February 7, 2018: We wish our clients and colleagues a very prosperous new year and, this being the kickoff of 2018, we are all once again bestowed with the SEC National Exam Program Examination Priorities for the coming year! We believe this informal guidance, announced February 7, 2018, can be helpful to Chief Compliance Officers as they recalibrate their compliance programs to adjust for business model evolutions or to realign their own compliance priorities following the 2017 annual review.
The following is a synopsis of the 2018 SEC examination priorities, abridged to present content pertaining primarily to investment advisers. The strategy and principles content has been extracted directly from the release to provide appropriate context to the Commission’s strategic and tactical execution of their mission.
The Commission’s Strategy
“Our work stands on four “pillars”: promoting compliance, preventing fraud, identifying and monitoring risk and informing policy. This is the sixth year we have published our examination priorities. It is our hope that this publication provides transparency into our thinking on issues and areas that we believe constitute an appropriate focus for us in the upcoming year and which entail the most effective use of examination resources in fulﬁlling our mission.”
The Commission’s Principles
“Principle 1: We are risk-based. A central part of this (risk based) effort is ongoing analysis of root causes of harm to investors and markets and the identiﬁcation of the greatest risks. The analysis ﬂows into a number of aspects of our program, including our process for setting priorities, the criteria we use to select potential examination candidates, and determining the appropriate scope of our exams, as well as resource allocation more generally.”
“Principle 2: We are data-driven. Our use of data is integral to the program and complements our risk-based exam approach and utilization of technology. We use data in areas such as risk assessment and exam scoping, planning, and execution. For example, we are rapidly advancing in our capacity to use data to analyze regulatory ﬁlings and trading activity. … Our sophistication in using data analytics to identify potential non-compliance with the securities laws, including possible fraudulent behavior, is ever growing. We also use data to better identify high-risk exam candidates and to more efﬁciently analyze information during examinations.”
“Principle 3: We are transparent. We believe that publicly sharing certain information about our examination program—particularly our priorities, common ﬁndings, and what we believe to be the highest risk areas—will ultimately beneﬁt investors by assisting the work of legal, compliance, and risk staff at registered entities as they work within their organizations to achieve compliance with the securities laws. To this end, we have been publishing more information about what we are doing, why we are doing it, and what we have found and learned in the process. Risk Alerts, in particular, have become a valuable tool, and we have made a concerted effort to publish them more frequently. The ultimate goal of these Risk Alerts is to promote compliance.” HRL note: we would also point out that the SEC has initiated enforcement actions predicated upon Risk Alerts and related guidance. Enforcement actions are published for public consumption, further exacerbating the attendant reputation risk.
“Principle 4: We rely heavily on our talented and experienced staff, many of whom are subject matter experts in key risk areas. We also increasingly leverage technology and data in our risk assessment and examination processes. Resources, however, are limited. We continually assess our resource deployment and ask: Are we using our resources in a way that maximizes the beneﬁt to investors?”
“Principle 5: We embrace innovation and new technology, both as a means to do more with less and as a necessary focal point of our analytic efforts. We recognize that technology in the ﬁnancial markets often spurs innovation in ways that are beneﬁcial to investors. It has the potential, for example, to help drive down costs to investors and provide new ways for people to access our ﬁnancial markets, investment information, and ﬁnancial advice. Where technological advances lead to new business models, we seek to assess their potential impact on the ﬁnancial markets, identify ways investors may be harmed, if any, and work with our colleagues to share critical observations that may assist the Commission in adapting to emerging risks and concerns. We also seek to keep pace with advancing technology, to monitor for cybersecurity risks, to engage with industry in efforts to help combat cybersecurity attacks, and to prevent investor harm.”
2018 Exam Priorities
With an appreciation of the Commission’s conceptual orientation of its mission triad which encompasses the provision of investor protections, the facilitation of capital formation and ensuring fair, orderly, and efficient markets, the following synopsis of its 2018 priorities reveals no great surprises.
Matters of Importance to Retail Investors Including Seniors and Those Saving for Retirement
Disclosure of the Costs of Investing: Assess related disclosures and calculation of fees, expenses, and other charges that investors pay; conﬂicts of interest extant with adviser product/service recommendations; ascertain whether fees and expenses are calculated and charged in accordance with the disclosures provided to investors; and account valuation methodology and its congruence with disclosed valuation policy and protocol, particularly where the fee is dependent on the value of the account. OCIE will also focus on ﬁrms that have practices or business models that may create increased risks that investors will pay inadequately disclosed fees, expenses, or other charges.
