SEC EXAMS Division Announces 2024 Priorities Ahead of Schedule

On October 16, 2023, the SEC’s Division of Examinations (EXAMS) published its exam priorities for 2024. The timing is notable, with the release coming several months ahead of the typical timeline and only eight months after EXAMS announced its 2023 priorities. The priorities letter addresses this specifically, noting that SEC EXAMS is “aligning the publication of our priorities with the start of the fiscal year with the hope that it will better inform investors and registrants of the key risks, trends, and examination topics that we plan to focus on in the upcoming year.” Although the priorities are issued by EXAMS, they provide meaningful visibility into the SEC's overall priorities for the coming year, including those of the Division of Enforcement. EXAMS and Enforcement staff work closely with one another, with the former often making referrals to pursue remedial efforts, monetary penalties, and other sanctions.

Registrants should note that EXAMS staff has been conducting more in-person fieldwork while still providing virtual options to both registrants and examiners to “broaden access.” Although EXAMS staff will surveil for compliance with all of the SEC’s rules and regulations, the staff has identified the following as key focus areas for 2024.

Perhaps notable for its absence, the SEC EXAMS priorities do not focus on ESG, a key focus of the 2023 priorities. Cybersecurity is mentioned in the context of overall operational resiliency for broker-dealers and investment advisers but is not itself highlighted as a distinct priority. EXAMS will also begin assessing broker-dealer registrants’ preparations for the shortening of the settlement cycle to T+1, the compliance date for which is May 28, 2024.

Broker-Dealers

Reg. BI and Form CRS
For broker-dealers, Regulation Best Interest again tops EXAMS list of priorities. EXAMS staff will continue to focus on:

(1) recommendations with regard to products, investment strategies, and account types;
(2) disclosures made to investors regarding conflicts of interest and related conflict mitigation practices;
(3) processes for reviewing reasonably available alternatives;
(4) factors considered in light of the investor’s investment goals and account characteristics.

EXAMS staff's focus also remains on specific types of products, including:

(1) complex products such as derivatives and leveraged (including inverse) ETFs;
(2) high-cost products (e.g., variable annuities);
(3) illiquid products (e.g., nontraded REITs and private placements);
(4) proprietary products;
(5) microcap securities.

To prepare for exams in this area, broker-dealers should ensure that they establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg. BI in light of the product types recommended, including ensuring that such policies are tailored to specific “costs, risks, and rewards of the securities and investment strategies” of the products. For example, when considering reasonably available alternatives, broker personnel should be able to document key features of alternative products and their rationale for recommending the product in light of such alternatives.

Regarding Form CRS, EXAMS staff will look at disclosures relating to:

(1) the relationships and services that broker-dealers offers to retail customers;
(2) fees and costs;
(3) conflicts of interest; and
(4) whether the broker-dealer discloses any disciplinary history.

Prompt delivery of Form CRS to customers and timely filing of updates to CRS, along with fair and accurate disclosures, remain key compliance drivers in this area.

Financial Responsibility
EXAMS staff will prioritize compliance with the Net Capital Rule and Customer Protection Rule along with related internal processes, procedures, and controls. Perhaps in light of banking system turmoil earlier this year, a focus in this area will be on assessing “broker-dealer credit, interest rate, market, and liquidity risk management controls to assess whether broker-dealers have sufficient liquidity to manage stress events.” Broker-dealers, especially those that may be newer (and thus have known largely low-interest-rate environments) should ensure they have policies in place related to risk management in these areas and continually monitor market developments to ensure their financial controls are adequate.

Interestingly, EXAMS staff will also focus on fully paid lending programs and broker-dealer accounting for certain types of liabilities, such as reward programs, point programs, gift cards, and non-brokerage services. The focus on rewards, points, and gifts likely dovetails with the SEC’s overall focus on digital engagement practices, including its proposed rules for investment advisers and broker-dealers to “neutralize” conflicts of interest relating to the use of certain “covered technologies” like predictive data analytics that are generally designed to drive engagement and trading activity.

Trading Practices
EXAMS staff highlighted specific broker trading practices, such as:

(1) Regulation SHO, including the rules regarding aggregation units and locate requirements;
(2) Regulation ATS, including whether ATS operations are consistent with the disclosures provided in Forms ATS and ATS-N;
(3) Exchange Act Rule 15c2-11, regarding publishing quotations other than on exchanges.

Examination of Investment Advisers

Fiduciary Duty
EXAMS staff will focus on the fiduciary duty advisers owe to clients. Specifically, EXAMS staff will focus on

(1) complex products, high-cost, and illiquid products and unconventional strategies, including strategies that purport to address the change in interest rates;
(2) fiduciary duty processes, including (i) making initial and ongoing suitability determinations; (ii) seeking best execution; (iii) evaluating costs and risks; and (iv) identifying, disclosing, and/or addressing conflicts of interest (including, when appropriate, mitigating or eliminating the conflict);
(3) economic incentives advisers may have in connection with recommending products, services, or account types (including incentivized revenue arrangements, use of affiliated firms to perform brokerage and other client services, share class selection and similar issues, and recommendation of proprietary products); and
(4) disclosures of all material facts relating to conflicts of interest and the receipt of informed consent to the conflict.

Compliance Programs
EXAMS staff will maintain an emphasis on advisers’ compliance programs, including whether policies and procedures reflect the various aspects of the adviser’s business. This will include compliance policies and procedures with respect to one or more of:

(1) portfolio management process;
(2) disclosures made to investors and regulators;
(3) proprietary trading by the adviser;
(4) personal trading of supervised persons;
(5) safeguarding of client assets;
(6) creation and maintenance of required records;
(7) trading practices;
(8) marketing advisory services;
(9) valuation assessments of client assets (and related fee calculations);
(10) business continuity programs;
(11) the privacy of client records and information;
(12) selection and use of third-party and affiliated service providers;
(13) oversight of branch offices; and
(14) obtaining informed consent to material changes to advisory agreements. EXAMS staff will also consider whether advisers’ compliance programs are sufficient to support applicable fiduciary obligations.

