2024 SEC Examination Priorities: Remember the Essentials While Adapting to Change
In a departure from its usual schedule, the U.S. Securities and Exchange Commission’s (SEC's) Division of Examinations (Division) released its 2024 annual examination priorities (the Priorities) this week to “inform investors and registrants of the key risks, examination topics, and priorities the Division plans to focus on in the upcoming year.”
The SEC emphasized the departure, aligned with the closing of the fiscal year, was designed to provide earlier insights to registrants, investors, and the marketplace. This approach helps stakeholders prepare, adapt, and respond to regulatory changes. As expected, the Priorities remain anchored around the Division’s four pillar approach - promote compliance, prevent fraud, monitor risk, and inform policy.
Considering the broader context of ongoing rule proposals and changes, the theme here appears to be that, while compliance teams race to adapt to new and evolving regulatory requirements, they should not lose sight of compliance fundamentals. A firm’s ability to maintain a strong compliance program, even as they navigate the complexities of emerging regulations and priorities, is critical.
Perennial Priorities & What’s New
In its 2024 Priorities, the SEC carried forward several priorities from 2023, with some receiving heightened emphasis. This continuity is due, in part, to the relatively short time between the publication of the ‘23 and ‘24 Priorities, but also to the importance of these issues to the SEC’s primary objectives.
It is worth noting that many of the recently adopted rules have compliance deadlines extending well into the upcoming year. While the Priorities contain hints of future examinations, firms will be challenged in 2024 to stay focused on implementing new rules and on the essential elements of existing compliance programs. The panoply of priorities this year exemplifies this challenge.
Here's what’s new and noteworthy in the 2024 Priorities:
- Return to Offices: Reflecting on Fiscal 2023, the SEC called out the return to registrants’ offices, with more exams involving in-person fieldwork. The SEC signaled that they will continue to take a hybrid approach, combining both in-person and remote engagement, while noting that 2023 witnessed a notable increase in visits to advisers' offices.
- Emerging Financial Technology: The SEC is paying attention to the increase in various types of investments like cryptocurrencies and the services related to them. They are also keeping an eye on new financial technologies, such as mobile apps used by investment firms, and advisers using automated systems to provide advice to their clients.
- Anti-Money Laundering (AML): In 2023, the SEC discussed its focus on AML for broker-dealers and certain other financial institutions. New to the priorities in 2024 is a reference to the obligations of investment advisers and broker-dealers to comply with sanctions imposed by the Office of Foreign Assets Control (OFAC), which reflects a challenging geopolitical environment.
In the following sections, we’ll provide highlights from the diverse range of areas the SEC's 2024 Priorities encompass, organized across various market participants and key topics.
The SEC continues to prioritize issues arising from advisers' fiduciary duty, with a key emphasis on verifying that firms’ compliance policies and procedures reasonably cover all facets of their business. This includes compensation structure, services, client base, and operations. Furthermore, exams will aim to confirm that investment advice offered aligns with the client’s best interests and that the firm’s disclosures effectively communicate information about conflicts of interest and other material changes. Areas of priority for 2024 include:
- Complex, High Cost & Illiquid Products: Expect the SEC to scrutinize investment advice related to complex products, such as derivatives and leveraged exchange-traded funds (ETFs), and high-cost and illiquid products, like variable annuities and non-traded real estate investment trusts (REITs). These will be reviewed with an emphasis on suitability and transparency of risk disclosures.
- Unconventional Strategies: The SEC will examine unconventional strategies, especially those claiming to address rising interest rates, to ensure that they align with clients' goals and risk profiles.
- Suitability and Best Execution: Examinations will assess the processes for making initial and ongoing suitability determinations and seeking best execution for client transactions.
- Costs and Risks: Investment advisers will be reviewed to evaluate how they assess costs and risks, considering clients' investment profiles and goals.
- Conflicts of Interest: The SEC will examine how advisers identify, address, and, when appropriate, eliminate conflicts of interest, including conflicts related to investment allocations among various account types and economic incentives (ex. compensation arrangements, revenues sharing, and markups).
