The Securities and Exchange Commission yesterday announced its examination priorities for 2023, and the agency said it’s going to zero in on Regulation Best Interest, revenue-sharing, ESG, the new marketing rule and a host of other hot buttons in the coming fiscal year.

Derek Steingarten, a partner at Morrison Foerster, said he is showing his clients how to document their processes for dually registered reps to make sure they consider reasonably available investment alternatives. The processes should take into account fees and expenses, risk management and performance history, as well as what’s in the best interest of the client.

“One thing I’d add, is that when a rep recommends funds or other investments, the firm really needs to focus on whether reps are offering proprietary or third-party products [and] disclose and manage inherent conflicts of interest in the comparison and assessment,” Steingarten said. 

The road map set out by the nation’s top securities cop for its exams has both expected and unexpected twists, say other compliance experts.

“The regulatory regime for Reg BI clearly has matured, and both broker-dealers and investment advisors should expect enhanced examinations,” said Tim Nagy and Steffen Hemmerich, partners at the law firm of Mayer Brown.

The SEC is going to look at the ways firms beat down and eliminate conflicts of interest, including the ways firms document their work practices and procedures, particularly the way they make recommendations and look to reasonably available alternatives and ESG investments, the attorneys said.

“I know we are planning to work with our clients to tighten up documenting their recommendation process, including their evaluation of reasonably available alternative products and accounts, as well as costs and risks,” said Kurt Gottschall, a former director of the SEC’s Denver office and now a partner at Haynes Boone who works with firms navigating the exam process.

“This can be tricky, because firms can have a policy, but if reps aren’t documenting it, it will be difficult for firms to verify for SEC examiners,” Gottschall added.

The regulator has also flagged any advisor recommendations of complex, high-risk and illiquid products for greater scrutiny to make sure they dovetail with Reg BI requirements, he said.

“So, for example, exam staff will want to test if reps understand leveraged ETFs and whether they match stated client risk tolerances and goals,” Gottschall said. “And exam staff may look at relatively illiquid products like non-traded REITs or private placements to make sure that those investments match client risk and investment horizons.”

Reg BI And ESG
A number of experts said it is apparent that SEC examiners also expect firms to apply Reg BI standards to ESG recommendations.

That means a firm must ask: “Is the ESG strategy operating in the manner disclosed?” said consultant Carlo di Florio.

“A new focus seems to be whether recommendations of ESG-related products are in retail investors’ best interest,” said di Florio, a global advisory leader at ACA Group.

That application of Reg BI may have challenges, Gottschall noted. “Everyone knows that [Gary Gensler, chair of the SEC] has been focused on ESG, but I think applying Reg BI to ESG will be particularly difficult, because investors’ motivations for ESG investing can be complex and nuanced.”

Nagy and Hemmerich said it’s no surprise that the SEC’s new marketing rule, which went into effect in November and allows advisors to advertise their practices and use third-person testimonials for the first time ever, will be a major focus of SEC exams in the coming year.

Advisors must be able to substantiate statements in their testimonials and endorsements and offer support for performance advertising and ratings, the attorneys said, otherwise they could fall into the SEC’s crosshairs.

“Where the SEC sees a factual assertion in a piece, they’ll ask for backup. If the firm doesn’t have any support for the statement, they’ll be in violation,” di Florio said.

Gottschall agrees that performance advertising is going to be a key challenge.

He said advisors should also be prepared to justify their revenue-sharing arrangements with clearing brokers and their cash management practices, which can differ depending on the share class that is recommended. Gottschall added that he expects the SEC’s steady stream of class share enforcements to continue.

Oftentimes, a firm has the discretion to mark up charges for clients, but the firms must also disclose them, he warned.