SEC’s 2023 Exam Priorities: Registered Investment Advisers Take Center Stage
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 2023 examination priorities on February 7, 2023.1
This marks the 11th year that the Division of Exams has published its exam priorities in a continuing effort to provide transparency about its activities. While other 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 2023 exam priorities are thematically similar to the 2022 priorities but reflect a more targeted focus on certain areas involving registered advisers. The announcement notes that, to generate the annual examination priorities, the Division of Exams solicits input from stakeholders within and outside of the SEC. The information considered includes:
- Data collected through examinations.
- Communications with other regulators.
- Feedback from investors and registrants.
- Other industry sources.
New this year, with respect to the development of the 2023 exam priorities, the Division of Exams requested input from representatives of state securities regulators and investor groups to factor in additional viewpoints on potential risks and issues relevant to investors and market participants.
This article will expand on the following exam priorities expected to have a particularly strong impact on investment advisers of private funds:
- Notable new and significant focus areas, including:
- Compliance with recently adopted rules under the Investment Advisers Act of 1940 and the Investment Company Act of 1940;
- Registered investment advisers to private funds;
- Standards of conduct: Regulation best interest, Fiduciary duty, and Form CRS; and
- Environmental, social, and governance (ESG) investing;
- Information security and operational resilience;
- Crypto assets and emerging financial technology;
- 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 2022
In fiscal year 2022 (FY22), the Division of Exams examined approximately 15% of registered investment advisers. While this was on par with the coverage of the population achieved in fiscal year 2021, the Division expressed concern that increased coverage can only be achieved with significant hiring and investment in technology, consistent with comments in the prior year examination priorities announcement. The announcement notes that the number of registered investment advisers has grown to more than 15,000, overseeing more than $125 trillion in assets under management.
Exam Priority: Notable New and Significant Focus Areas
Compliance with recently adopted rules under the Investment Advisers Act of 1940 and the Investment Company Act of 1940
The exam priorities announcement notes that the Division is prioritizing examining for compliance with recently adopted rules, including:
Advisers Act Rule 206(4)-1 (Marketing Rule)
The compliance date for the SEC’s new Marketing Rule was November 4, 2022. The Division of Exams will evaluate whether RIAs have adopted and implemented written policies and procedures that are reasonably designed to prevent compliance breaches with respect to the new Marketing Rule. The Division of Exams will focus on whether RIAs have complied with the condition that RIAs have a reasonable basis for believing they will be able to substantiate material statements of fact and rules governing performance advertising, testimonials, endorsements, and third-party ratings.
Investment Company Act Rule 18f-4 (Derivatives Rule)
For registered investment companies (RICs) that rely on the Derivatives Rule (which may include mutual funds, exchange-traded funds, closed-end funds, and business development companies), the Division will evaluate whether RICs have adopted and implemented policies and procedures reasonably designed to prevent compliance breaches with respect to the Derivatives Rule, including the adoption and implementation of a derivatives risk management program, board oversight, and whether disclosures concerning the fund’s use of derivatives are incomplete, inaccurate, or potentially misleading.
Investment Company Act Fair Valuation Rule 2a-5
The Division will examine funds’ and fund boards’ compliance with the new requirements for determining fair value, implementing board oversight duties, setting recordkeeping and reporting requirements, and permitting the funds’ board to designate valuation designees to perform fair value determinations subject to oversight by the board. The Division will also focus on whether adjustments have been made to valuation methodologies, compliance policies and procedures, governance practices, service provider oversight, and reporting and recordkeeping.
Registered Investment Advisers to Private Funds
The Division of Exams intends to focus on RIAs to private funds in its 2023 examinations. The number of registered investment advisers managing private fund assets exceeds 5,500, representing more than 35% of all RIAs. Together, they manage approximately 50,000 private funds amounting to more than $21 trillion in assets. The Division noted that there had been an 80% increase in the gross assets of private funds over the past five years, with a substantial contribution to this asset growth coming from retirement plans.
Advisers should be aware of the following areas highlighted by the Division of Exams in the 2023 exam priorities, which represent areas it intends to examine closely:
- Conflicts of interest;
- 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;
- New Marketing Rule compliance;
- Use of alternative data and compliance with Advisers Act Section 204A; and
- Compliance with the Advisers Act Rule 206(4)-2 (Custody Rule), including timely delivery of audited financials and selection of permissible auditors.
The following specific risk characteristics applicable to certain private funds were also discussed in the 2023 exam priorities:
- Highly-leveraged private funds;
- Private funds managed parallel 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 and real estate-connected investments, with a focus on commercial real estate;
- Private funds that invest in or sponsor Special Purpose Acquisition Companies (SPACs); and
- Private funds involved in adviser-led restructurings, including stapled secondary transactions and continuation funds.
