The United States Securities and Exchange Commission’s Division of Examinations announced its examination priorities for fiscal year 2024 on October 16, 2023. The timing of the announcement is significant because it is the first time the Division’s annual publication of its priorities coincides with the beginning of the Commission's fiscal year, which began on October 1.
Many of the Division’s priorities for 2023 were included in its priorities for fiscal year 2024. However, “environmental, social and governance” investing, which was included in the “Notable, New and Significant Focus Areas” last year was not mentioned as a priority for fiscal 2024.
In a press release that accompanied the publication of the priorities, Division Director Richard K. Best, said: “We hope that aligning the publication of our examination priorities with the beginning of the SEC’s fiscal year will provide earlier insight to registrants, investors, and the marketplace of adjustments in our areas of focus year to year.” Best also stated: “Continuing to make our examination priorities public increases transparency into the examination program and encourages firms to focus their compliance and surveillance efforts on areas of potentially heightened risk to retail investors.”
The Division’s examination authority extends to investment advisers, investment companies, broker-dealers, self-regulatory organizations, clearing agencies, and other market participants. This update highlights certain of the announced examination priorities that will affect investment advisers, investment companies and broker-dealers.
Investment Advisers
The Division will continue to examine investment advisers’ adherence to their fiduciary duties to clients, which consist of a duty of care and a duty of loyalty. Areas of focus will include both investment advice provided to clients and the processes for determining that the investment advice provided is in the client’s best interest. With respect to the investment advice provided, the Division will focus on investment products and investment strategies, as well as account types. Specifically, it intends to look at (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 real estate investment trusts (REITs); and (3) unconventional investment strategies, including those that purport to address rising interest rates. Investment advisers can expect that their processes for formulating investment advice will be carefully scrutinized.
Examinations will focus on the economic incentives and conflicts of interest associated with investment advisers who are dually registered as broker-dealers, use affiliated firms to provide client services, and have financial professionals servicing both brokerage customers and advisory clients. Another area of focus will be the disclosures made to investors and whether they include all material facts relating to conflicts of interest with the investment advice that is sufficient to allow a client to provide informed consent to the conflict. The Division’s review of advisers’ annual reviews of the effectiveness of their compliance programs will permit examiners to assess whether an adviser’s conflicts of interest are addressed in the adviser’s compliance program.
Noting that advisers to private funds remain a significant portion of the universe of SEC-registered investment advisers, the Division outlines specific examination priorities for advisers to private funds. One area of focus will be on the portfolio management risks present when there is exposure to market volatility and rising interest rates. Another area of focus will be on the accuracy of calculating and allocating private fund fees (both at the fund-level and the investment-level), especially under circumstances when illiquid investments – investments for which market quotations are not readily available - are valued. The Division will also conduct examinations for private fund advisers aimed at (1) evaluating compliance with the specific requirements of the Investment Advisers Act of 1940 regarding custody, the accuracy of Form ADV reporting, timely completion of fund audits by a qualified auditor and the distribution of private fund audited financial statements; and (2) the adequacy of policies and procedures for Form PF reporting.
Investment Companies
The Division will continue to prioritize registered investment companies, including mutual funds and ETFs, because of their importance to retain investors, especially investors saving for retirement. Mutual funds and ETFs are popular investment options for retail investors because they provide access to a professionally managed portfolio at a reasonable cost and they provide liquidity. It would be fair to describe the Division’s approach to examining registered investment companies as one that looks at investment company operations through a prism that takes into account the compliance, governance and risk management functions. Examinations often include an assessment of compliance programs, fund governance practices, disclosures to investors and the accuracy of reporting to the SEC. An important focus will continue to be valuation practices, especially when market quotations for portfolio securities are not readily available, and, as applicable, on the adequacy and effectiveness of a fund’s derivatives risk management and liquidity risk management programs.
Broker-Dealers
The Division’s commentary on its examination program for broker-dealers begins with the explicit statement that Regulation Best Interest (Reg. BI) establishes the standard of conduct for broker-dealers at the time that they recommend a securities transaction or an investment strategy to a retail customer (emphasis added). The Reg. BI standard of conduct is met only if the broker-dealer complies with these specified obligations:
(1) Providing certain required disclosure, before or at the time of the recommendation, about the recommendation and the relationship between the retail customer and the broker-dealer (Disclosure Obligation);
(2) Exercising reasonable diligence, care and skill in making the recommendation (Care Obligation);
(3) Establishing, maintaining and enforcing policies and procedures reasonably designed to address conflicts of interest (Conflict of Interest Obligation); and
(4) Establishing, maintaining and enforcing policies and procedures reasonably designed to achieve compliance with Regulation Best interest (Compliance Obligation).
Examinations will review whether broker-dealer recommendations are in the customer’s best interest and will include consideration of numerous factors including, among others, factors considered in light of the investor’s investment profile, including investment goals and account characteristics. Examinations will focus on recommended products that are: (1) complex, such as derivatives and leveraged ETFs; (2) high cost, such as variable annuities; (3) illiquid, such as non-traded REITs and private placements; (4) proprietary; and (5) microcap securities.
Broker-dealer examinations will involve an evaluation of whether the broker-dealer has established, maintained and enforced written policies and procedures reasonably designed to achieve compliance with the areas enumerated above as well as with Regulation Best Interest as a whole. Examinations will also review the content of a broker-dealer’s Form CRS relationship summary and compliance with the Net Capital Rule.
