On January 13, 2015 the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) announced its Examination Priorities for 2015. Remember, the SEC works on a fiscal year, which started October 1, 2014, so the SEC has been conducting examinations now for over three months. Wouldn’t it be nice if the SEC could communicate their priorities for the year before they start conducting examinations?
As Andrew Bowden, the Director of OCIE, has said, “We share our annual examination priorities to promote compliance. We have observed that when we share our areas of focus, many industry participants independently review their controls in the areas we have identified.”
We (Focus 1) have traditionally incorporated the examination priorities into our “compliance readiness” discussions with our clients, and into our request lists for third party compliance reviews and mock SEC examinations we conduct throughout the year. It is equally as important that we not “de-emphasis” the other areas of compliance, as they too may be focused on during an SEC examination. We see many of our clients incorporate themes into their annual reviews, with consideration given to the following:
- Any compliance matters that arose during the previous year;
- Any changes in business activities of the adviser; and
- Any changes to the laws, rules and regulations.
Given the SEC’s risk based approach to examinations, all areas of compliance are open game if the examiner feels it’s a high-risk area for the firm and may be an area of focus during their on-site visit and/or as part of the examination staff’s supplemental requests.
Evolution of Examination Priorities
Before we discuss the 2015 exam priorities, let’s take a brief walk down memory lane.
In February of 2012, the SEC issued “Examinations by the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations,” summarizing OCIE’s “self-assessment” that it began in 2010 as a result of Dodd-Frank, along with the goals and objectives of the National Examination Program (“NEP”). The document goes on to outline, among other things, several new developments (enforcement cases) in 2011; OCIE’s intention of issuing a significant number of Risk Alerts and sweep examination reports on a wide range of topics; the Compliance Outreach Program for Investment Advisers, among other market constituents; Current Issues and 2012 Priorities; and finally, Fiscal Year 2011 Examination Results.
To help compare and contrast the priorities of the NEP, we’ve created a comparison of OCIE’s examination priorities for 2012 through 2015. Like an effective compliance program, always evolving, considering new tests, and incorporating new areas of focus, OCIE’s examination priorities also contain new and re-spirited areas of focus. Nonetheless, here are the areas of priority that seem to be more constant than others:
- Governance – be it fund, corporate or enterprise;
- Fraud – used in conjunction with terms like detection, prevention, and safety of assets;
- Performance and Advertising – although it’s being encompassed in the broader topic of “Sales Practices” in 2015, don’t be fooled; keep it on your radar!;
- Technology – with an emphasis on cybersecurity, including the protection of client information;
- Conflicts of Interest – compensation, business models, and investment allocations;
- Money Market Funds and Alternative Investment Companies; and finally
- Custody – while it remains an area of focus, it didn’t make the list in 2015
It’s also worth noting what is (and what is not) being included on recent “routine” examination request lists. We’ve seen items such as proxy voting procedures and records, privacy procedures, and business continuity planning not included on the initial request list (interestingly, proxy voting is on the 2015 list of examination priorities). Keep in mind, as noted above, that subsequent requests could include such. In fact, as you may know, there have been sweep exams in the areas of business continuity and cybersecurity. We’ve made several request lists from OCIE’s various initiatives available in the Compliance Library on our website.
Additionally, if you’ve not done so already, we would encourage you to subscribe to the SEC’s communications, alerts, and enforcement case results. You can do so here; then select from the list of subscription options. Staying informed allows us to put into context the themes of the NEP.
2015 Examination Priorities
Let’s now take a look at OCIE’s 2015 examination priorities, where they’ve identified their priorities for advisers, broker-dealers, and transfer agents around three themes:
1. Examining matters of importance to retail investors and investors saving for retirement, including whether the information, advice, products, and services being offered are consistent with applicable laws, rules, and regulations (A significant initiative from 2014)
Fee Selection and Reverse Churning. Investment advisers employ a variety of fee structures for the services offered to clients, including fees based on assets under management, hourly fees, performance-based fees, wrap fees, and unified fees. Examiners will focus on recommendations of account types and whether they are in the best interest of the client at the inception of the arrangement and thereafter.
