SEC 2023 Examination Priorities
On February 7, 2023, the Securities and Exchange Commission’s Division of Examination (the “Division”) announced its 2023 examination priorities to “provide insights into its risk-based approach, including the areas it believes present potential risks to investors and the integrity of the U.S. capital markets.”1 The Division highlighted four notable new and significant focus areas for the coming year, along with nine other priorities described below. In its Message from the Leadership Team, the Division stated that despite the “tumult and change” of the last several years, the “four pillars” of its mission remain to (1) promote compliance; (2) prevent fraud; (3) monitor risk; and (4) inform policy.2 While events like recent market volatility and cyber-events have kept the Division busy, it remains focused on improving industry risk management practices and compliance with federal securities laws through the regular examination of investment advisers and broker-dealers.
New and Significant Focus Areas
The Division always seeks to prioritize examinations of certain practices, products, and services that it believes present potentially heightened risks to investors or the integrity of the capital markets. In the year ahead, the Division will focus on the following four areas that pose “unique or emerging risks” to investors and capital markets:3
- Compliance with Recently Adopted Rules under the Investment Advisers Act of 1940 and the Investment Company Act of 1940
Three new rules adopted by the SEC will be a focus of the Division’s examination priorities in 2023: the Marketing Rule, the Derivatives Rule, and Fair Valuation Rule 2a-5.
Marketing Rule (Advisers Act Rule 206(4)-1). The Marketing Rule is a “significant change” to a “core examination area” for registered investment advisers (“RIAs”).4 The Division notes that in the coming year it will assess whether RIAs have adopted the Rule’s required policies and procedures. It also emphasizes substantive compliance; RIAs must have a “reasonable basis” for believing they can substantiate “material statements of fact and requirements for performance advertising, testimonials, endorsements[,] and third-party ratings.”5
Derivatives Rule (Investment Company Act Rule 18f-4). The Derivatives Rule applies to registered investment companies (“RICs”), including mutual funds (other than money market funds), exchange-traded funds (“ETFs”), closed-end funds, and business development companies (“BDCs”). The Division will assess whether funds have adopted and implemented policies and procedures “reasonably designed” to manage their derivatives risk and to prevent violations of the Rule.6 It will also review funds for compliance with Rule 18f-4, specifically: (i) the adoption and implementation of a “derivatives risk management program”; (ii) “board oversight”; and (iii) the sufficiency of “disclosures concerning the fund’s use of derivatives.”7
Fair Valuation Rule 2a-5 (Investment Company Act Fair Valuation Rule 2a-5). The Division will assess whether funds and their boards have complied with the requirements for: (i) determining fair value; (ii) implementing board oversight; (iii) establishing recordkeeping and reporting requirements; and (iv) ensuring boards are permitted to set “valuation designees” for fair valuation determinations subject to board oversight.8 It will also review whether required adjustments have been made to: (a) “valuation methodologies”; (b) policies and procedures; (c) governance; (d) “service provider oversight”; and (e) reporting and recordkeeping.9
- RIAs to Private Funds
In 2022, the Division took notice that assets managed by advisers to private funds had increased 70% in the past five years.10 Accordingly, it decided that this needed to be one of its most significant focus areas. In 2023, this asset class has increased again — by almost 20% — growing from $18 trillion to $21 trillion,11 and so it remains a top priority. This year, the Division will focus on examining private fund RIAs for: (i) conflicts of interest; (ii) calculation and allocation of fees and expenses; (iii) compliance with the new Marketing Rule; (iv) policies and practices regarding the use of alternative data; (v) compliance with Advisers Act Section 204A; and (vi) compliance with Advisers Act Rule 206(4)-2.12
Of note, the Division has emphasized that it will focus on RIAs to private funds with specific risk characteristics, including: (a) highly leveraged funds; (b) funds managed side-by-side with BDCs; (c) private equity funds that use affiliated companies and advisory personnel to provide services to clients and underlying portfolio companies; (d) funds that hold certain hard-to-value investments; (e) funds that invest in or sponsor special purpose acquisition companies (“SPACs”); and (f) funds involved in adviser-led restructurings.13
- Standards of Conduct
The SEC’s 2019 adoption of Regulation Best Interest, the Form CRS Relationship Summary (“Form CRS”), and the Interpretation Regarding Standard of Conduct for Investment Advisers (“Fiduciary Duty Interpretation”) remains a driver of one of the Division’s most significant examination focuses in 2023.
