SEC’s Office of Compliance Inspections and Examinations Announces 2019 Examination Priorities

The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) has issued its examination priorities for 2019. In it, OCIE points out that its examination program covers some 13,200 investment advisers with managed assets of about $84 trillion, approximately 10,000 mutual funds and ETFs, roughly 3,800 broker-dealers, about 330 transfer agents, 7 active clearing agencies, 21 national securities exchanges, nearly 600 municipal advisors, the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), the Securities Investor Protection Corporation and the Public Company Accounting Oversight Board.

In its newly published list of priorities, OCIE said that, in the coming year, it will focus on six principal areas:

1. Retail investors, including senior investors and those saving for retirement;
2. Critical market infrastructure;
3. Select areas and programs of FINRA and MSRB;
4. Digital assets;
5. Cybersecurity; and
6. Anti-Money Laundering (AML) programs.

As OCIE always notes, this is not an exhaustive list. OCIE will identify and focus on additional priorities as needed to address changing conditions. OCIE’s examinations also will continue to be guided by the same four “pillars” presented in OCIE’s examination priorities for 2018: (1) promoting compliance; (2) preventing fraud; (3) identifying and monitoring risk; and (4) informing policy.

Matters of Importance to Retail Investors

OCIE will continue to prioritize protecting retail investors, particularly senior investors and retirement savers. To that end, OCIE will focus on:

• Fees and Expenses – OCIE will continue to look for transparency and proper disclosure of investment costs to investors. Wrap fee programs, which provide for bundling of fees for advisory and brokerage services, and how mutual fund share classes are selected for advisory clients were flagged as of special interest.
• Conflicts of Interest – Conflicts of interest with respect to investment advisers and broker-dealers continue to be paramount concerns for OCIE, which will look to ensure advisers adequately disclose those conflicts to investors. Of particular interest to OCIE are: (1) portfolio management practices and compensation arrangements, among other things, in connection with affiliated service providers and products; (2) financial incentives to recommend securities-backed non-purpose loans and lines of credit to investors; and (3) borrowing funds from clients.
• Senior Investors and Retirement Accounts and Products – OCIE examinations will review how broker-dealers interact with their clients and their ability to identify “financial exploitation” of senior and retirement investors by registered representatives. They will focus on compliance programs of investment advisers, appropriateness of investment recommendations provided to senior investors and the supervision of employees and representatives with respect to their interactions with senior investors and retirement savers.
• Portfolio Management and Trading – OCIE’s examinations will cover, among other things, an investment adviser’s portfolio management processes, allocation of investment opportunities among clients and disclosure of critical information, such as risk assessment, to its clients.
• Never-Before or Not Recently-Examined Investment Advisers – OCIE will continue to prioritize review of investment advisers that have never been examined, including newly registered investment advisers or those that have substantially grown or changed business models since their last examinations.
• Mutual Funds and Exchange Traded Funds – OCIE will focus on risks associated with the following: (1) index funds that track custom-built bespoke indexes; (2) ETFs with little secondary market trading volume and smaller assets under management; (3) funds with higher allocations to certain securitized assets; (4) funds with aberrational underperformance relative to their peer groups; (5) funds managed by advisers that are relatively new to managing regulated products; and (6) advisers that provide advice to both registered investment companies and private funds with similar investment strategies.
• Municipal Advisors – Reaching municipal advisors that have never been examined will continue to be a focus. OCIE will concentrate on whether municipal advisors have satisfied their registration requirements and professional qualifications, disclosed appropriately conflicts of interests or violations of fiduciary duty and complied with the recently effective MSRB rules.
• Broker-Dealers and Customer Protection Rule – Examinations of broker-dealers that hold customer cash and assets will look to ensure compliance with the Customer Protection Rule, which restricts the use of customer assets and prevents broker-dealers from using such assets as working capital.
• Microcap Securities – With respect to broker-dealers that sell microcap securities (market capitalization under $250 million), OCIE will review for manipulative (i.e., “pump and dump”) schemes and compliance with various laws and regulations, including Regulation SHO and Securities Exchange Act Rule 15c2-11.

Absent from the 2019 examination priorities as compared to 2018 examination priorities in the retail investor space is the monitoring of investment advisers and broker-dealers that offer investment advice through automated or digital platforms (e.g., robo-advisers). We do not believe however, that such omission necessarily signals OCIE’s intention to shift its attention away from robo-advisers, especially in light of the SEC’s recent examination of and enforcement actions against such advisers or broker-dealers. Industry participants should accordingly remain focused on addressing risks relating to investment advice offered through automated or digital platforms, which will continue to be of interest to OCIE.

Critical Market Infrastructure

OCIE will continue to focus on the same four groups of registrants responsible for critical market infrastructure as it did last year:

• Clearing Agencies – OCIE will continue its annual examinations of “systematically important” clearing agencies subject to SEC jurisdiction. Its examinations will generally concentrate on compliance with the SEC’s Standards for Covered Clearing Agencies and other applicable federal securities laws, whether timely corrective actions have taken place in response to prior examinations, and other areas identified by the SEC’s Division of Trading and Markets and other regulators.
• Regulation Systems Compliance and Integrity (SCI) Entities – Examinations of SCI entities will continue to concentrate on, among other things, controls relating to software development life cycles and related governance procedures, effectiveness of internal audit programs, inventory management and threat management capabilities.
• Transfer Agents – Candidates for examination will include transfer agents that: serve as paying agents for issuers; develop blockchain technology; or provide services to issuers of microcap securities, private offerings, crowdfunded securities or digital assets.
• National Securities Exchanges – OCIE will examine internal audit and surveillance programs, and funding for regulatory programs.

Focus on FINRA and MSRB

OCIE’s focus on FINRA and MSRB remains largely identical to last year. OCIE will continue its inspection of FINRA’s operations and regulatory programs, and the quality of FINRA’s examinations of broker-dealers and municipal advisors that are also registered as broker-dealers. OCIE will continue its examination of MSRB to evaluate the effectiveness of its policies, procedures and controls.

Digital Assets

In response to the rapid growth of the market for digital assets, including cryptocurrencies, and the rapid development of blockchain technology, OCIE’s examinations will focus on, among other things, portfolio management of digital assets, trading, safety of client funds and assets, pricing of client portfolios and compliance and internal controls relating to digital assets. Digital assets were included under the retail investor category last year, but they are now a separate standalone category.

Cybersecurity

As with previous years, OCIE will continue prioritizing cybersecurity, emphasizing, among other things, proper configuration of network storage devices, information security governance generally and policies and procedures related to retail trading information security. Specific to this year, OCIE will also concentrate on cybersecurity practices at investment advisers with multiple branch offices, including those that have recently merged with other investment advisers. 

AML Programs

OCIE will continue its examination of broker-dealers for compliance with their AML obligations, including whether they are meeting their suspicious activity report (SARs) filing obligations, implementing all elements of their AML programs and robustly and timely conducting independent tests of their AML program.

Our Take

OCIE’s priorities for 2019 are very similar to those from 2018, with the notable but unsurprising addition of digital assets and blockchain as their own category. OCIE’s continued “pivot” (our term, not theirs) from private funds to a focus on retail savers, registered investment companies and ETFs also appears to signal a clear trend. But, as we cautioned when reviewing OCIE’s 2018 priorities at the start of last year, the private funds community should continue to remain vigilant. While not a “priority,” we expect that OCIE will continue its focus on private fund managers.