The Office of Compliance Inspections and Examinations (“OCIE”) at the Securities and Exchange Commission (“SEC”) recently published their 2017 examination priorities.[1] OCIE functions as the “eyes and ears” of the SEC and conducts examinations of regulated entities to “promote compliance, prevent fraud, identify risk, and inform (SEC) policy.”[2] The 2017 examination priorities focus on three thematic areas: (i) examining matters of importance to retail investors, (ii) focusing on risks specific to elderly and retiring investors, and (iii) assessing market-wide risks.
Several of the priority areas are carryovers from the 2016 examination priority letter[3] meaning that these will continue to be focuses during examinations in 2017.
Protecting Retail Investors:
- Exchange-Traded Funds (“ETF”) – while ETFs are registered investment companies, they differ from mutual funds in a number of ways, including in how ETF shares are sold and redeemed. In order to operate as they are designed, ETFs must be granted and comply with certain exemptive relief from the Securities Exchange Act of 1934 (“Exchange Act”), the Investment Company Act of 1940 (“40 Act”), and other regulatory requirements. The SEC states in the 2017 examination priorities letter that they will continue to examine ETFs for compliance with such regulatory requirements, review the ETF unit creation and redemption processes, and focus on sales practices and disclosures involving ETFs and the suitability of broker-dealers’ recommendations to purchase ETFs with niche strategies (e.g., leveraged or inverse ETFs). This examination focus fits nicely with the three thematic areas since due to their low cost, ETFs have been increasingly recommended to investors as superior retirement solutions compared to other financial instruments and/or products. The growth in ETFs has been at such a rapid pace that some estimates have it exceeding $7 trillion by 2021.[4]
- Electronic Investment Advice – for the first time the SEC has explicitly cited “electronic advice” or advice offered through what are more commonly referred to as “Robo-advisers” in its examination priorities list. Robo-advisers utilize automation and digital techniques to build and manage portfolios of exchange-traded funds (ETFs) and other instruments for investors with little to no human intervention.[5] The area is projected to continue to grow rapidly; in 2014, U.S. robo-advisers services managed $16 billion in assets and by 2015, that figure had jumped to $50 billion.[6] A recent concern was voiced by the Massachusetts’ chief securities regulator on whether robo-advisers are able to actually act in the best interest of their clients as fiduciaries.[7] The examination priority letter indicates that the SEC may be similarly interested in this question given that the letter states that examinations will likely focus on registrants’ compliance programs, marketing, formulation of investment recommendations, data protections, and disclosures relating to conflicts of interest. The SEC furthermore indicated that compliance practices for overseeing the algorithms that generate investment recommendations will also be reviewed.
- Multi-Branch Advisers – in the 2016 annual examination priorities letter, the SEC stated that they will continue to review regulated entities’ “supervision of registered representatives and investment adviser representatives in branch offices of SEC-registered investment advisers and broker-dealers.”[8] According to the SEC, the use of a branch office can pose unique risks and challenges to advisers especially in the design and implementation of a compliance program and the supervision of people and processes in branch offices. In light of this, the SEC issued a Risk Alert in December 2016 providing more information on its Multi-Branch Adviser Initiative.[9] The Risk Alert details that areas of examination include: fees and expenses, custody, advertising, conflicts of interest, allocation of investment opportunities, code of ethics.
- Never-Before Examined Investment Advisers – another point of interest is the SEC stated that they are “expanding their Never-Before Examined Adviser initiative to include focused, risk-based examinations of newly registered advisers as well as of selected investment advisers that have been registered for a longer period but have never been examined by OCIE.”[10] The Never-Before Examined (“NBE”) Initiative was launched by the SEC in February 2014 targeting investment advisers that have never been examined by the SEC and concentrating on those that have been registered with the SEC for three or more years.[11]
Focusing on Senior Investors and Retirement Investments:
- ReTIRE – an acronym for OCIE’s “Retirement-Targeted Industry Reviews and Examinations Initiative.” This is a multi-year examination initiative launched in June 2015 that focuses on the services offered by SEC-registered investment advisers and broker-dealers to investors with retirement accounts.[12] The focus includes examining the reasonable basis for recommendations made to investors, conflicts of interest, supervision and compliance controls, and marketing and disclosure practices. In the 2017 examination priorities letter, the SEC specifically made note of examinations focusing on variable insurance products, sales and management of target date funds, and assessing controls surrounding cross-transactions particularly with respect to fixed income securities.
