Division of Examinations provides key areas of focus for the upcoming year
The SEC Division of Examinations (“the Division”) recently announced its 2024 Exam Priorities. The priorities outlined within the report provide an overview of key areas where the Division intends to focus its resources; however, it does not encompass all the key risk areas the Division routinely evaluates in an overall effort to promote and improve compliance.
In a departure from tradition, the Division has divided its 2024 priorities by entity. The following is an overview of the seven examination focus areas the Division has put forth to fulfill its mission of protecting investors.
Market participants should review these priorities carefully and possibly adjust their compliance activities as needed to minimize regulatory risk.
The first entity the Division lists is investment advisors, which comes as no surprise, as the Division, and the SEC as a whole, have continued to place advisors in the crucible of their regulatory authority to show their commitment to consumer protection. The Division will be focusing specifically on both the examinations of investment advisors and the examinations of investment advisors to private funds.
About the Division of Examinations
Formed in 1995, the Division is charged with prioritizing examinations of certain practices, products and services that it believes present potentially heightened risks to investors or the integrity of the U.S. capital markets.
The Division’s examinations of investment advisors will focus on products, investment strategies and account types offered by the advisors, and the division may place special emphasis on services offered to older investors and those saving for retirement. These examinations will also focus on the processes that advisors use in facilitating their services and the disclosures the advisors must make to their clients. Finally, these examinations will also focus on compliance components, namely those relating to marketing practices, compensation arrangements, valuation assessments and controls that surround the safeguarding of client non-public information.
The Division’s examinations of investment advisors to private funds will differ slightly from those of other investment advisors. The examinations will focus more on portfolio management risks due to market volatility and higher interest rates; adherence to contractual obligations; accurate calculation and allocation of private fund fees and expenses; due diligence practices for consistency throughout policies; procedures and disclosures; third-party practices; and proper use and application of SEC-required forms.
These focus areas aren’t very different from the prior year but remain top of mind during examinations.
The second entity the Division lists is investment companies, on which the SEC has continued to focus closely, given their proximity to retail investors. The Division will focus on registered investment companies’ compliance programs and governance practices, with a specific focus on board oversight and companies’ derivatives risk management and liquidity risk management programs. In their review of these areas, the Division has stated they will focus on:
- Whether written policies and procedures exist to oversee the fees and expenses charged to clients. The Division stated it will evaluate whether companies are: 1) charging different advisory fees to different share classes of the same fund; 2) offering identical strategies by the same sponsor through different distribution channels but charge different fees; 3) administering high advisory fees relative to peers, and 4) administering high fees and expenses specifically for those companies with weaker performance in comparison to their peers.
- Companies’ oversight of derivates risk management to evaluate whether companies have adopted written policies and procedures reasonably designed to adhere to the SEC’s fund derivatives rule. The Division will likely include a review of whether companies have adopted and implemented a derivatives risk management program, board oversight and adequacy of companies’ fund disclosures. The Division may also inspect companies’ compliance with the terms of any exemptive order conditions and issues associated with recent market dislocations and volatility, such as following appropriate liquidation procedures.
The third entity the Division lists is broker-dealers. The Division selected four areas of focus for broker-dealers:
- Regulation Best Interest: Regulation Best Interest establishes the standard of conduct for broker-dealers at the time they recommend to a retail customer a securities transaction or investment strategy. In reviewing whether broker-dealers are acting in the best interest of their clients, the Division will focus on 1) product recommendations, investment strategies, and account types; 2) conflict of interest disclosures; 3) conflict mitigation practices; 4) the review process of reasonably available alternatives; and 5) factors considering individual investors’ investment profiles, including investment goals and account characteristics.
- Form CRS: The Division’s examinations will review the content of a broker-dealer’s relationship summary, such as how the broker-dealer describes: 1) the relationships and services that it offers to retail customers; 2) its fees and costs; and 3) its conflicts of interest, and whether the broker-dealer discloses any disciplinary history. These examinations will also evaluate whether broker-dealers have met their obligations to file their relationship summary with the SEC and deliver their relationship summary to retail customers.
- Broker-dealer Financial Responsibility Rules: Examinations will focus on broker-dealer compliance, specifically with the Net Capital Rule and the Customer Protection Rule, and any related internal processes, procedures and controls. Areas of review will include fully paid lending programs and broker-dealer accounting for certain types of liabilities, such as reward programs, point programs, gift cards and non-brokerage services, and will also assess broker-dealer credit, interest rate, market, and liquidity risk management controls to assess whether broker-dealers have sufficient liquidity to manage stress events.
- Broker-dealer trading practices: The Division will focus on broker-dealer equity and fixed-income trading practices, focusing specifically on: 1) Regulation SHO, including rules regarding aggregation units and locate requirements; 2) Regulation ATS, and whether the disclosures provided in Forms ATS and ATS-N are consistent with the operations of alternative trading systems; and 3) Exchange Act Rule 15c2-11, which in most circumstances prohibits broker-dealers from publishing or submitting securities of private issuers in a quotation medium other than a national securities exchange.
The fourth entity the Division lists are self-regulatory organizations, specifically national securities exchanges, the Financial Industry Regulatory Authority (FINRA), and the Municipal Securities Rulemaking Board (MSRB).
