What Compliance Officers Should Expect from SEC Exams in 2014
If there is one thing that keeps compliance officers up at night, it is that dreaded message from the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), “We have decided to conduct an examination of your firm, and please do not treat this as an adversarial proceeding, rather we are here trying to learn about your firm, and we are here to help.” Hardly comforting given the many recent referrals from OCIE to Enforcement, and the fact that Enforcement lawyers now routinely accompany OCIE examiners to on-site inspections.
Last month, OCIE published its 2014 Examination Priorities giving broker-dealers and advisers guidance on areas of OCIE concern. The Exam Priorities are divided generally into areas that are system-wide that affect both broker-dealers and advisers, and core risk areas specific to each type of firm.
Examination Priorities for Both Brokers and Advisers
System-wide, OCIE will continue to focus on broker and adviser policies around fraud detection and prevention, corporate governance including the control environment and “tone at the top”, conflicts of interest, enterprise risk management, technology and supervision of IT systems. OCIE also intends to take a close look at dual registrants and incentives to firms when customers choose to open accounts at dual registrants as an advisory client or brokerage client. OCIE also plans to look at how advisers and brokers are addressing new laws and regulations, and sales and marketing practices related to retirement products such as IRAs and 401(k) plans. These broad areas affect nearly every adviser and broker-dealer, and all firms should be prepared for an SEC exam in these areas.
Examination Priorities Specifically for Investment Advisers and Investment Companies
Adviser Core Risks
Still stung by the failure to detect Madoff, for advisers, OCIE intends to continue to examine custody of client assets and compliance with the custody rules. OCIE will pay particular attention to advisers that fail to realize that they have custody through non-conventional methods such as check-writing authority or power of attorney.
Another core risk for advisers is conflicts of interest in business practices such as best execution, soft dollars, and agency/principal transactions. OCIE examinations will also scrutinize undisclosed compensation arrangements, allocation of investment opportunities, controls and disclosure when an adviser manages both performance-based accounts and traditional fee accounts, valuation of illiquid securities and higher risk products that are sold to retail and elderly investors. OCIE will also review the accuracy of advisers’ performance advertising. Advisers that have wrap-fee programs should expect a review of fiduciary duties and controls to monitor wrap fee conflicts of interest, best execution and trading away from the wrap sponsor. Finally, the SEC will continue to review disclosure and compliance issues related to payments by advisers to distributors, solicitors and other intermediaries.
Areas of Focus for New Advisers Including Hedge Fund and Private Equity Fund Managers
New advisers that have not been examined in the last three years, including hedge and private equity fund managers, should expect a visit from OCIE in 2014. OCIE intends to look closely at new advisers’ marketing and sales practices, portfolio management including compensation methodologies, conflicts of interest and safety of client assets, and valuation particularly with respect to hard-to-value illiquid securities and their relationship to portfolio manager compensation.
Examination Priorities for Broker-Dealers
Broker Core Risks
In the broker-dealer area, the SEC’s examination priorities will focus on sales practices toward senior citizens, micro-cap securities trading, suitability and disclosure around complex financial products. OCIE will also pay particular attention to supervision. Supervision of remote offices, independent contractors, registered representatives with disciplinary histories, and registered representatives’ private securities transactions are areas of particular concern. Another core risk for broker-dealers concerns trading practices such as erroneous orders, technology and algorithmic and high frequency trading, market manipulation such as fraudulent orders, and excessive mark-ups and mark-downs. OCIE also will look at broker-dealer internal controls related to liquidity, credit and market risk management, valuation and compliance practices. Anti-money laundering policies and controls particularly for firms that allow clients to access U.S. markets from “higher risk” jurisdictions will also be scrutinized closely.
New and Emerging Issues for Broker Dealers
For brokerage firms that permit customers to access alternative trading systems, OCIE intends to examine risk management policies and financial risk controls. OCIE will also review variable annuity sales practices, particularly the suitability of buybacks of annuity products and the value of any replacement annuity, especially for elderly clients.
Increasingly Aggressive Examinations
There is little doubt that the market and regulatory failures of the Great Recession has led to increasingly aggressive and skeptical examinations by the SEC. This creates compliance and reputational risks for firms. The 2014 exam priorities, although quite extensive, nevertheless provide a helpful guide for compliance professionals in determining where to devote finite compliance resources.