Standards of Conduct: Regulation best interest, Fiduciary duty, and Form CRS
The 2023 exam priorities referred to several SEC standards of conduct, including regulation best interest, Form CRS, and a registered investment adviser’s fiduciary duty concerning the Investment Advisers Act of 1940.
Regulation Best Interest and Fiduciary Duty
The announcement notes that all broker-dealers and investment advisers have at least some conflicts of interest with investors. The Division will evaluate the economic incentives that a firm and its employees have in place to recommend products, services, or account types. Such economic incentives include revenue sharing, commissions, or other incentivizing revenue arrangements. The Division will assess how firms are managing conflicts of interest. Additionally, the Division will scrutinize whether firms have customer or client agreements that inappropriately waive or limit their standard of conduct, including through hedge clauses.
The Division of Exams will focus on firms’ compliance with SEC rules requiring that firms deliver their relationship summaries to new, prospective, and existing investors, file their relationship summaries with the SEC, and post the current relationship summary on the firm’s public website.
Environmental, Social, and Governance (ESG) Investing
The 2023 exam priorities announcement discusses risks related to environmental, social, and governance (ESG) investment strategies, particularly the risk that a registered investment adviser may provide inaccurate, incomplete, or misleading disclosures to investors. The announcement notes increasing competition for RIAs and registered investment companies responding to heightened investor demand for ESG-related investments and strategies. The Division will assess whether RIAs and funds are operating in a manner that is consistent with their disclosures, whether ESG products are appropriately labeled, and whether recommendations of such products are made in investors’ best interest.
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 announcement states, “The current risk environment related to cybersecurity is considered elevated given the larger market events, geopolitical concerns, and the proliferation of cybersecurity attacks, particularly ransomware attacks.”
The Division expressed a special interest in protecting clients’ personal financial information, records, and assets, including efforts to:
- Prevent unauthorized access to client accounts, including risk resulting from a dispersed workforce in a work-from-home environment;
- Oversee vendors and service providers, including whether registrants achieve suitable visibility into the security and integrity of third-party products and services.
The Division also communicated its interest in registrants’ business continuity and disaster recovery plans, specifically to whether such plans (particularly those of systemically important registrants) adequately address increasing physical and other pertinent risks associated with climate change.
Exam Priority: Crypto assets and emerging financial technology
Emerging financial technology
In its discussion of this examination priority, the Division of Exams observed that firms are increasingly utilizing new financial technologies that 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 cited investment recommendations from automated investment tools and platforms (so-called “robo-advisers”) in discussing new financial technologies and services. The Division also expressed an interest in whether a firm’s risk assessment, with respect to digital technology, sufficiently considers risks the technology may present to seniors.
The announcement cites the “disruptions caused by recent financial distress among crypto asset market participants” and the Division’s intention to continue focusing on impacted registrants. Examinations will give particular attention to the offer, sale, or recommendation of advice regarding trading in crypto or crypto-related assets and whether those activities (a) meet the firm’s standard of care concerning the provision of investment advice and (b) are appropriately addressed in the firm’s compliance, disclosure, and risk management practices.
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. Areas of focus include:
- Compliance programs and governance practices of registered funds, including boards’ processes for assessing and approving advisory and other fund fees, especially for funds with weaker performance relative to their peers. The Division will also evaluate the effectiveness of funds’ derivatives risk management programs and liquidity risk management programs.
- Registered funds with specific characteristics, such as;
- Turnkey funds;
- Mutual funds that converted to ETFs;
- Non-transparent ETFs, to review such funds’ compliance with the conditions of their exemptive relief;
- Loan-focused funds, such as leveraged loan funds and funds focused on collateralized loan obligations, for liquidity concerns and to evaluate whether the funds have been significantly impacted by rising interest rates;
- Medium and small fund complexes that have experienced excessive staff attrition, to assess any impact on the funds’ controls and operations; and
- Volatility-linked and single-stock ETFs.
As in previous years, the examination program will focus on RIAs who have never been or have not been examined for several years. The Division will also consider whether RIA operations and compliance programs adequately react to current market factors, including factors that may impact valuation. Areas of particular focus during RIA examinations include:
- The compliance program and related disclosures, including custody and safekeeping of client assets, valuation, portfolio management, and brokerage and execution.
- Fees and expenses, including the calculation of fees, alternative ways that RIAs may try to maximize revenue, including revenue earned on clients’ bank deposit sweep programs, and excessive fees.
- Electronic communications, including RIA policies and procedures for retaining and monitoring electronic communications and selecting and using third-party service providers.
Exam Priority: The London Inter-Bank Offered Rate (LIBOR) Transition
The 2023 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 (LIBOR is currently scheduled for discontinuation in mid-2023), 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 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 2023 Examination Priorities published by the Securities and Exchange Commission’s Division of Examinations.