SEC Announces 2022 Examination Priorities
On March 30, 2022, the Division of Examinations (formerly known as the Office of Compliance Inspections and Examinations) (the “Division”) of the Securities and Exchange Commission (the “SEC”) announced its 2022 examination priorities for registered investment advisers (“RIAs”).1
The Division grouped the priorities into six general thematic areas:
- the operation of private investment funds;
- environmental, social and governance (“ESG”) investing;
- standards of conduct for RIAs;
- information security and operational resiliency;
- emerging technologies and crypto-assets; and
- additional focus areas involving RIAs, registered investment companies, broker-dealers and municipal advisors.
Moreover, the Division noted that it will continue to assess RIAs’ exposure to LIBOR in connection with the transition away from that benchmark. This client alert focuses on identified priorities particularly relevant to private fund managers that are RIAs.
Operation of Private Investment Funds
With respect to RIAs that manage private funds, the Division will focus on, among other things:
- the calculation and allocation of fees and expenses such as post-commitment period management fees and the impact of valuation practices at private equity funds;
- preferential treatment of certain investors by advisers to private funds that have experienced issues with liquidity, including imposing gates or suspensions on fund withdrawals;
- compliance with Rule 206(4)-2 (or the Custody Rule) under the Investment Advisers Act of 1940, as amended, and related reporting and updating of Form ADV, specifically regarding the audit and auditors;
- adequacy of disclosure and compliance with any regulatory requirements of cross trades, principal transactions or distressed sales; and
- conflicts around liquidity, such as RIA-led fund restructurings and transactions where new investors purchase the interests of existing investors while also agreeing to invest in a new fund.
The Division will also continue to focus on private fund advisers’ portfolio strategies, risk management and investment recommendations and allocations, and associated conflicts disclosures, including, for example, advisers who sponsor special purpose acquisition companies (or SPACs). The Division will additionally review the practices, controls and investor reporting around risk management and trading for systemically important private funds, such as outsized counterparty and/or gross notional exposure when compared to similar firms.
The Division stressed that it will continue to concentrate on RIAs that employ ESG strategies or incorporate certain ESG criteria, particularly given the uncertainty and general lack of standardization and expectations surrounding ESG. The Division will review the adequacy and accuracy of these RIAs’ ESG investment-related disclosures, and confirm that such RIAs have implemented policies and procedures designed to prevent violations of the securities laws in connection with such disclosures. The Division will also continue to review proxy voting policies and procedures and votes to determine whether they align with the ESG strategies.
Standards of Conduct for RIAs
The Division will continue to focus on whether RIAs have fulfilled their fiduciary duties of care and loyalty, as well as their compliance with Form CRS2 . The Division will also examine whether RIAs are appropriately mitigating conflicts of interest and, where necessary, providing disclosure of conflicts that is sufficient to enable informed consent. As in prior years, the Division will focus on risks associated with fees and expenses (including using, and/or recommending clients use, certain products and services that may have lower-cost alternatives), best execution and undisclosed or inadequately disclosed compensation arrangements, such as revenue sharing arrangements.
Information Security and Operational Resiliency
The Division will continue reviewing whether RIAs have taken appropriate measures to:
- safeguard customer accounts and prevent account intrusions, including verifying an investor’s identity to prevent unauthorized account access;
- oversee vendors and service providers;
- address malicious email activities, including account intrusions or phishing;
- respond to incidents, such as those related to ransomware attacks;
- identify and detect red flags related to identity theft; and
- manage operational risk due to dispersed employees in a work-from-home environment.
The Division will continue reviewing RIAs’ business continuity and disaster recovery plans, and as indicated last year, will pay particular attention to the impact of climate risk and substantial disruptions to normal business operations. The general scope will include a focus on the maturation and improvements to these plans, as well as RIAs’ resiliency and preparation to anticipate, respond to and adapt to sudden disruptions and incremental changes stemming from climate-related situations.
Emerging Technologies and Crypto-Assets
Given the significant growth and risks presented in the financial technology and digital asset space, the Division intends to focus on both:
- RIAs using automated or other digital investment technology—specifically assessing whether (i) proper controls are in place, consistent with disclosures, to account for unique risks and ensure the RIAs’ applicable standards of conduct, and (ii) RIAs’ advice and recommendations, including by algorithms, are consistent with proper standards of conduct and disclosures; and
- RIAs engaged in crypto trading—specifically, whether they: (i) meet the applicable standards of conduct when advising investors and with respect to the initial and ongoing understanding of the various digital assets; and (ii) routinely review, update and enhance their compliance practices (e.g., crypto-asset wallet reviews, custody practices, anti-money laundering reviews, and valuation procedures), risk disclosures and operational resiliency practices (i.e., data integrity and business continuity plans).
Additional Areas of Focus
In addition, the Division’s examinations will focus on:
- whether RIAs are implementing appropriate controls and compliance around the creation, receipt and use of alternative data, or data gleaned from non-traditional sources; and
- the scope of RIA disclosure of fees and expenses, specifically with respect to issues associated with: advisory fee calculation errors, inaccurate calculation of tiered fees (including failure to provide breakpoints and aggregate household accounts), and failures to refund prepaid fees for terminated accounts or pro-rated fees for onboarding clients.
With respect to the discontinuation of LIBOR, the Division examinations will continue to assess RIAs’ understanding of any exposure to LIBOR, their preparations for the cessation of many LIBOR rates and the transition to an alternative reference rate, in connection with RIAs’ own financial matters, those of their clients and RIAs’ obligations when recommending LIBOR-linked instruments.
As in prior years, the Division will continue to prioritize examinations of RIAs that (i) have never been examined (even if recently registered) or have not been examined for a number of years, with a particular focus on their compliance programs, and (ii) are dually registered as, or are affiliated with, broker-dealers.
Though this description of Division examination priorities is not exhaustive, private fund managers that are RIAs should take note of these stated priorities and review their businesses and operations to determine if any enhancements or changes are necessary.
If you have any questions regarding this topic, please contact your primary Kleinberg Kaplan attorney or the authors.
1 The Division’s 2022 Examination Priorities are available here.
2 Based on guidance from the Division staff, RIAs that exclusively manage private funds are not required to file Form CRS.