPA, Partner, Assurance Services, Alternative Investment Group
The Securities and Exchange Commission’s (SEC) Division of Examinations (Division of Exams) announced its 2022 examination priorities on March 30, 2022.1
This marks one decade 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 areas 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.
The 2022 exam priorities are thematically similar to the 2021 priorities but reflect a more targeted focus on certain areas involving registered advisers. The announcement refers to certain priorities as “perennial priorities,” noting that they represent fundamental obligations under the federal securities laws. These priorities include high-risk areas such as conflicts of interest, disclosures of fees and expenses, safety of investor and client assets, sales practices, organizations that are deemed to be systemically important, and cybersecurity and emerging technologies.
The announcement also notes that not all exam priorities are perennial and cites the SEC’s continuous efforts to identify emerging risks. Some areas may warrant more or less of the Division of Exams’ focus based on whether those areas are generating higher or lower risks to investors and the markets.
This article will expand on the following exam priorities expected to have a particularly strong impact on investment advisers of private funds:
- Private funds;
- Environmental, social, and governance (ESG) investing;
- Standards of conduct, including regulation best interest, fiduciary duty, and Form CRS;
- Information security and operational resiliency;
- Emerging technologies and crypto assets;
- Focus areas involving registered investment advisers and investment companies; and
- The London Inter-Bank Offered Rate (LIBOR) transition.
First, a look back at fiscal year 2021.
The Division of Exams completed 3,040 examinations of registrants in fiscal year 2021 (FY21), which included 2,200 examinations of investment advisers. These 3,040 examinations resulted in the issuance of more than 2,100 deficiency letters, a return of more than $45 million in fees and charges to investors, and more than 190 referrals of examination findings to the Division of Enforcement.
In FY21, the Division of Exams examined approximately 16% of registered investment advisers. While this exceeded the Division’s targeted annual coverage ratio of 15% of the population, the Division expressed concern that it may need to lower its annual coverage target due to the continuing growth in the number of registered investment advisers, which is expected to outpace staffing increases at the Division. Over the last five years, the number of registered investment advisers has grown from 12,250 to more than 14,800, representing a 20% increase. More than 35% of registered investment advisers manage a private fund.
Exam Priority: Private Funds
The Division of Exams intends to focus on private funds in its 2022 examinations. The number of registered investment advisers who manage private fund assets exceeds 5,000; together, they manage approximately $18 trillion in assets. The Division noted that private funds managed by registered investment advisers often have investors comprised of state and local pensions with working family beneficiaries, charities, and endowments.
Advisers should be aware of the following areas highlighted by the Division of Exams in the 2022 exam priorities which represent areas it intends to examine closely:
- Calculation and allocation of fees and expenses, including the calculation of post-commitment period management fees and the impact of valuation practices at private equity funds.
- Preferential treatment of certain investors after their funds experienced liquidity challenges.
- Compliance with the custody rule under the Investment Advisers Act of 1940, including the “audit exception” to the surprise examination requirement and related reporting and updating of Form ADV regarding the audit.
- Disclosure and compliance issues with respect to cross trades, principal transactions, or distressed sales.
- 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.
- The following areas of interest were also discussed in the 2022 exam priorities:
- Private funds’ investments in special purpose acquisition companies (SPACs), including cases when the private fund adviser is also the SPAC sponsor.
- Risk management and trading for private funds considered systemically important. The Division noted that identifying such private funds may involve considering counterparty exposure or gross notional exposure compared to other firms.
Exam Priority: Environmental, Social, and Governance (ESG) Investing
The 2022 exam priorities announcement discusses risks related to environmental, social, and governance (ESG) investment strategies, in particular the risk that a registered investment adviser may provide inaccurate, incomplete, or misleading disclosures to investors. Regarding disclosures made to investors, the risk is exacerbated by the following:
- Lack of standardization in ESG investing terminology: References to strategies incorporating ESG criteria include “sustainable,” “socially responsible,” “impact investing,” and “ESG-conscious,” among others.
- Variety of ESG investing approaches: Does the portfolio use ESG factors as the main consideration in choosing investments, or are ESG factors considered alongside traditional factors (e.g., financial, industry-related, and macroeconomic indicators)? Is the portfolio using impact investing to achieve measurable ESG impact goals?
- Legal and compliance issues: Have these matters been appropriately considered and addressed prior to the launch of new lines of business and products?
The Division intends to focus on the following areas related to ESG investment strategies:
- Did the investment adviser accurately disclose the ESG investing approach?
- Did the investment adviser vote client securities in accordance with proxy voting policies and procedures, and were the votes consistent with their ESG-related disclosures?
