Publications

On February 7, 2023, the Securities and Exchange Commission’s (the “SEC”) Division of Examinations (the “Division”) published its examination priorities for the upcoming year. The published priorities reflect the Division’s focus on certain practices, products and services it believes pose unique or emerging risks to investors and the U.S. capital markets, as well as areas which, in the Division’s view, present core and perennial risks. Here, we summarize the Division’s identified areas of focus with respect to its in its examinations of registered investment advisers (“RIAs”). The complete description of the Division’s 2023 priorities can be found here.

Compliance with Recently Adopted Rules

The Division indicated that compliance with recently adopted rules under the Investment Advisers Act of 1940 (the “Advisers Act”) and the Investment Company Act of 1940 would be a significant area of focus for upcoming exams. Most relevant for RIAs is the new Advisers Act Rule 206(4)-1 (the “Marketing Rule”), compliance with which became mandatory on November 4, 2022. Examinations will focus on whether RIAs have adopted and implemented written policies and procedures reasonably designed to prevent violations of the Marketing Rule. The Division will also focus on the substantive aspects of the Marketing Rule, including the rules for performance presentation, testimonials and endorsements and the requirement that RIAs have a reasonable basis for believing they will be able to substantiate material statements of fact upon request from the SEC.

The Division previously issued a Risk Alert (available here) regarding upcoming exams for compliance with the Marketing Rule and noted they will conduct a number of specific national initiatives, as well as broad reviews through the examination process to assess compliance.

Private Funds

The Division will continue to prioritize examinations of RIAs to private funds. Specifically, examinations of RIAs to private funds will focus on:

• Conflicts of interest;

• Calculation and allocation of fees and expenses, and specifically, consistency with disclosure in the private fund’s offering documents, calculation of post-commitment period management fees and the impact of valuation policies at private equity funds;

• Compliance with the Marketing Rule, including with respect to performance advertising and compensated testimonials and endorsements;

• Policies and practices regarding the use of alternative data and compliance with Advisers Act Section 204A (which requires RIAs to adopt and maintain policies and procedures reasonably designed to prevent the misuse of material nonpublic information); and

• Compliance with Advisers Act Rule 206(4)-2 (known as the “Custody Rule”), including timely delivery of audited financials to investors and selection of permissible auditors.

The Division also identified its intent to focus on RIAs to private funds that have specific risk characteristics. Examples provided in the Alert include:

• Highly-leveraged private funds;

• Private funds managed side-by-side with business development companies;

• Private equity funds that use affiliated companies and advisory personnel to provide services to clients and underlying portfolio companies;

• Private funds that hold certain hard-to-value investments, such as crypto assets and real estate-connected investments, with an emphasis on commercial real estate;

• Private fund that invest in or sponsor Special Purpose Acquisition Companies; and

• Private funds involved in adviser-led restructurings, including stapled secondary transactions (i.e., when a purchaser acquires existing fund interests from current investor(s) while also committing to a new fund under common control) and continuation funds.

Fiduciary Duty and Form CRS

The Division will continue to focus on whether RIAs are fulfilling their fiduciary duties, including the obligation to act in a retail investor’s best interest and not to place the RIA or its financial professionals’ interests ahead of the investor’s. The Division will also review whether RIA conflicts of interest disclosures are sufficient to allow a client to provide its informed consent to the conflict (whether such consent is express or implied). Part of this inquiry will focus on whether the RIA has established written policies and procedures to identify conflicts of interest and periodically reviews and updates the policies and procedures, as applicable. The Division will also examine whether RIAs have customer or client agreements that purport to waive or limit fiduciary standards, such as through the use of hedge clauses.

Core examinations of RIAs will continue to prioritize compliance with Form CRS, including whether the RIA has delivered its relationship summaries to new and prospective retail investors (as well as to existing retail investors), filed the relationship summary with the SEC and, if the RIA maintains a public website, posted the current relationship summary on the site.

Environmental, Social and Governance (“ESG”) Investing

ESG investing continues to be priority area for the SEC. The Division will examine whether ESG-related advisory services are being offered in a manner that is consistent with disclosures made to investors. Additionally, examinations will assess whether ESG products have been appropriately labeled and whether recommendations of such products to retail investors have been made in a manner consistent with the RIA’s fiduciary obligations to its clients.

Information Security and Operational Resiliency

The Division will examine RIA’s cybersecurity policies and procedures, including the RIA’s compliance with Regulations S-P and S-ID, where applicable. These policies and procedures will be reviewed to see whether they are reasonably designed to safeguard customer records and information (both information in the RIA’s system and stored through any third-party providers), as well as whether the RIA has properly disclosed the location of such records to the SEC where required. Additionally, examinations will look at the RIA’s practices to prevent account intrusions and safeguard customer information (including personally identifiable information) and focus on whether there has been any unauthorized use of third-party providers, particularly for transition assistance when departing RIA employees attempt to move client information to a different firm.

Crypto Assets and Emerging Financial Technology

The Division will continue to scrutinize cryptocurrency assets and other emerging financial technologies, such as broker-dealer mobile apps and automated digital investment advisory services. The Division will look to examine RIAs offering new financial technology products or services to investors. The priorities specifically reference the “recent financial distress among crypto asset market participants” and state that, when appropriate, the Division will conduct examinations of potentially impacted or affected RIAs. Specifically, the Division mentions reviewing whether RIAs: (i) met and followed their respective standards of care when making recommendations, referrals or providing investment advice; and (ii) reviewed, updated and enhanced their compliance, disclosure and risk management practices.

RIA examinations will also prioritize firms employing digital engagement practices to determine whether: (i) investment advice or recommendations were provided; (ii) representations are fair and accurate; (iii) operations and controls are in place and consistent with disclosures; (iv) any advice or recommendations given are in the best interest of the investor; and (v) the risks associated with digital engagement practices are considered, including the impact they may have on certain investors, such as seniors.

Takeaways

The priorities outlined above are in line with past examination priorities and statements by the SEC, including recent Risk Alerts issued by the Division. An area not specifically identified in the examination priorities, but one that RIAs should be aware of, is electronic communications—specifically the use of unapproved or “off-channel” communications for advisory purposes. RIAs should review their current compliance policies and procedures, as well as any private fund documents and disclosures to ensure compliance with all relevant statutory and/or regulatory requirements. Additionally, RIAs should consider the priorities listed above and be prepared to address each during any future examinations.

The Division’s published description of priorities is not exhaustive and the staff will also conduct examinations focused on new or emerging risks, issues and policy matters arising from market developments and new information learned from examinations or other sources, including tips, complaints, referrals and other regulators.

For more information on the topic discussed, contact:

• Wayne H. Davis  |  davis@thsh.com  |  212-508-6705
• Haylie Gordon  |  gordon@thsh.com  |  212-508-6745
• Michele Itri  |  itri@thsh.com  |  212-508-6732
• Beth Smigel  |  smigel@thsh.com  |  212-702-3176
• Michael G. Tannenbaum  |  tannenbaum@thsh.com  |  212-508-6701