SEC Announces 2022 Examination Priorities
05/19/2022 | New York Law JournalBy Meryl E. Wiener
Introduction
On March 30, 2022, the Securities and Exchange Commission’s Division of Examinations (“DOE”) announced its examination priorities for 2022 (2022 Examination Priorities) (available here). Examination priorities, which are released annually, provide investors and registrants with transparency into those areas that DOE believes bring heightened risks to investors, registrants, and the markets.
In fiscal year 2021, DOE completed 3,040 examinations. It issued more than 2,100 deficiency letters (approximately 70% of all examinations) and made more than 190 referrals to the Division of Enforcement (approximately 6% of all examinations).
The 2022 Examination Priorities reflect DOE’s assessment of “certain risks, issues, and policy matters” that arise out of market and regulatory developments, information gathered from examinations and other sources, including tips, complaints, and referrals, and coordination with other divisions and offices at the SEC, as well as other regulators. Examinations of these priority areas are grounded in the DOE’s four pillars: “promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy.”
These are DOE’s 2022 Examination Priorities:
1. Significant Focus Areas
A. Private Funds
B. Environmental, Social, and Governance (ESG) Investing
C. Standards of Conduct: Regulation Best Interest, Fiduciary Duty, and Form CRS
D. Information Security and Operational Resiliency
E. Emerging Technologies and Crypto-Assets
2. Investment Adviser and Investment Company Examination Program
A. Registered Investment Advisers (RIAs)
B. Registered Investment Companies, Including Mutual Funds and Exchange Traded Funds
3. Broker-Dealer and Exchange Examination Program
A. Microcap, Municipal, Fixed Income, and Over-the-Counter Securities
B. Broker-Dealer Operations
C. National Securities Exchanges
D. Security-Based Swap Dealers
E. Municipal Advisors
F. Transfer Agents
4. Clearance and Settlement Examination Program5. Regulation Systems Compliance and Integrity (SCI)
6. Financial Industry Regulatory Authority (FINRA)
7. Municipal Securities Rulemaking Board (MSRB)
8. The London Inter-Bank Rate (LIBOR) Transition
9. Anti-Money Laundering
While the stated priorities that drive many of DOE’s examinations are critical, they are not exhaustive and will not be the only issues DOE will address. DOE is flexible; its examinations also may cover new and exigent risks to investors and the marketplace as they arise, as well as core and perennial risk areas.
DOE 2022 Examination Priorities
1. Significant Focus Areas
A. Private Funds
Private funds include hedge funds, private equity funds, real estate funds and other types of funds that are deployed in a variety of investment strategies. DOE will continue to prioritize its focus on RIAs to private funds. Examinations will review issues under the Investment Advisers Act of 1940 (Advisers Act), including an “adviser’s fiduciary duty, and will assess risks, including a focus on compliance programs, fees and expenses, custody, fund audits, valuation, conflicts of interest, disclosures of investment risks, and controls around material nonpublic information (MNPI).”
DOE will review the following issues: (1) calculation and allocation of fees and expenses; (2) potential preferential treatment of certain investors by RIAs to private funds that have experienced issues with liquidity; (3) compliance with the Advisers Act Custody Rule, including the “audit exception” to the surprise examination requirement and related reporting and updating of Form ADV; (4) adequacy of disclosure and compliance with any regulatory requirements for cross trades, principal transactions, or distressed sales; and (5) conflicts around liquidity.
DOE also will review private fund advisers’ portfolio strategies, risk management, and investment recommendations and allocations, focusing on conflicts and disclosures around these areas. Of recent relevance, this will include review of private funds’ investments in Special Purpose Acquisition Companies (SPACs), particularly where the private fund adviser is also the SPAC sponsor. In addition, DOE will review the “practices, controls, and investor reporting around risk management and trading for private funds with indicia of systemic importance, such as outsized counterparty exposure or gross notional exposure when compared to similarly situated firms.”
