(Article from Registered Funds Regulatory Update, April 2022)
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The SEC’s Division of Examinations announced the following five enumerated priorities for 2022: (i) private funds; (ii) ESG investing; (iii) Regulation Best Interest, fiduciary duties and Form CRS; (iv) information security and operational resiliency; and (v) emerging technologies and crypto-assets. “The Division’s 2022 examination priorities identify key risk areas that we expect registrants to address, manage, and mitigate with vigilance,” said SEC Chair Gary Gensler.
“In this time of heightened market volatility, our priorities are tailored to focus on emerging issues, such as crypto-assets and expanding information security threats, as well as core issues that have been part of the SEC’s mission for decades—such as protecting retail investors,” said Division of Examinations’ Acting Director Richard R. Best. “Our priorities cover a broad landscape of potential risks to investors that firms should consider as they review and strengthen their compliance programs.”
The following is an overview of the Division’s 2022 examination priorities:
Private Funds. The Division will prioritize its focus on advisers to private funds, including hedge funds, private equity funds, and real estate funds. The Division will focus its examinations on fiduciary duties, compliance programs, fees and expenses, custody, fund audits, valuation, conflicts of interest, disclosure of investment risks and controls around material non-public information. The Division will also review private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations as well as the disclosures relating to each of those areas.
ESG Investing. The Division recognizes that ESG offerings by funds and advisers have continued to increase to meet investor demands for such products and highlighted that risk disclosures relating to ESG may include “materially false and misleading statements or omissions” given the lack of standardization. This risk may be compounded by the: (i) lack of standardization in ESG investing terminology (e.g., strategies that are referred to as sustainable, socially responsible, impact investing, and ESG conscious); (ii) variety of approaches to ESG investing (e.g., a portfolio may be labeled as ESG because of consideration of ESG factors alongside traditional financial, industry-related, and macroeconomic indicators, among others; other portfolios may use ESG factors as the driving or main consideration in selecting investments; or some portfolios engage in impact investing seeking to achieve measurable ESG impact goals); and (iii) failure to effectively address legal and compliance issues with new lines of business and products.
The Division’s focus during examinations will be on: (i) the accuracy of ESG investing disclosure and adoption and implementation of policies, procedures, and practices related thereto; (ii) whether proxy voting aligns with reported proxy voting policies and ESG-related disclosure; and (iii) “greenwashing” of strategy disclosure, performance advertising and marketing.
Standards of Conduct: Regulation Best Interest, Fiduciary Duty, and Form CRS. The Division will continue to focus on standards of conduct for broker-dealers and advisers, specifically related to compliance with Regulation Best Interest and the fiduciary standards of the Advisers Act. The Division will focus on the duties of care and loyalty, including best execution obligations, financial conflicts and the impartiality of advice.
The Division notes the following areas of assessment for its examinations:
- practices regarding consideration of alternatives (e.g., with regard to potential risks, rewards, and costs);
- management of conflicts of interest (e.g., incentive practices that favor certain products or strategies over others);
- trading (e.g., best execution obligations);
- disclosures (e.g., disclosures set forth in Form ADV and Form CRS and made pursuant to Regulation Best Interest);
- account selection (e.g., brokerage, advisory, or wrap fee accounts); and
- account conversions and rollovers.
The Division will focus on the effectiveness of the compliance programs, testing, training and disclosures that relate to these focus areas.
Information Security and Operational Resiliency. The Division will continue to review whether firms have taken appropriate measures to ensure information security and business continuity. Similar to prior years, the Division will continue to focus on whether firms have taken appropriate action to:
- safeguard customer accounts and prevent account intrusions, including verifying an investor’s identity to prevent unauthorized account access;
- oversee vendors and service providers;
- address malicious email activities, such as phishing or account intrusions;
- respond to incidents, including those related to ransomware attacks;
- identify and detect red flags related to identity theft; and
- manage operational risk as a result of a dispersed workforce in a work-from-home environment.
In addition, the Division will continue its focus on business continuity and disaster recovery with particular focus on the impact of climate risk and substantial disruptions to normal business operations.
Emerging Technologies and Crypto-Assets. The Division’s final area of focus will be on robo advisers and the technologies and practices they utilize. The Division will specifically focus on robo advisers claiming to offer new products and services to assess whether:
- operations and controls in place are consistent with disclosures and the standard of conduct owed to investors and other regulatory obligations;
- advice and recommendations, including by algorithms, are consistent with investors’ investment strategies and the standard of conduct owed to such investors; and
- controls take into account the unique risks associated with such practices.
In addition, the Division will focus on advisers that engage in the offering, sale, and trading of crypto-assets with a specific focus on custody arrangements and the recommendation and advice related to crypto-assets. In particular, the Division will review whether advisers:
- have met their respective standards of conduct when recommending crypto-assets with a focus on duty of care and the initial and ongoing understanding of the products (e.g., blockchain and crypto-asset feature analysis); and
- routinely review, update, and enhance their compliance practices (e.g., crypto-asset wallet reviews, custody practices, anti-money laundering reviews, and valuation procedures), risk disclosures, and operational resiliency practices (i.e., data integrity and business continuity plans).
The Division will also focus their examinations of mutual funds and ETFs that offer exposure to crypto-assets on the compliance, liquidity, and operational controls around portfolio management and market risk.
Investment Advisers and Investment Company Examination Program
Registered Investment Advisers. The Division will continue to review the compliance programs of advisers, including whether those programs and their policies and procedures are reasonably designed, implemented, and maintained. Specifically, the Division will examine the following core areas: marketing practices, custody and safety of client assets, valuation, portfolio management, brokerage and execution, conflicts of interest, and related disclosures. The Division will also focus on areas of heightened risk and the mitigation of such risks. In addition, the Division will continue its focus on fees and expenses, including fee calculations, errors, inaccurate calculations and failures to refund prepaid fees. As in previous years, the Division prioritizes advisers and registered funds that have never been examined, including recently registered firms, and those that have not been examined for a number of years.
Registered Investment Companies. The Division typically reviews certain perennial focus areas during its assessments of funds’ compliance programs and governance practices. Perennial areas include, including disclosure to investors, accuracy of SEC reporting, and compliance with new rules and exemptive orders. The Division will also focus on liquidity risk management programs to consider whether the programs are reasonably designed to assess and manage the fund’s liquidity risk and review the implementation of required liquidity classifications, including oversight of third party service providers. The Division will prioritize the examination of money market funds and business development companies. In addition, the Division will focus on certain portfolio investments, including mutual funds investing in private funds, and on funds that engage in certain practices, such as fee waivers and trading activities that may be designed to inflate fund performance.
2022 Examination Priorities, Division of Examinations, SEC (Mar. 20, 2022), available at: https://www.sec.gov/news/press-release/2022-57.