On March 30, 2022, the Securities and Exchange Commission’s (“SEC”) Examination Division (“Division”) released its examination priorities for 2022 (the “2022 Priorities”). Division are published annually and are designed to preview the key areas where the Division intends to focus its limited resources. Topping the list of “significant areas of focus” this year are private funds, which were also the subject of two recent regulations by the SEC and a risk alert by the Division. Interests include environment, social and governance (“ESG”), investment, fiduciary duty, information security and operational resilience, as well as emerging technologies and crypto-assets. As noted below, the 2022 priorities also include other specific areas that the Division will review with respect to Registered Investment Advisers (“RIA”). We remind our clients that the 2022 Priorities are not an exhaustive list of topics that the Division would consider during a review.
Citing a 70% increase in assets managed by private fund advisers over the past five years, $18 trillion in private fund assets managed by 35% of all RIAs, and the significant investments by private funds in state and local pensions with active family beneficiaries, charities and endowment funds, 2022 priorities state that the Division will review RIAs for private funds to consider issues under the Counselors Act Investment of 1940 (“Advisors Act”), including fiduciary duty. The division will focus on compliance programs, fees and expenses, custody, fund audits, valuation, conflicts of interest, investment risk disclosure and controls over material nonpublic information ( “MNPI”). Specific areas that the Division will examine include:
1. the calculation and allocation of fees and expenses, including the calculation of post-engagement management fees and the impact of private equity fund valuation practices;
2. the potential preferential treatment of certain investors by RIAs to private funds that have experienced liquidity problems, including the imposition of barriers or suspensions on fund withdrawals;
3. Advisers Act custody rule compliance, including the “audit exception” to the surprise review requirement and related Form ADV reports and updates;
4. the adequacy of disclosure and compliance with all regulatory requirements for cross trades, principal trades or distressed sales;
5. Liquidity disputes, such as RIA-led fund restructurings, including stapled secondary transactions where new investors purchase the interests of existing investors while agreeing to invest in a new fund;
6. portfolio strategies, risk management and investment recommendations and allocations, focusing on conflicts and related information;
7. private fund investments in special purpose acquisition companies (“SPACs”), particularly where the private fund adviser is also the sponsor of the SPAC; and
8. Practices, controls and reporting to investors regarding risk management and trading of private funds with systemically important indicia, such as excessive counterparty exposure or gross notional exposure to companies in a similar situation.
Many of these focus areas overlap not only with previously issued risk alerts by the Division, but also with the SEC’s proposed new rules for private fund advisers and proposed changes to Form PF. Interestingly, the 2022 priorities indicate that while the Division has targeted reviewing 15% of RIAs each year and reviewed approximately 16% of RIAs in fiscal year 2021, the Division will likely need to reduce its annual coverage target soon. , as the growth in the number of RIAs continues at a rate that far outpaces the increase in membership. In this regard, Priorities 2022 does not mention private fund advisers who are “exempt reporting advisers,” although we note that exempt reporting advisers are subject to review by the Division.
Other important focus areas
The 2022 priorities list the following additional areas as important focus areas involving both brokers and RIAs.
1. ESG investing. The Division will focus on ESG-related advisory services and investment products, including private equity offerings, focusing on whether RIAs (i) accurately disclose their approaches to ESG investment and have adopted and implemented policies, procedures and practices designed to prevent violations of the federal securities laws in connection with their ESG-related disclosures; (ii) vote on client securities in accordance with proxy voting policies and procedures and if the votes are consistent with their ESG-related disclosures and mandates; or (iii) exaggerate or misrepresent ESG factors considered or incorporated into portfolio selection (eg, greenwashing), such as in their advertising and performance marketing.
2. Standards of conduct: best interest regulation, fiduciary duty and CRS form. The Division will focus on how brokers and RIAs meet their obligations to act in the best interests of retail investors and not to put their own interests ahead of those of retail investors. RIA reviews will focus on whether they are acting in accordance with their fiduciary duty, including in the context of (i) revenue sharing agreements; (ii) recommend or hold more expensive categories of investment products when less expensive categories are available; (iii) recommend embedded fee accounts without assessing whether such accounts are in the best interests of clients; and (iv) recommending proprietary products that incur additional or higher charges.
3. Information security and operational resilience. The Division will review broker and RIA practices to prevent disruptions to mission-critical services and to protect investor information, records and assets, including compliance with SP and S-ID regulations. Reviews will include whether companies have taken appropriate steps to (i) protect customer accounts; (ii) supervise vendors and service providers; (iii) address malicious email activity; (iv) respond to incidents; (v) detect identity theft red flags; and (vi) manage operational risk resulting from a dispersed workforce or work-from-home environment. The Division’s review of business continuity and disaster recovery plans will pay particular attention to the impact of climate risk and substantial disruptions to normal business operations.
4. Emerging technologies and crypto-assets. The Division will review brokers and RIAs that use developing fintechs to determine whether the unique risks these activities present have been considered by firms when designing their regulatory compliance programs. With respect to market participants engaged with crypto-assets, the Division will review custodial arrangements for such assets and assess the offering, selling, recommending, advising and trading of crypto-assets.
Registered Investment Advisors
Priorities 2022 explains that in a typical review, the Division examines RIA compliance programs in one or more of the following key areas to assess whether their policies and procedures are reasonably designed to prevent violations of the Advisors Act and of its rules, including breaches of RIA fiduciary duties: marketing practices, custody and security of client assets, valuation, portfolio management, brokerage and execution, conflicts of interest and related disclosures.
The Division will consider whether: (1) the investment advice is in each client’s best interest; (2) oversight of service providers is adequate; and (3) sufficient resources exist to perform compliance tasks. Specific areas mentioned in the 2022 Priorities include the following:
1. To the extent companies use alternative data or data gathered from non-traditional sources in their business and investment decision-making processes, the Division will consider whether RIAs implement appropriate compliance and controls regarding the creation, reception and use of MNPI potential.
2. The Division will consider whether a firm has implemented monitoring practices to mitigate increased risk, for example whether RIAs employing individuals with disciplinary histories have implemented enhanced monitoring practices for such individuals or whether RIAs operating from multiple branches have adapted their compliance programs appropriately. oversee the activities of their branches.
3. The Division will focus on disclosures of AIR and other issues relating to fees and expenses, in particular issues relating to: (i) errors in the calculation of consultancy fees, including but not limited to limit the non-adjustment of management fees in accordance with agreements with investors; (ii) inaccurate tiered fee calculations, including failure to provide breakpoints and aggregated household accounts; and (iii) non-refund of prepaid fees for terminated accounts or prorated fees for onboarding customers.
Consistent with previous years, the 2022 priorities indicate that the Division prioritizes RIAs that have never been reviewed, including newly registered companies, and those that have not been reviewed for a number of years.