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January 15, 2020

Stroock Special Bulletin

By: Eric Requenez, Abdulmajeed F. Alhogbani

On January 7, 2020, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) announced its 2020 examination priorities and released the results of its 2019 fiscal year.[1]  As in prior years, the examination priorities reflect, in OCIE’s view, certain practices, products and services that present a potentially heightened risk to investors or the integrity of the U.S. capital markets.  While OCIE continues to focus on many of the same areas as in prior years, including an emphasis on the protection of retail investors, this year’s priorities include an emphasis on new developments and market trends, including compliance with recent regulatory developments (e.g., Reg BI, Form CRS and the recent amendments to the Advisers Act), financial technology (“FinTech”) and innovation, transitioning away from LIBOR and environmental, social and governance investing, and provide additional detail regarding specific areas OCIE will prioritize in examinations.

2020 Examination Priorities

OCIE identified eight examination priorities for 2020: (i) retail investors, including seniors and individuals saving for retirement; (ii) information security; (iii) FinTech and innovation, including digital assets and electronic investment advice; (iv) specific areas involving registered investment advisers and investment companies; (v) specific areas involving broker-dealers and municipal advisors; (vi) anti-money laundering programs; (vii) market infrastructure (i.e., clearing agencies, national securities exchanges, alternative trading systems, transfer agents); and (viii) oversight of the Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board.

Set forth below is a detailed summary of the eight examination priorities OCIE has identified for 2020.  A full copy of the 2020 Examination Priorities Memorandum can be found here.[2]

Retail Investors, Including Seniors and Individuals Saving for Retirement

OCIE continues to emphasize the protection of retail investors and has stated that it will prioritize examinations of (i) the various intermediaries that serve retail investors, particularly registered investment advisers, broker-dealers and dual registrants and (ii) the investments marketed to, or designed for, retail investors (e.g., mutual funds, exchange-traded funds, municipal securities, fixed income securities and microcap securities).  Examinations in these areas will include reviews of disclosures relating to fees, expenses and conflicts of interest.

Specifically, examinations in this area will focus on recommendations and advice given to retail investors, with a particular focus on: (i) seniors, including recommendations and advice made by entities and individuals targeting retirement communities; and (ii) teachers and military personnel.

OCIE also intends to focus on the oversight of products it has characterized as “higher risk,” including private placements and securities of issuers in new and emerging risk areas, specifically identifying those (i) that are complex or non-transparent; (ii) that have high fees and expenses; or (iii) involving an issuer that is affiliated with or related to the registered firm making the recommendation.

In addition, OCIE will focus on firms’ supervision of the outside business activities of its employees and associated persons, conflicts that may arise from such activities and the disclosure firms provide to investors regarding such activities.

OCIE further identified the following three product types as an area of focus in its efforts to protect retail investors.

Mutual Funds and Exchange-Traded Funds (“ETFs”)

In respect of mutual funds and ETFs, OCIE will continue to prioritize examining:

•  the financial incentives provided to financial services firms and professionals that may influence the selection of particular mutual fund share classes; and

•  mutual fund fee discounts that should be provided to investors as a result of policies, contractual or disclosed breakpoints (e.g., discounts provided based on achieving managed investments of a specific size).

Municipal Securities and Other Fixed Income Securities

OCIE will examine broker-dealer trading activity in municipal and corporate bonds for compliance with:

•  best execution obligations;

•  fairness of pricing, mark-ups and mark-downs, and commissions; and

•  confirmation disclosure requirements, including retail disclosures relating to mark-ups and mark-downs.

Microcap Securities

OCIE will examine broker-dealers and transfer agents to review for those that may be engaged in, or aiding and abetting, pump and dump schemes, market manipulation, and illegal distributions of securities of smaller market capitalization companies (i.e., companies with a market capitalization under $250 million).  Focus areas for examinations will include:

•  transfer agent handling of microcap distributions and share transfers;

•  broker-dealer sales practices;

•  broker-dealer supervision of high risk registered representatives; and

•  broker-dealer compliance with certain regulatory requirements, including those concerning quotations under Rule 15c2-11 under the Securities Exchange Act of 1934, the locate requirement of Regulation SHO, and the obligation to file suspicious activity reports (SARs).

Broker-dealers may be selected for examination based on factors such as (i) employing registered representatives with disciplinary history; (ii) engaging in significant trading activity in unlisted securities; and (iii) making markets in unlisted securities.

