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SEC Releases 2023 Examination Priorities

Client Updates

On February 7, 2023, the Securities and Exchange Commission’s Division of Examinations (the “Division”) published its 2023 Examination Priorities report, in which it highlighted key compliance areas that will be the focus of its 2023 examination program. In support of its “four pillars”: to (i) promote compliance; (ii) prevent fraud; (iii) monitor risk; and (iv) inform policy, the Division identified four new and significant focus areas and nine additional priorities for 2023. The four new and significant focus areas include: (i) compliance with new investment adviser and investment company rules; (ii) investment advisers to private funds; (iii) standards of conduct (including Regulation Best Interest); and (iv) ESG investing.

As detailed herein, the Division’s 2023 Examination Priorities Report contains important updates for registered investment advisers (“RIAs”), as well as updates regarding a range of other priority compliance and risk management areas, including cybersecurity practices and crypto trading. Herein we address select 2023 examination priorities most relevant to RIAs to private funds and areas that are now often related to private fund offerings. The full list of the 2023 Examination Priorities can be found here. A full list of “Risk Alerts” issued by the Division over the past year is included at the end of this article for further reference. The 2023 examination priorities list provides a useful guide to registered market participants for review of vital compliance practices, policies, and procedures to address gaps and enhance compliance efforts in areas of greatest risk.

Compliance with Recently Adopted Rules Under the Investment Advisers Act of 1940 (the “Advisers Act”) and the Investment Company Act of 1940 (the “Investment Company Act”)

The SEC adopted several rules as part of its ongoing efforts to modernize and promote capital market efficiency, such as the Marketing Rule (Advisers Act Rule 206(4)-1). The Marketing Rule is a “significant change” to a “core examination review area” for RIAs. In the coming year, the Division notes that it will assess whether RIAs have adopted and implemented written policies and procedures that are reasonably designed to prevent violations by the advisers of the Marketing Rule. The Division also noted that it will review whether RIAs have complied with the substantive requirements of the Marketing Rule; for example, RIAs must 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.

RIAs to Private Funds

The Division emphasized the growth and size of private funds, noting that over 35% of all RIAs manage private funds which have aggregate gross assets exceeding $21 trillion, and that in the past five years there has been an 80% increase in the gross assets of private funds. Given the size and growth of private funds, the Division marked private fund RIAs as a main focus area for 2023, and specified several focus points such as (i) potential conflicts of interest, (ii) the calculation and allocation of fees and expenses, (iii) compliance with the new Marketing Rule, (iv) policies and practices regarding the use of alternative data and compliance with Advisers Act Section 204A and (v) compliance with the Advisers Act Rule 206(4)-2 ( the “Custody Rule”), where applicable, including timely delivery of audited financials and selection of permissible auditors.

Further, the Division noted that risk characteristics posed by certain types of funds will garner greater focus, including those private funds that (i) are highly-leveraged, (ii) are managed side-by-side with business development companies (“BDCs”), (iii) use affiliated companies and advisory personnel to provide services to their fund clients and underlying portfolio companies, (iv) hold certain hard-to-value investments, such as crypto assets and real estate-connected investments, with an emphasis on commercial real estate, (v) invest in or sponsor Special Purpose Acquisition Companies (“SPACs”) and (vi) are involved in adviser-led restructurings, including stapled secondary transactions and continuation funds.

Environmental, Social, and Governance (“ESG”) Investing

The Division continues to closely monitor the rise of ESG investing and included it as a significant focus area of the Examination Priorities. As private funds increasingly offer ESG-related investments and strategies incorporating certain ESG criteria, the Division will continue to focus on ESG-related advisory services and fund offerings, specifically whether funds are operating in a manner consistent with their ESG disclosures. Additionally, the Division will review whether the labelling of ESG products is accurate and whether recommendations of such products are in fact in the best interest of investors.

Information Security and Operational Resiliency

The Division noted that cybersecurity risk is elevated given broader market events, geopolitical concerns and the rise in cybersecurity attacks. As such, cybersecurity remains an important area of focus for the Division. The Division will focus on RIAs’ policies and procedures, governance practices, responses to ransomware attacks and, as applicable, compliance with Regulation S-ID. The focus of any review of policies or procedures, the Division noted, will be to determine whether such policies are “reasonably designed” to safeguard customer records and information, whether housed in a registrant’s system or with a third-party provider, and whether the location of records has been properly disclosed to the Division. Further, the Division will continue to review firms’ practices with respect to preventing account intrusions and safeguarding customer information, particularly given continued remote access by personnel. Additional focus will be placed on the use of third-party vendors, registrant visibility into the security and integrity of third-party vendors’ services and whether there has been unauthorized use by third-party providers. Finally, the Division will continue to assess the operational resiliency planning of “systemically significant” firms.

Crypto Assets and Emerging Financial Technology

The Division flagged crypto assets and associated products and services, and RIAs choosing to provide automated digital investment advice to clients, as a continued area of focus. The Division noted that it will conduct examinations of RIAs offering crypto products or employing new practices, including technological and on-line solutions to service investor accounts such as internet advisers, automated investment tools and trading platforms and robo-advisers. In light of recent disruptions in the crypto market, the Division will monitor and occasionally conduct examinations of affected registrants. Such examinations will generally focus on the “offer, sale, or recommendation of, advice regarding and trading in” crypto assets and, specifically, whether firms have (i) met and followed their respective standards of care when making recommendations, referrals or providing investment advice and (ii) routinely reviewed, updated and enhanced their compliance, disclosure and risk management practices. The Division also noted that it will focus on new or never before examined registrants offering crypto or crypto-related assets. RIA examinations will also focus on firms that use “digital engagement practices” to assess whether (i) recommendations were made or advice was provided, (ii) representations are fair and accurate, (iii) such RIA has operations and controls in place consistent with disclosures made to investors, (iv) any advice or recommendations given by such RIA are in the best interest of the investor, and (v) risks associated with such practices are considered, including the impact these practices may have on certain at-risk investors.

Focus Areas for Examinations of RIAs

The Division noted that it remains focused on whether various elements of RIAs’ operations and compliance practices have adopted and considered current market factors, including those that impact the valuation or the accuracy of RIA regulatory filings. The Division provided insight into its examinations, noting that it typically reviews the compliance programs of RIAs in one or more core areas, such as custody and safekeeping of client assets, valuation or portfolio management. Further, the Division noted that examinations often include a review for conflicts, compliance issues and the oversight process related to RIA fees and expenses, such as the calculation of fees and methods to maximize earnings. In accordance with its focus on cybersecurity, examinations will also include reviews of policies and procedures for retaining and monitoring electronic communications, as well as the use and selection of third-party data providers. Finally, the Division noted that RIAs which have never been examined, or have not been examined for a number of years, will be prioritized, and that such examinations will focus on firms’ compliance programs.

Overall Notes & Takeaways

Overall, the 2023 Examination Priorities Report is an important reminder that RIAs need to maintain a close watch on market developments, industry trends and emerging risks to investment management. RIAs should continue to regularly review and enhance their compliance programs, particularly with respect to the key priority compliance areas identified by the Division. RIAs should prepare early for potential examinations, especially if an RIA has not been examined or has not been examined for a number of years. RIAs also should be cognizant of the Commission’s notable enforcement actions concerning investment advisers, and should pay particular attention to compliance areas that are consistently identified by the Division as areas with recognized deficiencies. Finally, RIAs should engage counsel early in connection with examinations to ensure any potential deficiencies are promptly remedied and to minimize the risks of enforcement.

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