SEC Examinations Priorities for 2022
The SEC’s Division of Examinations (DOE) has issued the latest installment of annual exam priorities (better late than never). Many of these are perennial topics, with a few new features that serve as precursors to rulemakings and likely presage areas of enforcement. Unsurprisingly, the staff’s primary focus areas include private funds, ESG (environmental, social, and governance) investments, retail investor protection, information security, and digital assets. The report also identifies broad areas of interest for both registered advisers and funds, and there is a nod to the transition away from LIBOR. The report provides several interesting statistics, including an increase in the number of examinations last year to pre-pandemic levels (more than 3,000 in 2021), with approximately 69% of those exams resulting in deficiency letters (which seems lower than historical norms).
Each of the primary focus areas has broad general application to all segments of the market. That is true even for the focus on private funds, which the SEC sees as having retail reach through either registered fund investments or pension plans that allocate assets to private vehicles. Each of the primary focus areas (with the possible exception of digital assets, which is among the Chairman’s considerable interests) also has a companion rulemaking or risk alert. Thus, it should not be lost on anyone that the SEC is laser-focused on these areas. Key considerations for our adviser and fund clients include the following:
Private Funds. DOE will focus on evergreen topics such as compliance programs, valuation, conflicts of interests, disclosures, and MNPI controls. DOE has a laundry list of other focus areas, including the calculation and allocation of fees (continuing a theme in recent risk alerts), preferential treatment of private funds experiencing liquidity issues, custody, cross-trade and principal transaction disclosures, and investments in SPACs. More generally, the staff will be assessing portfolio strategies, risk management, and allocations, particularly with respect to conflicts and related disclosures.
ESG Investing. The SEC professes not to want to regulate ESG (or climate), but the Commission wants to be sure advisers and funds are doing what they say they are doing and not just “greenwashing” their offerings. In short, DOE is focused on ESG-related disclosure. As with last year’s priorities, the staff will consider whether proxy voting aligns with ESG disclosures and mandates. Observing a “lack of standardization” in ESG investing terminology, DOE seems to hint at the thrust of rulemakings that would allow investors to make informed decisions based on comparative data.
Standards of Conduct – Retail Investors. Following rulemaking and various guidance, DOE will assess how advisers and broker-dealers are satisfying Reg BI and adviser fiduciary duties. This generally includes sales practices, conflicts, and disclosures. The staff also will focus on revenue sharing and share class selection, which are familiar enforcement themes. As if on trend, DOE notes it will look at sales practices related to SPACs among other products that may be unsuitable for certain retail investors, such as leveraged or inverse products, REITs, private placements, annuities, and microcap securities.
Information Security and Operational Resiliency. Following our experience with recent examinations and a companion to the cybersecurity rulemaking, DOE is focusing on safeguarding customer information, cybersecurity, incident response and disaster recovery (including climate-related risks), and business continuity. Registrants also are reminded to oversee vendors, address malicious email (phishing), and manage the risks of a dispersed workforce in a work-from-home environment. In short, police the waterfront and keep the lights on.
Emerging Technologies and Crypto-Assets. This is the one focus area that does not (yet) have a corresponding rulemaking, but the SEC is clearly projecting its concerns. DOE will focus on new products and practices, such as fractional shares and digital engagement, seeking to ensure that proper operational controls are in place to address unique risks. The staff will assess whether market participants engaged with digital assets have proper custody arrangements and are mindful of standards of conduct when recommending products. They also will assess whether compliance practices have been enhanced and risk disclosures are updated to address the unique features of these products. And registered funds with exposure to crypto-assets will be assessed for compliance, liquidity, and operational controls surrounding such investments.
DOE’s report identifies several priorities specific to registered funds and advisers, and DOE will prioritize exams of registrants that have never been examined. The exam topics are consistent with our experience over the past several years. For funds (including mutual funds and ETFs), DOE will focus on compliance programs, disclosures, and compliance with new rules and exemptive orders. This will reach ETF compliance such as non-transparent management and the use of custom baskets. The staff also will review liquidity risk management and oversight of third-party services providers. Money market funds and BDCs are invited to the exam party, with a focus on money market requirements like stress testing and BDC valuation practices. DOE also will focus on mutual funds that invest in private funds with an eye toward risk disclosure and valuation.