Information Security

OCIE intends to continue its initiative to examine for cyber and other information security compliance procedures and controls, including proper configuration of network storage devices, information security governance generally, and retail trading information security.  With respect to registered investment advisers, OCIE will continue to focus on assessing the protection of clients’ personal financial information with a particular focus on:

•  governance and risk management;

•  access controls;

•  data loss prevention;

•  vendor management;

•  training; and

•  incident response and resiliency.

OCIE’s other key areas of focus include:

•  oversight practices related to certain service providers and network solutions, including those leveraging cloud-based storage;

•  compliance with Regulations S-P and S-ID;

•  controls surrounding online access and mobile application access to customer brokerage account information; and

•  the proper disposal of retired hardware that may contain client information and potential network information that could create an intrusion vulnerability.

Financial Technology (“FinTech”) and Innovation, Including Digital Assets and Electronic Investment Advice

OCIE acknowledged that developments in financial technologies, methods of capital formation and market structures, as well as registered firms’ use of new sources of data (often referred to as “alternative data”), warrant ongoing attention and review.  OCIE’s examinations in this area will focus on firms’ use of alternative data and technologies to interact with and provide services to investors, firms and other service providers and will seek to assess the effectiveness of the firms’ compliance and control functions as it applies to these areas.

OCIE has a particularly acute focus on digital assets and “robo-advisers” (i.e., registered investment advisers that provide services to clients through automated investment tools and platforms).

Digital Assets

OCIE stated that its examinations related to digital assets will assess:

•  investment suitability;

•  portfolio management and trading practices;

•  safety of client funds and assets;

•  pricing and valuation;

•  effectiveness of compliance programs and controls; and

•  supervision of employee outside business activities.

Electronic Investment Advice / Robo-Advisers

OCIE identified the following five areas of focus for its examinations of robo-advisers:

•  SEC registration eligibility;

•  cybersecurity policies and procedures;

•  marketing practices;

•  adherence to fiduciary duty, including adequacy of disclosures; and

•  effectiveness of compliance programs.

Additional Focus Areas Involving Registered Investment Advisers and Investment Companies

OCIE has identified three categories of firms that it will prioritize in examinations: (i) registered investment advisers that are dually registered as, or are affiliated with, broker-dealers, or have supervised persons who are registered representatives of unaffiliated broker-dealers; (ii) firms that utilize the services of third-party asset managers to advise clients’ investments; and (iii) firms that have never been examined.

In addition to its typical assessment of the compliance program of registered investment advisers generally, the key focus areas for examinations of dually registered firms and firms with affiliated broker-dealers, or with supervised persons of unaffiliated broker-dealers, include whether the firms maintain effective compliance programs to address the risks associated with (i) best execution, (ii) prohibited transactions, (iii) fiduciary advice, or (iv) disclosure of conflicts regarding such arrangements.  Firms that engage third-party asset managers should be aware that OCIE intends to review the scope of their due diligence practices, policies and procedures when selecting and engaging the services of such third-party asset managers.  In addition, firms that have not been examined for a number of years should be aware that OCIE intends to assess whether such firms’ compliance programs have been appropriately adapted to address any substantial growth in such firms and changes in their business models.

OCIE further identified the following as key areas of interest:

Mutual Funds and ETFs

OCIE has stated its priority to examine mutual funds and ETFs, the activities of their registered investment advisers, and the oversight practices of their boards of directors.  OCIE’s focal points in this sector include:

•  registered investment that engage third-party administrators to sponsor the mutual funds they advise or are affiliated with;

•  mutual funds or ETFs that have not previously been examined; and

•  registered investment advisers to private funds that also manage a registered investment company with a similar investment strategy.

New and Emerging Investment Strategies

OCIE is particularly interested in the accuracy and adequacy of disclosures provided by registered investment advisers offering clients new types of or emerging investment strategies, such as strategies focused on sustainable and responsible investing, which incorporate environmental, social, and governance (“ESG”) criteria.

Private Fund Advisers

Consistent with its emphasis on the protection of retail investors, OCIE will continue to focus on registered investment advisers 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.  In particular, OCIE has stated that it will examine private fund advisers to 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 affiliates to provide services to clients.

Additional Focus Areas Involving Broker-Dealers and Municipal Advisors

OCIE’s examinations of broker-dealer examinations will focus on:

•  issues relating to the preparation for and implementation of recent rulemaking (e.g., Regulation Best Interest and Form CRS Summary);

•  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;

•  payment for order flow arrangements;

•  compliance with the Customer Protection Rule and the Net Capital Rule, including the adequacy of internal processes, procedures, and controls;

•  trading and risk management practices (e.g., OCIE will examine firms’ trading and other activities in “odd lots”);

•  controls around the use of automated trading algorithms by broker-dealers—how broker-dealers supervise algorithmic trading activities, including the development, testing, implementation, maintenance, and modification of the computer programs that support their automated trading activities and controls around access to computer code; and

•  use of internal procedures, practices, and controls to manage trading risk.

Municipal advisor examinations will concentrate on:

•  the satisfaction of registration, professional qualification, and continuing education requirements;

•  fiduciary duty obligations to municipal entity clients;

•  fair dealing with market participant requirements;

•  conflicts of interest disclosure;

•  conduct when faced with conflicts while representing clients; and

•  compliance with recently-effective Municipal Securities Rulemaking Board (“MSRB”) Rule G-40 concerning advertisements.

Anti-Money Laundering (“AML”) Programs 

Money laundering and terrorist financing continue to be risk areas on which OCIE’s examination program focuses.  OCIE will continue to assess firms’ compliance with applicable anti-money laundering requirements, including an assessment of whether firms (i) have established appropriate customer identification programs, (ii) are satisfying their SAR filing obligations, (iii) are conducting due diligence on customers, (iv) are complying with beneficial ownership requirements, and (v) are conducting robust and timely independent tests of their AML programs.

Market Infrastructure

OCIE will continue its focus on entities that provide services critical to the functioning of our capital markets, including clearing agencies, national securities exchanges, alternative trading systems, and transfer agents.  Particular attention will be focused on the security and resiliency of their systems.

Clearing Agencies

Examinations of SEC registered clearing agencies will focus on, where applicable:

•  compliance with the SEC’s Standards for Covered Clearing Agencies and other federal securities laws applicable to registered clearing agencies;

•  liquidity risk management;

•  collateral and investment risk management;

•  default risk management;

•  cyber security and resiliency;

•  recovery and wind-down procedures;

•  governance, legal, compliance and risk management frameworks, including efforts to escalate deficiencies identified by OCIE and internal auditors;

•  whether firms have taken timely and appropriate action to correct, and mitigate the risks associated with, those deficiencies; and

•  other areas identified in collaboration with the SEC’s Division of Trading and Markets and with other regulators.

National Securities Exchanges

Examinations of national securities exchanges will focus on:

•  reactions to market disruptions;

•  the monitoring of member activity for compliance with federal securities laws and rules; and

•  efforts concerning abusive, manipulative, and illegal trading practices to protect the integrity of the marketplace.

Regulation Systems Compliance and Integrity (“SCI”)

Examinations of SCI entities (e.g., national securities exchanges, registered and certain exempt clearing agencies, the Financial Industry Regulatory Authority (“FINRA”), MSRB, plan processors, and certain alternative trading systems) will continue to focus on the following areas:

•  an evaluation of whether SCI entities have established, maintained, and enforced written SCI policies and procedures;

•  IT inventory management;

•  IT governance;

•  incident response;

•  third-party vendor management, including the utilization of cloud services; and

•  whether firms have taken timely and appropriate action in response to past examinations.

Transfer Agents

OCIE’s examinations of transfer agents will continue to focus on:

•  their core functions, including:

•  the timely turnaround of items and transfers;

•  recordkeeping and record retention; and

•  safeguarding of funds and securities;

•  the annual obligation to file a report by an independent accountant concerning the transfer agent’s system of internal accounting controls;

•  compliance with obligations to search for lost securityholders; and

•  notifications to unresponsive payees.

Transfer agents that are candidates for examination include those that (i) serve as paying agents for issuers, (ii) are developing blockchain technology, and (iii) provide services to issuers of microcap securities, private offerings, crowdfunded securities or digital assets.

Focus on FINRA and MSRB

OCIE will continue to oversee FINRA by focusing examinations on FINRA’s operations, regulatory programs and the quality of FINRA’s examinations of broker-dealers and municipal advisors. OCIE also will continue to examine MSRB to evaluate the effectiveness of its operations and internal policies, procedures and controls.

Impact of 2019 Rulemaking

In addition to the aforementioned examination priorities, the SEC finalized various rules and interpretations in 2019 that will impact firms and OCIE in 2020.  Specifically, OCIE identified the following as the most significant rulemakings and interpretations of 2019 and notes that these will be examination priorities in 2020.

