On January 7, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) published its 2020 examination priorities.1 OCIE’s examination priorities include certain practices, products and services that, in OCIE’s view, may magnify risks to investors or to the integrity of U.S. capital markets. According to OCIE, its examination priorities are intended to support the SEC’s mission to protect investors, facilitate capital formation, and maintain fair, orderly, and efficient markets. Highlights of the priorities include the following:
We discuss OCIE’s priorities and areas of focus in more detail below.
Retail Investors – Particularly Seniors and Those Saving for Retirement
Examinations will focus on broker-dealers and investment advisers who serve retail investor and on investments marketed to, or designed for retail investors, such as mutual funds and exchange-traded funds (ETF), municipal securities and other fixed income securities, and microcap securities.
Fraud, Sales Practices and Conflicts.
Examinations will focus on recommendations and advice given to retail investors, with a particular focus on: (1) seniors, including recommendations and advice made by entities and individuals targeting retirement communities; and (2) teachers and military personnel. Additionally, OCIE will focus on higher risk products—including private placements and securities of issuers in new and emerging risk areas—such as products: (1) that are complex or non-transparent; (2) that have high fees and expenses; or (3) where an issuer is affiliated with or related to the registered firm making the recommendation. A related focus of examinations will be registered firms’ disclosures and supervision of outside business activities of its employees and associated persons, and any conflicts that may arise from those activities.
OCIE also intends to continue to examine whether RIAs are satisfying their fiduciary duties of loyalty and care to their clients. Specific areas of focus will include whether RIAs are providing advice in the best of interest of their clients and whether they are eliminating, or at least fully and fairly disclosing, all conflicts of interest that could influence a RIA to provide biased advice. These conflicts can include fees, expenses and compensation arrangements.
- Mutual Funds and ETFs. One area of focus will be financial incentives to promote a particular share class, as well as whether breakpoints are being credited properly.
- Municipal Securities and Other Fixed Income Securities. OCIE will examine broker-dealer trading activity in municipal and corporate bonds for compliance with best execution obligations; fairness of pricing, mark-ups and mark-downs, and commissions; and confirmation disclosure requirements, including retail disclosures relating to mark-ups and mark-downs.
- Microcap Securities. OCIE will focus on broker-dealers and transfer agents to identify those that may be engaged in, or aiding and abetting, pump and dump schemes, market manipulation, and illegal distributions of securities of smaller market capitalization companies. Broker-dealers may be selected for examination based on factors such as employing registered representatives with disciplinary history, engaging in significant trading activity in unlisted securities, and making markets in unlisted securities. Focus areas for examinations will include broker-dealer sales practices, broker-dealer supervision of high risk registered representatives; and broker-dealer compliance with certain regulatory requirements, including those concerning quotations under Rule 15c2-11 Exchange Act, the locate requirement of Regulation SHO, and the obligation to file suspicious activity reports (SARs).
Standards of Care
June 30, 2020 is the compliance date for Regulation Best Interest, which enhances the current broker-dealer standard of conduct when transacting with retail investors, and the SEC’s updated investment adviser fiduciary duty interpretation. OCIE intends to assess implementation of the requirements of Regulation Best Interest, including policies and procedures regarding conflicts disclosures, and for both broker-dealers and RIAs, the content and delivery of Form CRS. Moreover, OCIE has already integrated the updated investment adviser fiduciary duty interpretation into its examination program.
Examinations will focus on, among other things, proper configuration of network storage devices, information security governance generally, and retail trading information security. A continuing area of focus on RIA examinations is protection of clients’ personal financial information. Particular focus areas will include:
- governance and risk management;
- access controls;
- data loss prevention;
- vendor management;
- training; and
- incident response and resiliency.
Financial Technology (Fintech) and Innovation, Including Digital Assets and Electronic Investment Advice
Digital Assets. Examinations will focus on:
- investment suitability;
- portfolio management and trading practices;
- safety of client funds and assets;
- pricing and valuation
- effectiveness of compliance programs and controls; and
- supervision of employee outside business activities.
Electronic Investment Advice. Areas of focus in examinations of robo-advisers will include:
- SEC registration eligibility;
- cybersecurity policies and procedures;
- marketing practices;
- adherence to fiduciary duty, including adequacy of disclosures; and
- effectiveness of compliance programs.
Additional Focus Areas Involving RIAs and Investment Companies
“Evergreen” Areas of Focus: OCIE will continue to focus on the appropriateness of account selection, portfolio management practices, custody and safekeeping of client assets, best execution, fees and expenses, and valuation of client assets for consistency and appropriateness of methodology. It will also focus on the accuracy of disclosures in these areas.
