The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE)1on January 13 issued its annual memorandum outlining examination priorities for 2015 (the Exam Priorities). OCIE’s Office of Market Oversight simultaneously sent a letter describing its examination priorities for securities exchanges to each National Securities Exchange (the Exchange Letter).
The Exam Priorities memorandum (the Priorities Memo) and the Exchange Letter provide securities industry participants with a window into current SEC concerns. While the matters set forth in the Priorities Memo and the Exchange Letter are not the only issues on which OCIE is focused, and may be adjusted as market conditions, industry developments and ongoing risk assessment activities dictate, they were chosen in consultation with the Commission, its policy divisions, regional offices, the enforcement division and the SEC’s Investor Advocate, as well as with other regulators. Regulated entities and individuals should take note and consider proactive steps to review controls in the identified areas.
The Priorities Memo also notes that OCIE plans additional examinations based on, among other things, complaints and referrals from the public, and encourages those observing or suspecting activity that may violate the securities laws or harm investors to notify the SEC through its Tips, Complaints and Referrals website.
I. The Exam Priorities. The 2015 Exam Priorities focus on three areas:
1. Alternative investments - protecting retail investors and investors saving for retirement: What are the risks to investors, especially retirees and those planning for retirement, of the trend toward offering retail investors retirement planning services and advice generally and, more specifically, products and services that were formerly characterized as “alternative” or viewed as appropriate for institutional investors? These alternative investments include private funds, illiquid investments, and structured products. Identified risks include:
- Fee selection and reverse churning. Are financial professionals serving as investment advisers or investment adviser/broker dealers acting in the best interests of their clients in the structuring of fees charged, services provided and disclosures to retail investors? Firms should expect heightened scrutiny of non-traditional fee structures as well as review of more traditional structures.
- Sales practices. Are firms using improper or misleading practices when recommending movement of retirement assets from employer plans into other investments and accounts, especially those with greater risks or higher fees?
- Suitability. Are financial professionals complying with diligence, disclosure and suitability requirements in recommending investment of retirement assets in complex or structured products and higher-yield securities?
- Branch offices. Are regulated entities adequately supervising branch offices? OCIE expects to use data analytics to identify branches that deviate from firms’ compliance practices.
- Alternative investment companies. Do funds holding “alternative” investments have adequate internal controls and appropriate leverage, liquidity and valuation policies and practices? How are funds holding such assets marketed to investors?
- Fixed income investment companies. Do mutual funds with significant exposure to interest rates have compliance procedures and investment and trading controls sufficient to ensure that disclosures are not misleading and that investments and liquidity profiles are consistent with such disclosures?
2. Assessing market-wide risks. OCIE will examine for structural risks and trends that may involve multiple firms or entire industries, focusing (along with the Divisions of Trading and Markets and Investment Management) on monitoring the largest US broker-dealers and asset managers to assess risks and maintain early awareness of industry developments. OCIE will examine all clearing agencies designated “systemically important” under Dodd-Frank, using a risk-based approach in collaboration with the Division of Trading and Markets and other regulators. OCIE will continue and expand its 2014 initiative to examine cybersecurity compliance and controls, and will examine whether firms prioritize order routing decisions based on payments or credits for order flow in conflict with best execution responsibilities.
3. Using data analytics to identify potential illegal activity. OCIE will use its developing data analytics capability to examine registrants that appear to be engaged in fraudulent and other possibly illegal activity. This will include:
- identifying individuals with records of misconduct and examining their firms
- examining broker-dealers and transfer agents for activities indicating possible involvement in pump-and-dump schemes or market manipulation
- identifying and examining introducing brokers and registered representatives apparently engaged in excessive trading and
- examining anti-money laundering (AML) programs, focusing on (i) firms that have not filed, or have filed incomplete or late suspicious activity reports, and (ii) AML programs of broker-dealers that allow customers to deposit and withdraw cash and/or provide customers with direct access to the markets from higher-risk jurisdictions.
4. Other areas of examination: In addition to the areas noted above, OCIE will examine:
- newly registered municipal advisors for compliance with applicable rules
- how proxy advisory service firms make recommendations and disclose and mitigate potential conflicts
- investment advisers’ compliance with fiduciary duties when voting proxies on behalf of investors
- selected registered investment company complexes that have never been examined
- fees and expenses of advisers to private equity funds and
- transfer agents, particularly those involved with microcap securities and private offerings.
II. The Exchange Letter. In the Exchange Letter, OCIE’s Office of Market Oversight advised each National Securities Exchange that its fiscal year 2015 examinations will focus on:
- Compliance with undertakings in any administrative cease and desist order in 2012, 2013 or 2014
- Internal controls surrounding regulatory responsibilities and decisions; for example, reviews of outsourced regulatory functions, funding of regulatory functions and governance and oversight of an exchange’s regulatory functions
- Monitoring and enforcement of listing standards for exchange-traded products
- Options exchanges’ listing programs, including compliance with listing requirements and policies and procedures regarding listing programs
- Information technology controls including written supervisory procedures; information security and incident response; business continuity planning and pandemic preparedness; computer, telecommunications and networking operations; software development and testing; outsourcing and vendor management; and enterprise risk management and
- Compliance with transaction fee obligations under Securities Exchange Act Section 31 and SEC Rule 31 thereunder.