The Office of Compliance Inspections and Examinations (“OCIE”) of the Securities Exchange Commission (“SEC”) on February 21, 2013 announced its examination priorities for this year. These highlight market-wide issues such as fraud detection and prevention and the mitigation and management of conflicts of interest, as well as specific issues relating to the National Examination Program’s (“NEP”) four program areas: (i) investment advisers and investment companies; (ii) broker-dealers; (iii) clearing and transfer agents; and (iv) market oversight.
Each year, OCIE, which manages the NEP, announces its examination priorities, which identify areas that the SEC Staff and senior management have concluded present increased risks to investors and registrants. “We are publishing these priorities to promote compliance and communicate with investors and our registrants about areas that we perceive to have heightened risk,” said Carlo V. di Florio, Director of OCIE. According to the SEC press release, the announced list is “not exhaustive,” and may be modified as the year progresses. The SEC Staff and management created the priorities list after conferring with each of the Commissioners, and examining resources including (i) tips, complaints and referrals from whistleblowers, customers and investors; (ii) information provided by registrants in required SEC filings; (iii) data kept in third-party databases; and (iv) information collected in examinations by the SEC and other federal regulators.
The NEP has identified four initiatives that apply to nearly all registrants: (i) fraud detection and prevention; (ii) corporate governance and enterprise risk management; (iii) conflicts of interest; and (iv) technology. First, the NEP will focus on fraud detection and prevention by, among other methods, using quantitative and qualitative tools to identify market participants engaged in fraudulent or unethical behavior. According to OCIE, “[n]othing is more lethal to [investors’] trust than loss of investor capital for anything other than knowingly assumed risk, including scams, theft, and other fraudulent conduct.” Second, the NEP will prioritize corporate governance and enterprise risk management by continuing its practice of meeting with senior managers and registrants’ boards and affiliates to discuss enterprise risk. In particular, these discussions will address how firms “govern and manage financial, legal, compliance, operational, and reputational risks.” Third, the NEP will focus on conflicts of interest, using the presence of such conflicts as one aspect of its process of determining which firms to target and which issues to examine. Fourth, given the “increasing complexity, interconnectedness, and speed fostered by technology,” the NEP may examine information technology systems for, among other things, operational capability, market access, and information security.
Program Area Specific Initiatives
The priorities announcement listed issues in each of the NEP’s specific program areas, generally divided into ongoing risks, new and emerging risks, and policy topics. According to the SEC, ongoing risks are areas of risk common to all or many of the business models used by a particular category of registrant and that have existed for a sustained period and are likely to continue for the foreseeable future. Some ongoing risks will be prioritized due to their inherent risk or reoccurrence in recent examinations. New and emerging risks are topics and practices that pose a heightened risk because of industry changes and developments, such as large changes in financial conditions, new products or investment strategies, technology, or regulations. NEP has also highlighted certain policy topics where it hopes to better understand certain practices or learn the practical application of existing rules and guidance.
Investment Adviser-Investment Company Examination Program
The IA-IC Examination Program will target the following areas.
- Safety of Assets: A risk-based asset verification process will seek to confirm the safety of client assets and compliance with custody requirements. Measures taken by registrants to protect client assets from loss or theft, audits of private funds, and policies and procedures will be reviewed.
- Conflicts of Interest Related to Compensation Arrangements: The Staff will examine financial and other records to identify undisclosed compensation arrangements and related conflicts of interest.
- Marketing/Performance: Examinations will center on the accuracy of advertised performance, assumptions or methodology used, and related disclosures and compliance with recordkeeping requirements.
- Conflicts of Interest Related to Allocation of Investment Opportunities: The Staff will review portfolio management practices of advisers managing accounts that do not pay performance fees (i.e., most mutual funds) alongside accounts that pay such fees (i.e., most hedge funds).
- Fund Governance: The Staff will review whether advisers are making full, accurate disclosures to boards and whether directors are reasonably reviewing the information in connection with contract approvals, service provider oversight, fund assets valuation, and assessment of expenses or viability.
