|January 17, 2014|
Previously published on January 14, 2014
On January 9, 2014, the Securities and Exchange Commission (the “SEC”) announced its 2014 examination priorities (the “Exam Priorities”) as part of the SEC’s National Examination Program (the “NEP”) to foster communication with both investors and registered entities. The Exam Priorities are a “road map” for how investment advisers, funds, broker-dealers and others in the asset management industry will be reviewed by the SEC’s exam staff in the year ahead. The Exam Priorities describe multiple levels of NEP initiatives, including NEP-wide initiatives and “program area-specific initiatives” (e.g., initiatives that focus on investment advisers or broker-dealers).
Some of the more significant NEP-wide initiatives include the following:
- Fraud Detection and Prevention. This initiative focuses on the NEP’s use of quantitative and qualitative tools and techniques to identify market participants engaged in fraudulent or unethical behavior.
- Corporate Governance, Conflicts of Interest, and Enterprise Risk Management. This initiative is designed to: (i) evaluate firms’ control environment and “tone at the top,” (ii) understand firms’ approach to conflict and risk management, and (iii) initiate a dialogue on key risks and regulatory requirements.
- Technology. This initiative focuses on firms’ governance and use of technology, including operational capability, market access, information security and preparedness to respond to sudden malfunctions and system outages.
- Dual Registrants. This initiative derives from concern that the convergence among broker-dealer and investment adviser activity creates a significant risk. Accordingly, the NEP will examine conflicts of interest, impacts to investors from different supervisory structures and legal standards of conduct related to dual registrants’ and their representatives' provision of brokerage and investment advisory services.
- New Laws and Regulation. This initiative focuses on general solicitation practices and verification of accredited investor status under newly adopted Rule 506(c) for Regulation D offerings. The NEP will also focus on compliance with regulatory requirements for crowdfunding compliance as these new rules become effective.
Program Area-Specific Initiatives
The Exam Priorities’ program area-specific initiatives are further categorized into “core risks”, generally selected based on issues identified in recently conducted examinations; “new and emerging issues and initiatives”, which the SEC generally believes pose increased risks due to changes in the industry; and “policy topics”, which generally represent areas of focus because the SEC is seeking to better understand them.
Some of the more significant area-specific initiatives for investment advisers/investment companies and broker-dealers include the following:
A. Investment Adviser/Investment Company Program
Safety of Assets and Custody. This initiative focuses on non-compliance with Rule 206(4)-2 under the Advisers Act (“Custody Rule”). Examiners will pay particular attention to those instances where advisers fail to realize they have custody and therefore fail to comply with requirements of the Custody Rule.
Conflicts of Interest Inherent in Certain Investment Adviser Business Models. This initiative focuses on conflicts of interest inherent in an adviser’s business model, including matters related to compensation and investment allocations.
Marketing/Performance. This initiative considers the accuracy and completeness of advisers’ claims about their investment objectives and performance, especially in connection with newly effective rules adopted under the Jumpstart Our Business Startups (“JOBS”) Act.
New and Emerging Issues and Initiatives
Never-Before Examined Advisers. This initiative involves focused, risk-based examinations of advisers that have been registered for more than three years but have not yet been examined under the NEP. The staff will also continue the use of shorter Presence Exams for newly registered advisers, which focus on key areas of marketing, portfolio management, conflicts of interest, safety of client assets and valuation.
Wrap Fee Programs. This initiative focuses on assessing whether wrap fee program advisers are fulfilling their fiduciary and contractual obligations to clients.
Quantitative Trading Models. This initiative involves examining investment advisers with substantial reliance on quantitative portfolio management and trading strategies to assess, among other things, whether these firms have adopted and implemented compliance policies and procedures tailored to the performance and maintenance of their proprietary models.
Payments for Distribution in Guise. This initiative involves review of the variety of payments made by advisers and mutual funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments and boards’ oversight of the same.
Fixed Income Investment Companies. This initiative focuses on risks associated with a changing interest rate environment and the impact this may have on bond funds and related disclosures of risks to investors.
Policy Topics. Policy Topics discussed in the Exam Priorities include a focus on “alternative” investment companies (i.e., mutual funds with certain hedge fund-like strategies) and securities lending arrangements.
B. Broker-Dealer Exam Program
Some of the Core Risks for Broker-Dealers discussed in the Exam Priorities are as follows:
Sales Practices/Fraud. This initiative focuses on detecting and preventing fraud and other violations in connection with sales practices to retail investors.
Supervision. This initiative considers broker-dealers’ supervision of: (i) independent contractors and financial advisors in “remote” locations and large branch offices, (ii) registered representatives with significant disciplinary histories, and (iii) private securities transactions.
Trading. This initiative involves broker-dealers’ market access controls related to, among other things, erroneous orders, the use of technology (with a focus on algorithmic and high frequency trading), information leakage, and cyber security.
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This description of the Exam Priorities is not exhaustive. In addition, while the NEP expects to allocate significant resources throughout 2014 to the examination of the issues described herein and the other issues identified in the Exam Priorities, the NEP will conduct additional examinations in 2014 focused on risks, issues and policy matters that are not discussed or identified in the Exam Priorities.