2022 SEC Division of Examinations Priorities – Summary for RIAs

Authors: Greg Reymann and Jim Obuchi

On Wednesday, March 30th, the SEC’s Division of Examinations (the “Division”) released its annual examination priorities for 2022, which cited a 20% increase in the number of RIAs over the past five years (from about 12,250 to over 14,800 RIAs). During this period, the number of RIAs with AUM over $10 billion rose by 30%, and total AUM now exceeds $113 trillion – almost 70% more than five years ago. Because the growth of RIAs has outpaced the Division’s own staff increases, the Division will likely lower its current examination coverage target of 15% of RIAs. However, as in past years, the Division intends to continue prioritizing RIAs that have never been examined, as well as those that have not been examined for several years.

Highlights:

1. Examination Focus Areas. The Division stated that it “will prioritize examinations of several significant focus areas that pose unique or emerging risks to investors or the markets, as well as examinations of core and perennial risk areas.” The significant focus areas are:

• Private Funds
• Environmental, Social, And Governance (ESG) Investing
• Standards of Conduct: Regulation Best Interest, Fiduciary Duty, and Form CRS
• Information Security and Operational Resiliency
• Emerging Technologies and Crypto-Assets

2. Fiduciary Duty. The third focus area listed above is, of course, central to all RIAs in that they have a fiduciary duty to their clients, “looking at both duties of care and loyalty, including best execution obligations, financial conflicts of interest and related impartiality of advice, and any attendant client disclosures.” The Division explains that key areas of RIAs it will review include:

(1) revenue sharing arrangements;

(2) recommending or holding more expensive classes of investment products when lower cost classes are available (e.g., RIAs that recommend no transaction fee mutual fund share classes that have 12b-1 fees in wrap fee accounts where the RIA may be responsible for paying transaction fees); 

(3) recommending wrap fee accounts without assessing whether such accounts are in the best interests of clients, including the impact of the move to zero commissions on certain types of securities transactions by a number of broker-dealers; and 

(4) recommending proprietary products resulting in additional or higher fees. Such reviews also will include an assessment of the adequacy of RIAs’:

(a) compliance policies and procedures designed to address conflicts and ensure advice in the best interest of clients, including the cost of investing; and 

(b) disclosures to enable investors to provide informed consent.”

3. Information Security and Operational Resiliency. Information security (and operational resiliency) is a perennial area of focus to all regulators given its critical role to ensuring the data of the RIA and its clients is protected. The Division will review RIAs to determine whether they “have appropriate measures to:

(1) safeguard customer accounts and prevent account intrusions, including verifying an investor’s identity to prevent unauthorized account access;

(2) oversee vendors and service providers;

(3) address malicious email activities, such as phishing or account intrusions;

(4) respond to incidents, including those related to ransomware attacks;

(5) identify and detect red flags related to identity theft; and

(6) manage operational risk as a result of a dispersed workforce in a work-from-home environment.”

The Division intends to review RIAs’ business continuity and disaster recovery plans, as well as to ensure they are complying with applicable privacy and information security regulations.

4. Emerging Technologies and Crypto-Assets. The last significant focus area is Emerging Technologies and Crypto-Assets and stems from the Division’s observation of a significant increase in the number of “robo-advisers” being used by RIAs, and the proliferation of offering crypto-assets as an investment option by RIAs.

5. Overview of the Division’s Examination Program. The Division’s examination of RIAs typically consists of a review “in one or more of the following core areas: marketing practices, custody and safety of client assets, valuation, portfolio management, brokerage and execution, conflicts of interest, and related disclosures.”

6. Policies and Procedures. In any examination of an RIA, it is a sure bet that the Division will review the RIA’s policies and procedures, its compliance program, and the RIA’s disclosure and assessment of its fees and expenses. The following chart summarizes what the Division will be looking for as it reviews these three key areas:

Policies & Procedures will be assessed to determine: 

(1) whether they are reasonably designed to prevent violations of the Advisers Act and its rules, including breaches of the RIA’s   fiduciary duty in violation of the antifraud provisions; and

(2) whether the RIA is reviewing and testing them periodically to ensure they are maintained and updated as appropriate. 

The RIA’s Compliance Program will be reviewed to determine:

(1) whether they address that investment advice is in each client’s best interest (i.e., that they are satisfying their obligations under Regulation BI); 

(2) whether the RIA’s oversight of service providers is adequate; 

(3) whether sufficient resources exist to perform compliance duties; 

(4) to   the extent RIAs use “alternative data or data gleaned from non-traditional   sources as part of their business and investment decision-making processes, whether RIAs are implementing appropriate compliance and controls around the creation, receipt, and use of potentially MNPI (material nonpublic information)”; and

(5) whether the RIA has implemented oversight practices to address any heightened risks. (The Division cites three (3) examples: (a) employing individuals with prior disciplinary histories; (b)   ensuring that a transition from a broker-dealer model to an RIA is in the   client’s best interest; and (c) for RIAs with multiple branch locations, ensuring their compliance program has been enhanced to appropriately oversee the activities of their branches.)

Disclosure and Assessment of Fees & Expenses  will be reviewed to identify any issues pertaining to: 

(1) advisory fee calculation errors, including, but not limited to, failure to adjust management fees in accordance with investor agreements; 

(2) inaccurate calculations of tiered fees, including failure to provide breakpoints and aggregate household accounts; and

(3) failures to refund prepaid fees for terminated accounts or pro-rated fees for onboarding clients.

Final Thoughts:

By conducting these examinations, the Division’s chief objective is to ensure RIAs have adequate and effective compliance programs (including ongoing testing, and training) that are designed to support and protect investors whose assets are entrusted with RIAs. To this end, every RIA should continue to place a high priority on maintaining and complying with their policies and procedures, compliance programs and disclosures (such as their Form ADV, Form CRS and any other client disclosures), and by doing so should result in having a fairly “pain-free” examination by the SEC’s Division of Examination. 

Please do not hesitate to contact Reymann Law Group, P.A. at office@reymannlawgroup.com should you have any questions or wish to have a review of any of your own materials that are addressed above.  

Sources:

The Division’s 2022 Priorities report may be viewed by following this link: https://www.sec.gov/files/2022-exam-priorities.pdf