The Securities and Exchange Commission (SEC) on January 9, 2014 announced its examination priorities for 2014. The priorities address: (i) market-wide issues, including fraud detection and prevention, corporate governance, technology controls and recent legal and regulatory developments; and (ii) specific issues relating to each of the four areas covered by the National Exam Program (NEP): (i) investment advisers and investment companies; (ii) broker-dealers; (iii) market oversight; and (iv) clearing agencies and transfer agents. The NEP is overseen by the SEC’s Office of Compliance Inspections and Examinations (OCIE).
The annual list of examination priorities highlights issues that OCIE considers “to have heightened risk.” Issues are identified based on various factors, including: (i) information reported by registrants in required SEC filings; (ii) information obtained through regulatory examinations; (iii) communications with other regulatory agencies; (iv) interactions with registrants and others outside the scope of an examination; (v) comments and tips; (vi) data kept in third-party databases; and (vi) industry and media publications. Andrew J. Bowden, Director of OCIE, stated that publishing the examination priorities would help “to increase transparency, strengthen compliance, and inform the public and the financial services industry about key risks that [OCIE is] monitoring and examining.” The SEC noted, in an accompanying press release, that the listed priorities “are not exhaustive and may be adjusted throughout the year in light of ongoing risk assessment activities.” As such, registrants should expect that examinations will not be limited to the issues highlighted in the list of examination priorities.
For 2014, OCIE identifies six issues that it views as affecting the entire market: (i) fraud detection and prevention; (ii) corporate governance, conflicts of interest and enterprise risk management; (iii) technology; (iv) firms that are registered as both investment advisers and broker-dealers (dual registrants) and the convergence between broker-dealer and investment adviser activities; (v) new laws and regulations; and (vi) retirement vehicles and rollovers.
First, OCIE emphasized that “[s]cams, theft, unfair advantage, and other fraudulent conduct erode . . . trust and adversely affect investors and the efficient functioning of our markets.” Consequently, OCIE’s fraud detection and prevention efforts will rely on quantitative and qualitative tools to detect market participants who may be engaging in fraudulent or unethical behavior. Second, examiners will focus on corporate governance, conflicts of interest and enterprise risk management by meeting with registrants’ senior management and boards. In these meetings, examiners will aim to “(i) evaluate firms’ control environment and ‘tone at the top,’ (ii) understand firms’ approach to conflict and risk management, and (iii) initiate a dialogue on key risks and regulatory requirements.” Third, OCIE will consider a registrant’s use of technology, including consideration of the registrant’s: operational capabilities given the increasing complexity of technology; governance and supervision of IT systems; information security; market access; and ability to respond to unexpected technological malfunctions. Fourth, OCIE will examine the risks to investors posed by the convergence of broker-dealer and investment adviser representative activity. These risks include the differing standards of conduct and supervisory structures in the respective services provided. Fifth, OCIE will consider whether and how registrants are complying with new legislation. In this respect, where applicable, examiners will focus on compliance with new Rule 506(c) under the Securities Act of 1933 (which allows for general solicitation in a Regulation D offering under certain circumstances). The examination priorities list notes that OCIE will review general solicitation practices, accredited investor status verification, and due diligence by broker-dealers and investment advisers. Examiners will also review compliance with the new crowdfunding rules that are expected and recent rules adopted for municipal advisors, as well as other rules arising from the Dodd-Frank Act, notably any final rules regarding security-based swaps dealers. Finally, OCIE will examine sales and advertising practices of broker-dealers and investment advisers who target retirement-age workers, focusing on, among other matters, the use of potentially misleading advertising and professional designations.
Specific Issues Affecting Investment Advisers, Investment Companies and Broker- Dealers
In addition to these market-wide issues, the examination priorities list details core risks, new and emerging issues and initiatives, and policy topics related to specific program areas that are considered to be priorities for the coming year. OCIE has indicated that different types of registrants will face different examinations regarding these issues, depending on the registrant’s business activities. The list below summarizes the issues that are most relevant to investment advisers, investment companies and broker-dealers.
Investment Advisers and Investment Companies
- Safety of Assets and Custody: The Staff will monitor compliance with Rule 206(4)-2 of the Investment Advisers Act of 1940 (Custody Rule), use a risk-based asset verification process to confirm existence of assets, and “pay particular attention to those instances where advisers fail to realize they have custody and therefore fail to comply with the requirements of the Custody Rule.”
- Conflicts of Interest Inherent in Certain Investment Adviser Business Models: The Staff will focus on adviser compensation, risk controls, disclosure, allocation of investment opportunities, and higher risk products and strategies targeted to retail investors.