Best Interest and Fiduciary Duty Interpretation. As to investors’ best interests and the fiduciary standard for broker-dealers and RIAs, the Division will continue to examine the sufficiency of: (i) advice, recommendations, and strategies; (ii) disclosures, specifically, whether “all material facts” regarding conflicts of interest are disclosed; (iii) processes for making best interest evaluations, including the review of “reasonably available alternatives,” evaluation of costs and risks, and identification and resolution of conflicts of interest; and (iv) factors considered based on a customer’s investment profile, including their “investment goals” and “account characteristics.”14
Such examinations may also focus on products, investors, and recommendations with specific characteristics, including: (a) complex products; (b) high cost and illiquid products; (c) proprietary products; (d) unconventional strategies; (e) microcap securities; (f) senior investors or investors saving for retirement; and (g) account recommendations regarding retirement account rollovers and 529 plans.15
The Division will continue to assess what economic incentives drive firms and their financial professionals in giving recommendations and advice. In particular, it emphasizes the potential impropriety of “incentivizing revenue arrangements,” such as using the services of, or investing in the products of an affiliate, especially when such an arrangement result in customers paying higher fees.16 Finally, the Division notes that it will review whether firms are using customer or client agreements that “purport to inappropriately waive or limit their standard of conduct,” for instance, “through the use of hedge clauses.”17
Form CRS. In 2023, the Division will continue to monitor broker-dealer and RIA compliance with Form CRS. It reemphasizes that firms must (i) deliver relationship summaries to new and prospective investors, as well as existing ones; (ii) file the relationship summary with the SEC; and (iii) post the current relationship summary on the firm’s public website, if it has one.18
- ESG Investing
The Division’s focus on ESG investing, which was first identified as an examination focus in 2020, has been designated as one of the most significant examination priorities for 2023. The Division will continue to examine ESG-related advisory services and fund offerings. Moreover, it will specifically assess whether: (i) “ESG products are appropriately labeled”; and (ii) “recommendations for [ESG] products . . . are made in investors’ best interest.”19
IT and Operational Resiliency
Ever since the Office of Compliance Inspections and Examinations (“OCIE”) — now called the Division of Examinations — first “prioritized information security in each of its five examination programs in 2019,”20 technological and operational resiliency has remained a critical component of examination efforts. In 2023, the Division notes an “elevated” risk environment, due to geopolitical concerns, and a proliferation of cybersecurity attacks, specifically, ransomware attacks.21 The examination of policies and procedures, governance, and compliance with Regulations S-P and S-ID will take on greater intensity in this heightened risk environment. Additionally, the Division emphasizes two focus areas pertaining to third-party vendors: (i) “registrant visibility” regarding the “security and integrity of third-party products and services,” and (ii) the unauthorized use of third-party providers, particularly for “transition assistance,” when registrants’ departing personnel “attempt to migrate client information to another firm.”22
Crypto Assets and Emerging Financial Technology
In 2023, the Division will continue to focus broadly on (i) the proliferation of “digital assets,” cryptocurrencies, coins, and tokens,23 and (ii) emerging financial technologies, like broker-dealer mobile apps, automated investment advice (“robo advisers”), online brokerage services, internet advisers, and automated investment tools and trading platforms.24 Of note, the Division has signaled an increased focus on compliance, disclosure, and risk management for firms that trade or offer advice regarding crypto and crypto-related assets, given recent disruptions in that market. Also noteworthy, the Division is continuing to focus on firms’ use of “digital engagement practices,” a category previously limited to the use of “fractional shares” or “Finfluencers,”25 which has now ballooned to include the use of tools with “behavioral prompts,” “differential marketing,” “game-like features,” “design elements or features” intended to facilitate engagement with online retail investors, as well as other “analytical and technological tools and methods.”26
