On March 3, 2021, the U.S. Securities and Exchange Commission (“SEC”) Division of Examinations (the “Division”)—formerly the Office of Compliance Inspections and Examinations—released its 2021 Examination Priorities (“2021 Priorities”).  The 2021 Priorities generally retain perennial risk areas as the Division’s core focus, but do include several new and emerging risk areas reflecting broader policy shifts under new SEC leadership.

The 2021 Priorities include:  retail investors; information security and operational resilience; financial technology (“Fintech”), including digital assets; anti-money laundering; transition from the London Inter‑Bank Offered Rate (“LIBOR”); several areas covering registered investment advisers and investment companies; market infrastructure; and oversight of the Financial Industry Regulatory Authority and Municipal Securities Rulemaking Board programs and policies.  Although not formal priorities, the Division will also focus on climate-related risks and environmental, social and governance (“ESG”) matters in light of recent market developments and broader attention in these areas.

In this post, we analyze the highlights in and our takeaways from the 2021 Priorities.

  • Examination “Risk Factors”. The Division reaffirmed its risk-based approach in selecting potential exam candidates and developing the scope of exams.  The Division identified well-established factors such as products and services offered, certain products that are identified as having high risk characteristics, compensation and funding arrangements, prior examination observations and conduct, disciplinary history of associated individuals and affiliates, change in leadership or other personnel, and whether the adviser has custody of investors’ assets.  The Division suggested “high risk products” could be those facing increased exposure to pandemic-related risks, such as non‑performing loans or real estate-related investments.  Advisers should review their disclosures and compliance policies and procedures regarding management and treatment of these assets.
  • ESG and Climate Considerations. The Division noted that it has become increasingly aware of investment strategies that focus on sustainability. For example, advisers have marketed products and services using terms such as “sustainable, socially responsible, impact, and ESG conscious.”  The Division intends to review the consistency and adequacy of the ESG disclosures that advisers provide their clients. The Division will also review advisers’ compliance programs and policies in this area, as well as proxy voting policies, procedures and votes to ensure they are consistent with disclosures and advertisements.  We expect advisers’ disclosures in general and marketing materials in particular to be an area of close scrutiny in exams, particularly in light of Acting Chair of the SEC, Allison Herren Lee’s, recent statement about the SEC’s overall focus on this area and the recently announced Climate and ESG Task Force in the Division of Enforcement.  Examination referrals to the Enforcement Division are likely to focus on the ESG area.
  • Retail-Targeted Investments. The Division will continue to prioritize examinations of issues regarding products that are marketed or sold to retail investors, including seniors and those saving for retirement. Specifically, the Division will focus on mutual funds and exchange-traded funds as the primary investment vehicles for many retail investors. The Division will continue prioritizing broker-dealer sales practices and compliance with Regulation BI.  For advisers that are active in this market segment, the Division will continue to focus on compliance with Form CRS and the principles in the fiduciary duty guidance issued in 2019.  Examinations since the fiduciary duty guidance have closely scrutinized disclosure and advisers’ compliance policies in areas such as allocations and conflicts of interest, which we expect to continue.  As such, advisers should remain diligent in regularly reviewing and updating their disclosures and policies to reflect their experience and business trends.
  • Private Funds. Advisers to private funds also remain a priority area for the Division.  Specific focus areas in the 2021 Priorities include:  preferential treatment to certain investors, such as by imposing gates or suspensions on fund withdrawals; portfolio valuations and the resulting impact on management fees; disclosure of conflict transactions, such as cross trades, principal investments, or distressed sales; and conflicts around liquidity, such as adviser-led restructurings and stapled secondary transactions; and in their portfolio valuations affecting their management fees.  One notable new area, driven by developments relating to the pandemic, is advisers that have a higher concentration of structured products, such as collateralized loan obligations and mortgage backed securities, as well as other real estate-related investments.  The Division intends to examine whether funds that focus on these assets are at a higher risk for holding non-performing loans and loans with higher default risk, specifically on whether those risks are adequately disclosed.
  • Fintech. The 2021 Priorities expanded on Fintech and digital asset innovation compared to last year’s priorities.  Exams will focus on whether firms are acting consistently with their representations to their clients in this area.  The Division noted that exams in this area will focus on whether investments are in the best interests of investors, portfolio management and trading practices, safety of client funds and assets, pricing and valuation, effectiveness of compliance programs and controls, and supervision of representatives’ outside business activities. Notably, the nominee for SEC Chairman, Gary Gensler, stated during his confirmation hearing on March 2 that he believes “financial technology can be a powerful force for good—but only if we continue to harness the core values of the SEC in service of investors, issuers, and the public.” We expect the SEC will move towards a more robust and critical review in exams given Mr. Gensler’s focus on this area while at the CFTC.
  • Information Security. In light of the pandemic, the Division has increased its focus on cybersecurity, particularly in the areas of endpoint security, data loss, remote access, use of third-party communication systems and vendor management. The Division plans to work with firms to identify and address cyber-attack related risks. Advisers should review their cybersecurity compliance programs in general, and more specifically their policies and procedures around safeguarding customer accounts and managing operational risk resulting from the current work‑from‑home environment.
  • LIBOR Transition. The Division noted that it will be working with advisers in exams to inform the SEC’s broader understanding of risks caused by exposure to LIBOR, as well as understanding what preparatory measures adviser have in place for the expected discontinuation of LIBOR and the transition to an alternative reference rate. The Division has been working with firms throughout the year on the LIBOR transition and we would advise firms to continue providing for the LIBOR transition in their disclosures.

Within its themes, the Division indicated it will continue to focus on several expected areas: custody and safekeeping, best execution, risks associated with fees and expenses, business continuity planning, and valuation of client assets.  The Division’s priorities are perennially important beyond their significance for examinations.  Each year they provide a roadmap of that areas will result in higher levels of referrals to the Enforcement Division or investigation.  For priorities that have been focus areas for the last few years, we would also expect to see the Enforcement Division bringing cases in these areas.  We believe that the new leadership at the SEC will continue to encourage, if not place a higher importance on, active coordination between the Division and the Enforcement Division.