- Disclosures & Informed Consent: In the vein of investor protection, the SEC plans to focus on the accuracy and completeness of regulatory filings, including Form CRS, with a focus on inadequate or misleading disclosures. Additionally, the SEC will assess advisers' policies and procedures for obtaining informed consent when implementing material changes to advisory agreements.
Once again, the SEC will assess the marketing of advisory services to ensure alignment with the reforms made to Marketing Rule 206(4)-1. In previous risk alerts, the SEC has emphasized the importance of written policies and procedures and adherence to new practices related to performance, third-party ratings, testimonials, and endorsements. It comes as no surprise that these same expectations have found their way into this year's examination priorities, along with Form ADV disclosures.
The focus on the ability to maintain substantiation of processes, books and records, as well as statements of material facts, serves as a good reminder for advisers to continue strengthening their practices related to documentation in all advertisements. We have already observed the impact of the Marketing Rule on hypothetical performance practices, which is highlighted in the examination priorities alongside predecessor performance. With ten recent enforcement actions concerning the use of hypothetical performance, advisers are strongly encouraged to concentrate on establishing policies and procedures, along with the necessary disclosures.
Investment risk and valuation have not gone unnoticed in previous Priorities, but the emphasis on these aspects is more pronounced in 2024. The SEC highlights valuation as a significant area of concern for investment advisers. The attention to investment risk management and valuation extends to private fund managers, with a specific consideration for how valuation issues might impact fee and expense calculations.
Registered funds are not exempt from scrutiny, with an extensive discussion regarding valuation, derivative risk management, and liquidity risk management in the release. Additionally, broker-dealer examinations will prioritize products with complexity or illiquidity.
Third-Party Due Diligence
Although the Proposed Rule on Outsourcing by Investment Advisers is still a proposal at the time of this article, broker-dealers and advisers should anticipate that examinations will probe firms’ selection and use of third-party and affiliated service providers. Exams will consider how registrants identify and address risks to their essential operations, particularly those involving third-party providers.
Branch Office Oversight
Oversight of branch offices, especially when advisers operate from numerous or geographically dispersed locations, will be reviewed. A May 2023 risk alert “Safeguarding Customer Records and Information at Branch Offices” offers broker-dealers and advisers insight into common deficiencies in this area.
In addition, exam staff will look at the topics advisers’ have come to expect:
- Custody & Safeguarding (See Proposed Safeguarding Rule fact sheet)
- Portfolio Management
- Trading Practices
- Business Continuity
- Material Non-Public Information
While the SEC will continue to focus on advisers to private funds, the new Private Fund Adviser Rules have rolling compliance dates depending on the rule and the AUM of the private fund adviser, with the first compliance date being September 14, 2024 and others not reaching their compliance date until March 2025.
In 2024, the SEC's exam priorities for private funds center around:
- How firms address portfolio management risks in the face of market volatility and higher interest rates, which may lead to performance challenges, withdrawals, and valuation issues
- Adherence to contractual obligations with limited partnership advisory committees
- Accurate calculation and allocation of fees and expenses
- Due diligence practices for prospective portfolio companies
- Controls for side-by-side management of private funds with registered investment companies and affiliated service providers
- Compliance with custody requirements
- Accurate reporting on Form PF, particularly when specific reporting events occur
In 2024, the Division plans to continue examining registered investment companies, including mutual funds and ETFs, with a focus on a wide range of areas, including compliance programs, fund use of derivatives, fund governance practices, investor disclosures, and reporting accuracy.
Notably, the SEC identified how fund boards oversee fees and the 15(c) process as an area of focus, particularly on higher priced funds that underperform relative to peers. Boards should understand how a peer group was selected for purposes of comparison, and gain comfort with that process. If there are circumstances that explain why a fund is an outlier (for example some funds are intended as hedging vehicles or may not lend themselves to peer comparison), then that should be documented in process.
