On January 9, 2014, the National Examination Program of the Office of Compliance Inspections and Examinations (“the NEP”) of the Securities and Exchange Commission (“the SEC”), in coordination with the staff of other SEC divisions, published its 2014 examination priorities to communicate with investors and registrants about areas and practices the NEP perceives to have heightened risk. The examination priorities address issues that span the entire market, as well as issues that relate specifically to particular business models and organizations. All investment advisers and broker-dealers should carefully review the examination priorities and consider necessary enhancements to their operations, policies and procedures, as well as potential revisions to the substance or focus of training programs. The full text of the examination priorities may be reviewed online here.
Market-wide Examination Priorities
The NEP identified numerous market-wide examination priorities, the following of which are most relevant to investment advisers and broker-dealers:
Fraud Detection and Prevention. As part of its risk-based approach to targeting registrants and business practices, the NEP will continue to utilize and to enhance its quantitative and qualitative tools and techniques to seek to identify market participants engaged in fraudulent or unethical behavior. To that end, in 2013 the NEP expanded its Quantitative Analytics Unit, a team of specialists that evaluate risks in the algorithms, models, and software used by many investment professionals and also enhanced its Risk Analysis Examination initiative, which examines clearing firms and large broker-dealers by downloading and analyzing all transactions cleared by a firm over a period of several years.
Corporate Governance, Conflicts of Interest and Enterprise Risk Management. The NEP will continue to meet with senior management and boards of entities registered with the SEC, including their affiliates where appropriate, to discuss how each firm identifies and mitigates conflicts of interest and legal, compliance, financial, and operational risks.
Technology. The NEP will continue to examine governance and supervision of information technology systems, operational capability, market access, information security and preparedness to respond to sudden malfunctions and system outages.
Dual Registrants. The NEP has identified the convergence between broker-dealer and investment adviser representative activity as a significant market-wide risk. As an example, the NEP points out that a dual representative may improperly influence whether a client establishes a brokerage or investment advisory account, with the client placed into an inappropriate account type that increases revenue to the firm without providing a corresponding benefit for the client. The NEP will continue to examine the significant risks to investors of migration and other conflicts that this business model presents, and will also focus on the impact to investors of the different supervisory structures and legal standards of conduct that govern the provision of brokerage and investment advisory services.
New Laws and Regulations. The staff will review general solicitation practices and verification of accredited investor status under newly adopted Rule 506(c) under the Securities Act of 1933 to the extent conducted by a regulated entity, generally will review, monitor, and analyze the use of Rule 506(c), and will evaluate due diligence conducted by broker-dealers and investment advisers for such offerings.
Retirement Vehicles and Rollovers. The staff recognizes that investment advisers and broker-dealers may have incentives to recommend certain investments when an individual transfers retirement plan assets following changes in employment or retirement. In light of that, the staff will undertake several initiatives, including the following: (i) examining the sales practices of investment advisers targeting retirement-age workers to roll over their employer-sponsored 401(k) plan into higher cost investments, including whether advisers are misrepresenting their credentials or the benefits and features of IRA plans or other alternatives; and (ii) examining broker-dealers and investment advisers for possible improper or misleading marketing and advertising, conflicts, suitability, churning, and the use of potentially misleading professional designations when recommending asset transfers.
Investment Adviser Examination Priorities
In addition to the market-wide examination priorities, the NEP identified the following key examination priorities specifically for investment advisers:
Safety of Assets and Custody. The NEP notes that it continues to observe non-compliance with Rule 206(4)-2 under the Advisers Act (the “Custody Rule”), notwithstanding the Risk Alert that it published in March 2013 sharing observations regarding the most common issues of non-compliance (which may be found online here). Given the importance of this requirement for a fiduciary, the staff will continue to test compliance with the Custody Rule and confirm the existence of assets through a risk-based asset verification process. Examiners will pay particular attention to those instances where advisers fail to realize they have custody and therefore fail to comply with requirements of the Custody Rule.
Conflicts of Interest Inherent in Certain Investment Adviser Business Models. The staff intends to conduct examinations focused on conflicts of interest inherent in the investment adviser business model, including the following areas of focus: (i) compensation arrangements for the adviser, with a particular focus on undisclosed compensation arrangements and their effect on investment recommendations; (ii) allocation of investment opportunities; (iii) controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts; (iv) risk controls and disclosure, particularly for illiquid investments and leveraged investment products and strategies; and (v) higher risk products or strategies targeted to retail investors, especially retired or elderly investors.
Marketing and Performance. The staff intends to focus on the accuracy and completeness of advisers' claims about their investment objectives and performance, with a specific focus on hypothetical and back-tested performance, the use and disclosure of composite performance figures, performance record keeping, and compliance oversight of marketing.
Wrap Fee Programs. The staff intends to assess whether advisers are fulfilling their fiduciary and contractual obligations to clients and will review the process in place for monitoring wrap fee programs recommended to advisory clients, related conflicts of interest, best execution, trading away from the sponsor, and disclosures.
Quantitative Trading Models. The staff will focus on investment advisers with substantial reliance on quantitative portfolio management and trading strategies and will assess, among other things, whether these firms have adopted and implemented compliance policies and procedures tailored to the performance and maintenance of their proprietary models, including such procedures as: (i) evaluating if any models are used to manipulate the relevant markets; (ii) reasonably reviewing or testing the models and their output over time; (iii) maintaining proper documentation within required books and records; and (iv) maintaining a current inventory of all firm-wide proprietary models.
Broker-Dealer Examination Priorities
In addition to the market-wide examination priorities, the NEP identified the following key examination priorities specifically for broker-dealers:
Sales Practices/Fraud. The staff intends to focus on the following potential fraudulent practices and other violations in connection with sales practices to retail investors: (i) affinity fraud targeting seniors or other groups; (ii) micro-cap fraud and pump and dump schemes; (iii) unsuitable recommendations of higher yield and complex products, as well as the adequacy of due diligence around such products; and (iv) unregistered entities engaged in the sale or promotion of unregistered offerings or other unusual capital raising activities.
Supervision. The staff will focus on broker-dealers' supervision of the following: (i) independent contractors and financial advisors in "remote" locations and large branch offices; (ii) registered representatives with significant disciplinary histories; and (iii) private securities transactions.
Trading. The staff intends to carefully monitor market access controls related to, among other things, the following: (i) erroneous orders; (ii) the use of technology with a focus on algorithmic and high frequency trading; (iii) information leakage and cyber security; and (iv) market manipulation involving practices such as marking the close, parking, fraudulent stimulation of demand, and excessive markup and markdowns.
Internal Controls. The staff will assess the standing, authority, and effectiveness of key control functions, including liquidity, credit and market risk management practices, internal audit, valuation practices, and compliance.
Financial Responsibility. The staff intends to review broker-dealers for compliance with the customer protection and net capital rules, as recently amended, with a focus on assets collateralizing large concentrated customer debit balances and the liquidity of firm inventory.
Anti-money Laundering. The staff will review clearing and introducing firms to assess anti-money laundering programs, and will also conduct examinations of such programs of proprietary trading firms that allow customers direct access to the markets from higher risk jurisdictions.
Given the multiple areas of supervisory focus for 2014, it is imperative that investment advisers and broker-dealers carefully review their practices, policies and procedures, and corresponding training programs to ensure that all facets of their operations are fully compliant with the examination priorities discussed above.