SEC Division of Examinations’ 2023 Exam Priorities – A Continued Focus on Private Funds, Regulation Best Interest, ESG, and Crypto

On February 7, 2023, the Securities and Exchange Commission’s (SEC) Division of Examinations (EXAMs) announced its 2023 Examination Priorities (the “Priorities”), which highlight areas it expects to target in 2023 examinations. The Priorities reinforce many of the same areas of interest from the 2022 Priorities, including investment advisers to private funds, Regulation Best Interest (“Reg BI”) compliance, ESG‑related investments and strategies, and crypto assets and identify additional areas of focus based on SEC rules which recently went into effect.  Registered investment advisers (RIAs), registered investment companies (“funds”), and broker-dealers should carefully review the Priorities to ensure that their compliance systems and policies are up to date, monitored, and enforced. Indeed, given the SEC’s history of pursuing enforcement actions in areas highlighted in prior years as Examination Priorities, appropriate attention to these Priorities today can save regulated entities considerable resources down the road.

Key Takeaways

• The Priorities highlight three recently adopted rules as new risk areas for 2023:  (1) Rule 206(4)-1 (the “Marketing Rule”)[1] under the Investment Advisers Act of 1940 (the “Advisers Act”); (2) Rule 18f-4 (the “Derivatives Rule”) under the Investment Company Act of 1940 (the “1940 Act”); and Rule 2a-5 (“Fair Valuation Rule”) under the 1940 Act. RIAs and funds should prepare for the EXAMs staff to closely assess the effectiveness of their practices and compliance programs under these new rules, as applicable. 
• Registrants should be vigilant about identifying, mitigating, and disclosing inter-affiliate conflicts of interest that can impact clients and customers. Throughout the Priorities, EXAMs stresses conflicts of interest among affiliates as presenting significant risks, especially related to the use of affiliated service providers, recommendations of proprietary products and services, and revenue sharing arrangements. The Staff notes EXAMs’ interest in continuing to leverage data provided to the SEC in various regulatory filings, including fund registration statements, Form ADV, Form PF, Form CRS, and other reports. Given the SEC’s focus on using technology to analyze and assess data across these various filings, registrants should continue to ensure that they include accurate and consistent information across their filings or risk flagging attention from SEC examiners. 
• The Priorities state that RIAs and funds that have not been examined previously or have not been examined in a number of years will be a focus area for 2023. Such firms should consider conducting a self-audit of their compliance program and regulatory filings to ensure they are prepared for any forthcoming examination.

Newly Adopted Rules

With respect to the SEC’s newly adopted rules, the Priorities identify the following focus areas for examinations:  

• Marketing Rule. EXAMs will assess whether RIAs have: (1) adopted and implemented written policies and procedures that are reasonably designed to prevent violations of the Marketing Rule; and (2) complied with the substantive requirements of the Marketing Rule, including the requirement that RIAs have a reasonable basis for believing they can substantiate material statements of fact and the requirements related to use of performance advertising, testimonials, endorsements, and third-party ratings.
• Derivatives Rule. EXAMs will assess whether funds have: (1) adopted and implemented policies and procedures pursuant to Rule 38a-1 under the 1940 Act that are reasonably designed to manage a fund’s derivatives risks and to prevent violations of the Derivatives Rule; and (2) adopted and implemented a derivatives risk management program, implemented board oversight procedures, and evaluated whether disclosures concerning the fund’s use of derivatives are complete, accurate and not misleading.
• Fair Valuation. EXAMs will assess whether: (1) funds and fund boards have adopted procedures to ensure compliance with the Fair Valuation Rule, implemented board oversight duties, established recordkeeping and reporting requirements, and considered if a fund’s board should designate a valuation designee to perform fair value determinations subject to the board’s oversight; and (2) adjustments have been made to valuation methodologies, compliance policies and procedures, governance practices, service provider oversight, and/or reporting and recordkeeping.

