United States: SEC Announces Examination Priorities For 2014

On January 9, 2014, the Securities and Exchange Commission (the "SEC") published its annual letter announcing examination priorities for 2014 (the "Priorities Letter").1 The Priorities Letter, which addresses both industry-wide and area-specific initiatives, aims to provide investment advisers, funds, broker-dealers, and other industry participants with a preview of key risks that the SEC intends to monitor and examine in 2014 through the National Examination Program (the "NEP").

I. Industry-Wide Initiatives

The Priorities Letter identifies six significant industry-wide initiatives for 2014:

  • Fraud Detection and Prevention.  Citing a string of fraud cases adjudicated in 2013 based on SEC exam referrals,2 the Priorities Letter indicates that the NEP will employ its quantitative and qualitative tools to detect fraud and unethical behavior in the market.  The NEP's resources in this field include the Quantitative Analytics Unit, which examines firms' transactions using a variety of algorithms and computer models.  Firms should expect that the NEP will continue to examine transactional data to identify potential fraud. 
  • Corporate Governance, Conflicts of Interest, and Enterprise Risk Management.  In an effort to evaluate each firm's control environment and "tone at the top" with regard to conflicts policies and the way firms address conflict and risk management, the NEP will meet with the senior management and boards of registrants to discuss conflicts policies and how each firm identifies and mitigates legal, compliance, financial, and operational risks. 
  • Technology.  The increasing complexity of the technologies employed in the market challenges both market participants and regulators.  In 2013, the NEP issued a risk alert addressing business continuity plans and operational disruptions caused by Hurricane Sandy.3  Firms should expect that the NEP will continue to monitor governance and supervision of information technology systems, operational capability, market access, information security, and preparedness to respond to unplanned system outages in 2014. 
  • Dual Registrants.  NEP examinations will focus on conflicts of interest and the suitability of account types recommended by representatives of firms that provide both brokerage and investment advisory services.  The SEC is concerned that recommendations made by the representatives of dual registrants may be improperly based upon the revenue potential to the firm, rather than the best interests of the client.  Because the NEP has identified significant risks to investors of migration and other conflicts presented by the dual registrant business model, examinations will also focus on the impact to investors of varying supervisory structures and the legal standards of conduct governing the provision of brokerage and investment advisory services.  Dually registered firms as well as investment advisers that have affiliated broker-dealers will be high on the SEC's radar screen for compliance exams. Such firms should consider adopting enhanced compliance policies to address best execution issues, cross trading and self-dealing issues, and the many other potential conflicts of interest associated with such status.   
  • New Laws and Regulation.  In 2013, the SEC adopted Rule 506(c) under the Securities Act of 1933, which permits private funds to engage in general solicitation in the context of Regulation D private offerings, provided that reasonable steps are taken to verify that purchasers are accredited investors.4  The NEP will review and monitor firms' use of Rule 506(c) and evaluate the due diligence conducted by firms relying upon the Rule.  The NEP will also examine compliance with rules recently adopted under the Dodd-Frank Act Wall Street Reform and Consumer Protection Act ("Dodd-Frank") requiring municipal advisors to register with the SEC,5 and, if rules are implemented regarding security-based swap dealers and other registered entities impacted by Dodd-Frank, the NEP will examine compliance with such rules. 
  • Retirement Vehicles and Rollovers.  The NEP plans to examine the sales practices of firms that recommend retirement-age employees roll over employer-sponsored 401(k) plans into higher cost investments, as well as the use of misleading professional designations by advisers who recommend the transfer of assets from retirement plans into IRA rollover accounts.

