The Situation: The U.S. Securities and Exchange Commission's ("SEC") Office of Compliance Inspections and Examinations ("OCIE") issued its 2020 examination priorities ("Exam Priorities").
The Result: The Exam Priorities set forth a nonexhaustive list of key areas where OCIE intends to concentrate its resources in 2020.
Looking Ahead: In addition to diligentlyadministering and improving their overall compliance programs, SEC registrants, including broker-dealers and registered investment advisers, should be particularly proactive in reviewing and enhancing, as necessary, their policies, procedures, and operations in the subject matter areas highlighted in the Exam Priorities.
On January 7, 2020, OCIE published the Exam Priorities, detailing the nonexclusive areas on which it intends to focus its resources for examinations in the coming year. As in previous years, the Exam Priorities contain the broad thematic categories of retail investors, market infrastructure, the activities of the Financial Industry Regulatory Authority ("FINRA") and the Municipal Securities Rulemaking Board ("MSRB"), information security (i.e., cybersecurity), and anti-money laundering ("AML") programs. This year, however, some areas of focus changed or were reorganized to highlight or expand upon particular areas OCIE intends to target, including: (i) fintech and innovation (e.g., digital assets and electronic investment advice); and (ii) certain additional subject matter areas (e.g., environmental, social, and governance ("ESG") policies, and LIBOR practices) involving registered investment advisers (including private fund advisers), investment companies, broker-dealers, and municipal advisors.
Below is an overview of some of the more notable areas from the Exam Priorities. However, not every focus area identified in the Exam Priorities is addressed.
As before, OCIE will continue its focus on retail investors, including senior investors, and will prioritize examinations of registered investment advisers, broker-dealers, and dual registrants serving retail investors. It also plans to assess investment products marketed to or intended for retail investors (e.g., mutual funds, exchange-traded funds ("ETFs"), fixed income (including municipal securities), and microcap securities (i.e., stock of companies that have a market capitalization of under $250 million)).
OCIE has incorporated Regulation Best Interest ("Reg BI") into its examination program for registered investment advisers. It plans to assess implementation of Reg BI following the June 30, 2020, compliance date, including the requirement that broker-dealers and investment advisers prepare and deliver a Client Relationship Summary ("Form CRS") to retail investors. See Jones Day's August 2019 Alert, "FINRA Advises Member Firms to Submit Questions to the SEC on Regulation Best Interest," for additional information about submitting questions to the SEC and FINRA about Reg BI, and Jones Day's July 2019 Commentary, "Final Rule on Regulation Best Interest Now Complete," for additional information about the SEC's adoption of Reg BI.
OCIE continues to prioritize cybersecurity, including examining the extent to which registered advisers are protecting clients' personal financial data and reviewing areas such as information security governance and risk management, access controls, data loss prevention, and vendor risk management (including the use of cloud-based storage network solutions).
Fintech and Innovation
Expanding on last year's priorities, OCIE will continue to focus on developments in the fintech area. In addition to focusing on the offer, sale, trading, and custodying of digital asset securities, it will also review other emerging products and services (including the use of "alternative data" to provide those services to clients) and firms' related compliance and control efforts.
Digital Asset Securities. OCIE will focus exams on investment suitability, portfolio management and trading, safekeeping of investor funds and digital assets, pricing and valuation of such assets, compliance program effectiveness, and outside business activity supervision. See Jones Day's July 2019 Commentary, "SEC/FINRA Issue Joint Guidance on Broker-Dealer Custody of Digital Assets," for additional information about SEC and FINRA guidance about broker-dealer custody of digital assets.
Robo-Advisers. OCIE intends to maintain its emphasis on registered advisers that use automated digital platforms to provide investment services to clients (i.e., "robo-advisers"). Among other things, OCIE will devote attention to robo-advisers' SEC registration qualification, cybersecurity policies and procedures, marketing activities, fiduciary duty fulfillment (including whether disclosures to investors are adequate), and compliance program efficacy.
Registered Investment Advisers and Investment Companies
Registered Advisers. OCIE will prioritize the review of the compliance programs of registered advisers, dual registrants, and registered advisers affiliated with broker-dealers or with supervised persons who are registered representatives of unaffiliated broker-dealers. OCIE will prioritize exams of registered advisers that have never been examined or have not been examined for a number of years. Compliance program elements that will be focused on include, among other things, best execution, prohibited transactions, and the use of third-party asset managers to advise clients.
ESG Factors. OCIE plans to pay particular attention to registered advisers' disclosures to clients about investment strategies that encompass ESG considerations. ESG is one of the hottest areas right now, so firms should ensure that their disclosures match their actual strategies. See Jones Day's December 2019 Alert, "SEC Scrutinizing ESG Funds," for additional information about the SEC's review of the methodologies and criteria of ESG-focused investment funds.
Mutual Funds and ETFs. OCIE will focus on investment advisers to mutual funds and ETFs, in addition to the funds themselves and their respective boards of directors. One practice that OCIE intends to prioritize for review is registered advisers' use of third-party administrators to sponsor mutual funds that are advised by or are otherwise affiliated with the registered adviser.