Private Fund Advisers

As in 2022, EXAMs will continue to focus on private fund advisers in 2023. The Priorities state that examinations of private fund advisers will generally focus on conflicts of interest, fees and expenses, custody,[2] and valuation. Specifically, the Priorities highlight EXAMs’ interest in the following topic areas:

• Private fund advisers’ use of alternative data and compliance with Section 204A of the Advisers Act.
• Private funds that are highly leveraged.
• Private funds managed alongside business development companies (BDCs).
• Private equity fund advisers that use affiliated companies and advisory personnel to provide services to their fund clients and underlying portfolio companies.
• Private funds that hold certain hard-to-value investments, including crypto assets and real estate-connected investments, specifically commercial real estate.
• Private funds that invest in or sponsor Special Purpose Acquisition Companies (SPACs).
• Adviser-led private fund restructurings (e.g., stapled secondary transactions and continuation funds).

Broker-Dealers and Reg BI Compliance

Since the June 30, 2020, Reg BI compliance date, EXAMs generally has taken a measured approach to assessing broker-dealers’ compliance with Reg BI. For example, initial Reg BI examinations following the compliance date focused on assessing whether firms had made a good-faith effort to implement policies and procedures reasonably designed to comply with Reg BI. Subsequent examinations focused on the specific requirements of Reg BI and included enhanced transaction testing designed to examine whether broker-dealers effectively implemented their written policies and procedures. The Priorities emphasize protection of retail investors and Reg BI compliance, and considering the recently published EXAMs’ Risk Alert, it appears that the SEC is signaling the end of the preliminary phase of Reg BI compliance. Broker-dealers should expect forthcoming examinations for Reg BI compliance to be more comprehensive.  In the Priorities, EXAMs stated that Reg BI examinations will focus on :

• Advice or recommendations regarding: (1) complex products, such as derivatives and leveraged exchange-traded funds (ETFs), exchange-traded notes, and other exchange-traded products; (2) high cost and illiquid products, such as variable annuities and non-traded REITs; (3) proprietary products; (4) unconventional strategies that purport to address rising interest rates; and (5) microcap securities.
• The broker-dealer’s process for making a best interest evaluation in connection with any recommendation.
• Whether compliance policies and procedures are tailored to the firm’s particular business model, compensation structure, product menu, and customer base. 
• The economic incentives that a firm and its financial professionals have to recommend products, services, or account types, which may include revenue sharing, commissions (including markdowns and markups), or other revenue arrangements.
• How broker-dealers are managing conflicts of interest, including mitigating the conflicts of interest or eliminating them when possible. In addition, EXAMs will consider whether the broker-dealer’s policies are sufficient for monitoring and identifying potential conflicts of interest.
• Compliance with Form CRS disclosure requirements.

In addition to Reg BI, EXAMs stated that broker-dealer examinations will also focus on:

• Compliance with the Customer Protection Rule (Rule 15c3-3 under the Securities Exchange Act of 1934 (the “Exchange Act”)) and the Net Capital Rule (Rule 15c3-1 under the Exchange Act), including the adequacy of internal processes, procedures, and controls.
• Use of digital engagement practices for online solicitation of customers.
• Compliance with Regulation SHO (short sales) and Regulation ATS (alternative trading systems).
• Broker-dealer credit, market, and liquidity risk management controls to ensure that broker-dealers have sufficient liquidity to manage stress events.
• Trading practices, including the fairness of pricing for fixed income securities and the adequacy of issuer information when entering quotations for micro-cap securities.
• Supervision and storage of electronic communications.

ESG Investing

Given the SEC’s broad interest in ESG investing and its importance to retail and institutional investors, it is understandable that EXAMs stated in the Priorities that it will focus on examinations of ESG-related advisory services and fund offerings in 2023. A specific focus is whether funds that incorporate ESG factors into their investment strategies operate in a manner consistent with their disclosures, whether ESG products are appropriately labeled, and whether recommendations of such products for retail investors are made in investors’ best interest (e.g., under traditional fiduciary duty rules and Reg BI).

Crypto Investing

Given the recent events in the crypto industry, EXAMs announced that it will focus on RIAs and broker‑dealers that offer crypto-related products in 2023. Specifically, EXAMs stated that it will focus on whether broker-dealers and RIAs:

• Met and followed their respective standards of care when making recommendations, referrals, or providing investment advice; and routinely reviewed, updated, and enhanced their compliance, disclosure, and risk management practices.
• Made fair and accurate representations; implemented controls consistent with disclosures made to investors; provided advice or recommendations in the best interest of the investor; and considered risks associated with such practices, including the impact these practices may have on certain investors, such as seniors.