Marketing Rule
EXAMS staff will also surveil for advisers’ compliance with the new Marketing Rule, including

(1) the adoption and implementation of required policies and procedures;
(2) disclosures on Form ADV;
(3) substantiation of the adviser's processes and other books and records;
(4) looking for any materially misleading statements in advertisements; and
(5) compliance with requirements with respect to performance (including hypothetical and predecessor performance), third-party ratings, and testimonials and endorsements.

Other Topics
EXAMS staff identified (1) compensation arrangements (including alternative revenue sources, such as from bank deposit sweep programs, and fee breakpoint calculation processes, particularly if not automated); (2) valuation assessments of illiquid or difficult-to-value assets (e.g., commercial real estate and private placements); (3) protection of material nonpublic information (specifically for shared office space, significant turnover of adviser representatives, and the use of expert networks); and (4) regulatory filings with respect to inadequate or misleading disclosures and registration eligibility as additional priority areas for the coming year.

Examinations of Private Funds

EXAMS staff identified the following priorities for private fund advisers, including:

(1) portfolio management risks when exposure to market volatility increases and interest rates rise (particularly where there is poor performance, significant withdrawals, valuation issues, and/or significant leverage and illiquid assets);
(2) adherence to contractual requirements regarding limited partnership advisory committees;
(3) accurate calculation, allocation, and disclosure of fees and expenses (particularly with respect to during the post-commitment period and offsets);
(4) due diligence practices and related policies, procedures, and disclosures (particularly for advisers to private equity and venture capital funds);
(5) conflicts, controls, and disclosures regarding private funds managed side by side with registered investment companies;
(6) conflicts, controls, and disclosures regarding using affiliated service providers;
(7) compliance with the Advisers Act Custody Rule (including Form ADV reporting and timely completion and distribution of audited financial statements); and
(8) policies and procedures for reporting of Form PF (including the new reporting requirements for certain reporting events).

Examination of Registered Investment Companies

EXAMS staff will continue to prioritize examinations of registered 1940 Act funds, including mutual funds and exchange-traded funds. EXAMS staff cited to the importance of registered funds for retail investors, including investors saving for retirement.

Focus on Fees and Expenses With an Emphasis on Registered Funds With Performance Challenges
EXAMS staff will review processes, including related policies and procedures, regarding oversight of registered fund fees and expenses, as well as the implementation of fee waiver/reimbursement arrangements. Focus areas for examinations will include (1) registered funds that charge different advisory fees by share class, which was the subject of February 2023 guidance issued by the staff of the Division of Investment Management; (2) fee structure differences between identical strategies offered by the same sponsor through different distribution channels; (3) registered funds with advisory fee structures that are higher, on a relative basis, than peer funds; and (4) high registered fund fees and expenses, particularly those of registered funds that have underperformed peers. As part of this focus area, EXAMS will review the annual contract review process conducted by registered fund boards pursuant to Section 15 of the 1940 Act.

Effectiveness of Derivatives Risk Management Programs
EXAMS staff will focus on reviewing the effectiveness of registered funds’ derivatives risk management programs (DRMPs) pursuant to Rule 18f-4 under the 1940 Act. Registered funds were required to comply with Rule 18f-4 as of August 19, 2022. EXAMS staff will review applicable compliance policies and procedures adopted in accordance with Rule 18f-4, including the adoption of the DRMP, registered fund board oversight, and disclosure by registered funds concerning their use of derivatives. Valuation of derivative instruments will also be reviewed. A summary of Rule 18f-4 can be found here.

Effectiveness of Liquidity Risk Management Programs
EXAMS staff will continue to review the effectiveness of registered funds’ liquidity risk management programs pursuant to Rule 22e-4, which had a compliance date of December 1, 2018, for larger registered fund complexes. A summary of Rule 22e-4 can be found here. In May 2023, the SEC brought its first enforcement action for alleged violations of Rule 22e-4.

Other Topics. EXAMs staff also will (1) continue to focus on registered fund practices concerning fair valuation, including policies, procedures, and practices to comply with Rule 2a-5 under the 1940 Act (a summary of Rule 2a-5 can be found here); (2) compliance with the terms of exemptive order conditions; (3) issues associated with recent market dislocations and volatility, such as whether registered funds in liquidation are following liquidation procedures (which would likely include a review of liquidation processes in accordance with plans of liquidation).

Crypto-Assets and Fintech

In parallel with the proposed rule regarding the use of predictive data analytics and the proposed safeguarding rule, EXAMS staff will conduct examinations of advisers that focus on advising in crypto asset securities (or at least alleged crypto asset securities) or related products, as well as advisers that offer technological or online solutions, including automated investment tools, artificial intelligence, and trading algorithms or platforms, and the use of emerging technologies and alternative data. In examining such advisers, EXAMS staff will review whether these advisers (1) uphold their fiduciary duty in advising on these products, in particular to retail (including senior) investors, and (2) comply with custody (including crypto-asset wallet reviews, Bank Secrecy Act compliance reviews, and valuation practices) rule requirements, risk disclosures, and operational resiliency practices (including cybersecurity and business continuity plans).

Based on this slate of priorities and the SEC’s numerous proposed and adopted new rules, it is shaping up to be a busy 2024 for the industry. To give credit where it’s due, hopefully the advance notice EXAMS provides at the beginning of its fiscal year (as opposed to midway through the year) will help the industry prepare for the numerous exams (and likely referrals to the Division of Enforcement) that will be forthcoming in these areas.

 

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