RIA Compliance Programs. OCIE will continue to review the compliance programs of RIAs, including whether those programs and their policies and procedures are reasonably designed, implemented, and maintained.
- Dually-registered IA/BDs; IAs affiliated with BDs; IAs employing Third-Party IAs. Examinations of these RIAs will remain a priority for OCIE. It will focus on, among other things, whether the firms maintain effective compliance programs to address the risks associated with best execution, prohibited transactions, fiduciary advice, or disclosure of conflicts regarding such arrangements. OCIE will also focus on RIAs that employ third-party asset managers to advise clients’ investments to assess, among other things, the extent of these RIAs’ due diligence practices, policies, and procedures.
- New and Emerging Investment Strategies. OCIE will examine the accuracy and adequacy of disclosures provided by RIAs offering clients new types or emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate environmental, social, and governance (ESG) criteria.
Never-Before and Not Recently-Examined RIAs. This continues to remain an area of focus. OCIE will examine RIAs that have not been examined for several years to assess whether the RIAs’ compliance programs have been appropriately adapted in light of any substantial growth or change in their business models.
Mutual Funds and ETFs. OCIE intends to prioritize examinations of mutual funds and ETFs, the activities of their RIAs, and oversight practices of fund boards. OCIE examinations will focus on:
- RIAs that use third-party administrators to sponsor the mutual funds or ETFs they advise or are affiliated with – as we read this point, RIAs that advise funds or ETFs that are part of multi-adviser series trusts ;
- mutual funds or ETFs that have not previously been examined; and
- RIAs to private funds that also manage a registered investment company with a similar investment strategy.
RIAs to Private Funds. OCIE will continue to focus on:
- RIAs to private funds that have a greater impact on retail investors, such as firms that provide management to separately managed accounts side-by-side with private funds;
- Compliance risks, including controls to prevent the misuse of material, non-public information
- undisclosed conflicts of interest, such as undisclosed or inadequately disclosed fees and expenses; and the use of RIA affiliates to provide services to clients.
Additional Focus Areas Involving Broker-Dealers and Municipal Advisors
Broker-Dealer Financial Responsibility. OCIE will focus on whether broker-dealers are safeguarding customer cash and securities in accordance with the Customer Protection Rule and the Net Capital Rule, including the adequacy of internal processes, procedures, and controls.
Trading and Broker-Dealer Risk Management. Among the areas of trading and risk management practices that represent OCIE areas of focus include:
- trading and other activities in “odd lots” – whether broker-dealers have in place adequate policies and procedures to seek best execution;
- use of automated trading algorithms – how broker-dealers are supervising algorithmic trading activities, including the development, testing, implementation, maintenance, and modification of the computer programs that support their automated trading activities and controls around access to computer code; and
- internal procedures, practices, and controls to manage trading risk.
Municipal Advisors. OCIE will focus on whether they have satisfied their registration, professional qualification, and continuing education requirements. OCIE will prioritize the review of municipal advisor fiduciary duty obligations to municipal entity clients, fair dealing with market participant requirements, and the disclosure of conflicts of interest. OCIE will also focus on the conduct of municipal advisors when faced with conflicts while representing their clients, and compliance with recently-effective Municipal Securities Rulemaking Board (MSRB) Rule G-40 concerning advertisements.
OCIE seeks to ensure that broker-dealers and investment companies have adequate policies and procedures in place that are reasonably designed to identify suspicious activity and illegal money-laundering activities. Consequently, OCIE will continue to prioritize examining broker-dealers and investment companies for compliance with their AML obligations in order to assess, among other things, whether firms:
- have established appropriate customer identification programs;
- are satisfying their SAR filing obligations,
- are conducting due diligence on customers;
- are complying with beneficial ownership requirements; and
- are conducting robust and timely independent tests of their AML programs.
OCIE’s priorities reflect its assessment of certain risks, issues, and policy matters arising from market and regulatory developments, information gathered from examinations, and other sources, including tips, complaints, and referrals, and coordination with other Divisions and Offices at the SEC as well as other regulators. Broker-dealers, investment companies, investment advisers and municipal advisers are on notice about OCIE’s priorities and areas of focus. For more information, please contact the author of this Legal Insight or one of the Practus attorneys with whom you work .
1 2020 Examination Priorities, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission (Jan. 7, 2020) (https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2020.pdf).