Last week I wrote about FINRA’s 2014 exam priorities. This week, the SEC announced its 2014 examination priorities covering a number of topics important to investment advisers, investment companies, broker-dealers, clearing agencies, exchanges and other self-regulatory organizations, hedge funds, private equity funds, and transfer agents.
While the SEC makes clear the list is not exhaustive, areas that firms will see heightened scrutiny include fraud detection and prevention, corporate governance and enterprise risk management, technology controls. Included also are issues concerning the growing relationship between broker-dealers and investment advisers, new rules and regulations, and retirement investments and rollovers.
Advisers and broker-dealers who were examined in the last couple years will recognize many of the highlights. According to the SEC, this years topics, broadly covered, include the National Examination Program priorities, as well as issues related more specifically to “particular business models and organizations.”
Investment Advisers and Investment Companies
Safety of Assets and Custody – continued testing adviser compliance with the Custody Rule and confirming assets through a risk-based asset verification process; focus on situations where advisers fail to realize they have custody.
- Conflicts of Interest Inherent in Certain Investment Adviser Business Models – examining undisclosed compensation arrangements and effect on recommendations made to clients; allocation of investment opportunities; disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts; disclosure for illiquid investments and leveraged investment
products and strategies; higher risk products or strategies targeted to retail, retired or elderly investors.
- Marketing/Performance – examine the accuracy and completeness of advisers’ claims about investment objectives and performance i.e. reviewing and testing hypothetical and back-tested performance, the use and disclosure of composite performance figures, performance record keeping, and compliance oversight of marketing; review marketing efforts arising out of new rules adopted under the JOBS Act.
- Advisers never previously examined – risk based examinations of advisers registered for more than three years but have not yet been examined.
- Wrap fee programs – review the processes in place for monitoring wrap fee programs recommended to advisory clients, related conflicts of interest, best execution, trading away from the sponsor, and disclosures.
- Quantitative trading models – examine adviser compliance policies and procedures tailored to the performance and maintenance of proprietary models, including procedures for evaluating if any models are used to manipulate markets, whether advisers reasonably review or test the models and their output over time, whether advisers maintain proper documentation within required books and records, and whether current inventory of all firm-wide proprietary models maintained.
- Presence Exams – five key focus areas of SEC examinations include marketing, portfolio management, conflicts of interest, safety of client
assets and valuation; prioritized exams of private fund advisers where analytics suggest higher risks to investors, or indicia of fraud, broker-dealer status concerns, or other serious wrongdoing.
- Payments by advisers and funds to entities that distribute mutual fund – examine payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight, and whether payments are, in fact, payments for distribution and preferential treatment.
- Fixed Income Investment Companies – examine risks associated with a changing interest rates and impact on bond funds and related disclosures of risks to investors.
- Money Market Funds – examinations at money market funds,
focused potential stress events managed; working with Division
of Investment Management staff to examine particular money market funds that exhibit outlier behavior in some respect.
- “Alternative” Investment Companies – assessment of funds offering “alternative” investment strategies, focused on: “(i) leverage, liquidity and valuation policies and practices; (ii) the staffing, funding, and empowerment of boards, compliance personnel, and back-offices; and (iii) the manner in which such funds are marketed to investors;” and representations and recommendations made regarding the suitability of such investments.
- Securities Lending Arrangements – The staff will examine securities lending arrangements to determine whether they comply with exemptive orders and evaluate consistency with relevant no-action
Sales practices and fraud – affinity fraud targeting seniors, Micro-cap fraud and pump and dump schemes.
Fixed-income market issues – unsuitable investment and due diligence in higher yield and complex products (e.g., leveraged ETFs and structured products).
Trading issues – including compliance with the new market access rule – erroneous orders; algorithmic and high frequency trading; information
leakage and cyber security; market manipulation schemes; abuses of the bona-fide market making exception to Regulation SHO, relationships between broker-dealers and Alternative Trading Systems (“ATSs”).
Supervision – independent contractors and financial advisors in “remote” locations and large branch offices, registered representatives with significant disciplinary histories, and private securities transactions.
- Internal Controls – including liquidity, credit, and market risk management practices; internal audit; valuation practices; and compliance.
- Financial Responsibility – customer protection and the net capital rules
- Anti-Money Laundering – clearing and introducing firms, proprietary trading firms that allow customers direct access to the markets from higher risk jurisdictions.
- Market Access Rule – is it being appropriately applied? adequacy of books and records.
- Suitability of Annuity Buybacks – disclosures made to customers.
- Fixed Income Market – including quality of executions, use of filters by market participants to control what is displayed by fixed income ATSs.
Risk-based examinations of securities exchanges and FINRA – areas outlined in Dodd-Frank.
- Control weakness at exchanges – options exchanges, business continuity planning at the exchanges.
- Pre-launch reviews of new exchange applicants – including ownership changes to assess compliance with laws and rules, examination security-based swap execution facilities, if SEC adopts rules.
- Section 31 Fee Examinations – annual review of controls and policies and procedures concerning reporting and payment of Section 31 fees.
Clearing and Settlement
- Clearing Agencies Designated as Systemically Important – conduct annual risk based examinations as required by the Dodd-Frank Act, pre-launch reviews of new clearing agency applicants.
Transfer Agents – timely turnaround of items and transfers, accurate recordkeeping and safeguarding of assets; focus on transfer agents that service microcap securities and private offerings, policies for handling and transferring certificates damaged by Hurricane Sandy, whether transfer agents providing “third party” administration appropriately registered.
- Direct Registration System – reviewing transfer agents’ policies and procedures around order taking, recordkeeping, and clearing relationships.
- Business Continuity and Disaster Recovery Plans – reviewing adequacy of transfer agents’ business continuity and disaster recovery plans based on the size and scope of their business models.
A copy o fthe SEC’s 2014 Exam Priorities can be found at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf.