The SEC Division of Examinations Announces 2023 Priorities, Including Key Areas for Registered Investment Advisers, Registered Investment Companies, and Broker-Dealers

On 7 February 2023, the Division of Examinations (the Division) of the U.S. Securities and Exchange Commission (SEC) announced its examination priorities for the 2023 fiscal year (the Report).¹ The Report, which identifies areas of focus for the upcoming year, highlights new rules applicable to registered investment advisers (RIAs) and registered investment companies, emergent risks to investors and the markets, previous examination findings, and information from state securities regulators as key sources of the Division’s examination priorities. The Report also highlights certain areas that are consistent with the current SEC’s stated priorities and goals, including high-profile areas such as cryptocurrency and environmental, social, and governance (ESG) investing practices.  As in past years, the Division also stated that it will prioritize examinations of RIAs and registered investment companies that have never been examined and those that have not been examined in several years.

In 2023, the Division will prioritize several key areas, including: (1) recently adopted rules for investment advisers and investment companies; (2) standards of conduct for broker-dealers and investment advisers; (3) ESG investing; (4) information security and operational resiliency; and (5) emerging technologies and crypto-assets.² While the majority of these focus areas were identified as examination priorities by the Division in 2022,³ this year’s examinations will scrutinize for the first time compliance by RIAs and investment companies with certain recently enacted rules. 

The Division’s scrutiny will not be limited just to these five topics. The Division will also continue to examine the compliance programs and practices of RIAs and registered investment companies, focusing on the following areas: 

RIAs

Custody and safekeeping of client assets, valuation, portfolio management, brokerage and execution, conflicts of interest, calculation of fees and expenses, retaining and monitoring electronic communications,⁴ selecting and use of third-party service providers, and whether RIAs have adopted and considered current market factors that might affect evaluation and accuracy of regulatory filings. 

Registered Investment Companies

Adviser compensation, practices and processes for assessing and approving advisory and other fund fees, the effectiveness of derivatives risk management and liquidity risk management programs. The Division also expects to focus on specific types of funds, including loan-focused funds (e.g., leveraged loan funds), smaller fund complexes that have experienced excessive staff attrition, turnkey funds,⁵ and matters relating to exchange-traded funds (ETFs), including mutual funds that converted to ETFs, non-transparent ETFs, and volatility-linked and single-stock ETFs. 

Broker-dealers

Compliance and supervisory programs, including electronic communication use and record keeping, anti-money laundering programs, and compliance with the Customer Protection Rule and Net Capital Rule; liquidity risk management controls; and trading activity in fixed-income securities and municipal securities.

New Areas of Examination Focus

The Division intends to examine compliance with new SEC rules under the Investment Advisers Act of 1940 (the Advisers Act) and the Investment Company Act of 1940 (the 1940 Act), each of which had compliance dates in 2022. Specifically, the Division will review compliance with Advisers Act Rule 206(4)-1 (the Marketing Rule),⁶ 1940 Act Rule 18f-4 (the Derivatives Rule),⁷ and 1940 Act Rule 2a-5 (the Fair Valuation Rule).⁸ 

The Marketing Rule 

The Division acknowledged in the Report that the Marketing Rule represents a “significant change to a core examination review area for advisers,” signaling that compliance with the Marketing Rule will be scrutinized heavily. This announcement follows remarks by Division Staff last fall that sweep exams focusing on Marketing Rule compliance would begin shortly after the Rule’s November 2022 compliance date.  Although Marketing Rule sweep exams have not started as of the date of this alert, we anticipate that they will begin soon.

Division Staff have previously stated that they will not be “playing gotcha”⁹ in these initial sweep exams, and that they will instead conduct exams with a goal of ensuring that RIAs are aware of the Marketing Rule and have engaged in good faith efforts to comply. Whether this plays out in practice remains to be seen, but all RIAs are advised to prepare for Marketing Rule examinations in any event. 

To prepare for either a routine examination or a sweep exam, RIAs should ensure: (i) that they have adopted and implemented policies and procedures reasonably designed to prevent violations of the Marketing Rule; and (ii) that their brochures, slide decks, and other advertisements comply with the Marketing Rule’s substantive requirements related to performance advertising, testimonials and endorsements, substantiation of material facts, and third-party ratings, among other requirements.

This task is made more difficult by the changing regulatory landscape. In recent weeks, many RIAs have struggled to respond to a FAQ published in mid-January by the SEC’s Division of Investment Management.¹⁰ The FAQ clarifies that an advertisement that presents gross performance of an individual position (such as a case study) must also present that holding’s net performance—a position that is contrary to many RIAs’ prior understanding of the Marketing Rule. It is unclear whether or to what extent the Division’s “gotcha” exam comments will extend to RIAs working in good faith to revise their marketing materials in response to this and any other new guidance issued after the Marketing Rule’s compliance date.

