SEC 2024 Examination Priorities Indicate Increased Scrutiny of Investment Advisers and Continued Focus on Cybersecurity, FinTech, and Anti-Money Laundering Programs
On October 16, 2023, the Securities and Exchange Commission (SEC) Division of Examinations (Division) announced its examination priorities for 2024. As it has done every year since it first began publishing its annual priorities in 2013, the Division enumerated the areas that will be a focus for the next fiscal year including: (i) investment advisers’ fiduciary duties and compliance programs, (ii) investment company compliance and governance practices, and broker-dealer practices, (iii) cybersecurity and resiliency, (iv) crypto assets and FinTech products and services, and (v) anti-money laundering (AML) programs.
Interestingly, unlike prior years, the Division did not identify Environmental, Social, and Governance (ESG) issues as an area of focus for any market participants. However, the absence of this topic in the announcement does not mean the Division will not focus on those issues. To the contrary, the SEC explicitly noted in the press release announcing the priorities that “[t]he published priorities are not exhaustive of the focus areas of the Division in its examinations, risk alerts, and outreach.”
These are the priority areas that will likely invite the most scrutiny:
Investment Advisers
The Division will continue to examine investment advisers for compliance with their duties of care and loyalty. These examinations will focus on:
Investment advice provided to clients, with particular focus on older investors and those saving for retirement, and on complex, high cost, or illiquid products and unconventional strategies;
Processes for determining that the advice provided is in the client’s best interests, including how the adviser manages conflicts of interest, suitability determinations, best execution, and evaluation of costs and risks;
Economic incentives and conflicts of interests in recommending certain products, services, or account types or conflicts that may arise in certain business models such as dual registration as broker-dealers or the use of affiliates to perform client services; and
Compliance programs, particularly those reflecting marketing practices, adviser compensation arrangements, valuation assessments, information safeguarding controls and disclosures, and policies and procedures for obtaining informed consent from clients regarding changes to advisory agreements.
Investment Advisers to Private Funds
The Division indicated that it also will focus on the following specific areas affecting investment advisers to private funds:
Portfolio management risks present when there is exposure to recent market volatility and higher interest rates. The SEC notes that such risks may, for example, be more present in private funds with more leverage and illiquid assets or those experiencing poor performance, significant withdrawals, and valuation issues;
Adherence to contractual requirements regarding limited partnership advisory committees, advisory boards or similar structures;
Accurate calculation and allocation of private fund fees and expenses (both fund-level and investment-level), such as the valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and offsetting of such fees and expenses;
Whether due diligence practices are consistent with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies (notably, this is the first-ever mention of venture capital funds in the Priorities);
Conflicts, controls, and disclosures regarding (1) funds managed side by side with registered investment companies and (2) use of affiliated service providers;
Compliance with Advisers Act requirements regarding custody; and
Policies and procedures for reporting on Form PF.
These prioritizations of key areas for exams build on the Division of Examinations’ September 6 risk alert describing the Division’s “risk-based approach” to selecting advisers and the scope of risk areas for examination. The criteria for selecting an adviser for examination include the adviser’s risk characteristics, information received about the firm (e.g., tips, complaints, or referrals), operation in a particular compliance risk area of interest, or firm-specific factors drawing the Division’s interest. The scope of those exams varies based on what the staff decides to focus on, but typically these examinations entail a review of the advisers’ internal operations, compliance practices regarding custody of client assets, valuation of investment products, portfolio management, best execution practices, and disclosures regarding fees and conflicts of interest, among other items. The risk alert also includes a sample information request to certain types of adviser examinees, which can serve as a useful resource for advisers to prepare for a potential exam.
Investment Companies and Broker Dealers
In addition to investment advisers, the Division will continue assessing compliance programs, disclosures, governance practices and SEC reporting of registered investment companies, such as mutual funds and ETFs. The Division will also increase its focus on advisory fees and will look to see whether such fees vary among the same fund’s share classes, vary by distribution channel for the same sponsor and investment strategy, or differ when compared to peers.
As in previous years, the Division of Examinations will examine broker-dealers’ policies and practices to comply with Regulation Best Interest, which “establishes the standard of conduct for broker-dealers at the time they recommend to a retail customer a securities transaction or investment strategy.” Areas of priority include complex, high-cost, and illiquid investment products, proprietary investments, microcap securities, and recommendations made to “older investors and those saving for retirement or college.”
Risk Areas Broadly Applicable to Various Market Participants
The Division will look at information security and operational resiliency in examinations of various market participants, including investment advisers and broker-dealers. The focus will be on efforts to prevent operational interruptions and protection of investor information, records, and assets. The Division also noted a focus on the registrant’s use of third-party vendors, including assessment of and response to potential security risks from such vendors.
Digital assets and other emerging financial technologies continue to be an area of concern for the SEC, especially as these technologies further integrate themselves into more investment products and strategies. The Division expressed a particular interest in the use by broker-dealers and investment advisers of automated investment tools, artificial intelligence, and trading algorithms and platforms. The Division will also continue to monitor and examine registrants on a wide range of activities related to crypto asset markets, including offers, sales, recommendations, and trades of crypto and digital assets.
The Division will also review compliance with AML requirements under the Bank Secrecy Act. These requirements include obligations to implement a risk-based AML program, conduct independent testing, comply with customer due diligence rules, and identify and report certain transactions. SOURCE