Registered Private Fund Advisers. OCIE intends to pay particular attention to registered advisers to private funds (e.g., hedge, private equity, venture capital, and real estate funds) that also manage registered investment companies (e.g., mutual funds) that have similar investment strategies as the adviser's private fund clients. OCIE states that there also will be an emphasis on registered private fund advisers that manage separately managed accounts side-by-side with private funds. Moreover, OCIE intends to evaluate controls concerning the misuse of material non-public information ("MNPI"), the accuracy and adequacy of disclosures of conflicts of interest relating to fees and expenses, and the use of affiliated service providers.
Broker-Dealers and Municipal Advisors
Broker-Dealers. In addition to OCIE's emphasis on broker-dealer sales practices and Reg BI mentioned above, the Exam Priorities address a number of other areas of significance to broker-dealers, including compliance with: (i) SEC Rule 15c3-3 under the Securities Exchange Act of 1934 ("Exchange Act"), as amended ("Customer Protection Rule"), which requires broker-dealers to periodically calculate the net amount of cash owed to customers and deposit that amount into a segregated Reserve Account; and (ii) SEC Rule 15c3-1 under the Exchange Act ("Net Capital Rule"), which requires broker-dealers to maintain at all times adequate liquid resources to satisfy customer claims. OCIE will also assess broker-dealer trading and risk management practices, including compliance with best execution for trades in odd lots (i.e., orders below 100 shares), controls relating to the practice of algorithmic trading, and internal procedures for trading risk management.
Municipal Advisors. OCIE will examine whether municipal advisors are meeting their registration, qualification, and continuing education obligations. Moreover, it will evaluate municipal advisor compliance with obligations relating to their fiduciary duty to clients, fair dealing with market participants, disclosure of conflicts of interest, and the MSRB's recently effective Rule G-40 that prohibits false or misleading advertisements.
AML is among the perennial priorities of OCIE, and the Exam Priorities indicate sustained prioritization of this area. OCIE will evaluate whether regulated entities are complying with requirements related to filing of suspicious activity reports, performing due diligence on customers, satisfying beneficial ownership obligations, and conducting independent assessments of their AML programs on a timely basis. See Jones Day's October 2019 Alert, "Financial Regulatory Leaders Highlight Anti-Money Laundering Issues With Digital Asset Transactions," about U.S. financial regulators highlighting some AML activities and countering the financing of terrorism regulatory obligations applicable to digital assets.
Clearing Agencies and National Securities Exchanges. OCIE will conduct exams of clearing agencies and national securities exchanges, particularly emphasizing certain areas impacting the infrastructure of the securities markets. For example, OCIE will assess compliance with SEC Regulation Systems Compliance and Integrity's ("Regulation SCI") requirement to implement and enforce written policies and procedures intended to ensure, among other things, that the regulated entity's technology systems can maintain its operational capabilities. Likewise, OCIE intends to evaluate areas such as IT inventory management and governance, incident response, third-party vendor management, and the use of cloud computing.
Transfer Agents. OCIE will continue examining the operations of transfer agents, including those that are: (i) paying agents for issuers; (ii) developing blockchain technology; and (iii) furnishing services to issuers of digital asset securities, private offerings, crowdfunded securities, and microcap stocks.
FINRA and MSRB
As in years past, OCIE will focus on the self-regulatory organizations ("SROs") FINRA and MSRB by conducting risk-based assessments of their operations to identify areas to examine. Examinations will evaluate the effectiveness of each SRO's policies, procedures, and controls. OCIE will use these reviews to make recommendations about ways to improve the SROs' programs, processes, and future examinations.
Although it was not specifically listed as an examination priority, OCIE noted that it will be reviewing firms' preparations and disclosures regarding their readiness for the transition away from using LIBOR as a reference rate in various financial instruments and agreements to the use of an alternative reference rate. Of particular interest will be firms' readiness to address the transition's effects on investors. OCIE also suggests that firms review their exposure to LIBOR throughout their operations, including in accounting systems, risk models, and client reporting, as well as its use in benchmarks and indices.
Three Key Takeaways
- The Exam Priorities are a good reminder for broker-dealers, investment advisers, and other SEC-regulated entities to review their existing policies, procedures, and practices to determine where enhancements and additional attention may be needed.
- Broker-dealers should pay particular attention to subject matter areas identified in the Exam Priorities as they review their sales practices and policies and procedures to ensure compliance with current regulatory requirements, namely those areas relating to Reg BI, Regulation SCI, the Customer Protection Rule, the Net Capital Rule, and activities involving digital asset securities.
- Investment advisers to private funds should particularly focus on the discussion in the Exam Priorities about disclosures relating to fees and expenses and ESG investment strategies, misuse of MNPI, use of affiliated services providers, and management of: (i) registered investment companies that have similar investment strategies as the adviser's private fund clients, and (ii) separately managed accounts' side-by-side trading with private funds.