What’s on the agenda?

Meeting the heightened SEC requirements with innovative technology,

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The number of proposed regulations and risk alerts put out by both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have made it clear the regulatory bodies plan to heighten the pressure on compliance requirements across several areas, including cybersecurity, cryptocurrency and what some have referred to as a “novel approach” to insider trading.

With such arduous requirements, the onus has been placed on firms to act quickly and decisively, defining and integrating new policies and procedures to meet the SEC’s demands.

Part #1

Breaking down the SEC’s priorities

While not a complete representation of the SEC’s priorities, these key areas make up some of the most significant changes being brought by the SEC in 2022.

PRIVATE FUNDS

The SEC will be examining these types of firms with a fine-tooth comb, looking for any deficiencies as it relates to the Investment Advisers Act of 1940 or risks pertaining to items such as disclosures, best interests, and MNPI.

The SEC will be focusing their reviews on:
“(1) The calculation and allocation of fees and expenses, including the calculation of post commitment period management fees and the impact of valuation practices at private equity funds.
(2) The potential preferential treatment of certain investors by RIAs to private funds that have experienced issues with liquidity,
including imposing gates or suspensions on fund withdrawals.
(3) Compliance with the Advisers Act Custody Rule, including the “audit exception” to the surprise examination requirement and related reporting and updating of Form ADV regarding the audit and auditors that serve as important gate-keepers for private fund investors.
(4) The adequacy of disclosure and compliance with any regulatory requirements for cross trades, principal transactions, or distressed sales.
(5) Conflicts around liquidity, such as RIA-led fund restructurings, including stapled secondary transactions where new investors purchase the interests of existing investors while also agreeing to invest in a new fund.”

INFORMATION SECURITY AND
OPERATIONAL RESILIENCE

Firms must ensure that all cyber activity is consistent with the stated requirements necessary to adequately protect a client’s critical information. As it relates to hybrid-work and the associated challenges that come with it, cybersecurity and “operational resilience” policies and procedures must reflect the new environment in which business is being conducted.

The SEC will focus their reviews on:
“(1) Safeguard customer accounts and prevent account intrusions, including verifying an investor’s identity to prevent unauthorized
account access.
(2) Oversee vendors and service providers.
(3) Address malicious email activities, such as phishing or account intrusions.
(4) Respond to incidents, including those related to ransomware attacks.
(5) Identify and detect red flags related to identity theft. (6) Manage operational risk as a result of a dispersed workforce in a work from-home environment. In the context of these examinations, the Division will focus on, among other things, broker-dealers’ and RIAs’ compliance with Regulations S-P and S-ID, where applicable.”

ESG INVESTMENTS

ESG-related investments have skyrocketed recently, with many investors looking at these types of investments as a means to increase their economic standing while simultaneously doing good for the world at large. The SEC takes issue when “materially false and misleading statements or omissions, which can result in misinformed investors.” In other words, they are taking specific efforts to reduce any and all greenwashing-related activities.

The SEC will be focusing their reviews on:
“(1) accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices designed to prevent violations of the federal securities laws in connection with their ESG-related disclosures, including review of their portfolio management processes and
practices.
(2) Voting client securities in accordance with proxy voting policies and procedures and whether the votes align with their ESG-related disclosures and mandates.
(3) Overstating or misrepresenting the ESG factors considered or incorporated into portfolio selection (e.g., greenwashing), such as in their performance advertising and marketing.”

STANDARDS OF CONDUCT

This focus area is all about the client’s best interest. From conflicts of interests to disclosures, the SEC’s aim is to ensure all advisors place their client’s interest ahead of their own.

The SEC will focus their reviews on:
“(1) Revenue sharing arrangements.
(2) Recommending or holding more expensive classes of investment products when lower cost classes are available (e.g., RIAs that recommend no transaction fee mutual fund share classes that have 12b-1 fees in wrap fee accounts where the RIA may be responsible for paying transaction fees).
(3) Recommending wrap fee accounts without assessing whether such accounts are in the best interests of clients, including the impact of the move to zero commissions on certain types of securities transactions by a number of broker-dealers.
(4) Recommending proprietary products resulting in additional or higher fees. Such reviews also will include an assessment of the adequacy of RIAs’: (1) compliance policies and procedures designed to address conflicts and ensure advice in the best interest of clients, including the cost of investing; and (2) disclosures to enable investors to provide informed consent.”

EMERGING TECHNOLOGIES AND CRYPTO-ASSETS

The evolving decentralized financial ecosystem has presented new compliance concerns, which the SEC, along with other governing bodies, have consistently made note of. While these new forms of investment open the door to potential revenue streams for clients, the SEC’s main concern is whether the “unique risks these activities present were considered by the firms when designing their regulatory compliance programs.”

The SEC will focus their reviews on:
“(1) Have met their respective standards of conduct when recommending to or advising
investors with a focus on duty of care and the initial and ongoing understanding of the products (e.g., blockchain and cryptoasset feature analysis).
(2) Routinely review, update, and enhance their compliance practices (e.g., crypto-asset wallet reviews, custody practices, anti-money laundering reviews, and valuation
procedures), risk disclosures, and operational resiliency practices (i.e., data integrity and business continuity plans). In addition, the Division will conduct examinations of mutual funds and ETFs offering exposure to cryptoassets to assess, among other things, compliance, liquidity, and operational controls around portfolio management and market risk.”

Download our comprehensive checklist to ensure your compliance program meets the requirements of the SEC’s 2022 agenda.

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Part #2

A Closer Look at the “Novel Approach” to Insider Trading

The word unprecedented has become vastly overused in the past few years. However, in the case of the SEC’s view on shadow trading, there is no more apt terminology. Let’s break it down and see why shadow trading could prove to be one of the biggest clouds over your compliance team this year.

The History: To be clear, the misuse and abuse of MNPI has always been a top priority and strategic focus of the SEC. However, in the past, the SEC relegated the scope of their rulings and associated sanctions to only include the trading activity regarding the direct subject of the MNPI.

For example, an employee buying stock in Company X because they overheard critical information regarding Company X’s new product which is predicted to change the market would be subject to potential sanction and litigation.

The Case: The case behind the “novel” approach to insider trading?

“SEC v. Panuwat, an insider trading case accusing a former pharmaceutical company employee of trading in a competitor’s stock ahead of a merger. This novel US Securities and Exchange Commission (SEC) enforcement action involves “shadow trading”—using inside information relating to one company to trade the stock of a separate, but comparable, company.”

National Law Review

The Impact: By expanding the scope of their rulings, the SEC has broadened the definition of insider trading, leaving firms with the challenge of adjusting their policies and procedures – and potential investigations – to include both direct and indirect subjects of MNPI. Understanding how big of an impact this will have on your firm’s program will require an in-depth examination of your existing policies. A quick checklist includes:

  • What is currently classified as MNPI and does it include comparable organizations
  • The system you use to track who has access to what information within your organization
  • The level to which you monitor broker feeds for employee trading activity
  • The investigative process through which you ascertain whether a rule violation has occurred
  • Any reporting metrics or documentation the SEC may require from your firm
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2022 SEC Enforcement Agenda Checklist

Download our SEC Agenda infographic and comprehensive checklist to ensure your compliance program meets the requirements of the SEC’s 2022 agenda.

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