New and Emerging Issues
- New Registrants: With around 2,000 advisers registering since Section 402 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank Act”) went into effect, the Staff will engage with all and examine many new registrants, analyze findings, and report to the industry.
- Dually Registered IA/BD: The Staff will increase examinations of dually-registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals, as these business models may present multiple conflicts.
- “Alternative” Investment Companies: The Staff will seek to examine the greater use of alternative and hedge fund investment strategies in, for example, open-end funds and exchange-traded funds.
- Payments for Distribution in Guise: Examinations will target the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same.
- Money Market Funds: The Staff will examine, among other matters, whether firms are performing stress testing as required under recent amendments to Rule 2a-7 of the Investment Company Act of 1940; if so, what factors are considered, and the results.
- Compliance with Exemptive Orders: The Staff will focus on compliance with previously granted exemptive orders, for example, those related to closed-end funds and managed distribution plans.
- Compliance with Pay to Play Rule: The Staff will examine compliance with, and practical application of, the “pay to play” rule that prevents advisers from getting business from government entities in exchange for political donations.
Broker-Dealer Exam Program
In considering and administering examinations in 2013, the B-D Program will target the following areas.
- Sales Practices/Fraud: Examinations often discover fraud relating to sales practices directed at retail investors, including (i) affinity fraud or fraud targeting seniors; (ii) unsuitable recommendations of higher yield products, as well as improper supervision and due diligence processes regarding those recommendations or those products; and (iii) conflicts of interest that are inappropriately mitigated, and not clearly disclosed in an understandable and timely manner.
- Trading: Examinations by the Staff will target high frequency trading, algorithmic trading, proper controls around the use of technology, alternative trading systems and order routing practices.
- Capital: The Staff aims to examine clearing firms with multiple correspondents engaging in high frequency/high volume trading, focusing on the clearing firms’ internal controls for managing intraday liquidity risk, as well as assessing intraday net capital and other financial risks.
- AML: The Staff will identify clearing and introducing firms with weak anti-money laundering (“AML”) programs, mainly customer identification programs, suspicious activity identification and reporting deficiencies, and weak due diligence procedures regarding certain accounts.
New and Emerging Issues
- Exchange Act Rule 15c3-5 (the “Market Access Rule”): The Staff will examine firms’ compliance with this rule, focusing especially on: (i) master/sub-accounts; (ii) controls relating to proprietary trading; (iii) supervision of registrants’ technology system controls and governance; and (iv) broker-dealers dually registered as futures commission merchants.
- Exchange-Traded Funds: Recent exams have focused on issues and risks relating to ETFs, such as fails to deliver and compliance with Regulation SHO.
- JOBS Act: Pending approval of a final rule exempting qualified “crowd funding” transactions from registration under the Securities Act of 1933, the Staff will review entities participating in that business.
- Other Regulatory Requirements: The Staff will assess compliance with the new registration and related rules applicable to municipal advisors as well as incentive compensation, pending adoption of final rules.
Market Oversight Exam Program
The Market Oversight Exam Program will target the following areas in 2013.
- Risk Assessment Examinations of Exchanges: The Staff will conduct examinations of equity exchanges to review the internal controls and governance around each exchange's rule making process and the supervision of regulatory service agreements by exchanges.
- FINRA Oversight: In determining focus areas, the Staff will examine program areas outlined in Dodd-Frank Section 964, as well as areas not articulated in Section 964.
- Examinations of New Registrants: The Staff will inspect recently registered exchanges and continue its practice of meeting with entities intending to register as an exchange.
- Regulatory Responsibility Examinations: The Staff will continue its review of the obligations of self-regulatory organizations (“SROs”) to enforce member compliance with financial responsibility requirements.
- SRO Monitoring: In addition to examinations, OCIE’s Office of Market Oversight and the SEC’s Division of Trading and Markets monitor SROs’ activities, including coordinating with SROs through joint regulatory conferences and evaluating oversight issues identified through the Staff’s broker-dealer examinations.