 II. Examination Priorities for Investment Advisers

The Priorities Letter further identifies core risks specific to investment advisers, as well as new and emerging initiatives and policy topics related to investment advisers that are likely to receive focus in the SEC's 2014 examination program. 
Core risks for investment advisers, or risks that have been frequently observed and are likely to persist for the foreseeable future, include:

  • Safety of Assets and Custody.  In 2013, the NEP released a risk alert identifying common issues of non-compliance with Rule 206(4)-2 under the Investment Advisers Act of 1940 (the "Custody Rule"),6 which requires investment advisory firms to meet certain standards when maintaining custody of client funds or securities.7 Future examinations are likely to test compliance with the Custody Rule, particularly in instances where advisers fail to realize they have custody over client assets.  Private fund managers in particular need to better understand the requirements of the audited financial statements exemption from the account reporting and surprise exam provisions of the Custody Rule and how the rule applies to their separately managed accounts. 
  • Conflicts of Interest.  The NEP will examine adviser compensation arrangements and their effect on client recommendations, allocation of investment opportunities, and the adequacy of risk controls and disclosure to determine whether an examined firm's business model creates an inherent conflict that places the firm's interests above the interests of its clients.  Advisers with multiple funds and/or accounts with overlapping investment strategies should adopt appropriate allocation policies that spell out how investments are equitably allocated among the various client accounts.  The Priorities Letter further emphasizes that special attention will likely be given to conflicts surrounding higher risk products that are targeted to retail investors, particularly those who are retired or elderly. 
  • Performance and Marketing.  SEC examinations will continue to review the accuracy of advisers' claims related to performance.  The NEP specifically notes that it will test the use of composite performance figures and performance record keeping.  Performance advertising also implicates the need for advisers to have objective and transparent valuation policies that support the underlying data, especially for those advisory firms that invest in less liquid securities.  Firms should also expect the NEP to review marketing efforts in connection with rules recently adopted under the Jumpstart Our Business Startups ("JOBS") Act, which broaden permissible marketing strategies by eliminating the ban on general solicitation.8

 The SEC's new and emerging initiatives identified in the Priorities Letter focus, in large part, on presence exams and investment advisers that have not previously been examined by the SEC.  In 2012, the SEC launched an initiative to examine advisers required to register for the first time under Dodd-Frank. Examinations of these new registrants, most of which advise hedge funds and private equity funds, will continue in 2014, and are likely to focus on marketing, portfolio management, conflicts of interests, safety of client assets, and valuation.   Similarly, the Priorities Letter announced a new initiative to examine advisers that were not required to register for the first time following implementation of Dodd-Frank, but have nonetheless never before been examined by the SEC.  This new initiative will focus on advisers that have been registered for more than three years.

In addition to presence exams, new and emerging initiatives will also focus on wrap fee programs and quantitative trading models.  The NEP will review the processes in place for monitoring wrap fee programs recommended to advisory clients, and assess whether wrap fee program advisers are fulfilling their fiduciary and contractual obligations to clients.  Firms that rely on quantitative portfolio management and trading strategies should expect the NEP to examine whether compliance procedures are in place, and whether such procedures are adequately tailored to the performance and maintenance of the particular model used.  Compliance procedures should confirm that use of a proprietary model does not result in market manipulation, test the model and its output over time, and ensure proper recordkeeping, including an inventory of firm-wide proprietary models.

The Priorities Letter further identified policy topics, or areas in which SEC examinations are likely to be geared toward obtaining a more comprehensive understanding of how previously adopted rules are applied in the industry.  For example, the NEP will continue to examine funds offering "alternative" investment strategies to investors to determine whether investments in such funds are suitable for the clients to whom they are marketed.  Examinations of these funds are likely to focus on leverage, liquidity and valuation policies, the staffing and funding of back-offices, and the manner in which such funds are marketed to potential investors.  Smaller fund managers in particular are more likely to be impacted by this heightened scrutiny to the extent they are offering more exotic and complex funds to high net worth individuals and other non-institutional investors.  Likewise, the NEP will target some examinations at money market funds, primarily to determine how firms manage potential stress events.