B. Environmental, Social and Governance (ESG) Investing
RIAs and registered funds are increasingly offering ESG strategy investments. There is a risk of false and misleading statements or omissions regarding these investments, compounded by the (1) “lack of standardization of ESG investing terminology;” (2) “variety of approaches to ESG investing;” and (3) “failure to effectively address legal and compliance issues with new lines of business and products.”
DOE will continue to focus on ESG-related advisory services and investment products and will examine whether RIAs and registered funds are: (1) “accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices designed to prevent violations of the federal securities laws in connection with their ESG-related disclosures;” (2) “voting client securities in accordance with proxy voting policies and procedures and whether the votes align with their ESG-related disclosures and mandates;” and (3) “overstating or misrepresenting the ESG factors considered or incorporated into portfolio selection (e.g., greenwashing).”
C. Standards of Conduct: Regulation Best Interest, Fiduciary Duty, and Form CRS
DOE will continue to examine standards of conduct issues for broker-dealers and RIAs, under Regulation Best Interest (BI) and the Advisers Act fiduciary standard to act in the best interests of retail investors and not to place their own interests ahead of retail investors’ interests. Examinations will include assessments of practices regarding consideration of alternatives, management of conflicts of interest, trading, disclosures, account selection, and account conversions and rollovers. Examinations will focus on the “effectiveness of compliance programs, testing, and training that are designed to support retail investors and working families receiving recommendations and advice in their best interests.”
Examinations of broker-dealers will review their recommendations and sales practices related to SPACs, structured products, leveraged and inverse exchange traded products, REITs, private placements, annuities, municipal and other fixed income securities, and microcap securities. Examinations will review practices, policies, and procedures concerning the evaluation of cost and reasonable alternatives relating to recommendations of these products being in the investor’s best interest. Examinations also will evaluate compensation structures, conflicts created by such structures, and sales of securities by highly compensated financial professionals.
Examinations of RIAs will focus on whether they are acting consistently with their fiduciary duty to clients, including best execution obligations, financial conflicts of interest and related impartiality of advice, and any attendant client disclosures. Focus areas include: (1) “revenue sharing arrangements;” (2) “recommending or holding more expensive classes of investment products when lower cost classes are available;” (3) “recommending wrap fee accounts without assessing whether such accounts are in the best interests of clients;” and (4) “recommending proprietary products resulting in additional or higher fees.” The reviews also will include an assessment of RIAs compliance policies and procedures and disclosures to investors.
With respect to dually registered RIAs and broker-dealers, in addition to the above, DOE will focus on potential conflicts of interest present at these firms, including with regard to account recommendations and allocation of investments across different accounts.
D. Information Security and Operational Resiliency
Applying information controls is critical to ensuring business continuity. Accordingly, DOE will continue to review whether firms have taken appropriate measures to: “(1) safeguard customer accounts and prevent account intrusions, including verifying an investor’s identity to prevent unauthorized account access; (2) oversee vendors and service providers; (3) address malicious email activities, such as phishing or account intrusions; (4) respond to incidents, including those related to ransomware attacks; (5) identify and detect red flags related to identity theft; and (6) manage operational risk as a result of a dispersed workforce in a work-from-home environment.”
DOE will continue to review registrants’ business continuity and disaster recovery plans, with particular focus on the impact of climate risk and substantial disruptions to normal business operations. The examinations will focus on improvements to business continuity and disaster recovery plans over the years, as well as registrants' ability to anticipate and adapt to disruptions and incremental changes stemming from climate-related situations.
E. Emerging Technologies and Crypto-Assets
There has been a significant increase in the number of RIAs using “robo-advisers,” the use of mobile apps by broker dealers, and trading of crypto-assets. DOE examinations will focus on whether the “unique” risks presented when firms use “developing financial technologies” were considered when designing their regulatory programs. Specifically, DOE will examine whether: (1) controls are consistent with disclosures and the standard of conduct owed to investors; (2) recommendations, including by algorithms, are consistent with investors’ investment strategies; and (3) controls take into account the unique risks associated with such practices.
