By: T.J. Mitchell, Securities Lawyer with JHKM
Every year for the last decade, the Division of Examinations of the Securities and Exchange Commission (the “Division” of the “SEC”) has published an annual report detailing its examination priorities for the forthcoming fiscal year. According to the SEC, these reports provide investors and industry professionals with “transparency into those areas we believe bring heightened risks to investors, registrants, and the markets.” As a result, the topics in the annual report provide insight into the areas SEC examiners may focus additional attention on.
Before announcing the priorities for the upcoming fiscal year, the Report summarizes takeaways from the past year by providing examination and enforcement statistics from fiscal year 2021. In fiscal year 2021, the Division completed 3,040 examinations which represented a 3% increase from fiscal year 2020. Of those 3,040 examinations, the Division issued more than 2,100 deficiency letters. The Division’s 3,040 examinations prompted firms to return over $45 million to investors, and more than 190 referrals were ultimately made to the SEC’s Division of Enforcement. The SEC also continued to see strong growth in the number of SEC-registered investment advisers (“RIAs”), with a net addition of approximately 900 new RIAs in fiscal year 2021. Over the last five years, the number of RIAs has increased 20%, growing from 12,250 to 14,800. The increase in the number of RIAs only tells part of the story, however: the assets under management of these RIAs ($113 trillion) has increased nearly 70% over the last five years.
Moving forward, the Report identifies five “Significant Focus Areas”. These include:
➢ Private Funds
According to the SEC, over 35% of all RIAs manage private funds, which include hedge funds, private equity funds, and real estate funds. The amount of assets in these funds today totals approximately $18 trillion, a number which has increased nearly 70% over the last five years. As a result of this trend, the Division is increasing its focus on issues that often arise related to RIAs and private funds, including those involving an adviser’s fiduciary duty (more on this later), risk assessment and disclosure requirements, proper assessment of fees and expenses, conflicts of interest, issues of valuation, and the implementation of proper compliance programs and protocols. The Division also plans to spend more time and attention on analyzing the portfolio strategies, risk management, and investment recommendations and allocations of private fund advisers, including investments in Special Purpose Acquisition Companies (SPACs).
➢ Environmental, Social and Governance (ESG) Investing
The popularity of investments that employ strategies surrounding ESG has risen dramatically in the last few years, and the SEC has taken notice. This increasing demand brings with it the temptation for portfolio managers to mislead or exaggerate the ESG factors incorporated into their portfolio selection (often called “greenwashing”). As a result, the Division has indicated they will be giving particular attention to ensuring that RIAs and registered funds are providing accurate disclosures regarding their ESG investment approaches, including statements made about ESG strategies in firm advertising and marketing.
➢ Regulation Best Interest, Fiduciary Duty, and Form CRS
Unsurprisingly, the SEC is continuing to place emphasis on ensuring firms’ compliance with Regulation Best Interest, a 2019 SEC regulation requiring broker-dealers and RIAs to act in their customers’ (you guessed it) best interest. In particular, the Division wants to ensure that firms are adequately considering reasonable alternative investments, managing conflicts of interest, and making proper disclosures to investors in their Forms ADV and CRS. Examiners will also review whether firms are recommending suitable investments for customers, in particular related to SPACs, REITs, and private placements. The Division has indicated that dually registered RIAs and broker-dealers will be under particular scrutiny, with focus on the sale of high fee products and incentive/compensation structures that inappropriately influence investment recommendations.
➢ Information Security and Operational Resiliency
The SEC has identified information security as a priority in the Division’s annual report each year since 2019, so it is of no surprise it makes a return in the 2022 Report. Specifically, the Division will focus on ensuring firms have implemented appropriate policies and procedures to safeguard customer accounts, oversee vendors, address malicious email and ransomware activities, identify identity theft, and manage operational risk. Continuing the trend for 2021, the Division will again be reviewing firms’ business continuity and disaster recovery plans with a specific focus on the ability of firms to anticipate, prepare for, respond to and adapt to sudden disruptions and incremental changes stemming from “climate-relation situations.”
➢ Emerging Technologies and Crypto-Assets
Digital assets, financial technology and cryptocurrency have been identified as areas of priority in every annual report since 2018, again reinforcing how much attention the SEC is focusing on these evolving fields. The Division is interested in how firms are developing new financial technologies and how these new technologies fit into their regulatory compliance programs. Other topics of interest to the Division include the accuracy of disclosures and suitability of recommendations to clients related to novel practices, such as the selling of fractional shares, crypto-assets, and the engagement of “Finfluencers” on social media. With the increase in interest of mutual funds and ETFs offering exposure to crypto-assets, the Division will also be conducting examinations to ensure these funds comply with regulatory, liquidity and operational controls around portfolio management and market risk.
While some of these priorities, such as information security, fiduciary standards, and emerging technologies are not surprising given their inclusion in previous reports, they are a good reminder that the Division’s examiners will continue to focus on these areas moving forward. New additions to the Report such as ESG and private funds follow strong industry trends that track the increasing popularity of these types of investments and suggest that firms need to devote sufficient resources into ensuring their compliance with regulatory requirements in the future.
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