Only four words are needed to terrify an investment adviser: “We’re from the SEC.…”1

The SEC’s Office of Compliance Inspections and Examinations (OCIE) recently sent a letter to certain advisers alerting them about its new “Never Before Examined Initiative.” Under this initiative, OCIE will examine some non-fund advisers that have been registered for more than three years but not yet examined. (Private fund advisers are still being examined under 2012’s “Presence Exam” initiative.) In January, the SEC and FINRA released their annual letters identifying focus areas for examinations of investment advisers and dual registrants. As part of the annual compliance review, advisers may want to review their compliance programs in the following regulatory focus areas.

The National Exam Program (NEP) Priorities

The NEP’s 2014 examination priorities were selected from SEC filings, examination findings, hotline tips, media and discussions with members of the industry and include:

  • Fraud Detection and Prevention — using quantitative and qualitative tools, NEP looks for scams, theft, unfair advantage and other fraudulent conduct, including recreating model results. Two dedicated teams analyze data collected from reports, and advisers with aberrational performance may be targeted for examination.
  • Corporate Governance, Conflicts and Risk Management — “tone at the top” and how senior management and fund directors identify, manage and disclose conflicts of interest and operational and investment risks.
  • Technology — scrutinizing firms’ technology supervision (including data protection and access), market access, information security and preparation for malfunctions and outages.
  • Dual Registrants — in dual registrant exams, focusing on conflicts of interest when customers are placed in account types (advisory, brokerage) that may not be suitable.
  • New Laws — reviewing general solicitation practices (including crowdfunding rules) and compliance with new rules for municipal advisers.
  • Retirement Vehicles — focusing on practices in the retirement investor market, including sales practices when retirees roll over their 401(k) plans into IRAs or other higher cost investments, and, for dual registrants, misleading advertisements, suitability and churning in connection with employment changes.

The NEP has adopted new risk categories — core, new and emerging risks, and policy topics — and focus areas within each category.

Core risks are continuing business or operational risks identified in previous exams, including:

  • Custody — advisers failing to realize that they have custody and failing to satisfy the custody rule (including on the timing of audited financial statements and account statements); confirmation of existence of assets remains an issue.
  • Conflicts inherent in adviser business models — undisclosed compensation arrangements, allocation of investment opportunities, calculation and disclosure of performancebased fees, disclosures about illiquid investments and leverage, and targeting high-risk products to retirees and other investors.
  • Marketing and performance — the accuracy and completeness of performance claims and marketing efforts in light of the new JOBS Act rules.

New and emerging risks include:

  • Wrap Fee Programs — how advisers using wrap fee programs monitor risks, and identify and resolve conflicts and trading issues. n Quantitative Trading Models — model compliance obligations for advisers who rely substantially on quantitative portfolio trading strategies.
  • Presence Exams — focusing on marketing, portfolio management (drift ), conflicts, safety of assets and valuation for advisers to hedge funds and private equity funds.
  • Payments for Distribution in Guise — disclosure and board oversight of payments to fund distributors and intermediaries, including determining whether payments are for distribution or preferential treatment.
  • Fixed Income Investment Companies — disclosures by bond funds about interest rates and the changing interest rate environment.

Policy topics include:

  • Money Market Funds — targeted exams of funds, focusing on how they managed potential stress events, and funds that exhibit outlier behavior.
  • Alternative Investment Companies — funds offering “alternative” startegies, focusing in (i) leverage, liquidity and valuation policies; (ii) staffing, funding and empowerment of boards and compliance personnel; and (iii) how these funds are marketed to investors (including suitability issues).
  • Securities Lending Arrangements — compliance with applicable exemptive orders and no-action letters.


FINRA also issued its annual regulatory and examination priorities letter. Advisers that offer investments through FINRA members should be aware of FINRA’s focus areas for 2014:

  • Suitability — broker recommendations, disclosure, and marketing of complex products to retail customers, including programs that reward brokers who place these products. In the crosshairs are complex structured products (including leveraged products), private REITs, frontier funds, and interest rate-sensitive securities (including MBS, long duration products, emerging market debt, municipal securities and baby bonds).2
  • Cybersecurity — integrity of firms’ policies, procedures and controls to protect firm infrastructure and customer data.
  • Conflicts of Interest — how firms identify and mitigate conflicts of interest, focusing on new products and post launch reviews, the impact of mitigation on customers, pressures to sell proprietary products or products with revenue sharing arragemets, and compensation structures.
  • Retirement Investors — firm rollover practices (encouraging clients to roll 401(k)s into IRAs) including marketing materials, supervision and securities recommendations, and how firms and brokers engage with and communicate to senior investors.
  • General Solicitations — private placement practices for compliance with due diligence and suitability rules, and general solicitation and filing requirements, focusing on distressed issuer placements, serial private placements and crowdfunding portals.
  • Microcap Fraud — firm oversight of activities related to speculative microcap and low-priced over-the-counter (OTC) securities, including supervision of employees and traders, and all firm activities when a firm-affiliate serves as a transfer agent for these securities, focusing on AML responsibilities.
  • Algorithmic Trading and Trading Systems — concerns about how firms develop, implement, and supervise algorithmic trading systems, including the roles of legal, compliance and operational staff, focusing on market disruptions.
  • Best Execution — best execution for equities, options, and fixed-income securities, including firms’ compliance with their affirmative duty to regularly and rigorously review execution quality to assure that order flow is directed to markets providing the most beneficial terms for customers.

As always, advisers that establish and document a “culture of compliance” and embrace compliance obligations, including a well-documented annual review, will be better prepared for regulatory examinations, and typically receive a more favorable outcome. Firms with products placed by FINRA members should also understand FINRA’s regulatory concerns, especially around disclosure and marketing. All firms should ensure that employees are trained to identify risks, and use controls to mitigate them, especially in these focus areas. Finally, FINRA-registered firms should ensure that suitability evaluations are properly conducted and documented.