On Tuesday, February 7, 2023, the Securities and Exchange Commission’s (“SEC”) Division of Examinations announced its 2023 examination priorities, which provide insights into the areas the Division believes present potential risks to investors and the integrity of the U.S. capital markets.[1] These priorities, SEC Chair Gary Gensler notes, will “emphasize compliance with new SEC rules applicable to investment advisers and investment companies as well as continue our focus on emerging issues and rules aimed at protecting retail investors.”[2] Below is a sampling of some of the more notable priorities described in the report:

New Rules

One such new SEC rule, emphasized in the examination priorities, is first on the published selection: the new Marketing Rule (Advisers Act Rule 206(4)-1).  The new Marketing Rule was borne out of the SEC’s decision in December of 2020 to overhaul and modernize the SEC’s “Advertising Rule” and the “Cash Solicitation Rule”.[3]  The new rule marks the first significant change to the SEC’s rules in this area, and is designed to regulate advisers’ marketing communications and to promulgate principles-based prohibitions that advisers must abide by for all advertisements.[4]  The Marketing Rule, which took full effect on November 4, 2022,[5] is now a “core examination review area” for registered investment advisers (“RIAs”).[6] The examination priorities explain two areas of focus with regards to the new rule:

• Whether RIAs have adopted and implemented the policies and procedures designed to prevent violations; and,
• Whether RIAs have complied with the substantive requirements of the Marketing Rule, including the requirement that RIAs have a reasonable basis for believing they will be able to substantiate material statements of fact and requirements for performance advertising, testimonials, endorsements and third-party ratings.[7]

Along with the new Marketing Rule, two other recently adopted rules are highlighted in the SEC priorities: the Derivatives Rule and the Fair Valuation Rule.  Focusing on the Derivatives Rule, the Division will, among other things, assess whether registered investment companies have adopted and implemented policies and procedures to manages the funds’ derivative risks and prevent violations of the rule, and will review for compliance with the rule, including a review of the companies’ adoption and implementation of a derivatives risk management program, board oversight, and whether disclosures concerning the fund’s use of derivatives are incomplete, inaccurate or potentially misleading.[8]

Similarly, with regards to the Fair Valuation Rule, the Division will assess funds’ compliance with the new requirements for determining fair value, implementing board oversight duties, setting recordkeeping and reporting requirements, and permitting the funds’ board to designate valuation designees to perform fair value.[9] It will also review whether funds’ methodologies and practices have been adjusted to enhance compliance with the rule.[10]

RIAs to Private Funds

The examination priorities note that currently, RIAs to private funds represent a significant portion of the RIA population.[11]  Since 2022, the asset class has increased from $18 trillion to $21 trillion.[12]  As such, the Division will continue to focus on private fund RIAs and will review issues under the Adviser’s Act, specifically looking at the adviser’s fiduciary duty, which the priorities note is broad and applies to all advisory clients and the entire adviser-client relationship.[13] To ensure compliance, the Division will specifically asses the funds’:

• Conflicts of interest;
• Calculation and allocation of fees and expenses;
• Compliance with the new Marketing Rule;
• Policies and practices regarding the use of alternative data and compliance with Advisers Act Section 204A (requiring certain defined “Access Persons” to report their personal securities transactions)[14]; and,
• Compliance with the Custody Rule.[15]

In addition to focusing on the fiduciary standards under the Adviser’s Act, the examination priorities also show a continued emphasis on how broker-dealers (“BDs”) and RIAs are satisfying their obligations under Regulation Best Interest (“Reg BI”).  In this regard, the examination will continue to focus on:

• Investment advice and recommendations with regard to products, investment strategies, and account types;
• Disclosures made to investors;
• Processes for making best interest evaluations;
• Factors considered in light of the investor’s investment profile, including investment goals and account characteristics; and
• In the case of RIAs, whether the conflicts of interest disclosures are sufficient such that a client can provide informed consent to the conflict, whether express or implied.[16]