DOE will examine custody arrangements, recommendations, and trading by firms engaged in crypto-assets. In particular, DOE will review whether firms have met their respective standards of conduct when recommending crypto-asset investments with a focus on duty of care owed and understanding of the products, and whether they routinely review, update, and enhance their compliance practices.
2. Investment Adviser and Investment Company Examination Program
A. Registered Investment Advisers
DOE typically reviews compliance programs of RIAs to assess whether the policies and procedure are reasonably designed to prevent violations of the Advisers Act. DOE will examine whether compliance programs address that: “(1) investment advice is in each client’s best interest; (2) oversight of service providers is adequate; and (3) sufficient resources exist to perform compliance duties.” In addition, DOE will examine whether RIAs are implementing appropriate compliance and controls around potential MNPI.
DOE also will review whether firms have implemented oversight practices to mitigate any heightened risks, such as whether RIAs (1) are employing individuals with “prior disciplinary histories;” (2) transitioning investor accounts to advised accounts (when migrating from the broker-dealer business model) is in the clients’ best interests; and (3) operating from multiple branch offices have appropriate compliance programs to oversee branch activities. DOE examinations will continue to focus on disclosures and other issues related to fees and expenses. DOE also will continue to prioritize examinations of RIAs and registered funds that never have been examined or those that have not been examined for a number of years.
B. Registered Investment Companies, Including Mutual Funds and Exchange Traded Funds (ETFs)
DOE will continue to prioritize examinations of registered investment companies, including mutual funds and ETFs. DOE examinations will focus on disclosures to investors, accuracy of reporting to the SEC, and compliance with new rules and exemptive orders. DOE also will examine whether registered funds’ Liquid Risk Management Programs are reasonably designed to assess and manage those funds’ liquidity risks.
DOE will prioritize examinations of money market funds, business development companies and mutual funds investing in private funds. DOE also will prioritize examinations of certain practices, including advisory fee waivers and trading activities of portfolio managers.
3. Broker-Dealer and Exchange Examination Program
A. Microcap, Municipal, Fixed Income, and Over-the-Counter Securities
DOE will continue to prioritize examinations of broker-dealers for compliance with the offer, sale and distribution of microcap securities. Focus areas will include: (1) transfer agent handling of microcap distributions and share transfers; (2) broker-dealer sales practices and their consistency with Regulation BI; and (3) broker-dealer compliance with certain regulatory requirements, including certain short sale practices (Regulation SHO), penny stock disclosure rules, and the obligation to monitor for and report suspicious activity and other anti-money laundering obligations.
DOE will examine the activities of broker-dealers, underwriters, and municipal advisors to assess whether they are meeting their respective obligations in relation to municipal issuer disclosure. DOE also will examine broker-dealer trading activity in fixed income securities. DOE examinations will focus on the sale of over-the-counter securities and whether broker-dealers recommending these securities are meeting their obligations under Regulation BI.
B. Broker-Dealer Operations
DOE also will continue to focus on compliance with the Customer Protection Rule and the Net Capital Rule. DOE will examine broker-dealer funding and liquidity risk management and trading practices. Examinations will focus on broker-dealer compliance with best execution obligations in a zero commission environment and potential conflicts of interest in order routing. Examinations also will focus on large trader reporting obligations, broker-dealer compliance with Regulation SHO, and operations of alternative trading systems for compliance with Regulations ATS.
DOE exams will continue to prioritize review of firms that are engaged in activities that appear to require broker-dealer registration and those that may be involved in the illegal distribution of unregistered securities.
C. National Securities Exchanges
DOE will examine the national securities exchanges to assess whether they are meeting their obligations under the federal securities laws and will focus on “exchange regulatory programs to detect and discipline violations, and participation in National Market System (NMS) Plans.”
D. Security-Based Swap Dealers
DOE’s initial examinations of security-based swap dealers (SBSDs) will focus on the policies and procedures related to compliance with security based swap rules generally. (Registration of SBSDs was required by October 6, 2021.)
