SEC Examination Priorities 2023 Review

The SEC’s Division of Examinations (“EXAMS”) has published its priorities for 2023. EXAMS is responsible for overseeing registered investment advisers, exempt reporting advisers, broker-dealers and other SEC-regulated entities. Understanding the publication will help examined practitioners prepare themselves for the future and avoid unexpected noncompliance.

EXAMS articulated the priorities to promote their four primary goals: (1) promote compliance; (2) prevent fraud; (3) monitor risk and (4) inform policy. Each area of focus should support these “four pillars.”

  1. Recently Adopted Rules

Marketing Rule (Advisers Act Rule 206(4)-1)

Registered investment advisers (“RIAs”) must adopt and implement written policies and procedures that prevent violations. They must also be able to demonstrate that they had a reasonable basis for believing the material facts they put forth.

Derivatives Rule (Investment Company Act Rule 15f-4)

Funds must adopt and implement policies and procedures to manage their derivatives risks and prevent violations. This should include a risk management program, board oversight and complete and accurate disclosures.

Fair Valuation Rule (Investment Company Act Fair Valuation Rule 2a-5)

Funds must properly oversee the determinations of fair value and comply with policies and procedures of reporting and recordkeeping. EXAMS will also specifically look for adjustments to valuation methodologies.

  1. Private Funds

RIAs to private funds should be aware of (1) conflicts of interest; (2) calculations and allocation of fees and expenses; (3) the Marketing Rule; (4) use of alternative data (Advisers Act Section 204A); and (5) the Custody Rule (Advisers Act Rule 206(4)-2).

EXAMS notes that private funds exhibiting any of these specific risk characteristics will receive heightened scrutiny:

  • Highly-leveraged
  • Managed side-by-side with BDCs
  • Use of affiliated companies and advisery personnel to provide services to clients
  • Holding certain hard-to-value investments, such as crypto and real estate
  • Invested in or sponsor Special Purpose Acquisition Companies (SPACs)
  • Involvement in adviser-led restructurings
  1. Standards of Conduct

Broker-dealers and RIAs servicing retail investors must prioritize the investor’s best interest ahead of the firm’s or professional’s interests. Carefully manage, and fully disclose, conflicts of interest. Special attention is paid to more complex investment products and advice or recommendations given to certain vulnerable investors. EXAMS notes they will be looking for inappropriate attempts to waive or limit standards of conduct, such as hedge clauses. Lastly, ensure compliance with Form CRS (Client or Customer Relationship Summary).

  1. Environment, Social and Governance (ESG) Investments

Investments and strategies bearing the Environment, Social and Governance (ESG) label will be scrutinized to ensure they operate as set forth in disclosures. Any recommendations of such products for retail investors must be in the investor’s best interest.

  1. Informational Security and Operational Resiliency

Broker-dealers and RIAs must plan and act to safeguard against cyberattacks and other disruptions. EXAMS specifically notes the cybersecurity vulnerabilities associated with third-party vendors. They also note the need to consider climate-related risks.

  1. Crypto Assets and Emerging Financial Technology

New or never before examined registrants interacting with crypto-related assets should prepare for examination. EXAMS will specifically look for adequate standards of care and routine review, update and enhancement of compliance, disclosure and risk management practices. Firms employing digital engagement practices will also receive more scrutiny.

  1. Investment Advisers and Investment Companies

EXAMS will examine RIAs’ operations and compliance practices. Accuracy of regulatory filings is key and EXAMS expects consideration of current market factors in the related valuations. EXAMS will pay special attention to RIAs’ fee calculations and alternative revenue streams.

Exams emphasizes the fiduciary obligations of RIAs to registered investment companies. Funds with these specific characteristics will receive heightened scrutiny:

  • Turnkey funds
  • Mutual funds that converted to ETFs
  • Non-transparent ETFs
  • Loan-focused funds
  • Medium and small fund complexes that have experienced excessive staff attrition
  • Volatility-linked ETFs
  • Single-stock ETFs
  • New, unexamined or not recently examined investment companies
  1. Broker Dealers

EXAMS will focus on broker-dealers’ compliance and supervisory programs, including those for electronic communications and recording those communications. EXAMS note special interest in issues specific to equities, fixed income securities, over-the-counter securities and microcap securities.

  1. Clearing Agencies

Registered clearing agencies should emphasize procedures for risk management including maintaining sufficient financial resources, protecting against credit risks, managing member defaults and managing operational and other risks.

  1. Regulation SCI

EXAMS will focus on the security and reliability of certain technological trading platforms.

  1. Anti-Money Laundering

Firms must establish appropriate customer identification programs and satisfy their SAR filing obligations. EXAMS will examine for full compliance with the Bank Secrecy Act.

  1. Discontinuation of LIBOR

EXAMS notes the potential disruption that discontinuation of the London Interbank Offered Rate happening in mid-2023 may cause. EXAMS will assess whether broker-dealers and RIAs are prepared for the transition.

3 Ways Crypto Prepares for Looming Regulation

Uncle Sam is taking “internet money” seriously.

As a result, elected officials are spending more time talking about crypto.

Do you know what that means? Regulation will follow the buzz.

In an interview with Yahoo!, U.S. Rep. Jim Himes (D-Conn.) characterized the current crypto climate as a showdown with Securities Exchange Commission Chairman Gary Gensler: “We’re sort of in a vapor lock around this issue of the registration of entities, exchanges, etcetera with Gary Gensler at the SEC saying, ‘I don’t need more statute. I’ve got all the law I need. What I need is for people to comply.’ And, of course, many people are saying, ‘Well, we don’t agree with that, and we are not going to comply’. So that suggests we are going to need to figure out whether additional statute is necessary, and Gary Gensler is wrong or whether Gary Gensler just needs to do a lot more enforcement to get people to see his point of view, that they should be registering under existing law.”

To make things more interesting, former SEC Chair Jay Clayton disagrees with Gensler’s stance, asking the agency to provide guidance on the custody of tokenized assets. In an op-ed piece, Clayton said the SEC should take the next step and present guidelines for crypto assets.

In the meantime, Gensler has embraced regulation through enforcement. He firmly believes the existing security laws on the books are fine for crypto.

So, what’s the play?

Here are three moves that will help small/midsize crypto companies prepare for looming regulation:

Register With The SEC

There remains a cavalier mindset about crypto. And that needs to change.

Crypto is not like going outside and throwing the frisbee, even though there is social media chatter about “going to the moon.” It is not fun and games; Crypto is an actual financial asset that has value. The notion that crypto is a novel, foreign idea wrapped in technology needs to give way to reality.

To protect your company, now is the time to register with the SEC. Long-awaited regulation for cryptocurrency is on the horizon. It is better to prepare now to fit into the current scheme than sit on the sidelines.

Do not wait for the government’s final verdict. Err on the side of caution. It is better to fill out more paperwork and “over-comply” than wait one year later to have the Securities Exchange Commission come knocking. When the agency files a complaint against your company, your reputation could take a hit—along with a hefty legal bill.

Eliminate ‘Dirty’ Money

Part of crypto’s allure is its anonymity, which could make it a prime vehicle for fraudulent activity that includes funding for terrorism. The government will soon introduce regulations that strongly encourage crypto companies to have anti-money laundering programs in place.

No matter how small your company is, you will need to have a designated compliance officer on the payroll. This person can perform other duties, but they must have the title. They also must maintain written policies and procedures. The anti-money laundering plan should be well thought out and detailed, not a two-page report. Ideally, your compliance officer would have the proper credentials, such as the ALMA designation, and appropriate experience. Each organization involved in a chain of transactions involving “dirty money” is accountable.

Sens. Elizabeth Warren (D-Mass.) and Roger Marshall (R-Kan.) have introduced The Digital Asset Anti-Money Laundering Act of 2022, which extends the Bank Secrecy Act. The objective is to subject crypto companies to the same rules as banks and broker-dealers. The bill would address a gap with digital wallets and prohibit financial institutions from transacting with forms of technology that enhances anonymity. Last summer, the currency-mixer Tornado Cash was sanctioned by the U.S. Department of Treasury, alleging money laundering activity with North Korea.

Add A Layer of Governance

Governance is a big part of compliance.

Board members can play a pivotal role. You will need seasoned professionals in many areas, ranging from marketing to technology. Make sure you have board members with deep experience in finance, compliance and internal controls.

Know Your Customer (“KYC”) is a process that identifies your customers and their activities. From a corporate level, do you have the entity’s EIN, articles of incorporation and financial statements? For individual investors, should you recommend a volatile asset to an investor in her 90s? What’s the rest of the story? What are the procedures to address these situations?

Back in 2019, the Commodities Futures Trading Commission, Financial Crimes Enforcement Network and SEC classified crypto exchanges as money service businesses (MSBs), which means they must follow the Bank Secrecy Act of 1970, as well as the anti-money laundering and KYC rules.

While your staff manages the day-to-day operations, your board members can still be part of the mix. Give them oversight of key committees, such as risk and compliance, to provide another layer of review, which would protect the firm.

(Tyler Rutherford is an associate attorney at Pastore with expertise in regulatory compliance, contract law and corporate law. He represents a wide range of clients, including crypto and blockchain companies.)

Pastore represents founder of only Private Mountain Ski Club on the East Coast in Federal Court Settlement

Pastore LLC represented the founder of the only Private Mountain Ski Club on the East Coast in connection with a dispute in Federal Court.  The Club, which is the East Coast version of the Yellowstone Club, is located in southern Vermont.    The dispute centered around UCC Article 9 and the complex assignment of interests in a LLC under Connecticut law.   The founder had an economic interest in a Limited Liability Company, which had an economic interest in a $11M 6 pack bubble chair, and the founder assigned that interest to a GRAT Trust.   As part of the settlement, the GRAT Trust will receive a distribution from the Limited Liability Company.   Monies will also flow to a former club employee and real estate developers.