The SEC Office of Compliance Inspections and Examinations (“OCIE” or the “Staff”) recently released its 2015 Exam Priorities. OCIE examines all types of SEC registrants, including investment advisers, broker-dealers, investment companies, municipal advisors and transfer agents. Each January, the release of the OCIE Exam Priorities provides a useful guide and reminder to registrants in connection with their individual compliance program and risk management reviews for the year ahead.
Exam Priorities are always a reflection of current trends and news and, in recent years, also reflect the SEC’s expanded capabilities for monitoring market activity through data analytics. They are not exclusive—actual exams may, and will, cover other topics.
Here are some highlights of the OCIE 2015 Exam Priorities (with Commentary in italics):
Fees and Expenses in Private Equity: Citing the high rate of deficiencies already observed among private equity fund advisers, the Staff will continue to examine fee and expense practices and related disclosures.
We note that several firms and persons have been charged or fined for improper fee and expense practices, and the Staff has been announcing its focus in this area throughout 2014.1 Bloomberg recently reported that two leading fund managers made new disclosures that their funds will pay them additional fees (i.e., in addition to management fee and carry) of $10 million – $20 million per year. Improved disclosure practices are arguably healthy and inevitable, although improved disclosures are no assurance of “safety” with regard to prior practices, and may, in fact, put the Staff on notice of prior opacity on fees. The same story reported that a recent speech by OCIE Chief Andrew Bowden highlighted the payment of fees to “operating partners” that “walk, talk, act and look like employees or affiliates,” without offsetting the management fee. According to Bloomberg, the Staff is also concerned about accelerated monitoring fees for services not yet rendered that are captured before the portfolio company is sold. Bloomberg data shows these accelerated fees total more than $1 billion charged to companies taken public since 2010.2
Alternative Investment Companies: Noting the recent rapid growth of funds promoting uncorrelated returns (the so-called “liquid alts” sector), the Staff, with respect to such funds, will focus on (1) leverage, liquidity and valuation policies and practices; (2) adequacy of internal controls, including staffing, governance and funding; and (3) marketing practices.
Funds and managers that have expanded into these products or strategies and have not yet reviewed and amended compliance, disclosure, and risk management programs accordingly, should do so promptly.
Fixed Income Investment Companies: Citing the consensus view that interest rates are expected to increase in the foreseeable future, the Staff will focus on interest-rate sensitive mutual funds, and whether they have implemented adequate compliance policies and procedures and investment and trading controls to assure that portfolio holdings and liquidity are consistent with disclosures to investors.
Protecting Retirement Investors: Keying off statistics showing that self-directed retirement assets are now twice the size of defined contribution plan assets, the Staff will focus on protecting retirement investors. They will focus on whether an adviser offers multiple types of fee arrangements and, if so, how different arrangements or account types are recommended to clients, and whether the recommendations are in the client’s best interest at inception and on an ongoing basis. Factors in this area include fees charged, services provided and disclosures made. Here, OCIE calls out its concern about reverse churning (i.e., moving clients to, or keeping clients in, asset-based fee products for an underlying portfolio that is lightly traded or static, when a commission-based product would lower the client’s costs). The Staff will also focus on recommendations to investors to move assets from defined contribution plans into other products, particularly whether sales practices in this regard are improper or misleading, and how those practices address any incremental risks and fees. Similarly, the Staff will evaluate registrant conduct in recommending complex or structured products and higher-yield securities. Here, the Staff will examine whether the registrant performed due diligence, made appropriate disclosures, and assessed the suitability of such products for retirement assets. They also announce that they will evaluate whether any such recommendations are “consistent with existing legal requirements” without elaborating on the meaning of this phrase in this context; presumably, existing legal requirements could range from contractual obligations to a client to regulatory limitations, such as assessing suitability, offering or selling only to properly qualified investors and using proper means of solicitation.
Multi-Office Advisors: The Staff will also focus on registrants’ supervision of branch offices, and specifically the use of data analytics to identify non-compliant practices in branches.
Market-Wide Risks: Staff priorities in the area of maintaining orderly markets include focus (or continued focus) on the following subjects: (1) cybersecurity for broker-dealers and advisers; (2) annual exams for clearing agencies; and (3) large firm monitoring. In addition, the Staff is again focusing on (4) best execution – this time, the concern is whether firms are taking payments or credits for order flow into consideration when routing orders, and whether that practice is in conflict with their best execution obligations.
Best execution practices are a recurring theme in OCIE Exam Priorities because the ways in which brokers can incentivize order flow seem endlessly mutable. In fact, advisers checking their trading room practices on order flow credits this year would be wise to make sure practices around soft dollars, directed brokerage, expense offsets, and gifts & entertainment have not drifted from the last time focus on these types of inducements came around. A best execution problem is likely to be charged as a Section 206 violation, which goes to adviser integrity and can be a difficult stain on future disclosures.
Data Analytics: The Staff reminds registrants of its new capabilities to identify potentially fraudulent or illegal market activity through data analytics. OCIE will be monitoring for (1) individuals with prior misconduct records; (2) pump-and-dump schemes and other market manipulation in microcap stocks; (3) excessive trading; and (4) AML compliance. Broker-dealers that have not filed suspicious activity reports (“SARs”) or that have filed incomplete SARs, and those that provide customers direct access to markets from higher risk jurisdictions, should expect to be examined.
The Staff's ability and intent to monitor persons with prior misconduct records is a new consideration for securities industry employers.
Other Initiatives: The Staff will also focus on (1) exams, outreach and education for newly registered municipal advisors; (2) exams for proxy advisory services focused on disclosure and mitigation of conflicts of interest; (3) risk-based exams of registered investment companies that have not yet had a first exam; and (4) exams of transfer agents.
We take this opportunity to remind our investment adviser clients that ADV annual updates are due within 90 days of your fiscal year end (or March 31, 2015, for most advisers), and that compliance programs must be reviewed annually and updated to reflect changes in law and regulation, as well as changes in your organization and operations. Advisers that used non-law firm service providers to accomplish registration and that have not discussed their ADV disclosures and/or compliance program with counsel are well advised to plan a review with counsel at this time. Discrepancies between operations and either disclosures or policies may become actionable violations, even if the statute or rules would not otherwise prohibit the adviser’s conduct.
Comments or questions regarding this client alert may be directed to Alexandra (Sandra) Poe, partner in Reed Smith’s Corporate & Transactional Advisory Group, and a leader of Reed Smith’s private fund formation and counseling practice.