On December 20, 2018, the Office of Compliance Inspections and Examinations (OCIE) of the U.S. Securities and Exchange Commission (the SEC) released its report (the 2019 Report) setting forth its list of examination priorities for 2019 (the Exam Priorities).1 OCIE announces its exam priorities annually to provide insights into the areas it believes present potentially heightened risk to investors or the integrity of the U.S. capital markets.2 The Exam Priorities can serve as a roadmap to assist advisers in assessing their policies, procedures and compliance programs; testing for and remediating any suspected deficiencies related to the Exam Priorities; and preparing for OCIE exams.
The number of investment advisers examined by OCIE has increased significantly in recent years. In fiscal year (FY) 2018, the OCIE National Exam Program examined approximately 17 percent of SEC-registered advisers (RIAs), up from 15 percent during FY 2017 and 11 percent during FY 2016. Just five years ago, 9 percent of RIAs were examined. Examinations of registered investment companies (RICs) were also up during FY 2018, increasing by approximately 45 percent.3
OCIE’s current examination priorities, as outlined in the 2019 Report, reflect both perennial risk areas that have been emphasized in recent years and risks associated with developing products and services. The priorities are organized around six themes: (a) retail investors, including seniors and those saving for retirement; (b) compliance issues and risks associated with entities responsible for critical market infrastructure, including clearing agencies, national securities exchanges, the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), transfer agents and other Regulation Systems Compliance and Integrity (Regulation SCI) entities (i.e., entities required to comply with Regulation SCI); (c) select areas and programs of FINRA and MSRB (d) digital assets, including cryptocurrencies, coins and tokens; (e) cybersecurity; and (f) anti-money laundering programs of financial institutions that are required by regulations adopted under the Bank Secrecy Act to establish such programs.
This Sidley Update summarizes selected points in the Exam Priorities that may be of particular interest to investment advisers.
Exams are Risk-Based and Data-Driven
OCIE notes in the 2019 Report that while the Exam Priorities provide a preview of key areas where OCIE intends to focus its limited resources and drive many of OCIE’s examinations, they do not encompass all of the areas that will be covered in exams. As explained in the 2019 Report, the scope of any examination is determined through a risk-based approach that includes analysis of the registrant’s operations, products offered and other factors. The 2019 Report emphasizes that this risk-based approach, both in selecting registered entities to examine and determining the scope of risk areas to examine, “remains flexible in order to cover emerging and exigent risks to investors and the marketplace as they arise.” To this end, “OCIE is increasingly leveraging technology and data analytics as well as human capital to fulfill its mission.”
Continued Focus on Retail Investors
The Exam Priorities continue OCIE’s trend in recent years to prioritize the protection of retail investors, particularly seniors and those saving for retirement. According to the 2019 Report, in examinations of investment advisers, OCIE will continue to review the services and products offered to these investors, focusing on, among other things, adviser compliance programs, the appropriateness of certain investment recommendations to seniors and the supervision by firms of their investment professionals and other employees.
In furtherance of its commitment to retail investors, OCIE will continue to prioritize the examination of mutual funds and exchange traded funds (ETFs), the activities of their advisers, and the oversight practices of their boards of directors. In the 2019 Report, OCIE references previous examinations that identified advisers that selected more expensive mutual fund share classes for clients when lower-cost share classes were available without adequate disclosure to investors and notes that in future exams, examiners will continue to evaluate financial incentives for financial professionals that may influence their selection of particular share classes.
With respect to mutual funds and ETFs, examiners also will focus on risks associated with (a) index funds that track custom-built or bespoke indexes, (b) ETFs with little secondary market trading volume and smaller assets under management, (c) funds with higher allocations to certain securitized assets, (d) funds with aberrational underperformance, (e) funds managed by advisers that are relatively new to managing RICs and (f) advisers that provide advice to both RICs and private funds with similar investment strategies. OCIE also will continue to focus on investment advisers participating in wrap fee programs, with a continued interest in brokerage practices and the adequacy of disclosures.