Sales Practices. (Carry forward from 2014) Examiners will assess whether registrants are using improper or misleading practices when recommending the movement of retirement assets from employer-sponsored defined contribution plans into other investments and accounts with greater risks and/or higher fees.
Suitability. (Carry forward from 2014) Examiners will evaluate recommendations or determinations to invest retirement assets into complex or structured products and higher yield securities, and whether the due diligence conducted, the disclosures made, and the suitability of the recommendations or determinations are consistent with existing legal requirements.
Branch Offices. (Long time carry forward) Examiners will focus on supervision of representatives in branch offices, including using data analytics to identify branches that may be deviating from compliance practices of the firm’s home office.
“Alternative” Investment Companies. (Carry forward from 2014) Examiners will continue to assess funds offering alternative investments and using alternative investment strategies, with a particular focus on: (i) leverage, liquidity, and valuation practices; (ii) factors relevant to the adequacy of the funds’ internal controls; and (iii) the manner in which such funds are marketed to investors.
Fixed Income Investment Companies. (Carry forward from 2014) Examiners will review whether mutual funds with significant exposure to interest rate increases have implemented compliance policies and procedures and investment and trading controls sufficient to ensure that their funds’ disclosures are not misleading.
2. Assessing issues related to market-wide risks
Large Firm Monitoring. (Carry forward from 2014) Examiners will continue to collaborate with the Division of Trading and Markets and the Division of Investment Management to monitor the largest U.S. broker-dealers and asset managers for assessing risks at individual firms and maintaining early awareness of developments industry-wide.
Cybersecurity. (Carry forward from 2014) Examiners will continue to examine broker-dealers’ and investment advisers’ cybersecurity compliance and controls.
Potential Equity Order Routing Conflicts. Examiners will assess whether firms are prioritizing trading venues based on payments or credits for order flow in conflict with their best execution duties.
3. Using the evolving ability to analyze data to identify and examine registrants that may be engaged in illegal activity, such as excessive trading and penny stock pump-and-dump schemes
Recidivist Representatives. (Long time carry forward) Examiners will continue to use their analytic capabilities to identify individuals with a track record of misconduct and examine the firms that employ them.
Microcap Fraud. (Long time carry forward) Examiners will continue to examine the operations of registrants for activities that indicate they may be engaged in, or aiding and abetting, pump-and-dump schemes or market manipulation.
Excessive Trading. (Very long time carry forward) Examiners will continue to analyze data obtained from clearing brokers to identify and examine registrants and their representatives that appear to be engaged in excessive trading.
Anti-Money Laundering (“AML”). (Carry forward from 2014) Examiners will continue to examine registrants’ AML programs, using analytic capabilities to focus on firms that have not filed suspicious activity reports (“SARs”) or have filed incomplete or late SARs.
Municipal Advisors. (Carry forward from 2014) Examiners will continue to conduct examinations of newly registered municipal advisors to assess their compliance with recently adopted SEC and Municipal Securities Rulemaking Board rules.
Proxy Services. (Carry forward from 2014) Examiners will examine select proxy advisory service firms, including how they make recommendations on proxy voting and how they disclose and mitigate potential conflicts of interest. Also examined will be investment advisers’ compliance with their fiduciary duty in voting proxies on behalf of investors.
Never-Before-Examined Investment Companies. (2014 was never-before-examined advisers) Examiners will conduct focused, risk-based examinations of selected registered investment company complexes that have not yet been examined.
Fees and Expenses in Private Equity. (Carry forward from 2014) Examiners will continue to conduct examinations, given the high rate of deficiencies that have been observed among advisers to private equity funds in connection with fees and expenses.
We do appreciate OCIE making this list available to the industry, and as we progress into 2015 and have the opportunity to observe specific themes and trends of the NEP, we will continue to share our perspective.
Just a brief note on the Washington scene – Congress has expressed an interest in rolling back some of the rules implemented under Dodd-Frank, but the President has indicated that he will veto anything that attempts to roll back any of his initiatives, including Dodd-Frank. That’s politics, so we’ll just have to wait and see.