By Kelly Howes/Morrison & Foerster
The SEC’s Office of Compliance Inspections and Examinations (OCIE) published its 2019 examination priorities on December 20, 2018. Although OCIE’s published priorities “provide a preview of key areas where OCIE intends to focus its limited resources,” registrants should be aware that OCIE will proactively seek insight into evolving markets “including changes in risks to markets and investors,” and that its examination program will continue to be refined based on its evaluation of such risks. Registered investment advisers, registered funds, and broker-dealers should carefully review OCIE’s examination priorities to ensure that their related compliance policies and procedures are well-established, monitored, and enforced.
Six Themes and Related Focus Areas
OCIE’s examination priorities address six “themes” related to “practices, products, and services that (OCIE) believes present potentially heightened risk to investors or the integrity of the U.S. capital markets.” Each theme is discussed below.
Matters of importance to retail investors, including seniors and those saving for retirement.
• Fees and expenses. As in prior years, OCIE will focus on disclosure to retail investors of the cost of investing and on ensuring that registrants are accurately calculating and charging such fees. In particular, OCIE will select firms with “practices or business models that may create increased risks of inadequately disclosed fees, expenses, or other charges.” According to OCIE, this includes firms that incentivize financial professionals to select certain mutual fund share classes over others, and advisers participating in wrap fee programs.
• Conflicts of interest. A perennial area of focus for OCIE is ensuring that registered investment advisers operate in a manner consistent with their fiduciary duty. This includes examinations focused on whether such advisers appropriately disclose conflicts of interest and the potential impact of such conflicts on their clients and potential clients. In 2019, OCIE will focus its attention on the conflicts of interest associated with the use of affiliated service providers and products, the availability of securities-backed non-purpose loans or lines of credit, and borrowing funds from clients.
• Senior investors and retirement accounts. OCIE plans to conduct examinations related to how broker-dealers oversee their interactions with senior investors and the types of services and products offered by registered investment advisers to senior investors and those saving for retirement. Among other things, such examinations will focus on the appropriateness of recommendations made to such investors and firms’ supervision of employees and representatives involved in providing services and products to such investors.
• Portfolio management and trading. OCIE intends to conduct examinations to ensure that registered investment advisers: (a) are fairly allocating investment opportunities among their clients; (b) have policies in place to ensure consistency of investments with a client’s objectives; (c) appropriately disclose to their clients any critical information related to such trades; and (d) comply with any applicable legal restrictions.
• Never before or not recently examined investment advisers. As in years past, in 2019, OCIE will focus certain reviews on investment advisers that have not been examined for a number of years or that have substantially grown or changed business models.
• Mutual funds and ETFs. OCIE recognizes that mutual funds and ETFs are the primary investment vehicles for many retail investors. Accordingly, OCIE will continue to prioritize examinations of such funds, their advisers, and their boards of directors. Consistent with a November risk alert that identified OCIE’s risk-based initiatives focused on registered funds, in 2019, OCIE will examine industry practices and regulatory compliance “in various areas that may have significant impact on retail investors” including:
• Index funds that track custom-built or bespoke indexes;
• ETFs with little secondary market trading volume or smaller assets under management;
• Funds with higher allocations to certain securitized assets;
• Funds with aberrational underperformance relative to their peer groups;
• Funds managed by advisers that are relatively new to managing registered investment companies; and
• Advisers that provide advice to both registered and private funds with similar investment strategies.
• Municipal advisors. In 2019, OCIE will continue to conduct select examinations of municipal advisors (MAs) that have never been examined, in order to ensure that such advisors are in compliance with the law, concentrating on whether these MAs have satisfied their registration requirements, professional qualifications, and continuing education requirements. OCIE will also evaluate whether MAs provided appropriate disclosures regarding their conflicts of interest to a municipal entity and whether MAs are complying with recently effective MSRB rules related to, among other things, advertisements by MAs and the standards of conduct for MAs obtaining CUSIP numbers on behalf of issuers.
• Broker-dealers entrusted with customer assets. Broker-dealers that hold customer cash and securities are subject to the Customer Protection Rule (Exchange Act Rule 15c3-3), and must ensure that such assets are safeguarded and accurately reported. OCIE intends to examine select broker-dealers for compliance with this rule.
