On March 30, 2022, the U.S. Securities and Exchange Commission (“SEC”) Division of Examinations (the “Division”)—formerly the Office of Compliance Inspections and Examinations—released its 2022 Examination Priorities (“2022 Priorities”). The Division is undergoing extensive leadership changes, with the recent departures of several top officials. Consistent with the aggressive agenda set by Chair Gensler for the SEC generally, the Division has returned to its pre-pandemic caseload, conducting over 3,000 exams in fiscal year 2021, issuing over 2,000 deficiency letters, and making 190 referrals to the Enforcement Division. Despite the management changes, the 2022 Priorities generally retain perennial risk areas as the core focus, but include several new and emerging risk areas reflecting the policy goals espoused by Gensler in recent proposed rule releases and public statements.
The 2022 Priorities include: private funds; environmental, social, and governance (“ESG”) investing; standards of conduct; information security and operational resiliency; emerging technologies and crypto-assets; standards of conduct for registered investment advisers, broker dealers and exchanges; and oversight of the Financial Industry Regulatory Authority and Municipal Securities Rulemaking Board programs and policies.
In this post, we analyze the highlights in and our takeaways from the key 2022 Priorities.
- Private Funds. Advisers to private funds remain a priority area for the Division, and we expect increased Enforcement referrals in 2022 consistent with the more aggressive attitude toward the industry under this SEC leadership. As was the case in the 2021 Examination Priorities, areas of focus in the 2022 Priorities include: preferential treatment to certain investors, such as by imposing gates or suspensions on fund withdrawals; portfolio valuations and the resulting impact on management fees; and conflicts around liquidity, such as adviser-led restructurings and stapled secondary transactions. Notable new areas in the 2022 Priorities include compliance with the Custody Rule, as well as investments in Special Purpose Acquisition Companies (or “SPACs”), particularly where the private fund adviser is also the SPAC sponsor. SPACs have been a recent area of focus for the SEC as a whole, and the SEC proposed rules on SPACs the same day that the Division released the 2022 Priorities addressing, among other things, disclosures, liability standards and SPAC status under the Investment Company Act of 1940. Advisers should pay careful attention to their process when making a decision to recommend an investment in a SPAC, particularly where the adviser is also the SPAC sponsor, and should review their disclosures regarding such investments.
- ESG Investing. The Division will continue to look at ESG-related advisory services and investment products, with a specific focus on reviewing whether registered advisers and registered funds are accurately disclosing their ESG investing approaches, are voting client securities in accordance with their ESG-related disclosures and mandates, and are not overstating or misrepresenting the ESG factors considered in portfolio selection. The Division specifically highlighted the practice of “greenwashing”, or conveying a false impression about how environmentally friendly a product or investment is, as a concern in such reviews. Like SPACs, environmental-related disclosures have been a focus for the SEC as a whole. The SEC proposed rules on such disclosures for public companies in registration statements and periodic reports in March 2022, and further releases are expected addressing use of ESG disclosures by advisers. Like private funds generally, we expect a significant increase in Enforcement referrals from ESG-focused examinations in 2022.
- Standards of Conduct. The 2022 Priorities discuss “standards of conduct” in exams for both registered investment advisers as well as broker-dealers. This is a reference to the Fiduciary Duty Guidance released in June 2019, discussed in our prior Alert Memorandum. For advisers, the Division highlighted revenue sharing arrangements, recommending or holding more expensive products where lower cost classes are available, and recommendations of wrap fee accounts, including the impact on such recommendations of the move to zero commissions by several broker-dealers. For broker-dealers, the Division highlighted firms’ recommendations and sales practices as well as their evaluation of whether products are in a customer’s “best interest” as required by Regulation Best Interest. The Division also highlighted dually registered investment advisers and broker-dealers as an area of interest, and noted that exams of such firms will emphasize potential conflicts of interest, including with regard to account recommendations and allocation of investments across different accounts. Registrants, particularly those that are dual-registered, should review their compliance policies and procedures in order to ensure that potential conflicts of interest are adequately accounted for and disclosed. Examinations in this area will no doubt follow last week’s Staff Bulletin on account recommendations for retail investors by investment advisers and broker-dealers, issued by the Division of Trading and Markets. Among other things, the Staff Bulletin: (1) outlines the staff’s view that, in order to comply with Reg BI and their fiduciary duties, broker-dealers and registered investment advisers must obtain sufficient information about their retail investors to have a reasonable basis for investment recommendations; (2) lists the multiple investor characteristics that should be considered; and (3) emphasizes that cost must always be considered in making account recommendations, including “indirect costs, such as those associated with payment for order flow and cash sweep programs.”
- Information Security. The Division will review registrants’ information security practices in order to prevent interruptions that could jeopardize the business, and to protect investor information, records, and assets. The Division will also be reviewing registrants’ business continuity and disaster recovery plans, which in some cases, will account for certain climate-related risks. This focus in information security goes hand in hand with the proposed cybersecurity rules released in February 2022, which included comprehensive reforms for registered advisers regarding cybersecurity risk management policies and procedures, mandatory reporting of certain cybersecurity incidents to the SEC (including a new Form ADV-C), and mandatory disclosures to investors and other market participants, as discussed in our prior Alert Memorandum. In light of the exam focus and expected adoption of the cybersecurity proposal, advisers should review their cybersecurity compliance programs in general, and more specifically their policies and procedures around safeguarding customer accounts and managing operational risk resulting from work-from-home or hybrid work arrangements.
- Emerging Technologies and Crypto-Assets. The Division will prioritize examinations of registrants using developing financial technologies like crypto-assets, robo-advisers, and mobile apps, and has noted that it will focus on whether advice and recommendations, including those generated by algorithms, are consistent with a registrant’s standard of care. The Division highlighted several specific areas of exam focus for registrants involved with crypto-assets, including whether registrants have an “initial and ongoing understanding of the products,” and compliance practices such as wallet reviews, custody practices, anti-money laundering reviews, and valuation procedures. Crypto-assets have been another point of focus for the SEC under Chair Gensler, and the SEC has adopted a policy of aggressive enforcement in this space, including against market participants like exchanges. Registrants involved with crypto-assets should review their compliance practices around such assets and should pay careful attention to their process when making a decision to recommend or advise investors in these assets.
- Business Development Companies. The Division will prioritize examinations of certain types of registered funds, portfolio investments, and fund practices, and specifically highlighted business development companies (“BDCs”), explaining that BDCs will undergo reviews of their valuation practices, marketing activities, and conflicts of interest with underlying portfolio companies. With marketing rule compliance becoming mandatory on November 4, 2022, BDC advisers should pay particular attention to reviewing and updating compliance policies underlying their marketing activities, as discussed in our prior Alert Memorandum.
In addition to the themes above, the Division indicated it will continue to focus on several expected areas: custody and safekeeping, best execution, risks associated with fees and expenses, and valuation of client assets. The Division’s priorities are perennially important beyond their significance for examinations. Each year they provide a roadmap of the areas that will result in higher levels of Enforcement referrals. For priorities that have been focus areas for the last few years, we would also expect to see the Enforcement Division bringing cases in these areas. In the last year, the Division made more than 190 referrals of its examination findings to the Division of Enforcement, and we expect to see a similarly large number of referrals this year given this administration’s heavy emphasis on coordination between examinations and enforcement.