The Office of Compliance Inspections and Examinations (“OCIE”) of the US Securities and Exchange Commission (“SEC”) has announced its 2015  examination priorities.1 OCIE stated that, in 2015, it will focus on the following thematic areas:  matters of importance to retiring or retired retail investors; structural risks and trends that are  market wide; and data analytics to identify illegal activity. The priorities identified by OCIE,  and those discussed herein, are merely intended to illustrate certain broader themes impacting the  investment adviser and broker-dealer industries, they are not exhaustive of the issues that are  important or are of  concern, or that will be focused on during an examination.

Protecting Retail Investors and Investors Saving for Retirement

OCIE has indicated that it will be focusing on a number of initiatives to assess the risks to  retail investors. It is doing this in recognition of: (i)  the increasing variety of new products  and services being offered to retail investors; (ii) retail investors’ growing dependence on  defined contribution (“DC”) plans, such as 401(k) accounts, for their retirement; and (iii) the  broad array of information, advice products, and services offered to retail investors to help them  pay for, and live in, their retirement years. These initiatives, and OCIE’s focus on these areas,   build upon those first cited by OCIE as part of its 2014 exam priorities and should be considered by standalone investment advisory entities and dually registered broker-dealer/investment advisers.  OCIE has designated the following six initiatives that will focus on protecting retiring or retired  retail investors.

  • Fee arrangements and reverse churning. Given the variety of account types and fee structures  that are increasingly becoming available to investors, OCIE will be focusing extensively on the  recommendation of account types and whether they are in the best interests of the investor, both at  inception of the arrangement and going forward. For instance, investors may have options to  choose  among traditional commission-only brokerage accounts versus advisory accounts. Further, within the  advisory account spectrum, investors may be able to select from traditional separate accounts  managed by the adviser (or discrete teams within the adviser, which in the context of retail  investors are more common at large financial service  firms), separate account wrap accounts,  mutual fund wrap accounts, unified fee  overlay accounts, private fund allocation programs, and  other programs.

It is important to recognize that OCIE reviews may consider the suitability of the underlying  products selected for the investor (e.g., mutual funds, ETFs versus alternatives, real estate,  direct management strategies, and other programs), as well as the suitability of the fees assessed, including fees assessed by the  advisory firm and fees that may be assessed by the underlying investment products utilized. Given OCIE’s efforts to assess the suitability of such  recommendations on an ongoing basis, registrants should consider the scope of their ongoing  surveillance and testing of their recommended allocations. Importantly, OCIE’s reference to  “reverse churning” might suggest an effort to evaluate the ongoing level of services provided by  the adviser with respect to each account.

  • Sales practices. Increased scrutiny of advisers’ sales practices when recommending that retail investors move their retirement assets from  a DC plan into another investment account, especially when the risks and fees increase. For  example, as noted in OCIE’s 2014 examination priorities, recommendations to rollover employer-  sponsored 401(k) plans into higher-cost investments remains a concern, including whether advisers  are misrepresenting their credentials or the benefits and features of individual retirement account  plans and other alternatives.
  • Recommendations to invest in structured products and higher- yielding investments. Increased focus on the suitability of, due  diligence conducted on, and disclosures made about recommendations to retail investors to move  their retirement assets into structured, complex or high-yield products (e.g., leveraged ETFs and  structured products). OCIE noted this initiative as part of its 2014 examination priorities, but   specifically in respect of its broker-dealer examination program. These concerns continue to build  upon results identified by  the SEC in 2011 as a result of an industry-wide sweep of broker-dealer  practices.2 Among other things, the staff noted an ostensible lack of training requirements for  supervisors and registered representatives that market structured products to their customers.  These resulted, at times, in the making of unsuitable recommendations and the omission of materials facts about structured products offered to retail  investors and raised a concern that certain questionable sales practices had been utilized. The  staff report included a number of recommendations for registrants, including the maintenance of  controls to independently review their desk prices of structured securities products in the  secondary market; controls to adequately review the suitability of these products for customers;  and controls to review customer concentrations in the structured securities products it sold.

