Publications

On October 16, 2023, the Securities and Exchange Commission’s (the “SEC”) Division of Examinations (the “Division”) published its examination priorities for the upcoming year. The Division published the priorities earlier than it had in years past to align with the SEC fiscal year and better inform registrants and investors of the key risks, trends, and examination priorities for the upcoming year. The published priorities demonstrate the Division’s focus on the practices, products, and services it believes pose unique or emerging risks to investors and U.S. capital markets and those areas which present core and perennial risks. In this alert, we summarize the Division’s identified areas of focus with respect to its examinations of SEC registered investment advisers (“RIAs”). The complete description of the Division’s 2024 priorities can be found here.

RIA Examinations Generally

The Division stressed the importance of RIAs serving the best interests of their clients and not placing their own interests ahead of the interests of their clients. When evaluating an RIA’s compliance with its fiduciary duties, the Division will focus on:

(i) Investment advice provided to clients with respect to certain investment strategies, including complex products such as derivatives and leveraged ETFs, and investment strategies that the Division considers “unconventional” (e.g., strategies meant to address rising interest rates);
(ii) Processes for ensuring all investment advice is in the best interests of the client, including determining suitability on an initial and ongoing basis and identifying and mitigating or eliminating conflicts of interest, as well as providing full and fair disclosure of such conflicts to clients; and
(iii) Economic incentives that an RIA or its related persons may have to recommend certain products or strategies, such as through revenue-sharing agreements, and economic incentives associated with dually registered broker-dealers and advisers who use affiliates to perform services for clients.

Examinations will also concentrate on an RIA’s compliance program, including whether its policies and procedures accurately reflect the RIA’s business, strategy, compensation, client base, and operations. The Division will review an RIA’s annual review of its policies, which must now be documented in writing in accordance with the amended compliance rule under the Advisers Act. Other areas of focus include:

(i) Ensuring RIAs have and continue to create all required records in an accurate manner and maintain them in a way that protects against unauthorized alteration or destruction;
(ii) RIA marketing practices, including whether RIAs have (a) adopted and implemented written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder, including the reforms to the Marketing Rule, (b) accurately disclosed their marketing practices on Form ADV, (c) maintained substantiation records of all material statements of fact contained in advertisements, and (d) complied with the requirements for presentation of different types of performance (including hypothetical and predecessor performance), testimonials and endorsements;
(iii) Valuation of illiquid or other difficult to value assets, such as commercial real estate or private placements;
(iv) Controls for protecting clients’ material non-public information when multiple RIAs share an office location;
(v) Adequacy of policies and procedures for (a) selecting and using third-party and affiliated service providers, (b) overseeing multiple branch offices, and (c) obtaining client consent when implementing material changes to advisory agreements; and
(vi) RIAs who have never been examined and RIAs who have not undergone an examination for several years.

Private Funds

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

(i) Portfolio management risks due to exposure to market volatility and increasing interest rates, including private funds that are performing poorly, experiencing substantial withdrawals, maintaining high leverage levels, and holding illiquid investments;
(ii) Compliance with contractual requirements regarding Limited Partner Advisory Committees (“LPACs”) or other advisory boards, including complying with any notification and consent requirements set forth in the private fund documents;
(iii) Accurate calculation and allocation of fees and expenses (investment-level and fund-level), including illiquid asset valuation, management fee step-down calculations, adequate disclosures, and any offsetting of such fees and expenses;
(iv) Due diligence practices to monitor compliance with stated policies, procedures, and disclosures, particularly for private equity and venture capital advisors’ evaluation of potential portfolio company investments;
(v) Conflicts, controls, and disclosures for private funds that are managed side by side with registered investment companies, and the use of affiliated service providers;
(vi) Compliance with Advisers Act Rule 206(4)-2 (known as the “Custody Rule”), including accurate Form ADV reporting and timely completion of audits; and
(vii) Adequate policies and procedures for reporting on Form PF, including new reporting requirements that will go into effect (in part) this year.

Information Security and Operational Resiliency

The Division will review RIAs’ business continuity practices intended to prevent interruptions to “mission critical services” and protect client information, records and assets, particularly in the face of elevated operational disruption risks due to cybersecurity attacks, weather-related events, geopolitical conflicts, and firms’ dispersed operations. The Division’s examinations will focus on reviewing RIAs’ policies and procedures for third-party vendor security, governance practices, and responses to cyber-related incidents, including whether an RIA adequately trains staff regarding identity theft prevention. Finally, the Division will focus on the information security and operational resiliency practices of RIAs’ branch offices to ensure all branch offices are following the policies and procedures of the main office.

Crypto Assets and Emerging Financial Technology

Crypto assets and other emerging financial technology continue to be an area of emphasis for the Division, with the priorities publication specifically mentioning the “continued volatility” of the crypto asset market. The Division will focus examinations on the offer, sale, trading, and recommendation of crypto assets and review whether RIAs in the crypto space follow their internal standards of conduct when advising on such assets and whether those RIAs routinely review, update, and enhance their compliance practices, risk disclosures, and operational controls. The Division will also monitor whether RIAs are complying with the Custody Rule with respect to those crypto assets that are considered funds or securities.

AML and Sanctions Compliance

Compliance with anti-money laundering laws and regulations is another priority area for the Division. The Division highlighted the need for RIAs to have AML programs reasonably tailored to address the risks associated with their customers and their business and that conduct ongoing monitoring to identify and report suspicious transactions. In addition, the Division will review whether RIAs are monitoring Office of Foreign Assets Control sanctions and ensuring compliance with such sanctions.

Takeaways

The priorities outlined above are consistent with past examination priorities and statements by the SEC. One area the Division did not specifically identify in the examination priorities, but that RIAs should continue to focus on, is electronic communications—specifically the use of unapproved or “off-channel” communications for advisory purposes. The SEC has imposed significant enforcement penalties against registrants, including dually registered broker-dealers and investment advisers, for alleged widespread record keeping failures due to off-channel (unrecorded) communications and seems poised to continue doing so. Keeping the above priorities in mind, RIAs should review their current compliance policies and procedures, regulatory filings, and any private fund documents and disclosures, to ensure compliance with relevant statutory and regulatory requirements.

The Division’s published description of priorities is not exhaustive and Division staff will also conduct examinations focused on new or emerging risks, products, and services, market events and investor concerns, and referrals from examinations, other regulators, or other sources, including tips and complaints.

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
• Mark D. Shaffer  |  mshaffer@thsh.com  |  212-508-6773
• Beth Smigel  |  smigel@thsh.com  |  212-702-3176
• Michael G. Tannenbaum  |  tannenbaum@thsh.com  |  212-508-6701