SEC Publishes Its 2014 List of Examination Priorities

February 12, 2014

By Matthew T. Boos & David E. Winkler

The National Examination Program (NEP) of the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations recently published its 2014 examination priorities. The purpose was to set forth the areas that the staff perceives to have heightened risk and to support the SEC’s mission “to protect investors; to maintain fair, orderly, and efficient markets; and to facilitate capital formation.” The NEP’s exam priorities address market-wide issues as well as those relating specifically to particular business models.

Listed below is a non-exclusive summary of key areas of focus:

Market-wide Issues

Fraud Detection and Prevention. The NEP will use quantitative and qualitative tools and techniques in trying to identify market participants engaged in fraudulent behavior.

Corporate Governance, Conflicts of Interest, and Enterprise Risk Management. The NEP will continue to meet with senior management and boards of entities registered with the SEC, including their affiliates where appropriate, to discuss how each firm identifies and mitigates conflicts of interest and legal, compliance, financial, and operational risks. This initiative is designed 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.

Technology. The NEP will examine supervision of information technology systems, operational capability, market access, information security, and preparedness to respond to sudden malfunctions and system outages.

Dual Registrants. Representatives of dual registrants, i.e., registrants that are both broker-dealers and investment advisers, and affiliated advisers and broker-dealers may influence whether a customer establishes a brokerage or investment advisory account. This heightens the risk that customers are placed in an inappropriate account type that increases revenue to the firm without corresponding benefit to the customer. The NEP will examine the risks to investors of migration and other conflicts this business model presents. The NEP will examine the impact to investors of the different supervisory structures and legal standards of conduct that govern the provision of brokerage and advisory services.

New Laws and Regulation. The staff will review general solicitation practices and verification of accredited investor status under newly adopted Rule 506(c) under the Securities Act of 1933 to the extent conducted by a regulated entity; generally will review, monitor, and analyze the use of Rule 506(c); and will evaluate due diligence conducted by broker-dealers and investment advisers for such offerings.

Retirement Vehicles and Rollovers. With respect to retirement plan assets held with a former employer, investment advisers and broker-dealers may have incentives to recommend that the assets be placed with an IRA or other alternative offered by a financial services firm. Staff initiatives will include (i) examining the sales practices of investment advisers targeting retirement-age workers to roll over their employer-sponsored 401(k) plan into higher cost investments, including whether advisers are misrepresenting their credentials or the benefits and features of individual retirement account (IRA) plans or other alternatives, and (ii) looking for possible improper or misleading marketing and advertising, conflicts, suitability, churning, and the use of potentially misleading professional designations when recommending the movement of assets from a retirement plan to an IRA rollover account.

Investment Advisers, Investment Companies, Hedge Funds

Custody. In March, 2013, the NEP published a Risk Alert, which contained information about the most common issues of non-compliance. The staff will continue to test compliance with the Custody Rule and confirm the existence of assets through a risk-based asset verification process. Examiners will pay particular attention to those instances where advisers fail to realize they have custody and therefore fail to comply with requirements of the Custody Rule.

Conflicts of Interest. The staff has explained that non-compliance with the federal securities laws often arises where there are unaddressed conflicts of interest. Registrants engage in activity that puts their own interests ahead of their clients. Yet, they too often do not perceive or properly mitigate the conflict. The staff will focus on the following:

  • Compensation arrangements, with a particular focus on undisclosed compensation arrangements and their effect on client recommendations;

  • Allocation of investment opportunities;

  • Controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts;

  • Risk controls and disclosure, particularly for illiquid investments and leveraged investment products and strategies; and

  • Higher risk products or strategies targeted to retail investors, especially retired or elderly investors.

Marketing/Performance. The staff will review the accuracy and completeness of advisers’ claims about their investment objectives and performance (e.g., review and testing of hypothetical and back-tested performance, the use and disclosure of composite performance figures, performance record keeping, and compliance oversight of marketing). The staff also expects to review marketing efforts arising out of newly effective rules adopted under the Jumpstart Our Business Startups (“JOBS”) Act.

New Initiatives

Below is a list of some of the new and emerging issues and initiatives that the staff expects to focus on when scoping and conducting examinations in 2014.

Never-Before Examined Advisers. This will address advisers that have never been examined and are not part of the Presence Exam initiative (referenced below). The staff will utilize a number of strategies to conduct focused, risk-based examinations of the adviser population that has been registered for more than three years but has not yet been examined by the NEP.

Wrap Fee Programs. The staff will assess whether advisers are fulfilling their fiduciary and contractual obligations to clients and will review the processes in place for monitoring wrap fee programs recommended to advisory clients, related conflicts of interest, best execution, trading away from the sponsor, and disclosures.

Presence Exams. The staff will continue the 2012 initiative to examine a significant percentage of the advisers registered since the effective date of Section 402 of the Dodd-Frank Act. The five key focus areas of these examinations are marketing, portfolio management, conflicts of interest, safety of client assets, and valuation. The vast majority of these new registrants are advisers to hedge funds and private equity funds that were not registered or regulated by the SEC prior to the Dodd-Frank Act, and have never been examined by the SEC. The staff will also continue to prioritize examinations of private fund advisers where the staff’s analytics indicate higher risks to investors, or where there are indicia of fraud, broker-dealer status concerns, or other serious wrongdoing.

Conclusion

Investment advisers and broker-dealers should carefully review these areas of focus and measure them against their own policies and procedures. They should use the list to help them take appropriate steps now to improve their compliance programs and to ensure that they do not fall short once they are subject to the inevitable compliance exam.