Registered Investment Advisers (“RIAs”) and Registered Investment Companies (“RICs”)
In recent years, in addition to core areas, the Division has focused on RIAs offering “ESG conscious” investment strategies and “manag[ing] private funds,”27 and has also assessed whether firms have “implemented oversight practices to mitigate any heightened risks.”28 In 2023, the Division indicates that it will focus specifically on policies and procedures for “retaining and monitoring electronic communications” and for “selecting and using third-party service providers.”29
As to RICs, a category that includes mutual funds and ETFs, the Division has emphasized that, in 2023, in addition to perennial focus areas, it will examine funds with specific characteristics: (i) “turnkey funds,” (ii) “mutual funds that converted to ETFs”; (iii) “non-transparent ETFs”; (iv) “loan-focused funds,” like “leveraged loan funds” and funds with “collateralized loan obligations”; and (v) “medium and small fund complexes that have experienced excessive staff attrition.”30 The Division has also indicated that it is monitoring “the proliferation of volatility-linked and single-stock ETFs.”31
Broker-Dealer and Exchange Examination Program
Broker-Dealers. The Division will continue to monitor broker-dealer compliance with the Customer Protection Rule, Net Capital Rule, Regulation SHO, Regulation ATS, Rule 15c2-11, and Rules 15g-2 through 15g-6. Of note, after the much-discussed $1.16 billion “ephemeral messaging” settlement last year,32 the Division has emphasized that it will examine compliance issues around “electronic communications related to firm business, as well as the recordkeeping for those electronic communications.”33
National Securities Exchanges. The Division will also continue monitoring national securities exchanges. But unlike last year’s priorities, this year, there may be a reduced focus on “exchange regulatory programs to detect and discipline violations,” participation in “National Market System (“NMS”) Plans,” and “exchange advisory services offered to issuers regarding ESG initiatives.”34
Security-Based Swap Dealers (“SBSDs”). October 26, 2021 marked the compliance date for several rules and requirements applicable to SBSDs. As such, the Division will continue to monitor compliance with SBS Rules generally, including, in particular, “accurately report[ing] SBS transactions to swap data repositories.”35
Municipal Advisors. The Division has indicated a specific focus in the coming year on compliance with MSRB Rule G-42, “which establishes the core standards of conduct and duties applicable to municipal advisors when engaging in municipal advisory activities.”36
Transfer Agents. The only apparent change with regard to the Division’s examination of transfer agents seems to be a reduced focus on the servicing of “municipal bond issuers.”37
Clearance and Settlement
Pursuant to Title VII of the Dodd-Frank Act, the Division will continue to examine clearing agencies designated as systemically important for which the SEC serves as the supervising agency. For 2023, the Division has indicated that it will also examine “other entities providing clearing services,” like “swap data repositories,” as well as “entities providing clearing services exempt from registration.”38 Furthermore, the Division has highlighted as new areas of focus for the coming year “counterparty credit stress testing,” “governance and escalation,” and “compliance function.”39
Regulation Systems Compliance and Integrity
In the coming year, the Division will continue to evaluate entities covered by Regulation SCI — national securities exchanges, registered and certain exempt clearing agencies, FINRA, MSRB, plan processors, and alternative trading systems that meet certain volume thresholds — for compliance with policies and procedures designed to ensure the operational capacity and resilience of technological systems. Of note, the Division has reduced its focus on return-to-work or hybridization protocols occasioned by the COVID-19 pandemic as well as software supply-chain risks.40 Instead, the Division’s focus has returned to the capacity and resilience of proprietary and third-party software and systems.
Software Development Life Cycle. For home-grown systems, the Division will evaluate whether policies and procedures ensure that system development and testing methodologies used by SCI entities are keeping pace with the market.
Network Segmentation. The Division will also assess whether, upon a security breach, the systems of SCI entities are protected from complete entropy through network segmentation.
