Financial Institutions Law Alert

It is clear that environmental, social, and governance (“ESG”) issues will be an “enhanced focus” for the SEC in 2021. See, the regulator’s recent announcement of an ESG task force and the Division of Examinations priorities letter for 2021.  However, whether that enhanced focus results in a material change to the regulator’s practices is, according at least to two of its commissioners, “not yet clear.”  As commissioners Hester Peirce and Elad Roisman discussed in a recent public statement, the Commission has already been focusing on climate-related issues for “decades,” and put into context, these recent ESG initiatives look more like a “continuation of the work staff has been doing” than “a program to assess public filers’ disclosure against any new standards.” As we wait for additional guidance related to these initiatives, firms and regulatory professionals can draw important insights (ESG-related and otherwise) from the recent SEC’s announcements in advance of upcoming examinations. Below, we summarize the important takeaways from these releases:

OCIE is now the “Division of Examinations.” In case you missed the December 2020 announcement, the Office of Compliance Inspections and Examinations has been renamed the Division of Examinations (with the new shorthand terms “Division” or “EXAMS”). This recent priorities letter is the first under the Division’s new title.

The Event and Emerging Risks Examination Team (“EERT”). Under the umbrella of EXAMS, the SEC recently formed EERT with a mission of proactively engaging firms on “emerging threats” in the market. In addition, EERT will be responsible for developing resources to quickly respond to critical market events in a coordinated, tactical manner. While not explicit in the announcement, EERT’s formation is likely a response to the market volatility around “meme stocks” and the operational challenges resulting from the COVID-19 pandemic.

LIBOR. Most LIBOR rates will end publication at the end of the year. EXAMS will focus on firms’ transition plans and areas of exposure for de-linking from the former lending rate standard.

Environmental, Social and Governance (“ESG”). The new ESG task force and EXAMS will both focus on RIAs and fund complexes that offer sustainable, socially responsible or “ESG conscious” investments, with a particular focus on potential “disclosure gaps” regarding the nature of those investments, the firm’s role in creating or distributing those investments, and whether the firm uses its proxy voting powers in line with its representations to investors. 

FinTech and Digital Assets. With the dramatic rise in the use of digital interfaces with customer trading activity and the eye-popping volatility seen in certain digital assets (e.g., Bitcoin), examinations will focus on whether firms’ practices are consistent with the representations they make to customers seeking out those digital platforms/assets. EXAMS will further look at firms’ supervisory policies around trade recommendations – specifically, whether such recommendations are occurring with mobile trading applications. The Division will also focus on best execution and order-routing, echoing FINRA’s recent examination priorities letter that also highlighted concerns around best execution, mobile trading applications and communications with the newer, tech-savvy investing public. And while RegTech has enabled many firms to implement their policies in a more efficient manner, EXAMS noted a rapid growth in RegTech-reliance and cautions firms from misusing this emerging technology.

Global Risk. An increase in the number of offshore RIAs (now over 900 managing $12 trillion in investor assets) has led to heightened concern over cybersecurity, data protection and cross-border applications. Firms with an international presence should expect EXAMS to focus on their cybersecurity and privacy programs and how they are applied overseas. Additionally, firms with a presence in the United Kingdom will be a focus for any customer impact resulting from Brexit.

Private Fund Advisers. With a little more than one third of RIAs acting as “private fund advisers,” the Division will review private fund advisors for evidence of preferential treatment of investors during liquidity events, portfolio valuation impact on management fees, disclosures around cross trades, principal investments and distressed sales, and advisor-led restructurings such as “stapled secondary transactions.”

Retail Investors, Regulation Best Interest (“Reg. BI”) and Form CRS. The “good faith” grace period for Reg. BI and Form CRS reviews is likely coming to an end. With the priorities letter, EXAMS signaled that 2021 examinations on those topics will include an “expanded scope” to assess whether broker-dealers have a reasonable basis to believe that recommendations are in the best interest of the client, and will also include “enhanced transaction testing” as part of those examinations. Other areas of focus for examiners include complex product recommendations, rollovers, procedures for considering reasonably available alternatives, conflicts of interest, and compensation under the new Reg. BI rubric.

Broker-Dealers, Best Execution and Zero Commission Models. EXAMS will focus on several areas concerning the safety of customer cash and securities, best execution in light of the effects of evolving commissions and other cost structures, certain types of trading activity, and the operations of alternative trading systems with a review of whether firms are complying with the Customer Protection and Net Capital Rules. Similar to the FINRA examination priorities focus, the Division highlighted best execution obligations in the ever-expanding “zero commissions” trading environment. This focus will include enhanced scrutiny around “payment for order flow” and its possible effect on order routing and best execution obligations. These issues were brought to the forefront with recent congressional hearings and regulatory scrutiny following the GameStop Corp. market volatility and “meme stock” explosion.  Accordingly, firms should expect EXAMS to focus heavily on this area.

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