On January 13, 2015, the Office of Compliance Inspections and Examinations (OCIE) of the Securities and Exchange Commission (SEC) published the examination priorities of the SEC’s National Exam Program for 2015 (Examination Priorities). The Examination Priorities address practices and products that OCIE believes present heightened risk to investors or the integrity of capital markets. The Examination Priorities are divided into three main categories:
- Matters of importance to retail investors and investors saving for retirement
- Issues related to market-wide risks
- Use of data analytics to assess whether registrants are engaging in illegal activities
The Examination Priorities also describe several additional initiatives while noting that other circumstances can and will cause the staff to conduct examinations unrelated to any of the listed priorities.
Retail Investors & Investors Saving for Retirement
The SEC is developing examination initiatives to assess the potential risks associated with new products and services offered to retail investors that were historically considered to be alternative or institutional (including private funds, illiquid investments and structured products intended to generate higher yields in a low-interest rate environment). Specifically, the Examination Priorities focus on:
- Alternative investment companies.OCIE will continue focusing on funds offering alternative investments and using alternative investment strategies. The staff will focus particularly on:
- Leverage, liquidity and valuation policies and practices
- Factors relevant to the adequacy of the funds’ internal controls, including staffing; funding; and empowerment of boards, compliance personnel and back offices
- The manner in which such funds are marketed to investors
- Fixed income investment companies. OCIE will also continue focusing on funds with significant exposure to interest rate increases. The Examination Priorities place emphasis on implementing compliance policies and procedures and investment and trading controls that are sufficient to ensure that fund disclosures are not misleading and that investments and liquidity profiles are consistent with those disclosures.
The SEC also indicates that due to investors’ increasing reliance on their own investments for retirement, the financial services industry is offering an expanded variety of products and services to help investors prior to and during retirement. As a result, in conjunction with the focus areas listed above, the Examination Priorities highlight the following:
- Sales practices. The Examination Priorities note that OCIE will assess whether financial professionals are employing improper or misleading practices when recommending the transition of retirement assets from employer-sponsored defined contribution plans into other investments and accounts, especially when such a shift exposes investors to greater risks and/or higher fees.
- Suitability of recommendations or determinations. OCIE will evaluate financial professionals’ recommendations or determinations to invest retirement assets into complex or structured products and higher-yield securities. OCIE will focus on the due diligence process related to such recommendations or determinations, disclosures made to investors, and the suitability of such recommendations or determinations relative to existing legal requirements.
- Fee selection and reverse churning. The Examination Priorities describe the industry trend toward financial professionals operating as investment advisers or dually registered investment advisers/broker-dealers, rather than solely as broker-dealers, thus increasing the variety of fee structures available to such professionals. In instances where an adviser offers a variety of fee arrangements, such as those based on assets under management, hourly fees, performance-based fees, wrap fees and utilized fees, OCIE will focus on whether account type selections are made and maintained in clients’ best interests.
- Branch offices. OCIE will also devote attention to supervision of branch offices, using data analytics to identify branches that may be deviating from the firm’s compliance practices.
The Examination Priorities note that the SEC is also charged with maintaining fair, orderly and efficient markets. To help achieve this, OCIE will focus on the following areas in 2015:
- Large firm monitoring. The SEC will continue monitoring the largest U.S. broker-dealers and asset managers to assess risks at individual firms and maintain early awareness of industry-wide developments.
- Clearing agencies. OCIE will continue conducting annual examinations of all clearing agencies designated systemically important, pursuant to the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
- Cybersecurity. OCIE will continue examining cybersecurity compliance and controls of broker-dealers and investment advisers, and will expand their efforts to include transfer agents in 2015.
- Potential equity order routing conflicts. OCIE will assess whether firms are prioritizing trading venues based on payments or credits for order flow, contrary to their best execution duties.
Registrants Potentially Engaged in Illegal Activity
The Examination Priorities explain that the staff will also employ data analytics to evaluate registrants and firms that appear to be potentially engaged in illegal activity, with a focus on the following areas:
- Recidivist representatives. OCIE will focus in 2015 on individuals with a track record of misconduct and will examine the firms that employ them.
- Microcap fraud. OCIE will examine broker-dealers and transfer agents who may be involved with pump-and-dump schemes or market manipulation.
- Excessive trading. OCIE will identify and examine introducing brokers and registered representatives who appear to be engaged in excessive trading.
- Anti-money-laundering (AML). OCIE will examine clearing and introducing broker-dealers’ AML programs, with a focus on firms with missing, incomplete or late suspicious activity reports. They will also conduct examinations of the AML programs of broker-dealers who allow customers to deposit and withdraw cash or provide customers direct access to the markets from higher-risk jurisdictions.
In addition, OCIE intends to allocate examination resources to the following areas:
- Municipal advisers. OCIE will focus on newly registered municipal advisers to assess their compliance with recently adopted SEC and Municipal Securities Rulemaking Board rules.
- Proxy services and proxy voting by investment advisers. OCIE will examine proxy advisory service firms, with a focus on the process under which recommendations on proxy voting are made, as well as how they disclose and mitigate potential conflicts of interest. OCIE will also examine investment advisers’ proxy voting on behalf of investors to confirm that advisers are not violating their fiduciary duties.
- Never-before-examined investment companies. OCIE will conduct risk-based examinations of registered investment companies that have not yet been examined.
- Fees and expenses in private equity. OCIE will continue to conduct examinations of private equity funds after encountering a high rate of deficiencies in the past in connection with fees and expenses.
- Transfer agents. OCIE intends to examine transfer agents, particularly those who are involved with microcap securities and private offerings.