On February 7, 2023, the SEC Division of Examinations released its annual risk alert focusing on SEC conclusions after its routine examination of newly registered investment advisors. The risk alert highlights common compliance issues that the SEC found during their examinations, and provides guidance for newly registered investment advisors to address these issues.
One of the major issues highlighted in the risk alert is the use of forgivable loans. Many advisors have clients who took out the forgivable loans, and some wealth management firms did the same. Three years after the government forgave the loans, the SEC found that many advisors were still not properly disclosing these loans to their clients. This lack of disclosure can be a violation of the Investment Advisers Act of 1940.
Another issue highlighted in the risk alert is pay-to-play violations. Ki Hong and Tyler Rosen of Skadden, Arps, Slate, Meagher & Flom LLP examine the impact of the SEC Pay-to-Play rule on investment advisors. The rule prohibits investment advisors from making political contributions to public officials in exchange for obtaining contracts to manage public funds. The risk alert found that many newly registered investment advisors were not familiar with the Pay-to-Play rule, and were not properly implementing policies and procedures to prevent violations.
The SEC is also proposing new rules that would prohibit registered investment advisors from outsourcing their compliance functions to third-party service providers. The proposed rules would require investment advisors to have their own internal compliance programs, and would provide guidance on the minimum requirements for these programs.
Another issue highlighted in the risk alert is the use of cryptocurrency by investment advisors. As long as crypto platforms and lenders aren't registered as exchanges or banks, they wouldn't qualify as custodians in the latest SEC regulations. This means that investment advisors who use crypto platforms or lenders must take extra precautions to protect their clients' assets.
Following the collapse of Silicon Valley Bank (SVB) and Signature Bank (Signature), the SEC launched an investigation into the banks' compliance with anti-money laundering laws. The investigation found that both banks had failed to implement adequate anti-money laundering programs, and had allowed billions of dollars in suspicious transactions to flow through their accounts.
The SEC recently proposed a new rule and rule amendments that would require investment advisors to provide additional disclosures regarding their use of derivatives. The proposed rule would require investment advisors to disclose the notional amount of derivatives they use, as well as the gross notional exposure of the client's portfolio.
Advisors who wear two hats – meaning they are dually registered as brokers and investment advisors – need to make that distinction clear to their clients. The SEC has found that many investors are confused about the difference between brokers and investment advisors, and may not understand the different standards of care that apply to each.
Overall, the SEC's annual risk alert provides valuable guidance for newly registered investment advisors on how to comply with SEC regulations and avoid common compliance issues. Investment advisors should carefully review the risk alert and take steps to ensure that they are in compliance with SEC regulations.
