On January 9, 2014, the Securities and Exchange Commission’s National Exam Program (the “NEP”) released its list of examination priorities for 2014 (the “Release”). This Release, issued annually, highlights areas that the SEC staff perceives to have heightened compliance risk for financial-market participants. Compliance officers should take note of these areas of concern and assess areas for improvement.
Among the new priorities noted in the Release are general solicitations made pursuant to Regulation D, suitability concerns with respect to IRA rollover recommendations as well as variable annuity buyback recommendations, risks associated with fixed income products in relation to changing interest rates, and controls over quantitative trading models. The Release also discusses many of the same issues addressed in prior years, including general suitability, conflicts of interest, anti-money laundering (“AML”), provision of market access, and alternative investment products, among other topics.
The Release begins with an overview of market-wide initiatives, and then presents specific examination priorities broken down by the NEP’s four categories: 1) investment advisers (“IAs”) and investment companies; 2) broker-dealers (“BDs”); 3) clearing and transfer agents; and 4) market oversight. The following is a discussion of some of the more salient points of the Release, a copy of which is available here.
Fraud detection and prevention: Review for fraudulent activities in general, through, among other things, the NEP’s new Quantitative Analytics Unit, which evaluates risks in the algorithmic models and programs of investment firms, as well as the Risk Analysis Examination initiative, which examines all transactions by clearing firms and large BDs by analyzing all transactions cleared by a firm over several years.
Corporate governance, conflicts of interest, and enterprise risk management: Identify and mitigate conflicts of interest and legal, compliance, financial, and operational risks.
Technology: Examine control and supervision of information technology systems, operational capability, market access, information security, and preparedness to respond to sudden malfunctions and systems outages (for a recent enforcement matter involving this topic, see the SEC’s October 2013 settlement with Knight Capital Americas LLC, Exchange Act Release No. 70694 (Oct. 16, 2013)).
Dual registrants: Assess the risks posed by dual registrants, registrants that are both BDs and IAs, and any improper influencing of their customers to pick an account type that increases revenue to the firm without providing corresponding benefits to the customer; assessing the different supervisory structures and legal standards applicable to BDs versus IAs.
New Laws and Regulations: Examine use of new Rule 506(c) of Regulation D, which eliminated the general prohibition against general solicitation or advertising for offerings exempted under Section 4(a)(2) of the Securities Act; examining compliance with new municipal advisor registration rules.
Retirement Vehicles and Rollovers: Review the sales practices of IAs who target retirement-age employees and recommend rolling over employer-sponsored 401(k) investments into higher cost investments, and examination of related issues regarding marketing and advertising, conflicts, suitability, churning, and use of professional designations.
Sales practices/fraud: Examine to detect and prevent fraud and other violations in connection with sales practices directed at retail investors, including:
- Affinity fraud targeting seniors and other groups;
- Micro-cap fraud and pump and dump schemes;
- Unsuitable recommendations of higher yield and complex products (e.g., leveraged ETFs and structured products), and adequacy of due diligence; and
- Unregistered entities engaged in sale or promotion of unregistered offerings or other unusual capital raising activities.
Supervision: Review supervision of (1) independent contractors and financial advisors in remote locations and large branch offices; (2) registered representatives with significant disciplinary histories; and (3) private securities transactions.
Trading: Review for compliance with trading regulations, including topics such as:
- Market access controls related to, among other things, erroneous orders;
- Use of technology with a focus on algorithmic and high-frequency trading;
- Information leakage and cyber security;
- Market manipulation such as marking the close, parking, and spoofing; and excessive markups and markdowns;
- Abuse of the bona fide marketing exception to Regulation SHO; and
- Relationships between BDs and ATSs.
Internal controls: Review the adequacy of key control functions, including: liquidity, credit, and market risk management practices; internal audit; valuation practices; and compliance.
- Review for compliance with customer protection and net capital rules with focus on assets collateralizing large concentrated customer debit balances and the liquidity of firm inventory.
- For firm computing net capital pursuant to Appendices E and F of the net capital rule (regarding derivatives) and its associated modeling requirements, review data integrity and testing approval process for any changes in such models.
AML: Review clearing and introducing firms for AML program compliance; conduct exams of AML programs of proprietary trading firms that allow customers direct access to markets from “higher risk jurisdictions”.
Market Access Rules: Examine whether firms are appropriately applying Market Access Rule (Rule 15c3-5 under the Exchange Act) to their proprietary trading, as well as adequacy of books and records maintained by BDs that provide market access through master/subaccount arrangements.
Suitability of variable annuity buybacks: Examine recommendations by registered representatives for a customer to accept a buyback offer from an insurance company, where the customer holds existing variable product that has guaranteed income benefits and death benefits that have substantially increased in value due to current market conditions, and ensuring the adequacy of suitability and disclosure related to such a recommendation.
Fixed income market: Evaluate the structure of market and its effect on quality of executions, and in particular, use of filters by market participants to control what is displayed by fixed income ATSs.
IAs AND INVESTMENT COMPANIES:
Never before-examined and newly registered IAs: Conduct focused, risk-based examinations on advisers that have been registered for more than three years and have not been examined, as well as IAs that have been registered since implementation of Dodd Frank Act, key areas of focus of these exams will be marketing, portfolio management, conflicts of interest, safety of client assets, and valuation.
Safety of Assets and Custody: Test compliance with Rule 206(4)-2 under the Advisers Act (the Release directs readers to the NEP’s March 2013 Risk Alert on the same topic), with particular attention to instances where advisers fail to realize they have custody.
Conflicts of interest: Examine conflicts of interest inherent in an adviser’s business model, such as undisclosed compensation arrangements, allocation of investment opportunities, side-by-side management of performance-based and asset-based fee accounts, and risk controls, disclosures, and suitability practices for illiquid and leveraged investment products and strategies.
Marketing/Performance: Review and test the accuracy and completeness of IAs’ claims regarding their investment objectives and performance, such as hypothetical and back-tested performance, use and disclosure of composite performance figures, performance recordkeeping, and compliance oversight of marketing.
Wrap fee programs: Review processes in place for monitoring wrap fee programs recommended to advisory clients, and related issues concerning conflicts of interest, best execution, trading away from sponsors, and disclosures.
Quantitative trading models: Examine IAs that substantially rely on quantitative portfolio management and trading models, focusing on whether they have policies and procedures tailored to evaluating potentially manipulative use, reviewing and testing models and their output, and documenting and maintaining inventory of all firm-wide models.
Payments for Distribution in Guise: Review payments made by IAs and funds to distributors and intermediaries, and the adequacy of disclosure regarding any such arrangement, and whether such payments are for distribution and preferential treatment.
Fixed Income Investment Companies: Monitor the risk associated with changing interest rate environment and the impact on bond funds and related disclosure risks to investors.
Money market funds: Examine how money market funds manage potential stress events and specific money market funds that exhibit outlier behavior.
Alternative investment companies: Assess funds offering “alternative” investment strategies, focusing on (1) leverage, liquidity, and valuation policies and practices; (2) staffing, funding, and empowerment of boards, compliance personnel, and back-offices, and (3) marketing to investors; also reviewing representations and recommendations to investors regarding the suitability of such investments.
Security lending arrangements: Examine securities lending arrangements to determine whether they comply with exemptive orders and are consistent with relevant no-action letters.