- Did the investment adviser exaggerate or mislead, in its marketing or elsewhere, with respect to the ESG factors incorporated into portfolio selection (e.g., greenwashing)?
Exam Priority: Standards of Conduct — Regulation Best Interest, Fiduciary Duty, and Form CRS
The 2022 exam priorities referred to several SEC standards of conduct, including regulation best interest, Form CRS, and a registered investment adviser’s fiduciary duty with respect to the Investment Advisers Act of 1940. The Division of Exams reiterated its commitment to focusing on standard of conduct issues for both registered investment advisers and broker-dealers.
Examinations will concentrate on whether investment advisers’ behavior is consistent with their fiduciary duty to clients, including best execution obligations, financial conflicts of interest, and the related unbiased nature of investment advice and adequacy of disclosures. In particular, the Division will devote attention to:
- Revenue sharing arrangements;
- Selecting costlier classes of investment products when lower-cost classes are available;
- Promoting wrap fee accounts without evaluating whether such accounts are in the best interests of clients;
- Endorsing proprietary products resulting in additional or higher expenses;
- Compliance policies and procedures addressing conflicts of interest; and
- Disclosures to investors.
Exam Priority: Information Security and Operational Resiliency
The Division of Exams will continue to monitor operational resiliency and information security, including cybersecurity, in its exam program.
The Division expressed a special interest in protecting clients’ personal financial information, records, and assets, including efforts to:
- Prevent unauthorized access to client accounts;
- Oversee vendors and service providers;
- Address threats arising from email activities, such as phishing;
- Respond to ransomware attacks or other cybersecurity incidents;
- Monitor for identity theft; and
- Evaluate and mitigate operational risk resulting from a dispersed workforce in a work-from-home environment.
The Division also communicated its interest in 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: Emerging Technologies and Crypto Assets
In its discussion of this examination priority, the Division of Exams observed that firms are increasingly utilizing new financial technologies and that these technologies may influence investment decision-making. The Division intends to focus on firms that claim to offer new products and services, and firms utilizing new practices, to determine whether firms’ investment advice, including investment selections made by algorithms, is consistent with the investment strategies of its investors. The Division also intends to review whether the unique risks presented by new financial technologies and services were appropriately considered by a firm in the design of its regulatory compliance program. The division specifically cited fractional shares, “Finfluencers,” digital engagement practices, and investment recommendations made through automated investment tools and platforms (so-called “robo-advisers”) in its discussion of new financial technologies and services. 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, compliance practices (e.g., crypto-asset wallet reviews, custody practices, anti-money laundering reviews, and valuation procedures), risk disclosures, operational resiliency practices, liquidity, and operational controls around portfolio management and market risk. Exam Priority: Focus Areas Involving Registered Investment Advisers and Investment Companies The following examination priorities discussed in the announcement target registered investment advisers (RIAs):
- Registered funds, including mutual funds and exchange-traded funds: As retail investor exposure to these products increases, the Division of Exams is increasingly interested in monitoring industry practices and regulatory compliance. The Division is particularly attentive to money market funds (stress-testing, website disclosures, board oversight) and business development companies (valuations, marketing, and conflicts of interest involving portfolio companies held by the BDC).
- New RIAs: As in previous years, the examination program will incorporate a focus on RIAs who have never been examined, or who have not been examined for several years. Areas of particular focus include:
- The compliance program, including marketing practices, custody of client assets, valuation, portfolio management, best execution, conflicts of interest, and disclosures made to investors. The Division typically also reviews whether investment recommendations are in the best interest of clients, sufficiency of service provider oversight, and adequacy of compliance department resources.
- Fees and expenses, including failure to adjust advisory fees in accordance with investor agreements, calculation errors related to tiered fees and breakpoints, and refunding prepaid fees for terminated accounts.
Exam Priority: The London Inter-Bank Offered Rate (LIBOR) Transition
The 2022 examination priorities include the Division of Exams’ assessment of a registrant’s readiness for the LIBOR transition, including its inventory of exposure to LIBOR, its preparations for the expected discontinuation of LIBOR (including the cessation of many LIBOR rates beginning December 31, 2021), and the transition to an alternative reference rate.
The SEC is making a concerted effort to increase the transparency of its examination programs. The publication of exam priorities equips registrants with information that can be used to achieve compliance with securities laws. Furthermore, disseminating the exam priorities increases the reach of the SEC’s exam program by enabling registrants not selected for examination to access to the SEC’s priorities, focus areas, and concerns, and to incorporate these insights into their compliance programs.
- All information cited in this article is sourced from 2022 Examination Priorities published by the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations.