These Compliance Issues Are Top of Mind for Regulators. Are You Ready?

Investment advisors — and the attorneys that represent them — face a torrent of issues in 2022. Since January, the Securities and Exchange Commission has issued 11 new proposals, all while advisors are busy prepping for the Nov. 4 compliance date for the agency’s game-changing marketing rule.

Despite the SEC exam division continuing to struggle to keep pace with exams of investment advisors, industry attorneys see the agency and the Financial Industry Regulatory Authority ramping up exams of firms’ compliance with Regulation Best Interest.

Daniel Kahl, acting director of the SEC Division of Examinations, warned Friday at the Investment Adviser Association’s compliance conference that while the agency’s advisor exam rate reached 16% last year, the division has “squeezed out” its resources.

He questioned whether the regulator could reach a 15% exam rate in 2022. “We’re going to try to target 15%” of firms to examine, he said.

The number of examiners, Kahl reported, “has not materially increased for many years” as the number of RIAs increases, he said, adding that the number of net new advisors reached an all-time high in 2021.

IAA’s 2021 Investment Adviser Industry Snapshot found that the total number of firms registered with the SEC in 2021 hit a record high of 13,880 — an increase of 386 firms, or a 2.9% boost, from 2020. The number is drawn from data reported to the SEC on Form ADV.

Kahl stated at the IAA event, held in Washington on March 3-4, that examiners are still “completely remote” with plans to be back in the office in early June.

When onsite exams will resume, however, remains uncertain. “We’ve been very effective operating remotely,” Kahl said. “We don’t see the need to be aggressive” when it comes to onsite exams.

That said, the exam division is “going to push out” as many Risk Alerts as it can this year, Kahl added.

Reg BI Focus

In 2022, the priority for FINRA in examining BDs’ compliance with Reg BI “is to make sure that written supervisory provisions are, in fact, in place and to foster compliance with the rules,” Sandy Grannum, partner with Faegre Drinker, said on a recent webcast. FINRA also wants to see that BDs “are actually training individuals to make sure that they are capable of complying with the rules, and that there’s adequate disclosures to the public on what it is they’re doing.”

FINRA’s recently released 2022 exam report should serve as a Reg BI guidebook as it provides feedback on what FINRA deemed “faulty” compliance.

Jim Lundy, partner at Faegre Drinker in Chicago, added on the webcast that while Reg BI applies to broker-dealers, the SEC, under Chairman Gary Gensler, “is continuing to scrutinize” the investment advisory industry.

“We’re seeing more and more examinations with alleged violations of Section 206 — the statute that applies the fiduciary standard,” Lundy said. Best interest is “definitely much more aligned than it was historically … We see the term ‘best interest’ expressed under Section 206 findings and deficiency letters and referenced back to the Commission’s guidance that came out with Reg BI” in June 2020.

That commission guidance “talks about ‘best interest,’ while it does not define it, as a requirement under the fiduciary standard,” Lundy continued. “… We’re seeing the examination program aggressively use their tactics to allege findings under Section 206 and talk about ‘best interest.’”

For advisors and broker-dealers “that have not been examined in the last several years, we’re starting to see the examination program request payments back to clients for violations of Section 206 in the deficiency letters.”

SEC Rule Proposals

Karen Barr, president and CEO of IAA, noted during the conference the barrage of SEC proposals that the agency has issued — with short comment periods — since January.

The 11 proposals address such issues as cybersecurity rules for advisors, whistleblower and private fund rules.

Advisors aren’t fans of the SEC’s new cyber rules for advisors. Barr told SEC Commissioner Caroline Crenshaw during the IAA event that IAA’s members “take cybersecurity very seriously; it’s very important to them,” Barr said. “They already believe that the cybersecurity policies and procedures are required under the compliance program rule.”

IAA intends to submit “extensive” comments on the rule, Barr told Crenshaw. Comments are due to the agency by April 11.

William Birdthistle, director of the SEC’s Division of Investment Management, noted at the IAA even that “assets in separately managed accounts and private funds have swollen to around $43 trillion and $18 trillion, respectively, and include individuals, institutions, governmental and private pension funds, and nonprofit organizations.”

Approximately 46 million individuals currently receive services from RIAs, Birdthistle noted, with nearly 15,000 advisors reporting more than $110 trillion in assets under management.

Birdthistle noted that he’s interested “in considering ways to bring order to the new frontier of crypto assets and the expanding use of digital technology.”

He noted that “the expanding opportunities to invest in securities directly using digital platforms, such as robo-advisors, online brokerages, and mobile investment apps and portals, also present challenges.”

SEC Marketing Rule

Gail Bernstein, general counsel at IAA, stated at the event that IAA and its members have identified a lot of “interpretive” issues with the marketing rule that need further guidance. However, advisors “should not wait” until guidance is issued before they start getting their policies and procedures ready to go, she said.

Advisors will also have to contend with new Form ADV requirements related to the marketing rule, she said.

Bernstein told me in an email that for advisors with a Dec. 31 fiscal year end, their Form ADV filing in March 2023 must include responses to new Item 5.L.

“The new item asks if any of the adviser’s advertisements include performance results, specific investment advice, testimonials, endorsements, or third-party ratings,” Bernstein explained. “If so, the adviser must report whether it provided cash or non-cash compensation in connection with their use. The adviser must also report if it used advertisements with hypothetical performance or predecessor performance.”

Sanjay Lamba, associate general counsel at IAA, told me Monday that when it comes to the SEC’s advertising rule, advisors need more clarity regarding performance advertising, “which is a big chunk” of the rule. Some examples include how to calculate net performance fees.

Other questions remain concerning placement of performance advertising, Lamba said, as well as the definition of advertising, which is “pretty expansive” and also includes “indirect advertising.”

Christine Ayako Schleppegrell, senior counsel at the SEC, said at the IAA event that while the agency may consider further guidance on certain advertising rule topics, advisors should move ahead with compliance.

The law firm Eversheds Sutherland released in mid-February a marketing rule checklist for advisors to use as they prep for the Nov. 4 compliance date. Cliff Kirsch, partner and head of the Investment Services practice group at Eversheds, said in releasing the checklist that “legal and compliance personnel at advisory firms who are tasked with making sure their firms are in compliance with the new rules have a big job ahead of them over the next few months.”

Robo-Advisors in the Crosshairs

Adam Aderton, co-chief of the SEC’s Asset Management Unit, housed within the Division of Enforcement, noted at the IAA event that the agency has levied five actions against robo-advisors, three of them since last June.

“We follow where the money goes,” Aderton said. “Robo-advisors are projected to have something like $1 trillion in assets under management in the next couple years. So I think it’s quite likely that we’ll continue to see actions in that space as assets go that way and particularly areas like startups where they don’t have as robust of a compliance infrastructure as they try to get into a new area.”