  • Branch offices. Expanded initiative that looks at firms’ supervision of their branch offices and  whether the branch office adheres to the firm’s compliance practices

  • “Alternative” registered investment companies. Continued scrutiny of these funds’ policies and  procedures concerning valuation, leverage, and liquidity, as well as the adequacy of their internal  controls (including staffing, funding, board authority, compliance personnel, and back-office  support) and the manner in which such funds are marketed to investors. Liquidity management and the  use of derivatives in mutual funds and ETFs continue to be two key areas of focus by the SEC staff.  As indicated recently, the SEC staff has been considering whether broad risk-management programs  should be required for mutual funds and ETFs to address the risks related to their liquidity and  derivatives use, as well as measures to ensure the SEC’s comprehensive oversight of those  programs.3 The staff has also been reviewing options for specific requirements, such as updated  liquidity standards, disclosures of liquidity risks, or measures to appropriately limit the  leverage created by a fund’s use of derivatives.

  • Fixed-income investment companies. Expanded review of funds with exposure to interest rate increases to determine whether  their policies and procedures, controls, and disclosures are sufficient. This follows on a Guidance Update addressing these issues released by  the SEC’s Division of Investment Management in January 20144 and the widely reported sweep of bond  funds by OCIE in late 2014. 

Assessing Market-Wide Risks

Focusing on the markets, OCIE stated that it will examine structural risks and trends across firms  and the industry. OCIE announced the following initiatives targeted at the asset management  industry to achieve this objective:

  • Monitoring of large broker-dealers and investment advisers. Continued monitoring of the largest  broker-dealers and investment advisers for individual risk and for early awareness of industry-wide  developments. This follows on SEC Chair White’s speech on this topic on December 11, 2014.5
  • Cybersecurity. Continued focus on cybersecurity compliance and controls, and the expansion of  this initiative to include transfer agents. This follows on OCIE’s sweep exams of funds’  cybersecurity preparedness, which was announced in April 2014.6
  • Order routing. Initiative that focuses on whether firms are prioritizing trading venues based on  payments or credits for order flow, in conflict with their best execution duties.

Data Analytics

OCIE expects to significantly expand its use of data analytics to review firms that appear to be  engaged in illegal activity. OCIE’s data analytics initiatives will include a focus on investment  advisers that employ individuals with a history of misconduct. Further, as part of its Anti- Money  Laundering initiative, OCIE will focus on firms that have not filed, or that have filed incomplete,  suspicious activity reports. Other Initiatives

In addition to the initiatives pertaining to the three themes for 2015, OCIE has announced the  following four initiatives directed at the asset management industry:

  • Municipal advisers. Continued examinations, industry outreach, and education of newly registered  municipal advisers.
  • Proxy advisers. New initiative that entails examinations of proxy advisory service firms, with a  focus on the recommendation process and disclosures about potential conflicts, and of investment  advisers for compliance with their fiduciary duties when voting proxies for clients.
  • Never-before-examined investment companies. New initiative that consists of risk-based  examinations of funds that have not been examined. This initiative should be distinguished from the  2014 initiative, which had focused on never-before-examined advisers.
  • Private equity (“PE”) fund advisers’ fees and expenses. Continued focus on fees and expenses  assessed by PE fund advisers. These issues have previously been discussed by the SEC on several  occasions, perhaps most notably by OCIE Director Andrew Bowden in his May 2014 speech about the PE  industry entitled “Spreading Sunshine in Private Equity.”7 More specifically, Director Bowden noted  that when OCIE examined how fees and expenses were handled by advisers to PE funds, OCIE identified  what it believed to be violations of law or material weaknesses in controls more than 50% of the  time. Some of the more common areas of interest to OCIE are the use and disclosure of “operating  partners,” the misallocation of management company expenses, unfair allocation among side-by- side  clients, as well as the use, disclosure, and reasonableness of fees paid torelated-party service providers. Fees and expenses, as well as conflicts of interest and other general disclosure issues will continue to be emphasized by OCIE during examinations.