On January 7, 2020, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) announced its 2020 Examination Priorities. For the past 8 years, OCIE has released its examination priorities on an annual basis. Examination priorities highlight where OCIE will focus its resources as it continues to improve compliance and protect investors.
Importance of Compliance
In its 2020 release, OCIE continues to highlight the importance of compliance. Specifically, it emphasized the importance of compliance programs, chief compliance officers, and other compliance staff that play critical roles at a firm. OCIE indicated that a culture of compliance and the tone from the top were key, and effective compliance programs had positive impacts in its examination results. OCIE highlighted the hallmarks of an effective compliance program, which included compliance’s active engagement in most facets of firm operations, a knowledgeable and empowered chief compliance officer, and perhaps most importantly, a commitment to compliance from C-level and similar executives to set a tone from the top that compliance is integral to the organization’s success.
OCIE FY 2019 Results
OCIE prefaced its examination priorities by summarizing its FY 2019 results. OCIE indicated it completed 3,089 examinations in FY 2019. Examinations covered registered investment advisers (RIAs), investment companies, broker-dealers, national securities exchanges, municipal advisors, transfer agents, the Financial Industry Regulatory Authority (FINRA), and clearing agencies.
OCIE issued more than 2,000 deficiency letters, with many firms taking direct corrective action in response to those letters, including amending compliance policies and procedures, enhancing disclosures, and returning fees to investors.
OCIE 2020 Examination Priorities – 8 Themes
- Retail investors, including seniors and individuals saving for retirement. OCIE will once again focus on the protection of retail investors, particularly seniors and those saving for retirement. OCIE will prioritize examinations of intermediaries that serve retail investors, namely RIAs, broker-dealers, and dually registered firms, and the investments marketed to, or designed for retail investors, such as mutual funds and exchange-traded funds (ETF), municipal securities, and other fixed income securities, and microcap securities.
Examinations will focus on:
- Recommendations and advice given to retail investors, with a particular focus on seniors, teachers, and military personnel.
- Higher risk products, including private placements and securities of issuers in new and emerging risk areas, such as those that: (1) are complex, (2) have high fees and expenses, or (3) where an issuer is affiliated with or related to the registered firm making the recommendation.
OCIE will continue to examine RIAs to assess whether, as fiduciaries, they have fulfilled their duties of care and loyalty. OCIE will continue to focus on risks associated with fees and expenses, and undisclosed or inadequately disclosed compensation arrangements.
- Information security. OCIE will continue to prioritize information security. Examinations will focus on proper configuration of network storage devices, information security governance, and retail trading information security. Specific to RIAs, OCIE will continue to focus its examinations on assessing RIAs’ protection of clients’ personal financial information. Particular focus areas will include: (1) governance and risk management, (2) access controls, (3) data loss prevention, (4) vendor management, (5) training, and (6) incident response and resiliency.
In the area of third-party and vendor risk management, OCIE will focus on oversight practices related to certain service providers and network solutions, including those leveraging cloud-based storage.
- Financial technology and innovation, including digital assets and electronic investment advice. Examinations will focus on firms’ use of new sources of data and assess the effectiveness of related compliance and control functions.
- Digital assets. Examinations will assess the following: (1) investment suitability, (2) portfolio management and trading practices, (3) safety of client funds and assets, (4) pricing and valuation, (5) effectiveness of compliance programs and controls, and (6) supervision of employee outside business activities.
- Electronic investment advice. OCIE will focus on RIAs that provide services to their clients through automated investment tools, often referred to as “robo-advisers.” Areas of focus include: (1) SEC registration eligibility, (2) cybersecurity policies and procedures, (3) marketing practices, (4) adherence to fiduciary duty, including adequacy of disclosures, and (5) effectiveness of compliance programs.
- Additional focus areas involving RIAs and investment companies. OCIE typically assesses compliance programs of RIAs in one or more core areas, including the appropriateness of account selection, portfolio management practices, custody and safekeeping of client assets, best execution, fees and expenses, and valuation of client assets for consistency and appropriateness of methodology. In addition, OCIE will often assess the adequacy of disclosures and governance practices in the core areas reviewed.
OCIE will prioritize examinations of:
- RIAs that are dually registered as, or affiliated with, broker-dealers, or have supervised persons who are registered representatives of unaffiliated broker-dealers. Areas of focus will include whether the firms maintain effective compliance programs to address the risks associated with best execution, prohibited transactions, fiduciary advice, or disclosure of conflicts regarding such arrangements.
- Firms that utilize the services of third-party asset managers to advise clients’ investments to assess the extent of these RIAs’ due diligence practices, policies, and procedures.
- RIAs offering clients new types or emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate environmental, social, and governance (ESG) criteria. Areas of focus will be on the accuracy and adequacy of disclosures.
- Never-before and not recently examined RIAs.
- Mutual funds, ETFs, the activities of their RIAs, and oversight practices of their boards of directors.
