The SEC’s Division of Examinations last week announced its 2023 “examination priorities.” The division’s annual announcement of priorities provides valuable insight into the categories of registrants most likely to be the subject of an SEC examination and the issues most likely to be a focus of those examinations. In determining its priorities, the division employs a “risk-based approach,” focusing on areas it believes present potential risks to investors and the integrity of the capital markets and gathering input and advice from within the SEC itself, other federal financial regulators, investors, and industry groups.
Although examinations are commonly used by the SEC in a general way to inform rule-making initiatives, identify and monitor risks, and improve industry practices, it is critical to recognize that examinations may — and often do — lead to referrals to the SEC’s Division of Enforcement. For this reason, registrants should be aware of examination priorities.
Focusing on these priorities has two benefits. First, it allows registrants to proactively ensure compliance with the priorities, thus reducing the risk of an examination or enforcement action. Second, the SEC’s examination priorities are highly correlated with its enforcement activities, meaning that an examination in a priority area presents an increased risk of a referral for enforcement action. In those circumstances, the registrant should consider having counsel take a more proactive role in the examination process, including reviewing documents before they are produced to the staff, preparing employees for interviews by the staff, and considering prophylactic remediation of any deficiency. In addition, accurately assessing the risk of a referral can provide the registrant with an opportunity to confront the staff’s concerns directly and persuade the staff not to make the referral.
Many of the division’s 2023 priorities are not unexpected, as they reflect an emphasis on recently promulgated regulations or areas of recent enforcement activity. The division’s principal priorities include:
- New Investment Adviser and Investment Company Rules – The division will focus on the new “Marketing Rule” adopted in December 2020, which comprehensively regulates investment advisers’ marketing communications. The division will also focus on new rules applicable to investment companies, including the “Derivatives Rule,” which requires funds that engage in derivatives transactions implement a program with policies and procedures that are reasonably designed to manage the fund’s derivatives risks; and the “Fair Valuation Rule,” which requires that securities in a fund’s portfolio for which market quotations are readily available must be valued at their market value, and all other securities and assets must be valued at their fair value as determined in good faith by the fund’s board of directors. The focus on these rules is not surprising as they represent recent SEC regulatory priorities.
- Registered Investment Advisors to Private Funds – The focus here will be on the adviser’s fiduciary duty, fees and expenses, compliance with the “Custody Rule,” the Marketing Rule, and conflicts of interest. The division will direct particular attention to highly leveraged private funds and private funds managed side by side with business development companies, both of which it views as being particularly risky. The SEC’s focus on the private fund space is also unsurprising as the commission has recently emphasized the substantial growth of capital and need for greater transparency in that space.
- Retail Investors and Working Families – The division will focus on how registrants are satisfying their obligations under Regulation Best Interest and the Advisers Act fiduciary standard to act in the best interests of retail investors and not to place their own interests ahead of retail investors. Examinations will include assessments of practices regarding review of investment alternatives, management of conflicts of interest, and consideration of investment goals and account characteristics. The focus on retail investors has long been one of the division’s priorities, particularly following the adoption of Regulation Best Interest in June 2020.
- Environmental, Social, and Governance (ESG) – Consistent with the SEC’s recent ESG rulemaking, the division will continue its focus on ESG-related advisory services and fund offerings, including whether funds are operating in the manner set forth in their disclosures. In addition, the division will assess whether ESG products are appropriately labeled and whether recommendations of such products for retail investors are made in the investors’ best interests.
- Information Security and Operational Resiliency – The division will review registrants’ practices to prevent interruptions to mission-critical services and to protect investor information, records, and assets. This includes a focus on cybersecurity issues associated with the use of third-party vendors, including registrant visibility into the security and integrity of third-party products and services and whether there has been an unauthorized use of third-party providers.
- Emerging Technologies and Cryptoassets – The division will conduct examinations of broker-dealers and registered investment advisors that are using cryptoassets and other emerging financial technologies or employing new practices, including technological and online solutions to meet the demands of compliance and marketing and to service investor accounts. Examinations will focus on the offer, sale, recommendation of, or advice regarding trading in crypto or crypto-related assets and include whether the firm (1) met and followed their respective standards of care when making recommendations, referrals, or providing investment advice; and (2) routinely reviewed, updated, and enhanced their compliance, disclosure, and risk management practices.
Forewarned is forearmed. Knowing ahead of time the commission’s examination priorities provides registrants with the opportunity to review and update their compliance with these priorities and avoid having an examination turn into a far more disruptive enforcement referral.