E. Municipal Advisors
DOE will continue to examine whether municipal advisors have met their fiduciary duty and conflict disclosure obligations to municipal entity clients. DOE also will examine whether municipal advisors have “satisfied their registration, professional qualification, continuing education, and supervision requirements.”
F. Transfer Agents
DOE will continue to examine transfer agents’ “timely turnaround of items and transfers, recordkeeping and record retention, safeguarding of funds and securities, and filing obligations.” DOE will focus on never-before-examined transfer agents and transfer agents that service microcap or municipal bond issuers, or that use novel technologies.
4. Clearance and Settlement Examination Program
As required by the Dodd-Frank Act, DOE will conduct at least one risk-based examination of each clearing agency “designated as systemically important and for which the SEC serves as the supervisory agency.” These examinations will focus on “core risks, processes, and controls and will cover the specific areas required by statute.” In addition, DOE will conduct risk-based examinations of other registered clearing agencies that have not been designated as systemically important. DOE will examine clearing agencies for compliance with the SEC’s Standards for Covered Clearing Agencies to make certain they have policies and procedures in place that address “maintaining sufficient financial resources, protecting against credit risks, managing member defaults, and managing operational and other risks.”
5. Regulation Systems Compliance and Integrity
Regulation Systems Compliance and Integrity (SCI) was adopted to strengthen the technology and infrastructure of the U.S. securities markets. Regulation SCI entities must “establish, maintain, and enforce written policies and procedures reasonably designed to ensure that their systems’ capacity, integrity, resiliency, availability, and security is adequate to maintain their operational capability and promote the maintenance of fair and orderly markets.” DOE will evaluate whether SCI entities have established maintained and enforced the written policies and procedures, as required.
6. FINRA
DOE conducts risk-based oversight examinations of FINRA. It selects areas within FINRA to examine through a risk assessment process designed to “identify those aspects of FINRA’s operations important to the protection of investors and market integrity, including FINRA’s implementation of new investor protection initiatives.” Based on the outcome of this risk-assessment process, DOE conducts inspections of FINRA’s major regulatory programs and oversight examinations of FINRA’s examinations of certain broker-dealers and municipal advisors.
7. MSRB
MSRB regulates the activities of broker-dealers that buy, sell and underwrite municipal securities, and the activities of municipal advisors. Using a risk assessment process, DOE examines registered firms to assess compliance with MSRB rules and to evaluate the effectiveness of MSRB’s policies, procedures and controls.
8. The London Inter-Bank Offered Rate (LIBOR) Transition
The discontinuation of LIBOR could have a significant impact on the financial markets and may present a material risk for certain market participants, including RIAs, broker-dealers, and other market participants. DOE will continue to engage with registrants to assess their exposure to LIBOR, preparations for the cessation of many LIBOR rates beginning immediately after December 31, 2021, and the transition to an alternative reference rate.
9. Anti-Money Laundering
The Bank Secrecy Act requires financial institutions, including broker-dealers and registered investment companies to establish anti-money laundering (AML) programs. DOE will continue to prioritize examinations of broker-dealers and registered investment companies for compliance with their AML obligations in order to assess, among other things: “whether firms have established appropriate customer identification programs and whether they are satisfying their suspicious activity report (SAR) filing obligations, conducting due diligence on customers, complying with beneficial ownership requirements, and conducting robust and timely independent tests of their AML programs.” The goal of these examinations is to evaluate whether policies and procedures are reasonably designed to identify suspicious activity and illegal money laundering activities.
Conclusion
DOE’s 2022 Examination Priorities are not exhaustive and do not represent the only areas DOE will consider in assessing areas to examine and in identifying firms to examine. In addition to the priorities set forth, DOE also will conduct examinations that are focused on “new or emerging risks, products and services, market events, and investor concerns.” Underpinning DOE’s priorities is its stated desire to “protect investors, prevent fraud, and promote and improve compliance.”
Reprinted with permission from the “May 19, 2022 edition of the “NEW YORK LAW JOURNAL”© 2022 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.
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