•  Regulation Best Interest;[3]

•  the Form CRS Relationship Summary;[4] and

•  two interpretive releases issued under the U.S. Investment Advisers Act of 1940, as amended.[5]

Following the forthcoming June 30, 2020 compliance date for Regulation Best Interest and Form CRS, OCIE intends to assess the implementation of the requirements of Regulation Best Interest, including policies and procedures regarding conflicts disclosures, and for both broker-dealers and registered investment advisers, the content and delivery of Form CRS.  In addition, OCIE has already integrated the Interpretation Regarding Standard of Conduct for Investment Advisers into its examination program.

Summary of Fiscal Year 2019 Results

Set forth below are certain key highlights of OCIE’s 2019 Fiscal Year Results:

•  OCIE completed over 3,000 examinations, representing a 2.7% decrease from its 2018 fiscal year.

•  OCIE examined approximately 15% (2,180) of all registered investment advisers.

•  Investment company examinations increased by approximately 12% to over 150 examinations; the increase was due primarily to the six initiatives OCIE announced in November 2018.

•  OCIE also conducted:

•  350 examinations of broker dealers;

•  110 examinations of national securities exchanges;

•  over 90 examinations of municipal advisors and transfer agents; and

•  over 160 examinations of FINRA.

•  OCIE issued more than 2,000 deficiency letters.

•  Examinations closed in FY 2019 have resulted in firms returning more than $70 million to investors.

•  OCIE made more than 150 referrals to the SEC’s Division of Enforcement from the examinations it conducted during fiscal year 2019 and indicated that additional referrals are forthcoming.

•  OCIE issued 8 risk alerts, the most OCIE has issued in a year since it began publishing them in fiscal year 2019.[6]

OCIE’s Oversight of Registered Investment Advisers

OCIE reports that even though it has taken various actions over the past several years to increase its oversight of registered investment advisers, including by (i) implementing program efficiencies, through process and technology; (ii) realigning its internal staffing to address the coverage rates for registered investment advisers; and (iii) investing in their team by providing ongoing staff training and hiring experienced subject matter experts. OCIE faces a risk that it does not have sufficient resources dedicated to the oversight of registered investment advisers.  In particular, OCIE predicts that its coverage rates will not keep pace with the growth in the population and complexity of registered investment advisers unless the size of its staff increases.  OCIE notes that the growth trend in this sector remains a focus of both OCIE and SEC Chairman Jay Clayton.

Use of LIBOR

Notably, while not one of the stated examination priorities, in light of the transition away from LIBOR as a reference rate in various financial instruments to an alternative reference rate, OCIE states that it will be reviewing firms’ preparations and disclosures regarding their readiness to implement such transition, particularly in relation to the transition’s effects on investors.  OCIE specifically encourages registrants to evaluate their and their clients’ exposure to LIBOR in various contexts, including its use as fallback language in agreements, its use in benchmarks and indices, accounting systems, risk models, and client reporting, foreshadowing the areas in which examinations are likely to focus on LIBOR-related matters.

Conclusion

While the list of examination priorities released by OCIE is not exhaustive and OCIE expects to conduct additional examinations based on risks, issues and policy matters that arise from market developments, new information from current examinations and other sources, registrants would be well served to review OCIE’s examination priorities as applicable to their businesses and ensure that their internal compliance programs and practices adequately address such areas.

______________________________

For More Information:

Eric Requenez

Abdulmajeed F. Alhogbani

[1]      SEC Office of Compliance Inspections and Examinations Announces 2020 Examination Priorities, SEC Press Release 2020-4 (Jan. 7, 2020).

[2]      The web address where the 2020 Examination Priorities Memorandum is: https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2020.pdf.

[3] See Regulation Best Interest: The Broker-Dealer Standard of Conduct, Rel. No. 34-86031 (June 5, 2019), available

at https://www.sec.gov/rules/final/2019/34-86031.pdf.

[4] See Form CRS Relationship Summary; Amendments to Form ADV, Rel. No 34-86032 (June 5,

2019), available at https://www.sec.gov/rules/final/2019/34-86032.pdf.

[5] While not specifically identified in the 2020 Examination Priorities Memorandum, the SEC issued two interpretive releases concurrently with the release of Regulation Best Interest and the Form CRS Relationship Summary:

[6] OCIE issued the following eight risk alerts in fiscal year 2019:

This article is for general information purposes only. It is not intended as legal advice, and you should not consider it as such.