The Division further advises that it may provide advice or recommendations regarding: (1) complex products, such as derivatives and leveraged exchange-traded funds (ETFs); (2) high cost and illiquid products, such as variable annuities and non-traded REITs; (3) proprietary products; (4) unconventional strategies that claim to address rising interest rates; and (5) microcap securities.[17]  It will also focus on RIAs to private funds with specific risk characteristics, such as highly-leveraged private funds and private funds that invest in or sponsor Special Purpose Acquisition Companies (SPACs).[18]

Environmental, Social, and Governance Matters (ESG)

The Division makes clear that as RIAs are increasingly offering investments that employ and incorporate ESG criteria, it will continue to prioritize ESG-related advisory services by focusing on whether the funds are operating in the manner set forth in their disclosures, whether the ESG products are appropriately labeled, and whether recommendations of such products are made in the investors’ best interest.[19] 

Information Security and Operational Resiliency

In this year’s priorities, the Division notes that the current risk environment related to cybersecurity is elevated given the larger market events, geopolitical concerns, and the proliferation of cybersecurity attacks, particularly ransomware attacks.[20] Given those risks and concerns, cybersecurity remains a paramount focus area for registrants. As such, the Division plans to review whether firms’ policies and procedures take the appropriate measures with regards to:

• The safeguarding of customer records and information (both information residing in registrants’ systems and stored through a third-party provider);
• Supervision of third-party vendors, including registrant visibility into the security and integrity of third-party products and services and whether there has been an unauthorized use of third-party providers; and
• Resiliency planning, such as efforts to consider and/or address climate-related risks.[21]

Crypto Assets and Emerging Financial Technology

It is no surprise that recent financial distress caused by disruptions in the crypto asset market warrants a heightened focus on examinations of registrants trading in crypto or crypto-related assets in the 2023 priorities. As such, the Division will conduct examinations, as necessary, of registrants who are potentially impacted or affected by volatility in the crypto market, focusing on the offer, sale, or recommendation of, advice regarding and trading in crypto or crypto-related assets.[22] 

The Division will continue to focus broadly on the proliferation of “digital assets,” and emerging financial technologies, like broker-dealer mobile apps, automated investment tools and trading platforms (“robo-advisers”), on-line brokerage services, and internet advisers.[23] It will also focus on firms’ use of “digital engagement practices”, which include tools with behavioral prompts, differential marketing, game-like features (“gamification”), and other design elements such as website, portals and applications.[24]

Registered Investment Advisers (“RIAs”) and Registered Investment Companies (“RICs”)

RIAs and RICs remain a constant focus of the examination priorities. In 2023, the Division indicates that it will focus on RIA policies and procedures on retaining and monitoring electronic communications and selecting and using third-party service providers.[25]  As to RICs, the Division emphasizes a focus on funds with specific characteristics, such as: (1) turnkey

Funds, (2) mutual funds that converted to ETFs (3) non-transparent ETFs, (4) loan-focused funds, such as leveraged loan funds and funds focused on collateralized loan obligations, and (5) medium and small fund complexes that have experienced excessive staff attrition.[26]

The Division gives a “heads up” to both RIAs and RICs that have never been examined and those that have not been examined in a number of years, explaining it will prioritize those registrants and will review them on corporate governance practices, advisory contract approval processes, and their code of ethics, as well as other issues.[27]

Anti-Money Laundering (AML)

The Division will continue to monitor final institutions’ AML programs. This year, the Division notes that the importance of continued evaluations has been elevated due to the current “geopolitical environment” and the increased imposition of international sanctions. Therefore, firms will be reviewed for their monitoring and compliance with OFAC and Treasury-related sanctions.[28]

Conclusion

The Division notes that while these published priorities are not an exhaustive list of its focus areas, it reflects the Division’s assessment of risks, issues and policy matters that have arisen from recent market and regulatory developments, information gathered from prior examinations, and tips or complaints received from other sources. The Division notes its flexibility in devoting resources to new or emerging concerns as they arise.[29]