- Public Pension Advisers – the SEC will examine investment advisers to municipalities and other government entities to assess how they are managing conflicts of interest and fulfilling their fiduciary duty. Given the presidential election this year, it is arguably likely that the examination will also entail looking at compliance policies and procedures around pay-to-play[13] and undisclosed gift and entertainment practices. It is worth noting that just earlier last year, the SEC secured a $12 million settlement against State Street Bank and Trust Company for conducting a pay-to-play scheme to win contracts to service Ohio pension funds.[14]
Assessing Market-Wide Risks:
- Anti-Money Laundering (“AML”) – the SEC stated that it will continue to examine broker-dealers to assess whether AML programs are tailored to the specific risks that a firm faces such as money laundering and terrorist financing. Additionally, the SEC has noted that it will also review how broker-dealers are monitoring for suspicious activity at the firm in light of the risks presented and the effectiveness of independent testing of controls, policies, and procedures; a recent enforcement action on this topic is the $300,000 settlement by Albert Fried & Company for failure to file Suspicious Activity Reports (“SAR”) with bank regulators for more than five years despite red flags tied to its customers’ high-volume liquidations of microcap stocks.[15]
- Cybersecurity – another multi-year initiative that was launched in early 2014[16] that focuses on the cybersecurity preparedness in the securities industry and to obtain information about the industry’s recent experiences with certain types of cyber threats. In 2015, a second “sweep” of cybersecurity examinations was announced.[17] The 2016 and 2017 examination priority letters indicate that the SEC will continue their cybersecurity initiative examining for proper compliance procedures and controls, including testing the implementation of those procedures and controls. This has already been demonstrated in several SEC enforcement actions, with a $1 million settlement by Morgan Stanley Smith Barney LLC related to its failures to protect customer information,[18] being the latest example. Broker-dealers and investment advisers should take care to make cybersecurity governance a significant priority.
- Regulation Systems Compliance and Integrity (“Reg SCI”) – Reg SCI was adopted by the SEC in November 2014 with the purpose of strengthening the technology infrastructure underlying the securities markets. Specifically the rule was designed to reduce the occurrence of systems issues, improve system resiliency when problems do occur, and enhance the SEC’s oversight and enforcement of securities market technology infrastructure. The rule applies to “SCI entities” which include self-regulatory organizations (“SROs”) like FINRA, registered clearing agencies, stock and options exchanges, disseminators of consolidated market data feeds, and certain alternative trading systems (“ATS”). The SEC will examine SCI entities to evaluate whether they have established, maintained, and enforced written policies and procedures reasonably designed to ensure the capacity, integrity, resiliency, availability, and security of their SCI systems. This is expected to include things like assessing the resiliency of their primary and back-up data centers, evaluating whether computing infrastructure components are geographically diverse, and assessing whether security operations are tailored to the risks each entity faces. In the 2017 examination letter, the SEC made specific mention that the review will also include controls relating to how systems record the time of transactions or events (i.e., time synchronization), enterprise risk management, as well as the collection, analysis, and dissemination of market data.
- Payment for Order Flow – the SEC singled out “payment for order flow” as an examination focus in 2017. In the examination priorities letter, the SEC states that they “will examine select broker-dealers, such as market-makers and those that serve primarily retail customers, to assess how they are complying with their duty of best execution when routing customer orders for execution.”[19] This can arguably be considered a hot topic given all of the controversy and heated debate on market structure (i.e., order routing, best execution, and Regulation National Market System or “Reg NMS”) in 2016 due to IEX’s ultimately successful proposal to become a registered exchange.[20] Additionally, there have been several related enforcement actions such as a $22 million settlement by Citadel Securities LLC[21] for misleading retail clients about how it priced trades and provided best execution.
Other Initiatives:
- Private Fund Advisers – focus will continue to be on private fund advisers with examination emphasis on conflicts of interest and disclosure of conflicts as well as actions that appear to benefit the adviser at the expense of investors. Recent examples of enforcement cases include a $12 million settlement by BlackRock Advisors LLC[22] for failure to disclose a conflict of interest created by an outside business activity of a top-performing portfolio manager and a roughly $7.9 million settlement by Fenway Partners LLC,[23] a private equity firm, for failing to disclose conflicts of interest to a fund client and investors when fund and portfolio company assets were used for payments to former firm employees and an affiliated entity.
- Municipal Advisors – the SEC stated that they will continue to conduct examinations of municipal advisors for compliance with SEC and Municipal Securities Rulemaking Board (“MSRB”) rules.[24]
- Transfer Agents – the SEC mentioned that examinations of transfer agents will involve those that service microcap issuers and in such examinations, there will be a focus on policies and procedures governing the detection of issuers that may be engaged in unregistered, non-exempt offerings of securities. The SEC had several enforcements actions in 2016 against firms and individuals engaging in microcap fraud, including gatekeepers,[25] a former television commentator,[26] and even a former N.Y. Governor.[27]
Lastly, it is important to note that the examination priorities list is not exhaustive and with current SEC Chair Mary Jo White departing prior to President-elect Donald Trump taking office[28] and the appointment of Jay Clayton as the new SEC Chair,[29] the national examination priorities may change.
[13] The Pay-to-Play Rule was adopted by the SEC in 2010 and designed to mitigate pay-to-play practices by investment advisers seeking to manage government assets. As a general overview, the rule prohibits an investment adviser from providing investment advisory services for compensation to a state or local government entity if the investment adviser or any of its covered associates made a political contribution to an elected official or a candidate running for such office within the preceding two years, and the elective office is in a position to direct or influence the award of the government entity’s investment advisory business. The rule does not require a showing of actual intent to influence an official.
*Disclaimer: The views and opinions expressed herein are those solely of the author and do not necessarily reflect the views and opinions of any current or past employer.
