The Office of Compliance Inspections and Examinations (OCIE) of the U.S. Securities and Exchange Commission (SEC) on January 11, 2016 announced its examination priorities for this year, which “address issues across a variety of financial institutions, including investment advisers, investment companies, broker-dealers, transfer agents, [and] clearing agencies.” The priorities, as in 2015, focus on the following:
Protecting retail investors and investors saving for retirement;
Assessing market-wide risks; and
Using data analytics to identify elevated risk profiles and signal potential illegal activity.
In a separate letter, OCIE identified its priorities for the national securities exchanges.
In addressing investor protection, OCIE identifies “new areas of focus [that include] exchange-traded funds [and their] trading practices, variable annuity recommendations and disclosure, and potential conflicts and risks involving advisers to public pension funds.” In the category of market-wide risks, new areas of focus include “an evaluation of broker-dealers’ and investment advisers’ liquidity risk management practices, and firms’ compliance with the SEC’s Regulation SCI, designed to strengthen the technology infrastructure of the U.S. securities markets.”
OCIE also indicates that it expects to allocate resources to other priorities, including: (i) examination of newly registered municipal advisers, for compliance with recently adopted regulations; (ii) review of private placements to evaluate compliance with due diligence, disclosure and suitability requirements; (iii) examination of registered investment advisers and investment companies that have not previously been examined; (iv) examination of private fund advisers, particularly as to fees, expenses and related disclosures; and (v) examination of transfer agents, including with respect to turnaround, recordkeeping and safeguarding of funds and securities.
The examination priorities “reflect certain practices and products that OCIE perceives to present potentially heightened risk to investors and/or the integrity of the U.S. capital markets.” OCIE indicates that priorities were selected based on consultation with the SEC’s Commissioners, senior staff and policy-making and enforcement divisions, as well as other regulatory agencies. Mark Wyatt, Director of OCIE, stated that “OCIE’s transparency and information sharing has helped inform the industry,” and that OCIE “hope[s] that registrants will use this information to inform the evaluation of their own compliance programs in these key areas.” The SEC notes that the listed priorities are “not exhaustive,” and that OCIE staff will also allocate resources to examine matters that may arise from market developments, examination results and other sources during the year. As such, registrants should expect that examinations will not be limited to the issues highlighted in the list of examination priorities.
Protecting Retail Investors and Investors Saving for Retirement
OCIE states that protecting retail investors, including those saving for retirement, “will likely continue to be a focus for the foreseeable future.” Noting that investors are increasingly dependent on their own investments for retirement and receive extensive information and advice related to the products and services available to them in planning for retirement, OCIE is “planning and/or considering various examination initiatives to assess risks to retail investors,” in particular:
Retirement-Targeted Industry Reviews and Examinations (ReTIRE) Initiative: This is a multi-year initiative concentrating on the services offered by SEC-registered investment advisers and broker-dealers to investors with retirement accounts. As part of this initiative, OCIE will examine “the reasonable basis for recommendations made to investors [saving for retirement], conflicts of interest, supervision and compliance controls, and marketing and disclosure practices.”
Exchange-Traded Funds (ETFs): Pursuant to this new initiative, OCIE will examine ETFs “for compliance with applicable exemptive relief granted under the Securities Exchange Act of 1934 and the Investment Company Act of 1940 and with other regulatory requirements.” The examinations will include consideration of ETFs’ unit creation and redemption processes, sales strategies and trading practices and disclosures, excessive portfolio concentration, and primary and secondary market trading risks. OCIE will also assess the suitability of a firm’s investments in ETFs, particularly in the case of leveraged and inverse ETFs.
Branch Offices: In its examinations of branch office supervision of SEC-registered investment advisers and broker-dealers, OCIE uses, among other means, “data analytics to identify registered representatives in branches that appear to be engaged in potentially inappropriate trading.”