Information Security

Information security has become a perennial focus area for EXAMs. The Priorities expand upon this trend, noting that EXAMs will continue to review broker-dealers’ and RIAs’ practices to prevent interruptions to mission-critical services and to protect investor information, records, and assets. EXAMs stated that it will specifically examine:

• Broker-dealers’ and RIAs’ compliance with Regulations S-P and S-ID. 
• Firms’ practices to prevent account intrusions and safeguard customer records and information, including personally identifiable information, especially with firm personnel accessing information in a remote environment.
• Firms’ use of third-party vendors, including visibility into the security and integrity of third-party products and services.

Additional Focus Areas for RIAs

In addition to the focus areas noted elsewhere in the Priorities, EXAMs stated that it will focus on the following in examinations of RIAs:

• RIA’s calculation of fees, alternative ways that RIAs may try to maximize revenue (e.g., revenue earned on clients’ bank deposit sweep programs), and excessive fees.
• Whether RIAs adopted and implemented policies and procedures for retaining and monitoring electronic communications and selecting and using third-party service providers.[3]
• Compliance with Form CRS.
• RIAs’ use of hedge clauses.

Additional Focus Areas for Funds, Including Mutual Funds and ETFs

In addition to the focus areas noted elsewhere in the Priorities, EXAMs stated that it will focus on the following in examinations of funds:

• RIA’s fiduciary obligations to funds, particularly with respect to their receipt of compensation for services under Section 36 of the Investment Company Act of 1940. EXAMs stated that it will continue to evaluate boards’ processes for assessing and approving advisory and other fund fees, particularly for funds with weaker performance relative to their peers.
• Funds with specific characteristics, such as:  (1) turnkey funds, to review their operations and assess effectiveness of their compliance programs; (2) mutual funds that converted to ETFs, to assess governance and disclosures associated with the conversion to an ETF; (3) non-transparent ETFs, to assess compliance with the conditions and other material terms of their exemptive relief; (4) loan-focused funds, such as leveraged loan funds and funds focused on collateralized loan obligations, for liquidity concerns and to review whether the funds have been significantly impacted by, and have adapted to, elevated interest rates; and (5) medium and small fund complexes that have experienced excessive staff attrition, to focus on whether such attrition has affected the funds’ controls and operations.
• The Priorities also noted that EXAMs will monitor the proliferation of volatility-linked and single‑stock ETFs, and may review such funds’ disclosures, marketing, conflicts, and compliance with portfolio management disclosures, among other things.

Other Focus Areas

Finally, EXAMs also noted that it will focus on examinations of the following:

• Compliance with anti-money laundering (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 reporting (SARS) obligations, conducting ongoing due diligence on customers, complying with beneficial ownership requirements, and conducting robust and timely independent tests of their AML programs.
• Broker-dealers’ and RIAs’ preparation for the transition away from LIBOR, which is currently scheduled for discontinuation in mid-2023.
• Transfer agent processing of items and transfers, recordkeeping and record retention, safeguarding of funds and securities, and filings with the Commission.
• Whether municipal advisors have met their fiduciary duty to municipal entity clients as well as whether municipal advisors have complied with MSRB Rule G-42, which establishes the core standards of conduct and duties applicable to municipal advisors when engaging in municipal advisory activities.
• Whether Security-Based Swap Dealers (SBSDs) have implemented policies and procedures related to compliance with Security-Based Swap rules generally.

If you have any questions about the Priorities, or preparing for SEC examinations, please contact a member of MoFo’s Investment Management, Broker-Dealer, or Securities Litigation, Enforcement, and White Collar Defense group.

[1] As we previously noted, we expect that EXAMs will increasingly target RIAs, including private fund advisers, for their compliance with the Marketing Rule in examinations, since the Rule’s November 4, 2022 compliance date has passed. See Marketing Rule Implementation – Are you Ready for November 4th?, MoFo Client Alert (Sept. 23, 2022).

[2] On February 15, 2023, the SEC proposed amending and redesignating Rule 204-2 under the Advisers Act (the Custody Rule). See Safeguarding Advisory Client Assets, SEC Rel. No. IA-6240 (Feb. 15, 2023).

[3] We have previously noted that the SEC has been scrutinizing RIAs’ oversight and recordkeeping responsibilities related to their employees’ use of “off-channel” communications. See SEC Targeting RIAs for Use of “Off-Channel” Communications, MoFo Client Alert (Nov. 17, 2022).