Third-Party Dependencies. Next, the Division will evaluate whether policies and procedures ensure that third-party systems operated on behalf of SCI entities have sufficient capacity and resilience.
Application Programing Interface. Finally, the Division will assess whether SCI entities’ policies and procedures regarding third-party applications, such as cloud applications, ensure adequate security and operational capacity.
Financial Industry Regulatory Authority (“FINRA”) and Municipal Securities Rulemaking Board (“MSRB”)
The Division will continue to exercise its authority to conduct risk-based oversight examinations of FINRA. However, for 2023, the Division has emphasized that its review of how FINRA implements new investor protection initiatives will include an assessment of the implementation of “Regulation BI and Form CRS.”41 No particular new focus has been identified with regard to the Division’s compliance examination and risk assessment within the MSRB’s domain.
Anti-Money Laundering (AML)
In 2023, the Division will continue to examine broker-dealers and certain RICs to ensure they have policies and procedures in place that are reasonably designed to identify suspicious activity and illegal money-laundering activities. But unlike prior years, the Division notes the “elevated” importance of AML examinations due to geopolitical concerns, including an increase in “international sanctions.”42 This means that the Division will also be reviewing whether firms are (i) monitoring and (ii) complying with sanctions imposed by the Office of Foreign Assets Control (“OFAC”) and the U.S. Treasury.
The LIBOR Transition
In 2020, the OCIE first noted that the market would be “transition[ing] away from LIBOR as a widely used reference rate.”43 In 2023, the Division will “continue to assess broker-dealer and RIA preparation” for the LIBOR transition, in light of the current discontinuation schedule of mid-2023.44 Absent any delays, it is fair to assume that this will be a reduced priority in 2024.
1Press Release, SEC Division of Examinations Announces 2023 Priorities, Sec. & Exch. Comm’n (Feb. 7, 2023), https://bit.ly/3IjgzTY.
22023 Examination Priorities, at 1, Div. of Examinations, https://bit.ly/3E3iDNg.
3Id. at 9.
8Id. at 10.
102022 Examination Priorities, at 11, Div. of Examinations, bit.ly/3jPhous.
11Id.; 2023 Examination Priorities, at 10.
122023 Examination Priorities, at 10.
13Id. at 11.
15Id. at 12.
18Id. at 13.
202020 Examination Priorities, at 13, Off. of Compliance Inspections & Exams., bit.ly/3HS1w1Y.
212023 Examination Priorities, at 13.
22Id. at 14.
232019 Examination Priorities, at 5 n.1, Off. of Compliance Inspections & Exams., bit.ly/3XpCTPX.
242023 Examination Priorities, at 14.
252022 Examination Priorities, at 16.
262023 Examination Priorities, at 15 n.2.
272021 Examination Priorities, at 28, Div. of Examinations, bit.ly/3YHwQaM.
282022 Examination Priorities, at 17.
292023 Examination Priorities, at 16.
30Id. at 17.
32Rebecca Fike, Jake Beach, and Jacob Mathew, Don’t Forget the G: After Years of “Environmental” and “Social” Regulations and Enforcement, the SEC’s Recent Priorities Demonstrate a Focus on “Governance,” Vinson & Elkins (Nov. 4, 2022), bit.ly/3jRwY8D.
332023 Examination Priorities, at 17.
34Compare 2022 Examination Priorities, at 20, with 2023 Examination Priorities, at 18.
352023 Examination Priorities, at 19.
36Compare 2021 Examination Priorities, at 31, and 2022 Examination Priorities, at 21, with 2023 Examination Priorities, at 19.
37Compare 2021 Examination Priorities, at 34, and 2022 Examination Priorities, at 21, with 2023 Examination Priorities, at 19.
382023 Examination Priorities, at 20.
40Compare 2022 Examination Priorities, at 23 with 2023 Examination Priorities, at 21.
412023 Examination Priorities, at 22.
42Compare 2019 Examination Priorities, at 11–12, and 2022 Examination Priorities, at 25, with 2023 Examination Priorities, at 23.
432020 Examination Priorities, at 5, 8–9.
442023 Examination Priorities, at 23.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.