SEC Announces 2024 Examination Priorities
On October 16, the Division of Examinations (the Division or Exams) at the U.S. Securities and Exchange Commission (SEC) announced its 2024 examination priorities. The Division released these priorities only eight months after releasing its 2023 examination priorities (see our previous Advisory) to align with the start of the SEC’s fiscal year and to provide earlier insight to market participants of the areas of focus for the coming year.
The Division indicated it will continue to utilize a risk-based approach and focus examinations on certain practices, products, and services that it believes present potentially heighted risks to investors or the integrity of U.S. capital markets. For 2024, this focus will include, among other things: (1) information security and operational resiliency; (2) cryptocurrency assets and emerging financial technology; and (3) anti-money laundering (AML) practices. While environmental, social, and governance issues are not an articulated priority for 2024, as they have been the past several years, we expect Exams to continue to monitor the market for compliance in this area during the coming year.
We outline risk areas that broadly impact market participants and some entity-specific risks below.
Risk Areas Broadly Impacting Market Participants
Information Security and Operational Resiliency: The Division noted that “[o]perational disruption risks remain elevated due to the proliferation of cybersecurity attacks, firms’ dispersed operations, intense weather-related events, and geopolitical concerns.” Accordingly, Exams will monitor broker-dealer and registered investment adviser practices to prevent interruptions to mission-critical services and to protect investor information, records, and assets, focusing on policies and procedures, internal controls, governance practices, employee training, and responses to cyber-related incidents. Exams also will focus on cybersecurity issues associated with third-party vendors, including firms’ visibility into the security and integrity of third-party products and services.
Crypto Assets and Emerging Financial Technology: Observing “the continued volatility of, and activity around, the crypto asset markets,” Exams will focus on all activity related to crypto assets and related products, including the offer, sale, recommendation of, advice regarding, and trading in such investment opportunities. This will include evaluating whether firms are meeting their standards of conduct when it comes to understanding and recommending or advising about crypto assets, maintaining proper compliance policies and procedures regarding such investments, and satisfying custody obligations if the crypto assets are funds or securities. Exams will assess whether any technological risks associated with the use of blockchain and distributed ledger technology have been addressed, including whether compliance policies and procedures are reasonably designed to address these risks, accurate disclosures are made to investors, and whether risks pertaining to the security of crypto asset securities are addressed (if required by law). Exams also will remain focused on certain services, including automated investment tools, artificial intelligence, and trading algorithms or platforms, and the risks associated with the use of emerging technologies and alternative sources of data.
Anti-Money Laundering Programs: Exams will continue to focus on AML programs to review whether broker-dealers and certain registered investment companies are: (1) tailoring their AML programs to their business models and associated AML risks; (2) conducting independent testing; (3) establishing an adequate customer identification program, including for beneficial owners of legal entity customers; and (4) meeting their Suspicious Activity Reports filing obligations. Exams will also review whether broker-dealers and advisers are monitoring Office of Foreign Assets Control sanctions and ensuring compliance.
Registered Investment Advisers (RIAs): Exams will continue to focus on whether RIAs comply with their duty of care and duty of loyalty obligations and review:
- Investment advice provided to clients, particularly older investors and those saving for retirement, regarding complex financial products and high cost or illiquid products
- Processes for determining that the investment advice provided is in the clients’ best interests, including those for: (1) making initial and ongoing suitability determinations, (2) seeking best execution, (3) evaluating costs and risks, and (4) identifying and addressing conflicts of interest
- Economic incentives that an adviser and its financial professionals may have to recommend products, services, or account types, including revenue sharing, markups, or other incentivizing revenue arrangements
- Disclosures made to investors and whether they include all material facts relating to conflicts of interest sufficient to allow the client to provide informed consent to the conflict
Exams noted its continued review of advisers’ compliance policies and procedures, including areas discussed in the adopting release for the Compliance Rule under the Investment Advisers Act of 1940 (Advisers Act), and identified other particular areas of RIA examination focus for 2024:
- Marketing practices, including assessments for whether advisers, including advisers to private funds, have adopted and implemented reasonably designed written policies and procedures to prevent violations of the Advisers Act and the rules thereunder including reforms to the Marketing Rule, and whether marketing materials include any untrue statements of a material fact, are materially misleading, or are otherwise deceptive and, as applicable, comply with the requirements for performance (including hypothetical and predecessor performance), third-party ratings, and testimonials and endorsements
- Compensation arrangement assessments focusing on: (1) fiduciary obligations of advisers to their clients, including registered investment companies, particularly with respect to the advisers’ receipt of compensation for services or other material payments made by clients and others; (2) alternative ways that advisers try to maximize revenue, such as revenue earned on clients’ bank deposit sweep programs; and (3) fee breakpoint calculation processes, particularly when fee billing systems are not automated
- Valuation assessments regarding advisers’ recommendations to clients to invest in illiquid or difficult to value assets, such as commercial real estate or private placements
- Safeguarding assessments for advisers’ controls to protect clients’ material non-public information, particularly when multiple advisers share office locations, have significant turnover of investment adviser representatives, or use expert networks
- Disclosure assessments to review the accuracy and completeness of regulatory filings, including Form CRS, with a particular focus on inadequate or misleading disclosures and registration eligibility
As in prior years, Exams will continue to prioritize examinations of advisers that have never been examined or those that have not been examined for a number of years.
