Adherence to Fiduciary Standards of Conduct
Investment advice provided to clients regarding products, investment strategies, and account types, and whether that advice satisfies the fiduciary obligations owed to their clients. In particular, the Division will focus on recommendations related to: (1) high-cost products; (2) unconventional instruments; (3) illiquid and difficult-to-value assets; and (4) assets sensitive to higher interest rates or changing market conditions, including commercial real estate.
The impact of advisers’ financial conflicts of interest on providing impartial advice and best execution, with consideration given for non-standard fee arrangements.
Effectiveness of Advisers’ Compliance Programs
Rule 206(4)-7 under the Investment Advisers Act of 1940 (Advisers Act), often referred to as the “Compliance Rule,” requires SEC-registered investment advisers to: (1) adopt and implement written policies and procedures that are reasonably designed to prevent violations of the Advisers Act and the rules adopted under the Advisers Act by the adviser and its supervised persons; (2) designate an individual as Chief Compliance Officer to be responsible for administering the policies and procedures; and (3) review compliance policies and procedures at least annually for their adequacy and the effectiveness of their implementation.
The Division’s assessment of the effectiveness of advisers’ compliance programs is a fundamental part of the examination process. Examinations focusing on this topic typically include an evaluation of the core areas of advisers’ compliance programs which include, as applicable and appropriate for each examination, marketing, valuation, trading, portfolio management, disclosure and filings, and custody. In addition, examinations on this topic typically include an analysis of advisers’ annual reviews of the effectiveness of their compliance programs, which are a critical element for addressing and monitoring conflicts of interests, including those conflicts stemming from the advisers’ business and compensation arrangements, arbitration clauses, and/or affiliations with certain parties and transactions.
In reviewing advisers’ compliance policies and procedures, the Division continues to focus on whether the policies and procedures address compliance with the Advisers Act and the rules thereunder and are reasonably designed to prevent the advisers from placing their interests ahead of clients’ interests. Areas on which examinations may focus include: (1) fiduciary obligations of advisers that outsource investment selection and management; (2) alternative sources of revenue or benefits advisers receive, such as selling non-securities based products to clients; and (3) appropriateness and accuracy of fee calculations and the disclosure of fee-related conflicts, such as those associated with select clients negotiating lower fees when similar services are provided to other clients at a higher fee rate.
The Division’s review of an adviser’s compliance program may focus on or go into greater depth depending on its practices or products. For example, if clients invest in illiquid or difficult-to-value assets, such as commercial real estate, examinations may have a heightened focus on valuation. If advisers integrate artificial intelligence (AI) into advisory operations, including portfolio management, trading, marketing, and compliance, an examination may look in-depth at compliance policies and procedures as well as disclosures to investors related to these areas. If an adviser utilizes a large number of independent contractors working from geographically dispersed locations, examinations may focus on supervision and oversight practices. Examinations may also focus on compliance practices when advisers change their business models or are new to advising particular types of assets, clients, or services.
Never Examined Advisers, Recently Registered Advisers, and Advisers Not Recently Examined
As with previous years, the Division will prioritize examinations of advisers that have never been examined and those that have not been recently examined with a continued focus on newly registered advisers.
Risk Areas Impacting Various Market Participants
Cybersecurity
Regulation S-ID and Regulation S-P
Emerging Financial Technologies
The Division remains focused on registrants’ use of certain services, such as automated investment tools, AI, and trading algorithms or platforms, and the risks associated with the use of emerging technologies and alternative sources of data. As such, the Division will, in particular, examine firms that employ certain digital engagement practices, such as digital investment advisory services, recommendations, and related tools and methods. When conducting these reviews, assessments generally will include whether: (1) representations are fair and accurate; (2) operations and controls in place are consistent with disclosures made to investors; (3) algorithms produce advice or recommendations consistent with investors’ investment profiles or stated strategies; and (4) controls to confirm that advice or recommendations resulting from digital engagement practices are consistent with regulatory obligations to investors, including older investors.
With respect to AI, the Division will review registrant representations regarding their AI capabilities or AI use for accuracy. In addition, the Division will assess whether firms have implemented adequate policies and procedures to monitor and/or supervise their use of AI, including for tasks related to fraud prevention and detection, back-office operations, anti-money laundering (AML), and trading functions, as applicable. Reviews will also consider firm integration of regulatory technology to automate internal processes and optimize efficiencies. In addition, the Division will examine how registrants protect against loss or misuse of client records and information that may occur from the use of third-party AI models and tools.
Crypto Assets
The Division continues to observe the proliferation of investments involving crypto assets and their associated products and services. Given the volatility and activity involving the crypto asset markets, the Division will continue to monitor and, when appropriate, conduct examinations of registrants offering crypto asset-related services. Examinations of registrants will focus on the offer, sale, recommendation, advice, trading, and other activities involving crypto assets that are offered and sold as securities or related products, such as spot bitcoin or ether exchange-traded products.
In particular, these examinations will review whether the registrants: (1) meet and follow their respective standards of conduct when recommending or advising customers and clients regarding crypto assets with a focus on an initial and ongoing understanding of the products that have a particular focus on scenarios where investors are retail-based (including older investors) and investments involving retirement assets; and (2) routinely review, update, and enhance their compliance practices (including crypto asset wallet reviews, custody practices, Bank Secrecy Act (BSA) compliance reviews, and valuation procedures), risk disclosures, and operational resiliency practices (i.e., data integrity and business continuity plans), if required.
The Division will assess registrant practices to address the technological risks associated with the use of blockchain and distributed ledger technology, including risks pertaining to the security of crypto assets.