- RIAs to private funds that have a greater impact on retail investors, such as firms that provide management to separately managed accounts side-by-side with private funds. Examinations will assess compliance risks, including controls to prevent the misuse of material, non-public information, and conflicts of interest, such as undisclosed or inadequately disclosed fees and expenses, and the use of RIA affiliates to provide services to clients.
- Additional focus areas involving broker-dealers and municipal advisors. OCIE examinations of broker-dealers will focus on the safety of customer cash and securities, risk management, certain types of trading activity, the effects of evolving commissions and other cost structures, best execution, and payment for order flow arrangements
- Broker-dealer financial responsibility. Examinations will focus on compliance with the Customer Protection Rule and the Net Capital Rule, including the adequacy of internal processes, procedures, and controls.
- Trading and broker-dealer risk management. Examinations will focus on (1) firms’ trading and other activities in “odd lots,” (2) controls around the use of automated trading algorithms, and (3) use of internal procedures, practices, and controls to manage trading risk.
- Municipal advisors. Examinations will focus on: (1) whether advisors have satisfied their registration, professional qualification, and continuing education requirements, (2) fiduciary duty obligations to municipal entity clients, fair dealing with market participant requirements, and the disclosure of conflicts of interest, and (3) the conduct of municipal advisors when faced with conflicts while representing their clients, and compliance with recently-effective Municipal Securities Rulemaking Board (MSRB) Rule G-40 concerning advertisements.
- AML programs. OCIE will continue to prioritize examining broker-dealers and investment companies for compliance with their AML obligations. The goal of these examinations is to ensure that 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.
- Market infrastructure. OCIE will examine entities that provide services critical to the proper functioning of capital markets. These entities include Clearing Agencies, National Securities Exchanges, Alternative Trading Systems, and Transfer Agents.
- Clearing Agencies. The Dodd-Frank Act requires the SEC to examine, at least once annually, registered clearing agencies that the Financial Stability Oversight Council has designated as systemically important and for which the SEC serves as the supervisory agency.
- National Securities Exchanges. OCIE will examine operations, especially how they react to market disruptions, how the exchanges monitor member activity for compliance with the federal securities laws and rules, and will focus on exchange efforts concerning abusive, manipulative, and illegal trading practices to protect the integrity of the marketplace.
- Regulation Systems Compliance and Integrity (SCI). SCI was adopted by the Commission to strengthen the technology infrastructure of the U.S. Securities markets. SCI entities must establish, maintain, and enforce written policies and procedures designed to ensure that their systems’ capacity, integrity, resiliency, availability, and security is adequate to maintain their operational capability and promote the maintenance of fair and orderly markets. OCIE will continue to evaluate whether SCI entities have met these requirements. Areas of focus will include IT inventory management, IT governance, incident response, and third party vendor management, including the utilization of cloud services.
- Transfer Agents. OCIE will continue to examine transfer agents’ core functions including the timely turnaround of items and transfers, recordkeeping and record retention, and safeguarding of funds and securities. Examinations will also focus on the requirement for transfer agents to annually file a report by an independent accountant concerning the transfer agent’s system of internal accounting controls, as well as compliance with obligations to search for lost security holders and provide notice to unresponsive payees.
- Focus on FINRA and MSRB.
- FINRA. OCIE conducts risk-based oversight examinations of FINRA. It selects areas within FINRA to examine through a risk assessment process designed to identify those aspects of FINRA’s operations important to the protection of investors and market integrity. Based on the outcome of this risk-assessment process, OCIE conducts inspections of FINRA’s major regulatory programs.
- MSRB. MSRB regulates the activities of broker-dealers that buy, sell, and underwrite municipal securities, and municipal advisors. OCIE, along with FINRA, conducts examinations of registered firms to ensure compliance with MSRB rules. Examinations of MSRB evaluate the effectiveness of MSRB’s policies, procedures, and controls.
While the examination priorities of 2020 do not look much different than 2019, it is important to note several key points:
- Examination coverage. OCIE’s completion of over 3,000 examinations in FY 2019 represents only 15 percent of RIAs. While OCIE has made great strides in increasing its coverage of RIAs, it will continue to face challenges as it tries to keep pace with a growing and evolving industry.
- New regulation. The Securities and Exchange Commission (SEC) finalized many new rules and interpretations in 2019 that will affect firms and OCIE. The most significant is the package of rules and interpretations designed to enhance the quality and transparency of retail investors’ relationships with RIAs and broker-dealers. OCIE has noted that its FY 2020 examinations will include a focus on:
- Regulation best interest
- Form CRS relationship summary
- Interpretation regarding the standard of conduct for investment advisers
These new rules will require various market participants to make changes to their operations, including to required disclosures, marketing materials, and compliance programs. While this article offered a high level overview of OCIE’s examination priorities for 2020, it is important to understand how your firm may specifically be impacted. For more guidance or to discuss your individual circumstances, please contact us.
Dawn M. Levant can be reached at firstname.lastname@example.org or 215.441.4600.
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