SEC’s Division Of Examinations Issues 2021 National Examination Program Priorities

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sec examination priorities

SEC’s Division of Examinations Announces 2021 Examination Priorities

Authored by Financial Services Attorneys, Ken Earley and Karen Aspinall

On March 3, 2021, the SEC’s Division of Examinations (formerly the Office of Compliance Inspections and Examinations) published its 2021 examination priorities.1  The Division’s examination priorities include certain practices, products and services that, in the Division’s view, may magnify risks to investors or to the integrity of U.S. capital markets.  According to the Division, 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:

Examination Priority

Highlights

Retail Investors
  • Regulation Best Interest (“Reg BI”) and Form CRS
  • Duties of care and loyalty
  • Mitigation and disclosure of conflicts
  • Investments used by retail investors that present elevated risks
Information Security
  • Business continuity and disaster recovery plans
  • Growing physical and other relevant risks associated with climate change
  • Effective practices to help improve responses to large-scale climate-related events
  • Safeguarding customer accounts
Fintech and Innovation
  • Digital Assets
Anti-Money Laundering (AML) Programs
  • Adequate AML policies and procedures
Investment Advisers
  • Adequate compliance policies and procedures
  • Consistency and adequacy of disclosure to clients regarding ESG strategies
Mutual Funds and ETFs
  • Disclosures to investors
  • Personal trading activities
Advisers to Private Funds
  • Liquidity
  • Disclosures of investment risks and conflicts of interest
Broker-Dealers and Municipal Advisors
  • Compliance with Customer Protection Rule
  • Adequacy of internal processes and procedures for borrowing securities from customers
  • Best execution

  We discuss the Division’s priorities and areas of focus in more detail below.

Retail Investors – Particularly Seniors and Those Saving for Retirement

The Division will focus on conflicts of interest for broker-dealers (compliance with Reg BI), Form CRS, and whether RIAs have fulfilled their fiduciary duties of care and loyalty.  Additionally, the Division will examine whether firms are appropriately mitigating conflicts of interest and, where necessary, providing disclosure of conflicts that is sufficient to enable informed consent by retail investors.

Retail-Targeted Investments

  • Mutual Funds and ETFs.  One area of focus will be recommendations and disclosures by financial intermediaries involving ETFs, including adequacy of risk disclosure and suitability (particularly with regard to niche and leveraged/inverse ETFs).  The Division will also continue to focus on financial incentives to promote a particular share class when lower cost classes are available.
  • Municipal Securities and Other Fixed Income Securities.  The Division will examine the activities of broker-dealers, underwriters, and municipal advisors to assess whether these firms are meeting their respective obligations in relation to municipal issuer disclosure.  The Division will also 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.  The Division will continue to prioritize examinations of broker-dealers and transfer agents for compliance with their obligations in the offer, sale and distribution of microcap securities.  Focus areas for examinations will include transfer agent handling of microcap distributions and share transfers; broker-dealer sales practices and their consistency with Reg BI; and broker-dealer compliance with certain regulatory requirements, including the locate requirement of Regulation SHO, penny stock disclosures required by rules under the Securities Exchange Act of 1934 (the “Exchange Act”), and the obligation to monitor for and report suspicious AML-related activity and other AML obligations.

 PRACTUS NOTE: In 2020, the Division issued two Risk Alerts regarding Compliance with Reg BI and Form CRS.  With regard to Reg BI, the Division noted it would begin exams to assess implementation of Reg BI and these exams would be designed to evaluate whether firms have established policies and procedures reasonably designed to achieve compliance with Reg BI.  This Risk Alert can be found at Risk Alert – Regulation Best Interest Exams.pdf (sec.gov).  The Division also issued a Risk Alert on compliance with Form CRS, which indicated that the Division would commence exams to determine whether firms have made a good faith effort to implement Form CRS.  This Risk Alert can be found at Risk Alert – Form CRS Exams.pdf (sec.gov).
Moreover, the SEC staff has been very focused on the disclosure and mitigation of potential conflicts of interest.  On October 18, 2019, the Division of Investment Management issued Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation.  The FAQ discusses certain compensation arrangements and related disclosure obligations arising from both an investment adviser’s fiduciary duty and Form ADV.  This FAQ can be found at SEC.gov | Frequently Asked Questions Regarding Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation

Information Security and Operational Resiliency

The Division will continue to review business continuity and disaster recovery plans of firms, but will shift its focus to whether such plans, particularly those of systemically important firms, are accounting for the growing physical and other relevant risks associated with climate change.  As climate-related events become more frequent and more intense, the Division will review whether firms are considering effective practices to help improve responses to large-scale climate-related events.

