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1/14/19 - Promontory Currents - SEC Announces its Examination Priorities for 2019

By Jane Jarcho, Conway Dodge, Michael Sullivan, and Michael Vorhis  

On Dec. 20, 2018, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) announced its examination priorities for 2019,1 which emphasize the protection of retail investors and outline a number of emerging risks, such as those arising from digital assets.2 OCIE publishes its examination priorities annually to promote transparency of its examination program, reduce fraud, and improve compliance by highlighting heightened risks to investors or the integrity of the U.S. capital markets.

The SEC’s examination priorities for 2019 are largely similar to its priorities for 2018. In fact, each of this year’s six risk categories also appeared in last year’s priorities. Those categories are: 

  1. Retail investors 
  2. Critical-market infrastructure 
  3. The Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board (MSRB)
  4. Digital assets 
  5. Cybersecurity 
  6. Anti-money-laundering programs 

One noteworthy change from last year’s exam priorities appears to be a greater focus on the risks and compliance issues of digital assets. This is consistent with SEC Chair Jay Clayton’s public statement of concern about such assets3 and with recent SEC enforcement actions and staff guidance on issues that arise when digital assets meet the definition of a security for the purposes of federal securities laws.4

Below is a summary of the staff’s 2019 examination priorities for each of the six risk categories, which includes comparisons to last year’s examination priorities. 

1. Retail Investors

As it did in 2018, OCIE highlights the singular importance of protecting retail investors by detailing numerous compliance risks and issues it will prioritize during examinations of investment advisers, broker-dealers, and municipal advisors in 2019. Areas of new or heightened focus include investment advisers’ conflicts of interest and portfolio management, broker-dealer compliance with the customer-protection rule (Exchange Act Rule 15c3-3), and microcap securities.5 Removed from the list of examination priorities focusing on retail investors is the provision of investment advice by broker-dealers and investment advisers through automated or digital platforms (robo advisers). 

  • Fees and Expenses: OCIE notes that examinations will focus on whether fees and expenses charged by investment advisers and broker-dealers are accurately calculated and consistent with the firm’s disclosures and client agreements. Similar to the approach outlined in its 2018 examination priorities, OCIE will select firms that are of greater risk of inadequately disclosing fees and expenses to their investors due to their business models or other practices. These include firms that participate in wrap-fee programs and that offer sales incentives to its professionals (particularly those that may prioritize certain share classes of mutual-fund products). 
  • Conflicts of Interest: OCIE states it will examine firms’ policies and procedures relating to conflicts of interest arising from: (1) arrangements with affiliated service providers, (2) sales practices of investment advisers and broker-dealers that offer securities-backed lines of credit, and (3) investment advisers that borrow funds from clients. 
  • Seniors and Retirement Products: Just as it has in recent years, OCIE states it will focus on services provided by broker-dealers and investment advisers to senior investors and clients saving for retirement, including broker-dealers’ and investment advisers’ ability to identify financial exploitation of seniors, whether broker-dealers and investment advisers adequately supervise client-facing representatives, and the suitability of broker-dealers’ and investment advisers’ services and products. 
  • Portfolio Management: OCIE highlights risks and compliance issues associated with investment advisers’ portfolio management and trading, including trade execution, the allocation of investment opportunities, and the consistency of such practices with firm disclosures and the investment restrictions, objectives, and risk tolerance of clients. While portfolio-management issues are not new, their inclusion in the 2019 priorities suggests they are a renewed area of focus. Further, OCIE’s recent development of analytical tools and resources may lead to a more data-driven approach than in years past. 
  • Never-Before Examined Investment Advisers: OCIE is continuing this initiative, first announced in its 2014 examination priorities,6 to examine both investment advisers it has not previously examined and newly registered investment advisers, using risk-based factors to select examination candidates. However, it also notes that it will include as part of this initiative investment advisers whose business profiles may have changed substantially since the last exam.
  • Mutual Funds and ETFs: OCIE states that it will focus on risks related to funds with characteristics that give rise to conflicts of interest or that pose risks to investors. For example, OCIE will prioritize examination of investment advisers that are inexperienced in managing a registered investment-company fund or that have both registered-fund and private-fund clients. OCIE will also prioritize examination of the oversight provided by funds’ boards or trustees. Similar to the portfolio-management risks discussed above, firms should anticipate that OCIE will employ more advanced analytical capabilities than it has in years past to identify firms and investment companies of potentially greater risk.
  • Municipal Advisors: OCIE states it will prioritize examinations of municipal advisors that have never been examined to ensure they have satisfied registration requirements and professional qualifications. OCIE will also focus on municipal advisors’ disclosures of conflicts of interest and compliance with recently adopted MSRB rules, including those rules pertaining to advertisements and standards of conduct for obtaining Committee on Uniform Security Identification Procedures (commonly known by its acronym, CUSIP) numbers on behalf of municipal issuers. 
  • Customer-Protection Rule: OCIE states it will prioritize examination of the controls and procedures of broker-dealers to promote compliance with the customer-protection rule. 
  • Microcaps: OCIE states it will prioritize broker-dealers involved in selling microcap securities and issues such as potentially abusive market practices.

2. Critical-Market Infrastructure 

To support the SEC’s mission to maintain fair, orderly, and efficient markets and facilitate capital formation, OCIE described its priorities for assessing compliance and risk among the four categories of SEC registrants that comprise critical-market infrastructure: clearing agencies, national securities exchanges, transfer agents, and Regulation Systems Compliance and Integrity (Regulation SCI) entities. 

