SEC exam priorities race to keep up with record growth of RIAs

April 4, 2022 11:16 AM

SEC headquarters, Bloomberg News — The U.S. Securities and Exchange Commission oversees about 15,000 RIAs.

Although most SEC-registered RIAs won’t receive an examination this year, the advisory practices that do get an audit will already have a comprehensive cheat sheet in hand.

That’s because the regulator has provided financial advisors and other wealth management professionals with its annual listing of its priorities for the more than 2,000 RIA exams that the Division of Examinations will perform in 2022. About 1,000 staff members in the unit oversee roughly 15,000 RIAs with $125 trillion in assets under management and 3,500 brokerages with 150,000 branches, according to the SEC’s budgetary request to Congress.

Three areas of the closely watched annual report stand out to Douglas Kamin, a managing director with compliance firm Foreside who serves as a consultant to RIAs:

ESG criteria: “Firms’ marketing, or I would say ‘over-marketing,’ of ESG was probably a concern at the SEC, what euphemistically the industry would say is ‘greenwashing,’” Kamin said. “Just like any other type of portfolio management, if you say you're doing something, you're going to need policies and procedures that document what you're doing, how you're doing it and when you're doing it.”

Regulation Best Interest: “I don't think anyone should get a sense of comfort that it’s new,” Kamin said, noting the dozens of cases that the SEC has filed about the rule’s new required “customer relationship summary” document for RIAs. “It's part of their regular exam reviews as it pertains to wealth managers and other financial entities subject to the rule.”

Rollovers: “It was very subtle,” Kamin said of a small reference to rollovers and other account conversions in the section about Reg BI in the report. The Department of Labor plans to create a new rule that could potentially enforce a fiduciary duty in rollover recommendations under the Employee Retirement Income Security Act, although there’s no timetable for the proposal. “They didn't mention any other context to it,” Kamin said. “But, given the new DOL standards, that might be an area that they’re moving toward.”

Cybersecurity: “They're telling everyone, ‘You need to up your game,’” Kamin said, referring to a new SEC rule proposal on cybersecurity at RIAs and the increased emphasis in light of Russia’s invasion of Ukraine. “I would imagine that the SEC wants to see world-class information security procedures, and that's something they'll look at very closely.”

For a summary of the SEC’s 2022 Examinations Priorities and the key takeaways for advisors, scroll down our slideshow. To see the areas of focus in this year’s FINRA examinations, click here.

SEC milestones

Last year marked the 25th of the regulator’s standalone exams program, as well as a change the SEC describes as the “elevation” of the unit to being called the Division of Examinations from its previous moniker, the Office of Compliance Inspections. With the March 30 report, the SEC has released its examination priorities every year for the past decade, according to a message from Acting Director Richard Best and Acting Deputy Director Joy Thompson. “The annual publication of our examination priorities furthers the SEC’s mission and aligns with the division’s four pillars to promote and improve compliance, prevent fraud, monitor risk and inform policy,” they said. “The examination priorities have taken on greater prominence over the years and have become an important tool for the examination program.”

Total examinations and deficiencies

Exams ticked up 3% in the last fiscal year to 3,040 overall, with more than 2,000 deficiency letters prompting firms to return more than $45 million to their clients. Examiners referred 190 potential cases to the SEC’s Enforcement Division as well. “We are incredibly proud of the staff’s continued efforts this past year to perform meaningful examinations remotely while contending with the ongoing impacts of the COVID-19 pandemic,” the report states. “As we move further into FY22, we anticipate there will be more money returned to investors, and there will be additional referrals to Enforcement resulting from our FY21 examinations.”

Share of RIAs facing exams each year

More than 2,200 RIA exams pushed up the share receiving an audit slightly in the last fiscal year to 16% of firms from 15% in the prior two. After a record 900 new RIAs registered in 2021, the number of advisory firms has jumped by 20% to more than 14,800 in the past five years. The amount of RIAs with more than $10 billion in assets under management has surged by 30% during that span. In addition, 60% of RIAs are affiliated with other financial firms and over 35% manage a private fund. “Although there was a slight increase in the coverage percentage in FY21, we will likely soon have to lower our annual coverage target as the growth in the number of RIAs continues to grow at a rate that far outpaces staffing increases,” the report states. “The growth in the numbers of RIAs does not fully capture the increasing complexity of the asset management industry, and the resulting increased complexity of the compliance issues and risks covered by our examinations.”

Regulator seeking more Enforcement and Examinations staff

The SEC is seeking to hire 400 additional staff members across the agency, including 215 new employees for the Enforcement and Examinations divisions, according to its budget request to Congress for fiscal year 2023. The 125 new Enforcement employees would “enhance the division’s ability to timely pursue the wide variety of misconduct” and bulk up its ability “to investigate new and emerging issues” such as crypto assets, cybersecurity and ESG criteria,” according to the regulator. An additional 90 staff members on top of its roughly 1,000 in the Examinations division would be “critical and necessary to help [the division] address the ongoing disparity between the number of exam staff and the size of the SEC-regulated community,” the budget request states. “A majority of the requested resources will focus on examinations of investment advisers and broker-dealers, as these entities are critical market participants interacting with a rapidly growing retail sector.”

A word on the word ‘compliance’

The removal of the word “compliance” from the Examinations division’s name prompted speculation among some that the unit “intended to deemphasize our long-standing focus on and commitment to promoting compliance and to empowering compliance officers,” according to the exam priorities report. The agency is seeking to disavow anyone of that idea. “While many registrants demonstrate the value and importance they place on compliance, far too often we examine registrants where that is not the case,” the report states. “Compliance officers must be empowered and receive support in the form of resources and a tone from the top that recognizes their contributions. Senior officers and executives empower compliance and compliance officers through their words and actions.”

Private funds

The amount of assets held by private funds that are managed by RIAs has soared by 70% over the past five years to about $18 trillion, according to the exam priorities report. In 2022, examiners will home in on how firms calculate and allocate their fees, compliance with the Advisers Act Custody Rule and conflicts of interest relating to liquidity events such as times when new investors buy the holdings of existing ones, among other areas. “Given the significance of examination findings over the past several years, and the size, complexity, and significant growth of this market, the Division will continue to prioritize our focus on RIAs to private funds,” the report states.

ESG criteria

The lack of universal standards in ESG criteria and a vast range of products aimed at one goal or another have made it challenging for RIAs to address the rising attraction among clients, the SEC says. This year, exams will place a priority on accurate disclosures of any ESG criteria or methods, the alignment of shareholder votes with a firm’s stated policies and any exaggerations in marketing. “RIAs and registered funds are increasingly offering and evaluating investments that employ ESG strategies or incorporate certain ESG criteria, in part to meet investor demand for such strategies and investments,” according to the report. “There is a risk that disclosures regarding portfolio management practices could involve materially false and misleading statements or omissions, which can result in misinformed investors.”

Reg BI, fiduciary duty and Form CRS

About two years after the effective date of Reg BI and following more than 40 cases involving the new Form CRS, examiners plan to probe brokerage firms’ sales practices, cost evaluations and compensation structures and look closely at the revenue sharing, share-class selection, wrap fee accounts and proprietary products of certain RIAs. At firms that have the dually registered structure of most large wealth managers, the division will focus on high-fee and proprietary products, incentives that could place a firm’s interest ahead of its clients and compensation models that “inappropriately influence investment recommendations,” according to the report.

Information security

After the SEC issued a rule proposal in February that would create new cybersecurity requirements for RIAs, the agency’s examiners plan to inspect advisory firms’ compliance with existing guidelines. In particular, the exams will check for safeguards of client accounts, management of vendors, processes for responding to malicious email attacks, incident response plans, detection of identity theft threats and risks relating to remote work. “Applying information security controls is critical to ensuring business continuity,” according to the SEC. “Vigilant protection of data is also critical to the operation of the financial markets and the confidence of its participants.”

Emerging tech and crypto assets

RIAs “offering new products and services or employing new practices” such as fractional shares or working with so-called Finfluencers should expect many questions from examiners in 2022, the report states. The audits will revolve around an RIA’s operations and whether they have controls in place that “take into account the unique risks associated with such practices,” the SEC says. “Examinations of market participants engaged with crypto assets will continue to review the custody arrangements for such assets and will assess the offer, sale, recommendation, advice and trading of crypto assets,” the report states.

Typical RIA exam description

This year, examiners will be tasked with assessing advisory firms’ oversight of “any heightened risks” from employing advisors with prior disciplinary histories, a recent migration from a brokerage business model, operating many branches simultaneously and fee errors, according to the report. “As in previous years, the Division prioritizes RIAs and registered funds that have never been examined, including recently registered firms, and those that have not been examined for a number of years,” the report states. “Typically, these examinations focus on firms’ compliance programs.”

Remarks

The 2022 report identifies “key risk areas that we expect registrants to address, manage and mitigate with vigilance,” SEC Chair Gary Gensler said in a statement. “Investment advisers, broker-dealers, self-regulatory organizations, clearing firms and other registrants are critical market participants, and examinations against our laws and rules are fundamental to instilling the trust necessary for our markets to thrive.”

The issues come with even more importance “in this time of heightened market volatility,” Best, the acting director of examinations, said in a statement. “Our priorities are tailored to focus on emerging issues, such as crypto assets and expanding information security threats, as well as core issues that have been part of the SEC’s mission for decades — such as protecting retail investors,” Best said. “Our priorities cover a broad landscape of potential risks to investors that firms should consider as they review and strengthen their compliance programs.”