Exams also pointed out that because advisers to private funds remain a significant portion of the SEC-registered adviser population, those advisers also will remain a focus of examination in 2024, including with respect to the following specific topics: (1) portfolio management risks; (2) adherence to contractual requirements regarding limited partnership advisory committees or similar structures; (3) accurate calculation and allocation of private fund fees and expenses, including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and potential offsetting of such fees and expenses; (4) due diligence practices; (5) conflicts, controls, and disclosures regarding private funds managed alongside registered investment companies; (6) compliance with the Advisers Act requirements regarding custody, accurate Form ADV reporting, and timely completion of audits and distribution of private fund audited financials; and (7) policies and procedures for reporting certain events on Form PF.
Investment Companies: Exams indicated it will continue to prioritize examinations of registered investment companies, including mutual funds and exchange-traded funds, due to their importance to retail investors, particularly those saving for retirement. Exams will continue to focus on compliance programs and fund governance practices, disclosures to investors, accuracy of reporting to the SEC, valuation practices (particularly those addressing fair valuation practices), and effectiveness of derivatives and liquidity risk management programs. The Division highlighted examination focus areas will include: (1) fees and expenses and reviewing whether registered investment companies have adopted effective written compliance policies and procedures concerning the oversight of advisory fees and associated fee waivers and reimbursements; (2) derivatives risk management assessments; and (3) compliance with the terms of exemptive order conditions and the issues associated with recent market volatility, including whether investment companies are following liquidating procedures. Similar to investment advisers, the Division has indicated that it will prioritize examinations for registered investment companies that have never been examined or have not been for a number of years.
Broker-Dealers: Exams will assess broker-dealers’ compliance with Regulation Best Interest, which establishes the standard of conduct for when broker-dealers recommend to a retail customer a securities transaction or investment strategy. Specifically, Exams stated that particular areas of interest will include: (1) recommendations with regard to products, investment strategies, and account types; (2) disclosures made to investors regarding conflicts of interest; (3) conflict mitigation practices; (4) processes for reviewing reasonably available alternatives; and (5) factors considered in light of the investor’s investment profile, including investment goals and account characteristics. Exams indicated that it will evaluate whether the broker-dealer has complied with Regulation Best Interest as a whole, including by establishing, maintaining, and enforcing written policies and procedures reasonably designed to do so. The Division will continue to focus on dual registrants and potential conflicts of interest, account allocation and selection practices, as well as supervision of branch office locations. Finally, Exams may review: (1) the content of a broker-dealer’s relationship summary (i.e., Form CRS); (2) compliance with the Net Capital Rule and the Customer Protection Rule and related internal processes, procedures, and controls; and (3) equity and fixed income trading practices by the broker-dealer.
Other Market Participants: Exams will continue to focus on the following types of other market participants, including: (1) municipal advisors and whether they have met their fiduciary duty obligations and are in compliance with requirements to document municipal advisory relationships and to disclose conflicts of interest as well as those related to registration, professional qualification, continuing education, recordkeeping, and supervision; (2) security-based swap dealers, including whether they have implemented policies and procedures to comply with security-based swap rules and are complying with applicable capital, margin, and segregation requirements and relevant conditions in SEC orders governing substituted compliance; and (3) transfer agents, including processing of items and transfers, recordkeeping and record retention, safeguarding of funds and securities, filings with SEC, and transfer agents that service certain types of issuers (e.g., those that issue microcap and crypto assets) and that use emerging technologies.
Today’s Rule Is Tomorrow’s Exams and Enforcement Agenda
As we have discussed previously, new Commission rules routinely become Exams’ priorities, as well as priorities for the Division of Enforcement (Enforcement). For example, following the November 4, 2022 effective date of the Marketing Rule, which among other things proscribes how RIAs market hypothetical performance of their funds to investors, Exams put at the top of its 2023 Priorities a focus on whether RIAs have adopted and implemented written policies and procedures that are reasonably designed to prevent violations of the Marketing Rule by the RIAs and their associated persons. On September 11, Enforcement announced settlements with nine RIA firms as part of a months-long and ongoing industry-wide sweep of RIA firms’ “advertising hypothetical performance to the general public on their websites without adopting and/or implementing policies and procedures required by the Marketing Rule.” As noted above, compliance with the Marketing Rule remains an Exams priority for 2024.
On July 26, the SEC proposed new rules that purport to address risk to investors from conflicts of interest related to the use of predictive data analytics (PDA) and artificial intelligence (AI) by broker-dealers and RIAs — what we will refer to as the Proposed PDA/AI Rules. When it came to conflicts of interest, and as a disclosure-based agency, the SEC historically focused on broker-dealer and RIA disclosures to clients and investors about both actual and potential conflicts. The Proposed PDA/AI Rules take a different tack and would require firms to “eliminate, or neutralize” certain conflicts of interest from interactions with investors that involve “technologies that optimize for, predict, guide, forecast, or direct investment-related behaviors or outcomes.” The comment period for the Proposed PDA/AI Rules closed on October 10, and time will tell how the final rules may differ from what were proposed in July 2023. If past is prologue, broker-dealers and RIAs should expect PDA and AI, and firms’ compliance with the final PDA/AI Rules, will be Exams priorities for the foreseeable future.
The 2024 examination priorities report reflects the Division’s assessment of the most significant risks, issues, and policy matters affecting market participants and provides a road map to the specific areas that Exams will focus on during the coming year. As the SEC continues to pursue a rigorous regulatory and enforcement agenda, firms should carefully review their policies and procedures and proactively assess and, as necessary, address these areas prior to any upcoming examinations.
Arnold & Porter’s Securities Enforcement and Litigation, Investment Management, and Financial Services 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 continuously evolving landscape.
© Arnold & Porter Kaye Scholer LLP 2023 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.