  • Clearing Agencies: OCIE will continue to conduct annual examinations of clearing agencies designated by the Financial Stability Oversight Council as systemically significant and will conduct risk-based examinations for all other clearing agencies. 
  • National Securities Exchanges: OCIE will continue to examine the regulatory programs at the national securities exchanges facilitating transactions in the marketplace. 
  • Transfer Agents: OCIE reiterated its focus on assessing transfers, recordkeeping, and the safeguarding of funds and securities. A new priority for 2019 is a focus on the annual reports of transfer agents’ internal controls. The set of identified transfer-agent examination candidates is broader than that listed in the 2018 priorities. For example, OCIE will prioritize transfer agents that facilitate higher-risk issue types, such as digital assets, microcaps, and private offerings. 
  • Regulation SCI Entities: OCIE will continue to examine entities subject to Regulation SCI to evaluate whether they have effectively implemented written policies and procedures required by the rule. In addition, OCIE will focus on control processes to maintain operational capability as required by Regulation SCI. 

3. FINRA and the MSRB

OCIE echoed its 2018 examination priorities in stating the SEC’s critical responsibility to oversee these two self-regulatory organizations. Examinations of FINRA will continue to focus on its operations and examinations of FINRA members, while OCIE will continue to inspect the MSRB’s internal compliance program.

4. Digital Assets

OCIE has elevated digital assets into its own category of exam priorities this year, reflecting the rapid market growth and increasing number of SEC-regulated entities now participating in the digital-asset market. The 2019 examination priorities describe a proactive approach to monitoring the offer, sale, trading, and management of digital assets, including through high-level inquiries designed to assess the extent and nature of such activities across the industry. Accordingly, OCIE is clearly looking at firms that are entering or contemplating entering the digital-asset market.

For firms active in the digital-asset market, OCIE will conduct examinations on a wide range of practices, including portfolio management, trading, custody, and valuation.

5. Cybersecurity

It should be of little surprise that cybersecurity risks remain a key focus of OCIE. However, the 2019 examination priorities identify a few specific areas of focus for forthcoming examinations of regulated entities, which range from information security governance to the proper configuration of network storage devices.

OCIE also highlighted registered investment advisers’ cybersecurity practices as a focus for 2019, including advisers with multiple branch offices and advisers that have recently completed a merger or acquisition. These examples suggest OCIE is interested in the controls and practices of firms that face complex operational challenges, such as merging or harmonizing systems, policies, and training programs.

6. AML Programs 

The staff reiterated its focus on broker-dealers’ AML programs, including filings of suspicious-activity reports and whether independent testing is robust and timely.

OCIE’s examination priorities for 2019 can help guide the focus of compliance programs by highlighting key risk areas. However, it is important to recognize that OCIE sets the scope of any examination after consideration of a particular registrant’s products and client types, among other factors. Accordingly, examinations will also focus on areas not mentioned in the priorities. Compliance programs should therefore consider the risks highlighted in the release, as well as risks that are unique to their firms.

Over the last few years, OCIE has significantly increased its number of annual examinations. In 2018, it conducted a total of 3,150 examinations, a 10% increase from 2017. Examinations of registered investment companies also increased significantly, by 45%.7 This year-over-year increase in examinations is reflective of a larger trend; between 2013 and 2018, the total number of OCIE examinations increased by 95%.8 Moreover, the examination-coverage rate9 of registered investment advisers was just 9% in 2013,10 compared to 17% in 2018.11 We expect this multiyear trend of increased focus on examinations of investment advisers and investment companies to continue. 

Authors 

Jane Jarcho is a special adviser in Promontory’s asset-management practice. Conway Dodge and Michael Sullivan are managing directors, and Michael Vorhis is a principal, in Promontory’s Washington office.


   FOOTNOTES

  1. 2019 Examination Priorities,” Securities and Exchange Commission (Dec. 20, 2018).
  2. The staff uses the term “digital assets” to refer to coins, cryptocurrencies, and tokens, regardless of whether the asset meets the definition of a security for the purposes of federal securities laws.
  3. Jay Clayton, “Statement on Cryptocurrencies and Initial Coin Offerings,” Securities and Exchange Commission (Dec. 11, 2017).
  4. Statement on Digital Asset Securities Issuance and Trading,” Securities and Exchange Commission (Nov. 16, 2018).
  5. Microcap securities are equity securities issued by companies with a market capitalization of less than $250 million. 
  6. Examination Priorities for 2014,” Securities and Exchange Commission (Jan. 9, 2014).
  7. 2019 Examination Priorities,” Securities and Exchange Commission (Dec. 20, 2018).
  8. In 2013, OCIE conducted 1,615 examinations, compared to 3,150 in 2018. See “Fiscal Year 2013 Agency Financial Report,” Securities and Exchange Commission (Dec. 17, 2013).
  9. The coverage rate is a metric the SEC uses to track its performance and indicates the number of registrants examined during the year as a percentage of total registrants.
  10. Fiscal Year 2013 Agency Financial Report,” Securities and Exchange Commission (Dec. 17, 2013).
  11. Agency Financial Report: Fiscal Year 2018,” Securities and Exchange Commission (Nov. 15, 2018)