- Marketing/Performance: The Staff will review of the accuracy and completeness of advisers’ stated investment objectives and performance. This review may focus on hypothetical and back-tested performance, composite performance figures, performance record keeping and marketing, including the new solicitation rules under the JOBS Act.
New and Emerging Issues and Initiatives
- Never-Before Examined Advisers: Advisers who are not part of the presence exam (a limited scope exam focused on private fund managers) and have been registered for more than three years are a priority for the SEC in 2014.
- Wrap Fee Programs: Examinations of advisers involved in wrap fee programs will focus on fiduciary and contractual obligations, processes for monitoring wrap fee programs, related disclosures and conflicts of interest, best execution and trading away from the sponsor.
- Quantitative Trading Models: OCIE will examine whether advisers with substantial reliance on quantitative portfolio management and trading strategies have implemented appropriate compliance procedures and policies. These procedures include testing the models and output over time, evaluating if the models are being used to manipulate the markets and maintaining documentation and inventory.
- Presence Exams: The presence exam program will continue. In these exams, the Staff focuses on one or more of the following topics: marketing; portfolio management; valuation; safety of client assets; and conflicts of interest. Generally, advisers who have registered since the effective date of Section 402 of the Dodd-Frank Act (many of whom are advisers to hedge funds and private equity funds that were not previously registered with or regulated by the SEC) may be subject to presence exams, as will other private fund advisers that the Staff perceives as presenting higher risks to investors, potential fraud or broker-dealer status concerns.
- Payments for Distribution in Guise: The staff will review adviser and fund payments to distributors and intermediaries (including whether these are payments for distribution and preferential treatment), disclosure to the board and board oversight of the payments.
- Fixed Income Investment Companies: Exams will focus on the risks arising from changing interest rates and their impact on bond funds and risk disclosure.
- Money Market Funds: Special attention will be given to outlier behavior and how money market funds manage potential stress events.
- “Alternative” Investment Companies: OCIE will focus on liquidity, leverage and valuation policies, fund marketing, and the staffing, funding and empowerment of boards, back-offices and compliance staff. Examiners will also assess funds’ representations and recommendations about the suitability of alternative investments.
- Securities Lending Arrangements: OCIE will focus on compliance with exemptive orders and consistency with no-action letters.
- Sales Practices/Fraud: Examiners will seek to detect fraud targeting seniors and other groups, micro-cap pump and dump schemes, due diligence, recommendations of high yield and complex products, and the promotion of unregistered offerings by unregistered entities.
- Supervision: Examiners will consider how broker-dealers supervise private securities transactions, independent contractors and financial advisors working from remote locations or at large branch offices, and registered representatives of broker-dealers with notable disciplinary histories.
- Trading: Examiners will prioritize erroneous orders, technology (including algorithmic and high frequency trading), information security, market manipulation such as parking and “spoofing” (fraudulent stimulation of demand), excessive markups and markdowns, abuses of the bona-fide market making exception to Regulation SHO and relationships between broker-dealers and Alternative Trading Systems.
- Internal Controls: Examiners will review the standing, effectiveness and authority of key control functions, including liquidity, credit and market risk management practices. Attention will also be given to compliance, valuation practices, and internal audit procedures.
- Financial Responsibility: Examiners will review broker-dealers’ compliance with customer protection and net capital rules. Exams will specifically focus on assets collateralizing large concentrated customer debit balances and the liquidity of firm inventory. If a firm calculates net capital pursuant to Appendices E and F of the net capital rule, examiners will test the approval process for model changes and evaluate the integrity of the data.
- Anti-Money Laundering: Examiners will review clearing and introducing firms with respect to anti-money laundering (AML) programs, with a focus on proprietary trading firms that provide customers with direct access to the markets from higher risk jurisdictions.
New and Emerging Issues and Initiatives
- Exchange Act Rule 15c3-5 (Market Access Rule): Examiners will assess firms’ application of the Market Access Rule to proprietary trading. In addition, the Staff will review recordkeeping by broker-dealers who provide market access though master/subaccount arrangements.
- Suitability of Variable Annuity Buybacks: Examiners will focus on whether broker-dealers are recommending that customers accept the terms of insurance companies’ buyback offers of variable products with substantially increased values, the suitability of these recommendations and any related disclosure.
- Fixed Income Market: Examiners will focus on the structure of the market, the use of Alternative Trading Systems and their effect on the quality of executions. The Staff will pay specific attention to market participants’ use of filters to control what fixed income Alternative Trading Systems display.
This list is not comprehensive and OCIE has made it clear that it is subject to change if there are new regulatory and market developments, or if OCIE learns new information through examinations. However, the list indicates what areas will be prominent in SEC examinations. Registrants are encouraged to review any relevant policies and procedures in addition to conducting internal compliance checks to ensure that they are in compliance with SEC and other rules in the highlighted areas.