- Systems Compliance: The Staff will review significant market events with the assistance of SROs, in part to identify emerging risks and to work with SROs on mitigation strategies.
- Order Type Assessments: The Staff will inspect equities exchanges to identify types of orders available and the internal governance process around the manner in which order types are proposed, implemented, and monitored.
Clearance and Settlement – Transfer Agent Exam Program
The Transfer Agent Program will target the issues below in considering and administering examinations.
- Transfer Agent Core Activities: The Staff will review compliance with transfer agents’ three core activities: (i) timely turnaround of items and transfers; (ii) accurate recordkeeping and associated retention; and (iii) safeguarding of funds and securities.
- Transfer Agent Safeguarding: The Staff's examinations will ask whether transfer agents provide appropriate customer service without offering investment advice that would require the transfer agent to register as either a broker-dealer or an investment adviser.
- Transfer Agent Recordkeeping and Retention: The Staff will review transfer agents’ policies and procedures to account for events that heighten risks around recordkeeping and retention, such as electronic storage, appropriate redundancy, and timely retrieval for the required regulatory periods.
- Transfer Agent Size, Volume, and Experience: The Staff will focus on the size of, volumes processed by, and experience of, a transfer agent, which all may indicate increased risks.
New and Emerging Issues
- Microcap Securities and Private Offerings: To help prevent certain illegal schemes, the Staff will review whether transfer agents have effectively implemented formal written policies and procedures for the appropriate removal of restrictions on microcap securities.
- Conflicts of Interest: Examinations by the Staff will ask if transfer agents have implemented effective formal written policies and procedures to identify, disclose (where appropriate), and mitigate conflicts where conflicts of interest could lead to unlawful activities.
- Hybrid Securities: The Staff will examine whether transfer agents have implemented effective formal written policies and procedures that reflect all types of securities serviced by the transfer agent (including those that are new or complex) and understand the instructions required for transfers and/or conversions of those security types.
- Outsourcing: The Staff will examine whether transfer agents that outsource services have implemented effective written policies and procedures and appropriate contractual clauses (or service level agreements).
- Third Party Administration: The Staff will review whether registered transfer agents that provide “third party” administration services (e.g., accepting and routing plan-member orders) have implemented policies and procedures that evaluate their activities to help identify when the activities may require broker-dealer or investment adviser registration.
- The Staff may seek to better understand transfer agents’ practices, in order to assist the Staff in drafting new rules or to review the effects of any new regulation for transfer agents (if adopted), and associated compliance.
Clearance and Settlement – Clearing Agency Exam Program
In administering examinations in 2013, the Clearing Agency Program will target the following areas.
- Performance of Annual Exams Mandated by the Dodd-Frank Act: A risk-based approach will determine the policies, procedures, and associated internal controls to be examined. The Staff will also consider the requirements of Section 17A of the Securities Exchange Act of 1934 and the rules thereunder and, where applicable, factors defined by the Dodd-Frank Act. The Dodd-Frank Act factors include: the nature of the operations and the risks borne by the designated clearing agency; the financial and operational risks presented by the designated clearing agency to financial institutions, critical markets, or the financial system; and the designated clearing agency’s resources and capabilities to monitor and control such risks.
- Performance of Monitoring Activities: Beyond conducting examinations, the Staff will seek regular interaction with designated clearing agencies, including periodic discussions with the board, senior management, and the head of internal control functions, as well as review of risk management reports (e.g., back and stress tests), internal audit reports, compliance reports, incident reports, new initiatives committee documentation, and other similar documentation, where applicable and periodically as issued.
- Informing Policy and Process: If any rulemaking affects clearing agencies, the Staff will review draft rules and standards to provide the examination perspective.
OCIE’s 2013 examination priorities do not constitute an exhaustive or unchangeable list. The Staff may conduct examinations in areas left off the list or shift priorities as the year progresses. However, the list offers some indication of where OCIE intends to focus its energy in the coming year. As such, clients should consider reviewing policies and procedures and conducting internal compliance checks to ensure conformity with SEC rules in the highlighted areas.