The SEC Division of Examinations (“the Division”) recently published its list of priorities for 2022. While it was a bit late compared to a typical year, the priorities letter provides a roadmap for firms to better understand where the Division will take its examination efforts over the coming months. Significant focus areas for 2022 include:
- Private Fund Advisers: The first spot on the priories list went to private fund advisers. Our client alert covers this topic in depth. Heightened focus on this area aligns with recent rulemaking as the SEC looks to expand its reach over this space, which it says has grown 70% in five years. Exams of private fund advisers will cover a range of issues under the Advisers Act, including an adviser’s fiduciary duty, compliance programs, fees and expenses, custody, fund audits, valuation, conflicts of interest, disclosures of investment risks, and controls around MNPI.
- ESG: Given the recently announced behemoth of a proposal on climate disclosure, it is no surprise to see the SEC’s exam program focused on this area. A key concern of the staff will be “greenwashing” — using ESG references to make an investment more appealing. Exam staff will focus on: (1) accuracy, standardization, and consistency of disclosures related to ESG investments or products; (2) policies and procedures designed to prevent securities law violations in connection with ESG-related disclosures; (3) voting client securities in accordance with proxy voting policies and procedures, and whether votes align with ESG disclosures or mandates; and (4) whether advertising, marketing, or other disclosures overstate or misrepresent ESG factors considered relating to investments or portfolio selection.
- Reg. BI, Form CRS, and Fiduciary Duty: Reg. BI and Form CRS are now perennial areas of focus for the agency. In addition to being an area of focus for FINRA, we anticipate that SEC exams in these areas will continue to move beyond mere compliance with the forms and instructions, and begin to address substantive violations. Exam staff will likely focus on product recommendations (including SPACs, structured products, levered and inverse ETPs, REITs, private placements, annuities, municipal and other fixed income securities, and microcap securities), policies and procedures related to evaluating costs and reasonable alternatives, compensation structures, and conflicts of interest.
- Information Security and Operational Resiliency: Another perennial area of focus is information security and resiliency and cybersecurity generally. This is also an area that dovetails with the SEC’s proposal on expanded and accelerated cybersecurity disclosure. Exam staff will review registrants’ business continuity, not only in light of the pandemic, but also for climate risk for certain systemically important registrants. The SEC does not have a significant rule on business continuity, and it will be interesting to see how exams develop in this area and whether they are intended to be more prophylactic, rather than retrospective looking for potential rule violations. As it relates to rules, exam teams will focus on compliance with Reg. S-P and Reg. S-ID and review for (1) safeguards on customer accounts and preventing account intrusions, including verifying an investor’s identity to prevent unauthorized account access; (2) third-party vendor diligence and management; (3) effectiveness of policies and procedures around preventing malicious email activities, such as phishing or account intrusions; (4) incident response, including for ransomware attacks; (5) identity theft red flags (likely including SAR filings); and (6) managing operational risk in light of a dispersed workforce.
- Emerging Technologies and Crypto Assets: Given the agency’s recent focus, this list would not be complete without some mention of cryptocurrency and digital assets. Interestingly, the Division discusses its review of digital engagement practices (DEPs) along with crypto. When examining DEPs, SEC exam staff will key into (1) the use of “finfluencers;” (2) operations and controls consistent with disclosures made and the standard of conduct owed; (3) whether advice, including algorithmic advice, is consistent with an investor’s investment strategies and the standard of conduct owed; and (4) whether controls take into account the risks associated with the use of DEPs. With respect to crypto, the SEC’s proposed amendments to Rule 3b-16 could pave the way for the SEC to regulate defi protocols and crypto exchanges. The SEC’s dealer-trader proposal could similarly bring liquidity providers, such as automated market makers, into the SEC’s purview. Examinations relating to crypto assets will focus on whether registrants have met their appropriate standard of conduct (i.e., Reg. BI for broker-dealers or the fiduciary duty for investment advisers). Exam staff will consider whether firms understand the underlying products and routinely review and update policies and procedures to enhance compliance practices related to these products (wallet reviews, custody, AML, valuation and risk disclosure, for example).
Specifically regarding broker-dealers, the priorities letter outlines a number of other, more familiar focus areas:
- Unregistered broker activity: Exam staff will make it a priority to review for unregistered broker activity and the illegal distribution of unregistered securities. Issuers will want to ensure that their placement agents maintain necessary registrations and do not have disqualifying disciplinary history. Issuers should be mindful of the legal and regulatory grey zone within which “finders” operate, especially given that the SEC’s proposed finder exemption remains unadopted.
- Microcap Sales and OTC Trading: Exam staff will continue to focus on deterring microcap fraud and will view any microcap activity through the lens of Reg. BI, Reg. SHO (specifically the locate requirement), Rule 15c2-11 (which requires issuer financial information to be current and publicly available before a broker can publish quotes in a security), and AML obligations.
- Conflicts of Interest and Payment for Order Flow: Exam staff will continue to focus on broker obligations to satisfy best execution obligations, especially in the environment of zero commission trades and PFOF, including compliance with the order routing disclosures required by Rule 606. SEC staff looks at PFOF through a wide lens to include payments from wholesalers and also exchange rebates.
- Reg. ATS and Reg. SHO: Perhaps to inform policy on the proposed rulemakings for Rule 3b-16 (noted above) and Reg SHO, exam staff will examine registrants for compliance with both of these regulations. For ATSs, it appears the Division will largely focus on consistency of disclosures on Form ATS-N for ATSs that trade NMS stocks. For Reg. SHO, the priority will be on aggregation units and locate requirements.
We’ll continue to monitor for updates and we are available to discuss any of these issues. If you would like to discuss the contents of this alert or have any questions, please reach out to the authors of this alert or the Goodwin lawyer with whom you typically consult.