• Microcap securities. In 2019, OCIE will continue to examine broker-dealers involved in selling stocks of companies with a market capitalization of under $250 million. Such examinations will focus on identifying pump and dump schemes, compliance with Regulation SHO (governing short sales) and compliance with Exchange Act Rule 15c2-11, which governs the submission and publication of quotations by broker-dealers for certain over-the-counter equity securities.
Compliance and risk in registrants responsible for critical market infrastructure.
• Clearing agencies. OCIE will continue to conduct annual examinations of clearing agencies that the Financial Stability Oversight Council has designated as systemically important. In addition, OCIE will conduct risk-based examinations of other registered clearing agencies focused on compliance with the SEC’s Standards for Covered Clearing Agencies and whether such clearing agencies have taken timely corrective action in response to prior examinations. OCIE will also work with the SEC’s Division of Trading and Markets and with other regulators to identify other risk areas that may warrant examination.
• Entities subject to Regulation SCI. Regulation Systems Compliance and Integrity (SCI) requires subject entities to “establish, maintain, and enforce policies and procedures designed to ensure that their systems’ capacity, integrity, resiliency, availability, and security are adequate to maintain their operational capability and promote the maintenance of fair and orderly markets.” In 2019, OCIE will continue to evaluate whether entities that are subject to Regulation SCI have implemented written policies and procedures as required by Regulation SCI and to determine if such entities have adequate controls relating to software development life cycles and related governance procedures, effectiveness of internal audit programs, inventory management, and threat management capabilities.
• Transfer agents. OCIE will examine registered transfer agents to ensure that they have adopted and implemented adequate policies and procedures related to share transfers, recordkeeping, and the safeguarding of client funds and securities. OCIE will also focus on whether transfer agents are annually filing with the SEC an internal accounting controls report issued by an independent accountant. Among other things, OCIE will prioritize examination of transfer agents developing blockchain technology, and transfer agents that provide services to issuers of microcap securities, private offerings, crowdfunded securities, or digital assets.
Digital assets (including cryptocurrencies, coins, and tokens).
• OCIE’s examinations of digital asset market participants, such as broker-dealers, trading platforms, and investment advisers, will focus on the risks digital assets present to retail investors. Among other things, OCIE will continue to monitor the offer and sale, trading, and management of digital assets. Where digital assets are securities, OCIE will also examine market participants for regulatory compliance including, among other things, portfolio management of digital assets, trading, safety of client funds and assets, pricing of client portfolios, compliance, and internal controls.
• OCIE will continue to focus examinations on, among other things, proper configuration of network storage devices, information security governance generally, and policies and procedures related to retail trading information security. OCIE will also evaluate cybersecurity practices at investment advisers with multiple branch offices, and those that have recently merged with other investment advisers. These examinations will specifically evaluate governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, and incident response.
Anti-money laundering (AML).
• In 2019, OCIE will continue to examine broker-dealers to ensure that they have policies and procedures in place that are reasonably designed to identify suspicious activity and illegal money-laundering activities.
In particular, OCIE will focus on whether broker-dealers are meeting their obligations to file suspicious activity reports and robustly and timely conducting independent tests of their AML program.
Select areas and programs of FINRA and MSRB.
• FINRA – OCIE will focus its examinations on FINRA’s operations and regulatory programs as well as the quality of FINRA’s examinations of broker-dealers and MAs that are also registered as broker-dealers.
• MSRB – OCIE will focus its examinations of MSRB on evaluating the effectiveness of MSRB’s policies, procedures, and controls in light of MSRB’s broad mandate to regulate municipal securities transactions.
Registered investment advisers, broker-dealers, registered funds, and other market participants should carefully evaluate their existing policies and procedures in light of OCIE’s identified 2019 examination priorities. However, OCIE is clear that these priorities are not exhaustive and registrants should not become myopic.
“(T)he scope of any examination is determined through a risk-based approach that includes analysis of the registrant’s operations, products offered, and other factors. This risk-based approach often results in examinations that address key aspects of the SEC’s regulatory oversight, such as the disclosure of services, fees, expenses, conflicts of interest for investment advisers, and trading and execution quality issues for broker-dealers.” Registrants are reminded that OCIE’s efforts “remain firmly grounded in its four pillars: promoting compliance, preventing fraud, identifying risk, and informing policy” and they should conduct their annual review of their compliance policies and procedures from a similar broad and risk-based vantage point.