Another area of focus will be safeguarding customer accounts and preventing account intrusions.  Particular focus areas will include:

  • Verifying an investor’s identity to prevent unauthorized account access;
  • Overseeing vendors and service providers;
  • Addressing malicious email activities such as phishing or account intrusions;
  • Responding to incidents, including those related to ransomware attacks; and
  • Managing operational risk as a result of dispersed employees in a work-from-home environment.

 PRACTUS NOTE:  Both the Division and, more broadly, the SEC staff have been very focused on information security, business continuity and disaster recovery plans for some time.2  The Division also issued a number of Risk Alerts last year that review their observations in these areas, which can be found at:

Financial Technology (Fintech) and Innovation, Including Digital Assets

Among other areas, examinations of “robo-advisers” and other firms providing financial services to clients and customers in innovative and evolving ways will focus on evaluating:

  • Whether firms are operating consistently with their representations;
  • Whether firms are handling customer orders in accordance with their instructions; and
  • Review compliance around trade recommendations made in mobile applications.

Examinations of market participants engaged with digital assets will continue to assess the following:

  • Whether investments are in the best interests of investors;
  • Portfolio management and trading practices;
  • Safety of client funds and assets;
  • Pricing and valuation;
  • Effectiveness of compliance programs and controls; and
  • Supervision of representatives’ outside business activities.

 PRACTUS NOTE: The Division issued a Risk Alert on February 26, 2021 relating to observations made by its staff during exams of advisers, broker-dealers and transfer agents regarding digital assets that may help firms in developing and enhancing their compliance practices in this area.  This Risk Alert can be found at Risk Alert – Digital Assets.pdf (sec.gov).

Anti-Money Laundering (AML) Programs

The Division will continue to review for compliance with applicable AML requirements, including an evaluation of whether 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.


 PRACTUS NOTE: In 2015, the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) issued a proposed rulemaking that would require RIAs to adopt a written anti-money laundering program meeting certain minimum requirements under the Bank Secrecy Act.3  While this rule was not adopted, there are certain federal anti-money laundering requirements that may apply to advisers such as those under the Bank Secrecy Act and Office of Foreign Asset Controls requirements. 

The London Inter-Bank Offered Rate (LIBOR) Transition

The Division will continue to engage with firms through examinations to assess their understanding of any exposure to LIBOR, their preparations for the expected discontinuation of LIBOR, and the transition to an alternative reference rate.


 PRACTUS NOTE: On June 18, 2020, the Division issued a Risk Alert noting that the Division would be engaging with firms through examinations to assess their preparedness for the expected discontinuation of LIBOR and the transition to an alternative reference rate.  The Risk Alert provides firms with additional information regarding the scope and content of these exams, among other information.  The Risk Alert can be found at Risk Alert – OCIE LIBOR Initiative.pdf (sec.gov).

Additional Focus Areas Involving RIAs and Investment Companies

Compliance Programs

The Division will continue to review the compliance programs of RIAs, including whether those programs and their policies and procedures are reasonably designed, implemented, and maintained. 

  • ESG Investment Strategies.  In light of the increase in RIAs offering investment strategies that focus on ESG factors, the Division will continue to focus on products in these areas that are widely available to investors including open-end funds and ETFs, as well as those offered to accredited investors such as qualified opportunity funds.  The Division will review the consistency and adequacy of the disclosures RIAs and fund complexes provide to clients regarding these strategies, determine whether the firms’ processes and practices match their disclosures, review fund advertising for false or misleading statements, and review proxy voting policies and procedures and votes to assess whether they align with the strategies.

 PRACTUS NOTE: ESG investing and related disclosures is an emerging topic for the SEC staff.  With the increased focus on this area, the SEC recently created a Climate and ESG Task Force in the Division of Enforcement, which will develop initiatives to proactively identify ESG-related misconduct.  The SEC’s Acting Chair, Allison Lee, has been particularly vocal on ESG-related matters and has commented on this publicly in a number of speeches and other public statements.4  One such statement included a Public Request for Comment on Climate Change Disclosures.5  In addition, the SEC’s Asset Management Advisory Committee (“AMAC”) established a subcommittee to review matters concerning ESG investment products and tasked them with making recommendations regarding these products for consideration by the AMAC.  The AMAC issued its Discussion Draft of Potential Recommendations of the ESG Subcommittee on December 1, 2020, which can be found at Potential Recommendations of the ESG Subcommittee (sec.gov).  The SEC has also created a dedicated page on its website to bring together all SEC information about climate change and ESG issues, which can be found at SEC.gov | SEC Response to Climate and ESG Risks and Opportunities.
Firms that invest on a global basis also must consider whether they need to reconcile their activities based on requirements of other jurisdictions, such as the EU, which has been particularly active in this area.  For example, on March 10, 2021, the EU’s Sustainable Finance Disclosure Regulation (“SFDR”) went into effect.  The SFDR requires financial market participants and financial advisers, including AIFMs and UCITs management companies, to provide investors with certain ESG-related information in relation to certain financial products to enable investors to make informed investment decisions based on ESG factors.  The SFDR can be found at EUR-Lex – 32019R2088 – EN – EUR-Lex (europa.eu).  This forms part of a larger EU Commission Action Plan launched in March of 2018, which aims to promote ESG finance.
 
