Risk Alert: SEC Staff Explains Risk-Based Approach to Registered Investment Company Examinations

In a risk alert dated November 4, 2024,¹ the Division of Examinations (Division) of the U.S. Securities and Exchange Commission (SEC or the Commission) shed light on its risk-based approach in selecting investment companies for examination and how it selects substantive areas of an examination’s focus.

The risk alert also highlighted examples of deficiencies or weaknesses observed by the Division in three core areas and detailed the types of initial information, including documents, that the Division may request and review during a typical fund exam.

Our Take. While not a universal agenda for every fund examination, the risk alert highlights areas of focus that are of current importance to the Division when conducting an exam and may assist funds and their advisers in preparation for exams and overall governance and compliance efforts. The Division said it takes a risk-based approach and that individual examinations may focus on particular risks that the Division considers high priority. The Division said that it often modifies document requests to reflect its concern about particular risks or focus areas.

I. Examination Selection and Scoping

The Division identified certain criteria it considers when selecting fund candidates for examination, including (1) whether the fund’s investment strategy and/or portfolio holdings meet criteria relevant to the focus areas described in the Division’s annual priorities, (2) whether new regulatory requirements are applicable to the fund, and (3) the fund complex’s previous examination history. The Division also considers a fund’s or its adviser’s conflicts of interest, regulatory history, and any complaints or referrals.

The Division noted that fund examinations often include reviews of three core areas: (1) compliance programs, (2) disclosure and regulatory reports, and (3) fund governance. The Division may review

• compliance policies and procedures of funds and their service providers for effectiveness and whether they address certain risks, such as risks associated with allocating expenses between the adviser and the funds, or among funds/advisory clients
• funds' board governance processes and the efficacy of board oversight of funds' compliance programs
• funds' investment advisory agreement approval process and the thoroughness of the board's review of fund fees for consistency with disclosures
• fund disclosures for consistency with operations, conflicts, and portfolio management

II. Observations From Examinations

The alert summarized some common deficiencies and weaknesses it observed in examinations in recent years. The deficiencies and weaknesses cited in the risk alert include the following:

Fund compliance programs

• Funds failed to perform required oversight or reviews as stated in their policies and procedures or required assessments of the effectiveness of their compliance programs.
• Funds failed to adopt, implement, update, and/or enforce policies and procedures, including those addressing critical fund areas of compliance with federal securities laws.
• Policies and procedures were not tailored to funds' business models or were incomplete, inaccurate, or inconsistent with actual practices.
• Funds' code of ethics were not adopted, implemented, followed, or enforced.
• Fund CCOs did not provide requisite written annual compliance reports to fund boards.

Fund disclosures and filings

• Fund registration statements, fact sheets, annual reports, and semiannual reports contained incomplete or outdated information or potentially misleading statements.
• Sales literature appeared to contain untrue statements or omissions of material fact.
• Fund filings were not made on a timely basis or are not made at all.

Fund governance practices

• Fund boards failed to (1) timely review advisory and sub-advisory agreements; (2) request, obtain, and consider certain information to evaluate advisory agreements before approving; or (3) consider material changes to the advisory agreement.
• Funds did not receive certain information to effectively oversee fund practices.
• Fund boards did not perform required responsibilities, including making certain required determinations (e.g., annually determine whether certain joint liability insurance policies remain in the funds' best interest) and failing to adopt certain written policies and procedures tailored to funds' operations (e.g., liquidity risk management program, anti-money laundering program, and Rule 12b-1 plans).
• Fund board minutes did not fully document board actions.

III. Documents Requested

The risk alert includes a comprehensive list of requested information across 10 categories and commonly requested items, which are summarized as follows (please refer to the risk alert for the complete list).

Organizational and operational information, including general fund and adviser information; fund organizational structure; shareholder complaints; threatened, pending or settled litigation, arbitration, or administrative proceedings; filings and regulatory correspondence; and certain ETF-specific information.

Compliance program information, including fund compliance policies and procedures; compliance risks inventories, testing, exception reports, and annual reviews; internal audit reports; information regarding tools or systems used to carry out compliance-related oversight functions and reporting; compliance training or guidance provided to personnel; and due diligence on, and oversight of, service providers.

Portfolio management and trading information, including fund trade blotter and portfolio positions; executing broker-dealers and commission/fees; trade allocation practices; best execution; trade errors; soft dollar arrangements; and fund performance information.

Valuation information, including valuation policies and procedures of any third-party providers directly or indirectly involved in reviewing valuations; reports and/or recommendations from pricing services, quotation services and third-party valuation firms; information regarding valuation processes; communications with auditors and other third parties regarding valuations; and prices provided by a pricing service or third-party valuation firm that were overridden or stale.

Conflicts of interest, including codes of ethics; employee trading restricted lists and corresponding attestations; access person transaction reports; revenue sharing arrangements; cross-trading activities; soft dollar commissions; and information regarding trade aggregation and allocation.

Fees and expenses information, including expense caps and fee waivers; expenses of the adviser, sub-adviser, or any of their affiliates that were reimbursed by a fund and/or a portfolio company; and direct or indirect compensation received by the fund, its adviser(s), any sub-adviser(s), or any of their affiliates from any of the fund’s service providers.

Fund advertisements and sales literature, including newspapers, periodicals, television and radio ads, websites, fund fact sheets, form letters, and portfolio manager commentaries.

Fund board governance information, including general information regarding board members and board committees; board and committee meeting minutes and materials; insurance claims; advisory contract approval information, including information regarding expense caps and/or fee waivers; audits of the fund’s financial statements; report(s) provided by the fund’s and adviser’s CCOs; information regarding service providers, including direct or indirect compensation received from service providers; brokerage arrangements; best execution; 12b-1 plans; and multi-class plans.

Disclosures, including prospectuses, statements of additional information, and shareholder reports.

Financial records and financial analysis, including fund financial statements; ledgers; cash receipts and disbursements; and NAV errors.