On Tuesday, January 13, 2015, the Securities and Exchange Commission announced1 that for 2015 its Office of Compliance Inspections and Examinations’ (OCIE) will focus its examinations on three areas: protecting retail investors (with an express emphasis on investing for retirement); assessing market- wide risks; and the use of data analytics to identify potentially violative activity, such as excessive trading and penny stock schemes.
Protecting Retail Investors Saving for Retirement
In the face of historically low interest rates, investments traditionally geared to more sophisticated and/or institutional investors are being repackaged for retail investors in an effort to afford those retail investors access to potentially higher yields. The SEC suggests that this push for higher yields is exacerbated by the droves of baby boomers exiting the workforce with their retirement nest eggs built in 401(k) plans and individual retirement accounts. Moreover, given investors’ dependence on these types of accounts, firms are offering a broad array of products and services intended to guide clients toward retirement. As a result, issues related to retirement investing is an Exam focus for 2015 and includes the following:
Fee Selection and Reverse Churning – Investment advisers and dual registered individuals who might address client needs on a fee basis or on a commission basis will not escape scrutiny this year. In particular, the SEC does not want to see wrap fees charged in accounts with little or no trading activity, which reflects a broader concern of whether particular account types are appropriate for particular clients. Evaluation of this issue will turn on the nature of the recommendation, the sufficiency of the account disclosures and ultimately consideration of the type and amount of fees charged relative to the service provided.
Sales Practice – OCIE will assess practices used in connection with recommending that a client roll assets from employer-sponsored plans into other account types. Moreover, whether the alternative account type is accompanied by additional or special risks and/or greater fees, will be germane to the SEC’s analysis.
Suitability – As noted above, recommendations to invest – particularly retirement assets – in higher yield, complex or structured securities will be a focus for OCIE examiners. The nature and extent of the accompanying disclosures, the sufficiency of the product due diligence and the ultimate suitability of the recommendation will be central issues.
Branch Offices – We expect much greater use of data analytics to identify activity in individual branches that may be contrary to firm policies.
“Alternative” Investment Companies – Products containing alternative investments or investments with returns distinct from market returns will be scrutinized based on leverage, liquidity and valuation concerns, among other considerations.
Fixed Income Investment Companies – Based on the premise that interest rates will eventually rise, OCIE is focused on whether funds with significant interest rate sensitivity have procedures and controls in place to ensure clear and complete product disclosures, as well as that investment and liquidity profiles comport with those disclosures.
Assessing Market-Wide Risks
In terms of market-wide risk, OCIE officials intend to focus on the safety and soundness of larger firms; the condition of clearing firms deemed systemically important; firm’s respective cybersecurity compliance protocols and procedures, as well as firm’s potential vulnerability; and finally, equity order routing conflicts, considering whether certain trades being prioritized contrary to principals of best execution.
Use of Data Analytics
Finally, the SEC intends to continue to utilize “significant enhancements in data analytics” to identify recidivist advisers and examine firms that employ those individuals.
Additional, new initiatives for 2015 include inspection of proxy advisers and the mechanics of recommendations on proxy votes. Risk-based examinations of never-before examined investment companies will continue, as well as efforts to visit advisers that have not been inspected. OCIE also expects to devote more resources to inspecting so-called transfer agents, particularly those involved high-risk business such as microcap securities and private offerings.
Interestingly, this year’s letter is less than half the length of last year’s letter and a number of topics have been omitted that appeared in prior year’s, such as custody, conflicts of interest, and marketing and communication, among others.