Finally, the Commodity Futures Trading Commission (“CFTC”) is also involved in the ESG discussion.  On March 17, 2021, CFTC Acting Chairman Rostin Behnam announced the establishment of a CFTC Climate Risk Unit (“CRU”) to focus on the role of derivatives in understanding, pricing, and addressing climate-related risk and transitioning to a low-carbon economy.  The announcement and the focus areas of the CRU can be found at CFTC Acting Chairman Behnam Establishes New Climate Risk Unit | CFTC.

Mutual Funds and ETFs

Examinations of mutual funds and ETFs will focus on disclosures to investors, valuation, filings with the SEC, personal trading activities, contracts and agreements, and will include a review of fund governance practices and compliance programs.  The Division will prioritize examinations of mutual funds or ETFs that have not previously been examined or have not been examined in a number of years, and will generally focus on:

  • fund compliance programs and financial condition, particularly where funds have instituted advisory fee waivers;
  • compliance with exemptive relief, including for the newly created non-transparent, actively managed ETFs; and
  • funds’ and advisers’ disclosures and practices related to securities lending.

RIAs to Private Funds

  • The Division will continue to focus on advisers to private funds, and will assess compliance risks, including a focus on liquidity and disclosures of investment risks and conflicts of interest.
  • The Division will also focus on advisers to private funds that have a higher concentration of structured products, such as collateralized loan obligations and mortgage backed securities, to assess whether the private funds are at a higher risk for holding non-performing loans and having loans with higher default risk than that disclosed to investors.

 PRACTUS NOTE: On June 23, 2020, the Division issued a Risk Alert that includes certain observations in examinations of advisers that manage private equity funds or hedge funds.  The Risk Alert can be found at Risk Alert – Private Fund.pdf  (sec.gov).

Additional Focus Areas Involving Broker-Dealers and Municipal Advisors

Broker-Dealers

Examinations of broker-dealers will continue to focus on:

  • Compliance with the Customer Protection Rule (Rule 15c3-3 under the Exchange Act) and the Net Capital Rule (Rule 15c3-1 under the Exchange Act);
  • Adequacy of internal processes, procedures, controls, and compliance with requirements for borrowing securities from customers; and
  • Compliance with best execution in a zero commission environment, recently amended Rule 606 order routing disclosure rules under Reg NMS, and market-maker compliance with Reg SHO.

Municipal Advisors

Examinations of municipal advisors will focus on:

  • How municipal advisors may have adjusted their practices in light of the COVID-19 pandemic and its potential impact on municipal advisors and their clients; and
  • Whether municipal advisors have met their fiduciary duty obligations to municipal entity clients, including the disclosing of and managing conflicts of interest and documentation of the scope of their client engagements.

Conclusion

The Division’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 advisors are on notice about the Division’s priorities and areas of focus. 

Who should we talk to if we have further questions?

Please call Ken Earley (617-865-1870) or Karen Aspinall (949-629-3928) or the Practus attorney with whom you deal regularly with questions.  

Article Footnotes

  1. 2021 Examination Priorities, Division of Examinations, U.S. Securities and Exchange Commission (Mar. 3, 2021) (2021 Examination Priorities Report (sec.gov)).
  2. Information security was included in the Division’s 2020 exam priorities as well.  See 2020 Examination Priorities, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission (Jan. 7, 2020) (2020 Examination Priorities (sec.gov)).
  3. Department of the Treasury, Financial Crimes Enforcement Network, Anti-Money Laundering Program and Suspicious Activity Report Filing Requirements for Registered Investment Advisers, 80 Fed Reg. 169 (Sept. 1, 2015) (proposing 31 C.F.R. X).
  4. See e.g., Speech of Allison Herren Lee, Acting Chair, A Climate for Change; Meeting Investor Demand for Climate and ESG Information at the SEC (Mar. 15, 2021).
  5. See Public Statement of Acting Chair Allison Herren Lee, Public Input Welcomed on Climate Change Disclosures (Mar. 15, 2021), available at SEC.gov | Public Input Welcomed on Climate Change Disclosures.

Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.