Regulation Best Interest (Reg BI)
Reg BI is at the top of the SEC’s exam priorities list concerning broker-dealers. Exams will look at broker-dealers’ ability to demonstrate compliance with its obligations of care, disclosure (e.g., accuracy of CRS, conflicts of interest), and compliance. The SEC will consider a broker-dealer's duty of care under Reg BI in the following areas:
- Recommendation of products, investment strategies, and account types, including broker-dealers’ process for reviewing reasonably available alternatives
- Disclosures made to investors regarding conflicts of interest and conflict mitigation practices
- Factors considered in light of the investor’s investment profile, including investment goals and account characteristics
Additionally, the SEC will review compliance with the standards of financial responsibility (net capital) and trading practices (equities and fixed income). The SEC is also focusing on risk management areas of the broker-dealer including credit, interest rate, market and liquidity risks.
New Settlement Cycle
The Division will test firm readiness for shortened settlement cycles. The SEC’s new rule shortens the standard settlement cycle for most broker-dealer transactions from T+2 to T+1. The compliance date for this change is May 28, 2024.
In 2024, the SEC's examination focus on Municipal Advisors remains centered on their fiduciary duty to clients, particularly concerning advice for municipal securities' pricing, sales methods, and structures. Examinations assess compliance with documenting municipal advisory relationships, disclosing conflicts of interest, and meeting registration, qualification, continuing education, recordkeeping, and supervision requirements.
Furthermore, there's an emphasis on the new MSRB Rule G-46, effective from March 1, 2024, which sets out core conduct standards for solicitor municipal advisors, including the disclosure of conflicts of interest and the documentation of client relationships. The Division, during the latter part of fiscal year 2024, will particularly scrutinize compliance with this new rule.
In 2024, the Division will maintain a strong emphasis on information security and operational resilience across various firm types to safeguard investor information, records, and assets, and to prevent interruptions to critical services. This focus arises due to elevated risks from cybersecurity threats, dispersed operations, extreme weather events, and geopolitical concerns.
Key areas of scrutiny include:
- Registrants' policies
- Internal controls
- Third-party vendor oversight
- Governance practices
- Responses to cyber incidents, especially ransomware attacks
- Training of staff on identity theft prevention and data protection policies.
As part of the SEC’s focus on the role third-parties play in information security and operational resilience, the SEC will continue to examine how firms identify, assess, and manage the risks associated with third-parties. The SEC will also look for the unauthorized use of third-party providers during exams.
Crypto & New Financial Technologies
In 2024, the SEC will continue to keep a close eye on the growth of specific investments, like cryptocurrencies, and new financial technologies, such as mobile apps offered by broker-dealers and automated advisory services by investment advisers. Their attention is particularly on broker-dealers and advisers who introduce new products and services, especially those involving technology and online solutions designed to meet regulatory requirements. The Division's primary focus appears to revolve around services like automated investment tools, artificial intelligence, trading algorithms, and platforms, as well as the potential risks associated with these emerging technologies and alternative data sources.
ESG - Absent but Not Forgotten
Given the emphasis the SEC has placed on its efforts to address environmental, social, and governance (ESG) matters, many were surprised to see this topic did not make an appearance in the 2024 priorities. It’s absence notwithstanding, the SEC continues to focus significant effort on ESG.
The Exam program issued a Risk Alert setting forth extensive guidance on the topic identifying deficiencies and effective practices. The Enforcement Division has established an ESG and Climate Task Force with over twenty lawyers dedicated to bringing cases, and we just saw an enforcement action in September. The SEC also has two significant rule proposals concerning ESG and climate—one focusing on disclosure by public companies and the other focusing on disclosure by advisers and funds.
Taken in totality, together with broader global ESG efforts, it's reasonable to expect that the SEC and other regulators will continue to focus on ESG despite it not being specifically called out in the Exam priorities.
We advise firms to review their compliance programs in light of the above priorities and consider taking action before an examination.
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