III. The NEP's Broker-Dealer, Market Oversight, and Clearance and Settlement Exam Programs

Examinations conducted as part of the NEP's broker-dealer program will continue to focus on detecting and preventing fraud in connection with sales to retail investors.  The Priorities Letter indicates a significant focus on sales to elderly investors, micro-cap fraud and pump and dump schemes, and the suitability of higher yield and complex products.  Broker-dealers should also anticipate examinations that assess the adequacy of supervision over independent contractors, registered representatives with disciplinary histories, and private securities transactions.  Examinations will also likely assess the standing, authority, and effectiveness of key control functions utilized by broker-dealers, including risk management practices, internal audits, valuation practices, and compliance.  The NEP will also examine anti-money laundering programs, particularly programs of proprietary trading firms that provide customers from higher risk jurisdictions with access to the markets.

In 2011, the NEP issued a risk alert identifying master/sub-account trading arrangements as raising significant regulatory concerns, particularly in relation to Rule 15c3-5 under the Securities Exchange Act of 1934 (the "Market Access Rule").9  The Market Access Rule requires broker-dealers with market access to an exchange or alternative trading structure to employ a system of risk management controls and supervisory procedures designed to manage risks associated with providing customers or other persons market access, including those who trade in sub-accounts.10  The Priorities Letter identifies compliance with the Market Access Rule as a new and emerging initiative, and broker-dealers that provide market access through master/sub-account arrangements should expect examinations to focus on whether firms are appropriately applying the rule, and the adequacy of books and records maintained relative to such arrangements.

In addition to Market Access Rule compliance, new and emerging initiatives under the NEP's broker-dealer program will focus on the suitability of variable annuity buybacks.  Examinations will focus on whether representatives are recommending that certain holders of variable products accept offers from insurance companies to repurchase the products, and whether such recommendations, which may require customers to purchase new products with less favorable terms, are suitable for investors.

National securities exchanges, FINRA, and the Municipal Securities Rulemaking Board will continue to be examined under the NEP's market oversight problem.  Examinations in 2014 are likely to focus on areas of perceived control weakness at the national securities exchanges.  In coordination with the Division of Trading and Markets, the NEP will also examine whether new exchange applicants have the capacity to enforce the exchange's own rules and the federal securities laws.

The SEC, utilizing a risk-based approach in collaboration with other regulators, will also examine each of the four clearing agencies designated as systemically important under Dodd-Frank, including the Depository Trust Company, the National Securities Clearing Corporation, the Fixed Income Clearing Corporation, and the Options Clearing Corporation.

Transfer agents are also subject to examination by the NEP's clearance and settlement exam program, and examinations in 2014 will focus on the timely turnaround of items and transfers, accurate recordkeeping and associated retention, and the safeguarding of funds and securities.  Additionally, transfer agents that service micro-cap securities and private offerings, and those that serve as third-party administrators for parties other than issuers of registered securities, such as retirement plans, will be areas of focus in 2014.


1  National Exam Program, Office of Compliance Inspections and Examinations, Examination Priorities for 2014, available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf.

2 See, e.g., In re J.S. Oliver Capital Management (Aug. 30, 2013); SEC v. OM Investment Management LLC (Sept. 27, 2013); SEC v. Advanced Equity Partners, LLC (Sept. 26, 2013).

3 Risk Alert on SEC Examinations of Business Continuity Plans of Certain Advisers Following Operational Disruptions Caused by Weather-Related Events Last Year (Aug. 27, 2013), available at http://www.sec.gov/about/offices/ocie/business-continuity-plans-risk-alert.pdf.

4 See 17 CFR 230.506(c). 

5 See Securities Exchange Act Release No. 70462 (Sept. 20, 2013).

6 Significant Deficiencies Involving Adviser Custody and Safety of Client Assets (Mar. 4, 2013), available at http://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf.

7 See 17 CFR 275.206(4)-2.

8 See 17 CFR 230.506(c).

9 National Exam Risk Alert, Master/Sub-Accounts (Sept. 29, 2011), available at http://www.sec.gov/about/offices/ocie/riskalert-mastersubaccounts.pdf

10 17 CFR 15c3-5.

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