For national securities exchanges, the Division will focus on determining whether the exchanges are meeting their obligations to enforce compliance with self-regulatory organization rules and federal securities laws. Examinations will specifically inspect exchange order handling and exchange surveillance, investigation and enforcement programs to detect and discipline member firm violations.
For FINRA, the Division will focus on conducting its risk-based oversights of the regulatory authority, including inspections of FINRA’s major regulatory programs, to make detailed recommendations to improve FINRA’s programs, risk assessment processes, and future examinations.
For the MSRB, the Division will focus on its review of the MSRB and its identification of areas for its review of the MSRB going forward.
The fifth entity the Division lists are clearing agencies: specifically registered clearing agencies. The Division will focus on clearing agencies’ core risks, processes and controls and will cover specific areas such as the nature of clearing agencies’ operations and the assessment of financial and operational risk. The Division stated that other areas of examination in focus for 2024 may include risk management of liquidity, models and model validation, margin systems, third-party service providers, and operations and the internal audit function.
Other market participants
The sixth entity the Division will focus on is a broad-based category focusing on other market participants that do not fit neatly into any category listed above. This will include:
- Municipal advisors: Examinations on municipal advisors will focus on determining whether municipal advisors are meeting their duties to clients, especially regarding advice surrounding pricing, method of scale, and structure of municipal advisors. The Division will pay close attention to whether municipal advisors are documenting their relationships and are appropriately disclosing their conflicts of interest. Additionally, the Division will begin to enforce compliance with MSRB Rule G-46, a new rule coming into effect on March 1, 2024, that is designed to establish the core standards of conduct for solicitor municipal advisors.
- Security-based swap dealers: The Division will focus on security-based swap dealers with a broad scope on overall compliance, including whether they have implemented policies and procedures related to swap rules and are meeting their regulations under Regulation and Dissemination of Security-Based Swap Information. This will include examinations of whether dealers are complying with capital, margin and segregation requirements.
- Transfer agents: The Division will focus on transfer agent processing of items and transfers, recordkeeping and record retention, safeguarding of funds and securities, and filings with the Commission. Examinations will also focus on transfer agents that service certain types of issuers, including those issuing microcap and crypto asset securities, and transfer agents that use emerging technologies to perform their transfer agent functions.
Risk areas impacting various market participants
The seventh and final entity the Division will focus on is also a broad-based category: risk areas impacting various market participants. This seventh category features familiar faces from the SEC’s regulatory line-up, including:
- Information security and operational resiliency: The Division will continue to monitor broker-dealers’ and advisers’ practices to protect investor information, records and assets, and to avoid lapses in critical services. The Division’s focus will also be directed towards cybersecurity and registrants’ policies and procedures, internal controls, oversight of third-party vendors’ governance practices, and registrants' responses to cyberattacks. On May 5, 2023, the SEC adopted new rules shortening the standard settlement cycle for most broker-dealer transactions to one business day. The compliance date for this update is slated for May 28, 2024, and the Division will begin assessing broker-dealers’ compliance with the new rule then.
- Crypto assets and emerging financial technology: In an ever-changing market, the Division has also reaffirmed its continued focus on crypto assets and other emerging financial technologies (“fintech”) — such as mobile finance apps and automated investment advice. As has been the case in its risk alerts throughout 2023, the Division will focus heavily on broker-dealers’ compliance with the marketing of crypto assets and fintech. The Division will continue to examine registrants in the crypto asset market, given its substantial volatility. These exams will focus on nearly all facets of the crypto asset market, including the offer, sale, recommendation of, advice regarding, and trading in crypto assets. The exams will be used by the Division to determine whether registrants: 1) meet and follow their standards of conduct when recommending or advising customers and clients regarding crypto assets; and 2) regularly review, update and improve their compliance practices as appropriate.
- Regulation Systems Compliance and Integrity (SCI): The Division will continue to evaluate whether SCI entities have established, maintained and enforced written policies and procedures, as required. The Division stated one area of focus will include whether the policies and procedures of SCI entities are reasonably designed to ensure the security of the SCI systems, including the physical security of the systems housed in data centers, as required.
- Anti-money laundering (AML): A long-standing emphasis for the Division, AML makes its way into the SEC’s exam priorities for another year. The Division will continue to focus on AML programs to review whether broker-dealers and certain registered investment companies are: 1) appropriately tailoring their AML program to their business model and associated AML risks; 2) conducting independent testing; 3) establishing an adequate customer identification program, including for beneficial owners of legal entity customers; and 4) meeting their Suspicious Activity Reports filing obligations. Examinations of certain registered investment companies will also review policies and procedures for oversight of applicable financial intermediaries.
The stated 2024 priorities showcase the Division’s recommitment to focusing on those areas of risks, issues, and policy matters that most affect the average investor. The Division has signaled that it will continue to monitor industry developments and market events to assess the impact on retail investors and SEC-registered firms and will continue to tailor its risk-based program to respond accordingly.
With a seemingly new emphasis on the type of entities it reviews, on top of the services they provide, the Division may be displaying a new approach in how it will conduct its examinations going forward with a more made-to-measure approach in their reviews. While this summary covers the Division’s Exam Priorities at a very high level, the degree of scrutiny and details needed to remain compliant in 2024 has substantially increased.
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