What can registrants expect from the SEC in 2015? Among other areas, expect scrutiny of retail sales practices and fees, and use by the SEC staff of data analysis to detect trends. On January 13, OCIE, the SEC’s Office of Compliance, Inspections and Examinations, released its annual list of Examination Priorities for 2015. “We share our annual examination priorities to promote compliance,” said OCIE director Andrew Bowden in a press release accompanying the priorities. He observed that many in the industry will independently review the identified areas. We believe that understanding these annual priorities can provide valuable assistance to compliance and management personnel in maintaining their regulatory compliance programs.
The SEC examination staff will focus on three main areas. First, examinations will address matters of importance to retail investors and investors saving for retirement. The staff will also focus on market-wide risks, and the staff will emphasize use of in-house data analysis to uncover illegal activity. Recurring themes among this year’s examination priorities include the adequacy and accuracy of disclosures, identification and mitigation of conflicts of interest, and outreach and presence with new and previously unexamined registrants. The cybersecurity initiative launched last year remains a top priority in examining registrants, as does examination of the fee and expense practices of private equity fund advisers.
Here are the specific examination program priorities as described by OCIE.
Protecting Retail Investors and Investors Saving for Retirement
OCIE noted that retail investors face increasingly complex and evolving investment choices, including those once branded as alternative or institutional investments. The staff also observed that investors planning for retirement increasingly rely on their own investments, which places the funding and investment risk directly on such investors. The financial services industry has responded with a broad array of information, advice, products and services to assist these retail investors. As part of its examination initiatives, OCIE plans to assess the risks to retail investors relating to these trends.
- Fee Selection and Reverse Churning – The financial professionals serving retail investors often are registered both as broker-dealers and investment advisers, said OCIE. Advisors can charge a wider variety of fees than broker-dealers and where they do, the staff will focus on the account type recommendations and whether they are in the best interests of the client from inception and over the life of the account. The staff will consider the fees charged, services provided, and disclosures relevant to the relationship.
- Sales Practices – The movement of retirement assets from employer-sponsored defined contribution plans into other investments and accounts will invite higher scrutiny, especially when higher risks and/or higher fees result.
- Suitability – When retirement assets are invested in complex or structured products and high yield products, the staff will evaluate whether due diligence, disclosures and the suitability of the recommendation meet legal requirements.
- Branch Offices – Supervision of registered and financial adviser representatives in branch offices will be a focus, as well as using data analytics to identify branches deviating from home office compliance practices.
- Alternative Investment Companies – This category of funds has experienced rapid growth and remains a priority for assessment of practices such as leverage, liquidity, valuation, internal controls including empowerment of the board and compliance personnel, and marketing.
- Fixed Income Investment Companies – Funds with significant exposure to interest rate risk will be scrutinized for misleading disclosures and consistency between fund disclosures and fund investments and liquidity profiles. The staff will review such funds for investment and trading controls and compliance policies and procedures sufficient to manage the interest rate risk presented.
Assessing Market-Wide Risks
Maintaining fair, orderly and efficient markets is part of the SEC’s core mission, and OCIE intends to examine for structural risks and trends overarching multiple firms or entire industries. Particular areas of focus include:
- Large Firm Monitoring – In collaboration with the Divisions of Trading and Markets and Investment Management, OCIE will monitor the largest broker-dealers and asset managers for appropriate risk assessment and for early awareness of industry developments.
- Clearing Agencies – Clearing agencies that have been designated as systemically important under the Dodd-Frank Wall Street Reform and Consumer Protection Act will be examined in select areas based on a risk assessment conducted internally and in collaboration with other regulators.
- Cybersecurity – The examination initiative launched last year focusing on the cybersecurity compliance controls implemented by broker-dealers and advisers will be continued and expanded to include transfer agents.
- Potential Equity Order Routing Conflicts – Best execution practices will be assessed for conflicts such as prioritizing trading venues based on payments or credits for order flow.
Using Data Analytics to Identify Signals of Potential Illegal Activity
As the SEC continually seeks to leverage its own resources to more effectively detect and prevent fraud and other potentially illegal activity, OCIE continues to refine and enhance its data analysis capabilities. In the year ahead, examination initiatives based on these capabilities will include:
- Recidivist Representatives – OCIE will focus not only on individuals with a track record of misconduct but also on the firms that employ them.
- Microcap Fraud – Enhanced analysis techniques will seek to expose aiding and abetting, pump-and-dump schemes and market manipulation activities of broker-dealers and transfer agents.
- Excessive Trading – Data will be mined to identify clearing and introducing brokers and registered representatives that appear to be engaged in excessive trading activities.
- Anti-Money Laundering (“AML”) – OCIE has indicated that it will pay particular attention to broker-dealer AML programs that permit the deposit and withdrawal of cash and/or direct market access by customers from high-risk jurisdictions, as well as clearing and introducing brokers that have not filed, or file late or incomplete suspicious activity reports (known as “SARs”).
For the year ahead, OCIE has identified other priority areas for the allocation of examination resources as well, including:
- Municipal Advisors – Much like the presence exams conducted with newly registered private fund advisers back in 2012, these new registrants will be examined for compliance with recently adopted SEC and MSRB rules, and will also receive education and industry outreach.
- Proxy Services – How proxy advisory service firms make their recommendations and how they disclose and mitigate conflicts of interest will be examined in select firms, as well as how investment advisers meet their fiduciary duties to clients in the proxy voting process.
- Never-Before-Examined Investment Companies – Focused, risk-based examinations are planned for such fund complexes.
- Fees and Expenses in Private Equity – The persistent deficiencies identified by the staff in this area keep private equity fund advisers in OCIE’s sights.
- Transfer Agents – The Release also identified transfer agents as “important gatekeepers” to prevent violations of Section 5 of the Securities Act and other fraudulent activity. Examinations will focus in particular on transfer agents involved with microcap securities and private offerings.
In light of the announced priorities, we believe registrants should be proactive and prepare for the examination process and, in doing so, remain cognizant of the risks an SEC examination can pose to the firm. In order to avoid and minimize such risks, registrants should undertake a careful and thoughtful review of their compliance procedures and policies with respect to the above discussed areas. We welcome any questions regarding the matters discussed in this client alert. For more information or questions please contact the professionals listed below, or your regular Nelson Mullins contact.