Electronic Investment Advice: Exams will focus on registrant compliance programs, including the oversight of computer program algorithms that generate recommendations, marketing materials, investor data protection, and disclosure of conﬂicts of interest.
Wrap Fee Programs: OCIE will review whether investment advisers are acting in a manner consistent with their ﬁduciary duty and whether they are meeting their contractual obligations to clients. Areas of interest will include whether: (a) the recommendations to invest in a wrap fee program and to continue in the program are reasonable, (b) conﬂicts of interest are disclosed in compliance with applicable regulatory requirements, and (c) advisers are obtaining best execution and disclosing costs associated with executing trades through another broker-dealer.
Never-Before-Examined Investment Advisers: OCIE will continue to make risk-based assessments and select those investment advisers for examination that have elevated risk proﬁles.
Senior Investors and Retirement Accounts and Products: OCIE will continue to conduct exams of advisers that offer services and products to investors with retirement accounts. These examinations will focus on internal controls relating to sales of products and services directed at senior investors. Further, examinations will focus on investment recommendations, sales of variable insurance products, and sales and management of target date funds.
Mutual Funds and Exchange-Traded Funds
Mutual Funds: OCIE will focus on mutual funds that:
- have experienced poor performance or liquidity in terms of their subscriptions and redemptions relative to their peer groups;
- are managed by advisers with little experience managing registered investment companies;
- hold securities which are potentially difﬁcult to value during times of market stress, including securitized auto, student, or consumer loans, or collateralized mortgage-backed securities; and/or
- hold ETFs and mutual funds that seek to track custom-built indexes to review for any conﬂicts the adviser may have with the index provider and the adviser’s role with respect to the selection and weighting of index components.
Exchange-Traded Funds (ETFs): With respect to ETFs, the focus will be on funds that have little secondary market trading volume and that face the risk of being delisted from an exchange and having to liquidate assets. These scenarios would entail an ETF that will rapidly decline in value prior to the delisting wherein investors may pay the cost to liquidate the fund’s assets. The focus of these examinations will include analyzing whether investment risks are adequately disclosed to investors. It is noteworthy that ETFs are again being referenced as a culprit in significant market volatility, most recently in early February 2018. It is anticipated that several ETFs will be delisted before month-end. Significant guidance is likely forthcoming relative to ETF underwriting and adviser ETF recommendations.
Municipal Advisors and Underwriters: OCIE will continue to examine municipal advisors to evaluate their compliance with registration, recordkeeping, and supervision requirements, particularly those municipal advisors that are not registered as broker-dealers.
Fixed-Income Order Execution: OCIE will continue to focus on investor protection by focusing on adviser compliance with best execution rules for client trades, especially in the corporate and municipal bond market.
Cryptocurrency, Initial Coin Offerings (ICOs), Secondary Market Trading, and Blockchain: A relatively new focus, OCIE will monitor the sale of these products, and where the products are securities, examine for regulatory compliance.
Cybersecurity: OCIE will focus on adviser capacity to identify and manage cybersecurity risks and will continue to encourage registrants to retain a proactive posture on cybersecurity risk. Exams will continue to focus on governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, and incident response.
The 2018 Priorities document addresses other topics, which are not discussed in this newsletter:
- Compliance and Risks in Critical Market Infrastructure
- Focus on FINRA and MSRB
- Anti-Money Laundering Programs
The Commission’s own conclusions articulate in the 2018 Exam Priorities release provide interesting insight into today’s regulatory mindset:
“OCIE welcomes comments and suggestions regarding how we can better fulﬁll our mission to promote compliance, prevent fraud, identify and monitor risk, and inform SEC policy. If you suspect or observe activity that may violate the federal securities laws or otherwise operates to harm investors, please notify (the) SEC Staff …”
The SEC Whistleblower Program continues to bear fruit for the regulator. We urge every investment adviser to empower the whistleblower policy to do the same by ensuring that the enterprise remains compliant with SEC rules and by assuring staff that they have a duty to report suspected non-compliant activity and may do so without fear of retribution or disassociation.
Follow this link to read the complete priorities document: https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2018.pdf