Other Relevant Focus Areas
Many of the topics covered in the Exam Priorities, including those discussed primarily in the section on retail investors, are relevant not only to advisers with retail clients but also to advisers that advise other types of clients, including institutional clients and private funds. Selected focus areas include:
Disclosure of the Costs of Investing. OCIE stresses in the Exam Priorities that the proper disclosure and calculation of fees, expenses and other charges investors pay is critically important. Examiners will review, among other things, whether fees and expenses are calculated and charged in accordance with the disclosures provided to clients and investors in pertinent client agreements.
Conflicts of Interest. Examiners will focus on ensuring that investment advisers are acting in a manner consistent with their fiduciary duty and meeting their contractual obligations to their clients. The Exam Priorities include the following points, among others:
- A financial professional must inform investors of any conflicts of interest that might provide incentives for the professional to recommend certain types of products or services.
- OCIE will examine arrangements in which an investment adviser uses services or products provided by affiliated entities. These arrangements may present conflicts of interest related to, for example, portfolio management practices and compensation arrangements.
- Examiners will review policies and procedures with respect to securities-backed non-purpose loans and lines of credit to assess whether registrants are adequately disclosing the risks to clients and any conflicts of interest presented by recommending these loans.
- Borrowing funds from clients presents a number of conflicts of interest for an investment adviser. Examiners observing this practice will evaluate whether adequate disclosures, including the potentially poor or failing financial condition of the adviser, are made to the client and the adviser has acted consistently with these disclosures.
Portfolio Management and Trading. OCIE notes in the 2019 Report that an integral component of investment adviser exams is reviewing portfolio management processes. Examiners will review a firm’s practices for executing investment transactions, fairly allocating investment opportunities among clients, ensuring consistency of investments with client objectives, disclosing critical information to clients and complying with other legal restrictions.
OCIE also will examine portfolio recommendations to assess, among other things, whether an adviser’s investment or trading strategies are (a) in the best interests of investors based on their investment objectives and risk tolerance; (b) contrary to, or have drifted from, disclosures to investors; (c) venturing into new, risky investments or products without adequate risk disclosure; and (d) appropriately monitored for attendant risks.
Digital Assets. The digital asset market, which includes cryptocurrencies, coins and tokens, has grown rapidly, and the number of investment advisers engaged in this space continues to expand as well. In the 2019 Report, OCIE references investment adviser examinations that have identified emerging risks related to selling or recommending digital assets, such as concerns related to custody and safekeeping of investor assets, valuation, omitted or misleading disclosures regarding the complexities of the products and technology, and the risks of dramatic price volatility.
According to the Exam Priorities, OCIE will continue to monitor the sale, trading and management of digital assets and, where the products are securities, examine for regulatory compliance. In particular, OCIE will take steps to identify market participants involved with these products, or considering such involvement, and then assess the extent of their activities. For firms actively engaged in the digital asset market, OCIE will conduct examinations focused on, among other things, portfolio management and trading of digital assets, safety of client assets, pricing of client portfolios and compliance and internal controls.
Never-before-examined investment advisers. OCIE will continue to conduct risk-based examinations of certain investment advisers that have never been examined, including newly registered advisers as well as advisers registered for several years that have not yet been examined. OCIE also will prioritize examinations of certain investment advisers that have not been examined for a number of years and may have substantially grown or changed business models.
Cybersecurity. Cybersecurity remains a top SEC priority, and OCIE will continue to work with firms in all sectors to identify and manage cybersecurity risks. Examinations will focus on, among other things, proper configuration of network storage devices, information security governance generally and policies and procedures related to retail trading information security. Specific to investment advisers, OCIE will emphasize cybersecurity practices at firms with multiple branch offices, including those that have recently merged with other advisers, and continue to focus on, areas, governance and risk assessment, access rights and controls, data loss prevention, vendor management, training and incident response.
The themes and specific points outlined in the 2019 Report do not constitute an exhaustive list of OCIE’s concerns, and actual examinations are likely to include a number of other topic areas. Nevertheless, the Exam Priorities are likely to drive many of OCIE’s exams in the coming year, and investment advisers are encouraged to review their current policies, procedures and client disclosures with these priorities in mind.