Timothy M. Simons, CFA, CIPM, CSCP
Focus 1 Associates LLC
February 27, 2018
SEC FY2018 Examination Priorities!
On February 7, 2018, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) released the much anticipated FY2018 National Exam Program Examination Priorities. Unlike prior years, when the release was five pages, the FY2018 release is ten pages, and includes a Message from OCIE’s Leadership describing the process used to select the examination priorities. The Message also describes the process used to select examination candidates, much the same as when I was an examiner: risk-based, data driven, striving to put resources to their highest and best use, and embracing innovation and new technology.
Comparing last year’s priorities to this year’s:
From the 2017 Examination Priorities release:
- “Our 2017 priorities are organized around three thematic areas:
- 1. Examining matters of importance to retail investors;
- 2. Focusing on risks specific to elderly and retiring investors; and
- 3. Assessing market-wide risks.
With the objectives of being data-driven and risk-based, we have incorporated data analytics into the vast majority of our examination initiatives to identify industry practices and/or registrants that appear to have elevated risk profiles.”
From the 2018 Examination Priorities:
“In general, the priorities reflect certain practices, products, and services that OCIE believes may present potentially heightened risk to investors and/or the integrity of the U.S. capital markets. Our 2018 priorities are organized around five themes:
- 1. Matters of importance to retail investors, including seniors and those saving for retirement;
- 2. Compliance and risks in critical market infrastructure;
- 3. Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB);
- 4. Cybersecurity; and
- 5. Anti-Money laundering programs.
While we believe these areas are critical, this list is not comprehensive; OCIE remains flexible in order to cover emerging and exigent risks to investors and the marketplace as they arise. Rapid institutional and technological change in the market landscape demands a responsive approach. While the change is fast and perhaps accelerating, we keep both our analytic efforts and our examinations firmly grounded in our four pillars: promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy.”
The focus areas appear to be the same, but organized into slightly different themes.
1. Matters of importance to retail investors, including seniors and those saving for retirement
Particular focus on the following areas:
Disclosure of the Costs of Investing
Not just fees, but any other compensation the adviser may receive, and any other expenses that the client may pay. “Every dollar an investor pays in fees and expenses is a dollar not invested for his or her benefit.”
Electronic Investment Advice
Examining advisers offering investment advice through automated or digital platforms: focusing on compliance programs, marketing materials, investor data protection, and disclosure of conflicts of interest.
Wrap Fee Programs
Examiners will review whether advisers associated with wrap fee programs are acting consistently with their fiduciary duty, including the recommendation to invest in a wrap fee program and to continue in a program, disclosure of conflicts of interest, obtaining best execution, and disclosing costs for trading away.
This will include new registrants and those who have not been examined in some time. I have spoken with advisers that have been registered with the SEC for 15 years and never been examined. (They generally ask me if they should call the local SEC office and let them know that they have never been examined. After assuring that they have been filing an annual update of their Form ADV, my response is “no.”)
Senior Investors and Retirement Accounts and Products
Examiners will continue to visit investment advisers that offer services and products to investors with retirement accounts, focusing on investment recommendations, variable insurance products, and target date funds, looking for adequate disclosure of fees and expenses and conflicts of interest.
Mutual Funds and Exchange Traded Funds (“ETFs”)
Ninety-five mutual funds and ETFs were examined in FY2017, and the goal for 2018 is to examine 100. Examiners will focus on mutual funds that (i) have experienced poor performance or liquidity relative to their peer groups, (ii) are managed by advisers with little experience managing registered investment companies, or (iii) hold securities which are potentially difficult to value during times of market stress, including securitized auto, student, or consumer loans, or collateralized mortgage-backed securities. Examiners will also focus on ETFs and mutual funds that seek to track custom-built indexes to review for any conflicts the adviser may have with the index provider and the adviser’s role with respect to the selection and weighting of index components. The focus on ETF examinations will include analyzing whether investment risks are adequately disclosed.
Municipal Advisors and Underwriters
Examiners will continue to review for compliance with registration, recordkeeping, supervision requirements, and compliance with MSRB rules.
Fixed Income Order Execution
Examination will be conducted to insure that best execution policies and procedures have been implemented.
Cryptocurrency, Initial Coin offerings (“ICOs”), Secondary Market Trading, and Blockchain
These markets have grown rapidly and present a number of risks for investors. OCIE will continue to watch the sale of these products, and if securities, will examine for regulatory compliance.
“Areas of focus will include, among other things, whether financial professionals maintain adequate controls and safeguards to protect these assets from theft or misappropriation, and whether financial professionals are providing investors with disclosure about the risks associated with these investments, including the risk of investment losses, liquidity risks, price volatility, and potential fraud.”
2. Compliance and risks in critical market infrastructure
This will include examinations and/or oversights of:
- Clearing Agencies
- National Securities Exchanges
- Transfer Agents
- Regulation Systems Compliance and Integrity (SCI) Entities
- “Regulation SCI was adopted by the Commission to strengthen the technology infrastructure of the U.S. securities markets. Among other things, it requires SCI entities, which include national securities exchanges, clearing agencies, and certain alternative trading systems, to establish, maintain, and enforce policies and procedures for their systems’ capacity, integrity, resiliency, availability, and security.”
3. Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB)
FINRA oversees approximately 3,700 brokerage firms; 156,000 branch offices; and 630,000 registered representatives through examinations, enforcement, and surveillance. Examinations will focus on FINRA’s operations and regulatory programs and the quality of FINRA’s examinations of broker-dealers and municipal advisors that are also registered as broker-dealers.
Examination staff will examine the MSRB to evaluate the effectiveness of select operational and internal policies, procedures, and controls.
OCIE will continue to prioritize cybersecurity in each examination program. Examinations will continue to focus on governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, and incident response.
5. Anti-Money Laundering (“AML”) Programs
Currently, only broker-dealers and investment companies are subject to AML rules.
“This description of OCIE priorities is not exhaustive. While we expect to allocate significant resources throughout 2018 to the examination issues described herein, our staff will also conduct examinations focused on risks, issues, and policy matters that arise from market and regulatory developments, new information learned from examinations, or other sources, including tips, complaints, and referrals, and coordination with other regulators.
OCIE welcomes comments and suggestions regarding how we can better fulfill our mission to promote compliance, prevent fraud, identify and monitor risk, and inform SEC policy. If you suspect or observe activity that may violate the federal securities laws or otherwise operates to harm investors, please notify SEC Staff at https://www.sec.gov/tcr.”
I’m glad that OCIE has identified their examination priorities for FY 2018, but somewhat disappointed that there is so little change from prior years. Cryptocurrency, ICOs, and Blockchain are fairly new, but the market is still fairly small, so maybe this is just nipping a future problem in the bud.
OCIE examiners conducted examinations of 2,114 investment advisers in FY2017 (out of 12,217) and estimate they will conduct 2,120 examinations in FY2018 (out of 12,617), a slight decrease in the percentage of advisers examined, but the redeployment of examination staff may lessen the impact.
Last year, at about this time, OCIE was able to provide a list of the most commonly cited compliance topics which were: Compliance Rule, Regulatory Filings, Custody Rule, Code of Ethics Rule, and Books and Records Rule. I was hoping we would get an update on that list, and I was hoping that it would indicate that we have been able to correct some of these problems as an industry.