Fee Selection and Reverse Churning: In examinations of investment advisers (including firms dually-registered as investment advisers and broker-dealers) that provide services to retail investors pursuant to various fee arrangements, OCIE will focus on whether the types of account recommended are in the best interest of investors during the entirety of the advisory relationship.
Variable Annuities: Stating that variable annuities “have become a part of [many investors’] retirement and investment plans,” OCIE will evaluate the suitability of sales of these products, including the supervision of such sales and the adequacy of disclosure provided to investors.
Public Pension Advisers: OCIE will examine advisers to government entities, noting that key risk areas of focus include pay-to-play and undisclosed gifts and entertainment.
Assessing Market-Wide Risks
In connection with the SEC’s mission to maintain “fair, orderly and efficient markets,” OCIE will examine for market-wide structural risks and trends, with initiatives relating to cybersecurity, regulation systems compliance and integrity, liquidity controls and clearing agencies.
Cybersecurity: As part of its “second initiative to examine broker-dealers’ and investment advisers’ cybersecurity compliance and controls,” OCIE will continue to evaluate firms’ implementation of such procedures.
Regulation Systems Compliance and Integrity (SCI): OCIE will evaluate whether certain self-regulatory organizations (including registered clearing agencies), alternative trading systems, plan processors, and exempt clearing agencies subject to the SEC’s Automation Review Policy have instituted and administered “written policies and procedures reasonably designed to ensure the capacity, integrity, resiliency, availability and security of their SCI systems.”
Liquidity Controls: OCIE indicated that, in light of changes in fixed income markets, OCIE will examine: (i) advisers to mutual funds, ETFs and private funds “that have exposure to potentially illiquid fixed income securities”; and (ii) registered broker-dealers “that have become new or expanding liquidity providers in the marketplace.” Such assessments will include firms’ controls over “market risk management, valuation, liquidity management, trading activity and regulatory capital.” The expansion of the SEC’s examination focus on liquidity to private funds is noteworthy.
Clearing Agencies: Per requirements of the Dodd-Frank Act, OCIE will continue annual examinations of clearing agencies “designated systemically important,” in accordance with a risk-based approach.
Using Data Analytics to Identify Elevated Risk Profiles and Signals of Potential Illegal Activity
The SEC notes that OCIE uses the data and information gathered during its examinations and from regulatory filings “to identify registrants that appear to have elevated risk profiles.” In this process, OCIE collaborates with the SEC’s Division of Economic and Risk Analysis. OCIE identifies the following initiatives that draw upon its analytic capabilities.
Recidivist Representatives and their Employers: OCIE attempts to identify recidivist representatives with a history of misconduct, and in this regard will “assess the compliance oversight and controls of investment advisers that have employed such individuals after they have been disciplined or barred from a broker-dealer.”
Anti-Money Laundering: With respect to AML programs, in its examination of clearing and introducing broker-dealers, OCIE will focus on “firms that have not filed the number of suspicious activity reports (SARs) that would be consistent with their business models or have filed incomplete or late SARs.”
Microcap Fraud: These examinations look at “the operations of broker-dealers and transfer agents for activities that indicate they may be engaged in, or aiding and abetting, pump-and-dump schemes or market manipulation,” as well as assessing entities’ regulatory compliance when publishing quotes for, or trading, securities in OTC markets.
Excessive Trading: This involves OCIE’s attempt to identify firms and registered representatives that may be engaged in “potentially inappropriate trading.”
Product Promotion: Here, OCIE will “focus on detecting the promotion of new, complex and high risk products and related sales practices to identify potential sustainability issues and breaches of fiduciary obligations.”
Since the list of examination priorities is “not exhaustive,” firms should not expect that examinations will be limited to the issues highlighted above. However, the list offers some indication of where OCIE currently intends to focus its resources during the coming year. Firms therefore may wish to review their policies and procedures, as well as conduct internal compliance checks, with a particular focus on these priorities.