The Derivatives Rule

When examining registered investment companies (funds), the Division will consider whether the funds have complied with the Derivatives Rule, including by adopting and implementing, if applicable, a derivatives risk management program reasonably designed to manage the fund’s derivatives risks and to prevent violations of the Derivatives Rule. The Division will also review board oversight of fund derivative practices and whether disclosures regarding each fund’s use of derivatives are incomplete, inaccurate, or potentially misleading. 

The Fair Valuation Rule

The Division will evaluate the compliance of funds and their boards with recently adopted requirements for determining fair value of fund investments, implementing board oversight duties, setting recordkeeping and reporting requirements, and permitting boards to designate valuation designees to perform fair value determinations subject to oversight by the board. The Division will also assess whether appropriate adjustments have been made to valuation methodologies, compliance policies and procedures, governance practices, service provider oversight, and reporting and recordkeeping. 

Continuing Areas of Examination Focus

Standards of Conduct: Regulation Best Interest, Fiduciary Duty, and Form CRS 

The Division expects to examine whether broker-dealers and RIAs are complying with their respective standards of conduct, including with respect to investment advice and recommendations, investor disclosures relating to material facts and potential conflicts of interest, the process for best interest evaluations, and suitability assessments based on investors’ investment profile. The Division will also review registrants’ management of conflicts of interest and will continue to prioritize RIAs’ and broker-dealers’ Form CRS content and delivery practices.

Although the Division has prioritized compliance with fiduciary obligations in examinations for many years, the Division may be stepping up scrutiny of this area following the Division of Enforcement’s first action last year under Regulation Best Interest under the Securities Exchange Act of 1934. In June 2022, the SEC charged a brokerage firm for failing to conduct due diligence to understand the risks associated with products they recommended to customers.¹¹ 

Environmental, Social, and Governance Investing (ESG)

The Report notes a continuing focus on ESG-related advisory services and fund offerings. The Division intends to identify whether funds are operating consistent with their disclosures, whether ESG products are appropriately labeled, and if advisers’ recommendations for ESG products are in investors’ best interests. ESG has been a longstanding examination priority and the Division staff’s focus on ESG-related representations has increased in recent years—the Division engaged in focused ESG sweep examinations of many registrants in 2022. Several enforcement actions in 2022 highlight potential areas of focus, including allegations that investment advisers failed to maintain or to follow policies and procedures regarding ESG investing, and that advisers misled investors by falsely claiming they considered ESG principles in making investment decisions.¹²

Information Security and Operational Resiliency

Due to the increased risk environment presented by cyber security attacks such as ransomware, the Division expects to focus on firms’ policies and procedures for preventing and responding to cyber-related events. This is a perennial focus area for all registrants, and an area of “significant” enforcement action in fiscal year 2022.¹³ 

The Division will focus its reviews on broker-dealers’ and RIAs’ policies and practices to safeguard customer information, records, and assets and practices to prevent the interruption of “mission-critical” services. Examinations will also review RIAs’ and broker-dealers’ compliance with Regulations S-P and S-ID. The Division will also focus on risks related to the use of third-party vendors, including visibility into the security of third-party services and unauthorized use of third-party services. 

Emerging Technologies and Crypto-Assets

In another repeat area of focus, examinations will focus on offerings by broker-dealers and RIAs of new products and services emerging from new technologies. In light of recent crypto-market disruptions and the resulting Enforcement actions, the Division will also examine whether crypto-market participants meet the requisite standard of care and update their compliance and risk management practices. Broker-dealers and RIAs that employ digital engagement practices will be examined to assess whether (1) recommendations were made; (2) representations are fair and accurate; (3) controls are consistent with disclosures made to investors; (4) advice and recommendations are in the best interest of the investor; and (5) risks associated with such practices are considered, including impact these practices may have on certain investors, like seniors. The Division will also monitor market participants that hold crypto or crypto-related assets, ensuring they follow standards of care when providing advice and routinely update compliance and risk management practices. 

This examination focus follows first-of-their-kind enforcement actions by the SEC against crypto-lending platforms in 2022.¹⁴ The SEC brought enforcement actions for violations of registration requirements, crypto-related Ponzi schemes, and crypto-related insider trading. Scrutiny on crypto will continue to increase, particularly in light of the additional employees hired into the SEC’s Crypto Assets and Cyber Unit in 2022.¹⁵ 

Conclusion 

While the Report provides a window into the Division’s priorities, time will tell how aggressive the Division will be during the forthcoming exam period. Recent enforcement actions with record penalties and public statements from SEC staff have shown a strict current Commission. Firms should be mindful of this environment and should be diligent in keeping up to date on guidance in developing areas and ensuring ongoing compliance in order to be prepared for forthcoming examinations.