Today’s SEC Examination Priorities, Tomorrow’s SEC Enforcement Actions
Rounding out a series of quarter-end announcements from the US Securities and Exchange Commission (SEC), the Division of Examinations (Exams) announced its 2022 examination priorities on March 30, 2022. These priorities reflect SEC Chair Gary Gensler’s stated view that the examinations program is crucial to the SEC’s work to protect investors and instill trust in markets. Exams will focus on, among other things, (i) private funds, (ii) broker-dealers, (iii) Environmental, Social, and Governance (ESG) or impact investing, (iv) financial technology (FinTech) and crypto-assets, and (v) information security (InfoSec) and operational resiliency. In addition, a week before the 2022 examination priorities were announced, Richard Best was appointed as Exams’ new Acting Director. Mr. Best most recently served as the SEC’s Regional Director in New York after serving in similar roles in Salt Lake City and Atlanta, where he led both the examination and enforcement efforts of those three Regional Offices. We expect that the number of referrals from Exams to the Division of Enforcement (Enforcement) is likely to increase, as today’s Exams priorities are a likely preview of tomorrow’s Enforcement actions.
Private Funds: Exams observed that more than 5,000 registered investment advisers (RIAs) manage roughly $18 trillion in private fund assets in strategies that include hedge funds, private equity funds, and real estate funds, whose investors include state and local pensions, family beneficiaries, charities, and endowments. In light of the size, complexity, and growth of this market, Exams will focus on various issues under the Investment Advisers Act of 1940, including (i) fiduciary duties, (ii) compliance with the Custody Rule, (iii) disclosure and compliance for cross trades, principal transactions, and distressed trades, and (iv) conflicts around liquidity, such as RIA-led fund restructurings. Exams intends to review advisers’ conflicts and disclosures around portfolio strategies, risk management, and investment recommendations and allocations, including investments in Special Purpose Acquisition Companies (SPACs) and particularly where the private fund adviser is also the SPAC sponsor. Exams also will review all aspects of trading for private funds with indicia of systemic importance, such as outsized counterparty exposure or gross notional exposure when compared to similarly situated firms.
Broker-Dealers: Exams will continue to focus on broker-dealer activity involving microcap, municipal, fixed income, and over-the-counter securities, as well as broker-dealer operations. Exams also will monitor broker-dealer sales practices and consistency with Regulation BI, particularly related to SPACs, structured products, leveraged and inverse exchange traded products (ETPs), real estate investment trusts (REITs), private placements, annuities, municipal and other fixed income securities, and microcap securities. In addition, Exams will monitor broker-dealer compliance with the locate requirement of Regulation SHO, penny stock disclosure rules, monitoring for and reporting of suspicious anti-money laundering (AML) activity, and compliance with the safeguards of the Customer Protection Rule and the Net Capital Rule by firms that hold customer cash and securities. Exams acknowledged its continued interest in dually registered RIAs and broker-dealers, and firms that service both brokerage customers and advisory clients.
ESG or Impact Investing: Exams recognized that RIAs and registered funds are increasingly offering and evaluating investments that employ ESG strategies or criteria, and it noted the risk that disclosures regarding portfolio management practices could involve materially false and misleading statements or omissions. Exams will focus on RIA and registered fund disclosures about their approaches to ESG investing and their policies and procedures to ensure appropriate disclosures to clients and investors, including portfolio management processes and practices, as well as review whether voting of client securities aligns with ESG-related disclosures and mandates.
FinTech and Crypto-Assets: Exams observed that RIAs are increasingly providing automated digital investment advice to clients, which RIAs are often called “robo-advisers,” with a continued growth in the use of mobile apps by broker-dealers. Exams will look at the use of developing technologies to assess whether RIAs and broker-dealers have considered “the unique risks these activities present” when designing their regulatory compliance programs, and whether firms have in place the operations and controls necessary to satisfy their regulatory obligations, representations to clients, and the standard of conduct owed to investors. Exams also noted “a proliferation of the offer, sale, and trading of crypto-assets,” and advised that its review of market participants engaged with crypto-assets will include custody arrangements and communications in the offer, sale, recommendation, advice, and trading of such assets. Exams indicated it will examine mutual funds and ETFs that offer exposure to crypto-assets to assess, among other things, compliance, liquidity, and operational controls around portfolio management and market risk.
InfoSec and Operational Resiliency: Exams stressed that the consequences of information security failures by RIAs and broker-dealers may extend to other market participants and retail investors, making “vigilant protection of data . . . critical to the operation of financial markets and the confidence of its participants.” Exams will continue to review firms’ efforts to prevent interruptions to mission-critical services, protect investor information, and safeguard customer accounts and prevent account intrusions, both in-house and through oversight of vendors and service providers. Exams also will review firms’ efforts to address and respond to malicious email activities and ransomware attacks, identify and detect red flags related to identity theft, and manage operational risk as a result of a dispersed workforce. In addition, Exams will review business continuity and disaster recovery plans with a focus on the impact of climate risk and substantial disruptions to business operations and the maturation of the plans over the years.
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The 2022 examination priorities report marks the ten-year anniversary of Exams (previously the Office of Compliance Inspections and Examinations) publishing its examination priorities. As in prior years, the report provides a roadmap to broker-dealers, RIAs, and other market participants as to the specific areas that Exams will focus on during the coming year. Given the strong regulatory and enforcement stance of the SEC’s current leadership, firms would be well-advised to study the examination priorities, review their policies and procedures, and be prepared to address these focus areas during upcoming examinations. Proactively ensuring compliance at the outset will help avoid what otherwise might become an enforcement referral in the future.
Arnold & Porter’s Financial Services, Investment Management, and Securities Enforcement and Litigation practices have been actively monitoring and advising in this area. Please reach out to any of the authors or your regular Arnold & Porter contact to discuss how to stay ahead of this fast-moving landscape.
© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.