For advisers, DOE typically will review marketing practices, custody, valuation, conflicts, and disclosures. Further focus areas will include assessing whether compliance programs address client best interest, oversight of service providers, and whether resources are sufficient to discharge the compliance responsibilities. Not surprisingly, they will review whether there are sufficient controls in place for handling material non-public information and whether the adviser has proper oversight of heightened risks, such as employing persons with disciplinary histories. Fee disclosures and calculations also remain front of mind, in case anyone missed the several risk alerts and enforcement actions in this area in recent years.
The exam priorities also include brief discussions about other registrants, including transfer agents and broker-dealers. The staff also will assess AML compliance and exposure to LIBOR and preparedness for transitioning to a new reference rate. The priorities cover many other topics, ranging from clearance and settlement to FINRA oversight. For more information, we encourage you to consult DOE’s publication available on the SEC’s website:
Risk Alert: Private Fund Advisers
The SEC’s Division of Examinations issued a risk alert concerning private fund advisers. This is a follow-up to a 2020 risk alert (which had followed a 2017 alert) addressing the same topic. While not directly applicable to registered funds, the concepts also more generally could apply in other contexts. The staff issues risk alerts to share observations from the field, highlighting good and bad practices so that advisers can better design compliance programs. This new alert focuses on four principal areas:
- Acting Consistently with Disclosures. The staff observed that advisers did not follow their policies for obtaining consent from limited partner advisory committees (LPACs) or similar advisory boards as set forth in partnership agreements, operating agreements, PPMs, side letters, or other disclosures. Some advisers were cited for miscalculating management fees in post-commitment periods, or for using vague and inconsistent terms for making calculations without adequate policies and procedures. (This follows a November 2021 alert that focused on fee calculations, suggesting the staff is very attuned to this issue.) The staff also observed advisers making investments in contravention of disclosures regarding investment strategy. The staff was critical of “recycling” practices whereby a fund adds investment proceeds back into capital commitments so that, if not properly disclosed, the practice would generate excess fees. The staff also noted instances where advisers ignored “key persons” provisions in LPAs that may require notification to investors or other steps upon someone’s departure.
- Performance and Marketing Disclosures. An evergreen topic, the staff observed many instances of misleading performance data. This includes inaccurate information, cherry-picked data concerning track records, not disclosing material information such as the impact of leverage, or inaccurately portraying fees and expenses. The staff also noted that advisers did not always maintain records supporting, or omitted material facts concerning, predecessor performance at other advisers. Some advisers also made misleading statements above awards or made other unsupported statements (e.g., failing to disclose criteria for selection or fees paid to receive the awards).
- Due Diligence. The staff observed that advisers sometimes failed to conduct proper due diligence, or did not follow their own procedures, including failing to make a reasonable investigation into their investments and failing to conduct due diligence on key service providers (such as data providers or placement agents). The staff also noted that some advisers did not have reasonably designed policies and procedures, tailored to their business, regarding due diligence of investments – a familiar refrain in both examinations and enforcement actions.
- Hedging Clauses. The staff observed that some advisers used “hedge clauses” in documents that purported to waive or limit the Advisers Act fiduciary duty except for certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud. Such clauses could be inconsistent with Sections 206 and 215(a) of the Advisers Act. (Notably, the staff made similar observations about the misuse of hedge clauses in Form CRS, which is provided to retail investors.) This issue has resurfaced in the proposed rulemaking for private fund advisers, discussed above.
While not the most illuminating risk alert, advisers should review their compliance programs to ensure they do not offend any of these same issues using the alert as a road map for future examinations. For more information, please visit the SEC’s website at the following link:
Standards of Conduct for Broker Dealers and Investment Advisers
At the close of the quarter, the SEC staff issued a bulletin providing guidance that builds on prior SEC guidance regarding Regulation Best Interest (Reg BI) and investment recommendations to retail investors. This guidance document suggests that the distinction between adviser fiduciary standards and broker-dealer conduct standards is being reduced to the vanishing point: “Although the specific application of Reg BI and the IA fiduciary standard may differ in some respects and be triggered at different times, in the staff’s view, they generally yield substantially similar results in terms of the ultimate responsibilities owed to retail investors.” In short, the SEC staff believes both standards require registrants to manage conflicts so that the investor’s interests are placed ahead of the financial professional’s interests.
The Bulletin presents several FAQs and articulates factors that registrants should consider before making account recommendations. Firms should disclose the capacity in which they are acting, and they should decline to make account recommendations unless they have sufficient information about a retail investor to judge the investor’s best interest. They also must consider costs, reasonable alternatives, and investor preferences. The Bulletin also discusses account rollover recommendations and the need to document the basis for account recommendations. For more information, please visit the SEC’s website: