By Seth Gaureau and Stephen Wilkes
Since taking office, Chair Gary Gensler has pursued a robust agenda and expectations are high for another year of regulatory scrutiny. Below we discuss recent actions the U.S. Securities and Exchange Commission (“SEC”) has taken with respect to certain of its priorities. As this is not an exhaustive list of SEC actions/priorities, it is important for firms to carefully evaluate topics that may apply to them and consider whether their compliance programs and policies and procedures meet relevant standards.
2024 Examination Priorities Considerations for Investment Adviser
The SEC’s Division of Examinations (the “Division”) issued its annual examination priorities for 2024 (found here), in October this year. Previously the Division’s exam priorities were released near the start of the calendar year. The Division noted the short interval of eight months since the publication of the fiscal year 2023 priorities, and that several areas of focus from last year will remain as priorities for the Division in fiscal year 2024.
The Division highlighted new, notable and significant focus areas for examination, along with other perennial priorities. The following provides a summary of notable upcoming examination priorities.
Duty of Care and Duty of Loyalty
The Division will focus examinations on the fiduciary duty of care and a duty of loyalty advisers owe to clients including 1) serving the best interest of its clients and not subordinate its clients’ interest to its own and 2) eliminating or making full and fair disclosure of all conflicts of interest such that a client can provide informed consent to the conflict.
Generally, the Division will focus on:
- Investment advice meeting fiduciary standards with respect to complex products (e.g., derivatives and exchange-traded funds (“ETFs”), high cost and illiquid products (e.g., variable annuities and nontraded REITs), unconventional investment strategies that purport to address the change in interest rates, and investment advice provided to certain types of clients, including older investors and those saving for retirement;
- Conflicts of interest and the process advisers use to address, mitigate or eliminate the conflicts of interest and whether the investment advice was provided in a client’s best interest;
- Economic incentives that an adviser and its personnel may have to recommend 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
- Disclosures made to investors include all material facts relating to the conflicts of interest associated with the applicable advice sufficient to allow a client to provide informed consent to the conflict.
Compliance Programs
The Division will continue its focus on advisers’ compliance programs, including whether the investment advisers’ policies and procedures address aspects of the advisers’ business, compensation structure, services, client base, and operations, and address applicable market risks. Compliance program reviews will also assess whether the policies and procedures are sufficient to support compliance with advisers’ fiduciary obligations.
The Division’s focus will include compliance policies and procedures with respect to one or more of: (1) portfolio management processes; (2) disclosures made to investors and regulators; (3) proprietary trading by the adviser and the personal trading activities of supervised advisory personnel; (4) safeguarding of client assets; (5) the accurate creation and maintenance of required records; (6) safeguards for the privacy protection of client records and information; (7) trading practices; (8) marketing advisory services; (9) processes to value client holdings and assess fees based on those valuations; (10) business continuity plans; (11) selecting and using third-party and affiliated service providers; (12) branch office oversight; and (13) obtaining informed consent when advisers implement material changes to advisory agreements.
Specific focus areas will include:
- Marketing Practices. Whether advisers have adopted and implemented reasonably designed written policies and procedures to prevent violations of the Investment Advisers Act of 1940 (“Advisers Act”) and the rules thereunder, including reforms to the Marketing Rule and Form ADV disclosures. Focused on whether disseminated advertisements include any untrue statements of a material fact, are materially misleading, or are otherwise deceptive and, as applicable, comply with the requirements for performance (including hypothetical and predecessor performance), third-party ratings, and testimonials and endorsements
- Compensation Arrangements. Assessment of the advisers’ compensation arrangements, including: (1) the fiduciary obligations of advisers to their clients, including registered investment companies, particularly with respect to advisers’ receipt of compensation for services or other material payments made by clients and others; (2) alternative ways that advisers try to maximize revenue, such as revenue earned on clients’ bank deposit sweep programs; and (3) fee breakpoint calculation processes, particularly when fee billing systems are not automated.
- Valuation. Examination of advisers’ recommendations to clients to invest in illiquid or difficult to value assets, such as commercial real-estate or private placements.
- Safeguarding. Examination of advisers’ controls to protect clients’ material non-public information, particularly when multiple advisers share office locations, have significant turnover of personnel, or use expert networks.
- Disclosure. Disclosure assessments on the accuracy and completeness of regulatory filings, including Form CRS, with a focus on inadequate or misleading disclosures and registration eligibility.
Additional Risk Areas Applicable to Advisers
Information Security and Operational Resiliency. Cybersecurity remains a priority of the Division, affecting multiple market participants, including investment advisers. The Division will review firms’ practices designed to prevent interruptions to mission critical services and to protect investor information, records, and assets. Their reviews will focus on cybersecurity policies and procedures, internal controls, staff training, governance practices, and responses to cyber-related incidents, as well as issues associated with reliance on third-party vendors or unauthorized use of third-party providers.
Crypto-Assets and Emerging Financial Technology. Crypto assets and emerging financial technology are areas that remain high on the Division’s list of concerns. The Division continues to closely watch crypto assets and their associated products and services, focusing on the offer, sale, recommendation of, advice regarding, trading in, and other activities in crypto assets and related products. With respect to emerging financial technology, the Division remains focused on certain services, including automated investment tools, artificial intelligence, and trading algorithms or platforms, and the risks associated with the use of emerging technologies and alternative sources of data.
Examinations of Advisers to Private Funds. Advisers to private funds remain a significant portion of the population and the Division will prioritize specific topics such as: (1) portfolio management risks from market volatility and higher interest rates; (2) adherence to contractual requirements regarding limited partnership advisory committees or similar structures, including any contractual notification and consent processes; (3) accurate calculation and allocation of fees and expenses at both the fund level and investment level, including valuation of illiquid assets, the calculation of post-commitment period management fees, adequacy of disclosures and the potential offsetting of fees and expenses; (4) due diligence practices for consistency with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies; (5) conflicts, controls and disclosures regarding private funds managed side-by-side with registered investment companies, and use of affiliated service providers; (6) Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements; and (7) policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events.
Consistent with the Division’s practices, it will continue to prioritize examinations of advisers that have never been examined, including recently registered advisers, and those that have not been examined for a number of years.
Although this year’s examination priorities address similar concerns from prior years, there was the notable absence of matters pertaining to environmental, social, and governance (“ESG”). It is expected that the SEC will continue to focus on ESG-related issues. As discussed below, another area that was not specifically addressed but has continued to be an area of scrutiny and enforcement actions by the Division is off-channel communications.
Recent SEC Off-Channel Communications Enforcement Settlements
Although off-channel communications were not directly addressed in the SEC’s 2024 Exam Priorities, recent enforcement actions show this is an area in which scrutiny will continue.
At the end of September, the SEC announced settlements (found here) with five broker-dealers, three dual registered broker-dealers and investment advisers, and two affiliated investment advisers (collectively referred to as “firms”) for widespread and longstanding failures to maintain and preserve electronic communications. Specifically, the SEC focused on off-channel communications for securities-related business practices that cannot be or are not preserved by the firms. Off-channel communications generally include text messages, social media, and other messaging platforms, such as Slack or WhatsApp. The 10 firms agreed to pay approximately $79 million in combined penalties. This announcement falls in line with the previous SEC settlement announcements against financial institutions for similar violations of their recordkeeping obligations and retention of business-related electronic communications transmitted by firm employees outside of a firm’s recordkeeping system.
The SEC stated that they uncovered “pervasive and longstanding off-channel communications, in which the broker-dealer firms admitted that, from at least 2019, their employees communicated through personal text messages about the business of their employers, and the investment adviser firms admitted that their employees sent and received off-channel communications related to recommendations made or proposed to be made and advice given or proposed to be given.” Both the broker-dealer and the investment adviser firms failed to maintain or preserve the substantial majority of their off-channel communications in violation of their respective requirements under the Securities Exchange Act of 1934 (“Exchange Act”) and the Advisers Act. The failures involved employees at multiple levels of authority, including supervisors and senior managers. Further, the broker-dealer and the investment adviser firms failed to adequately enforce policies and procedures that may have prevented off-channel communications and failed to reasonably supervise employees within their respective requirements under the Exchange Act and the Advisers Act.
Along with the monetary penalties, the firms agreed to retain independent compliance consultants, among other things, to conduct comprehensive reviews of their policies and procedures relating to the retention of electronic communications found on personal devices and their respective frameworks for addressing non-compliance by their employees with those policies and procedures.
Off-Channel Communications Takeaways
These enforcement actions are the result of a continuing effort under SEC Chair Gary Gensler, which started in December of 2021 when JP Morgan admitted to similar recordkeeping failures. An area of focus under these actions continues to be off-channel communications by senior employees, including, among others, senior management or executives, group heads, supervisors responsible for supervising junior employees, managing directors, and partners.
In the press release, the SEC specifically made note of three self-reporting entities that were assessed a significantly smaller penalty of $2.5 million. Referencing these entities, Gurbir S. Grewal, Director of the SEC’s Division of Enforcement stated that “[t]here are real benefits to self-reporting, remediating and cooperating.” Currently, the SEC seems to be indicating that financial firms that self-report will be treated more leniently than those that do not self-report.
It is clear that this will be a continued area of focus for enforcement actions, and firms need to review their policies and procedures, specifically how they retain and monitor their employees’ electronic communications, to ensure compliance with their recordkeeping obligations.