SEC Releases Risk Alert for Investment Advisers: Assessing Risks, Scoping Examinations, and Requesting Documents

This piece has been published in conjunction with FinTech Law's sister firm and compliance partner, Joot.

As we've mentioned in previous blog posts, the registered investment adviser (“adviser”) count and financial landscape has grown exponentially over the past few years and shows no signs of stopping. As such, new regulations, proposed rules, and other information continue to expand from industry governing and regulating bodies such as the SEC. Recently, the SEC provided a risk alert that provides insight regarding adviser examinations and gave the industry an inside look at its typical initial request list for documents when conducting an adviser exam. In this piece, we'll discuss the SEC's exam risk alert, their risk-based examination approach, and some of the items they look for when conducting an examination.

The SEC's Primary Examination Selection Approach

According to their alert, the SEC explains that it takes a specific risk-based approach when selecting which advisers to examine. The SEC considers its approach dynamic in that it varies and adjusts based on changes in financial market conditions, general industry practices, and even investor preferences. The SEC utilizes technology to aggregate and decipher large sets of both industry and firm-level data that help them better identify specific risks and better understand a firm's business and practices during the examination. Along with technology, the SEC also carefully reviews a firm's individual disclosure documents and filings (i.e., Form ADV).

How Does the SEC Select Which Firms to Examine?

We know that the adviser space is vast and includes advisers of all shapes and sizes, so it's important to understand specifically how the SEC determines which advisers they will examine. Here the SEC lists a few specific reasons for selection. These may include, but aren't limited to:

• A firm's risk characteristics.
• A tip, complaint, or referral.
• The SEC's interest in a particular compliance risk area.

Another selection factor comes from the SEC's published list of risk priorities. In a previous FinTech Law blog, we discussed the SEC's annual priorities for 2023 and the carryover of items from 2020 to 2023. The SEC also considers which advisers provide services, or products or may meet criteria relevant to their specific focus areas for a given year.

The SEC also mentions firm-specific risk factors that are considered when selecting advisers for examination. Among others, some of the firm-specific items the SEC may consider include:

• Prior examination observations and conduct, such as when the staff has observed what it believes to be repetitive deficient practices during more than one review of a firm, significant fee- and expense-related issues, and significant compliance program concerns.
• Supervisory concerns, such as a disciplinary history of associated individuals or affiliates.
• The length of time since the firm's registration or last examination, such as advisers newly registered with the SEC.
• Indications that the adviser might be vulnerable to financial or market stresses.
• Whether the firm has access to client and investor assets and/or presents certain gatekeeper or service provider compliance risks.

How Does the SEC Select Examination Focus Areas?

While many of the factors used for selecting an adviser have crossover, the scope of an examination and the specific items requested through that examination will vary from firm to firm based on a firm's business model and clientele, any associated risks, or even specific reasons for conducting the exam.

But the SEC states that examinations typically include but are not limited to:

• Reviewing advisers' operations.
• Disclosures.
• Conflicts of interest.
• Compliance practices regarding certain core areas including areas such as custody, safekeeping of client assets, or best execution.

In requesting documents associated with these focus areas the SEC works to understand an adviser's potential conflicts of interest and risks as well as the effectiveness of a firm's compliance policies and procedures for monitoring and managing such conflicts of interest and risks.

What Kind of Documents Does the SEC Request?

The SEC will request a myriad of documents during an examination so an adviser should be prepared to provide information of any kind. This could range from general firm information to information about specific staff functions and compliance practices and everything in between. Included in this alert, the SEC provides an example of a typical exam request list that will be sent to investment advisers when the exam is announced. We recommend reviewing this list to properly understand what documents you may be asked to provide in an examination.

How Do You Prepare for an SEC Examination?

Our partners at our sister firm, Joot, have previously spoken about how to manage an SEC exam and what advisers can do to set themselves up for success in the wake of an SEC exam, but preparation will vary from firm to firm. A variety of factors determine levels of preparation, including the robustness of a firm's compliance program and procedures. A compliance consultant such as Joot can help your firm assess the strength of its compliance program, identify any significant gaps or weaknesses, and bolster the robustness of procedures of an internal compliance program. These assessments and adjustments can drastically assist in the preparation and/or management of any kind of SEC exam. Contact FinTech Law to learn how to strengthen your compliance program and avoid unnecessary risks.