The Securities and Exchange Commission's Division of Examinations (DOE) (formerly, Office of Compliance Inspections and Examinations) recently announced its examination priorities for 2021. Examination priorities are released annually. The 2021 priorities highlight the following nine non-exhaustive areas on which DOE intends to focus during the year.
- Retail investors, including seniors and individuals saving for retirement
- Information security and operational resiliency
- Financial technology (Fintech) and innovation, including digital assets
- Anti-money laundering (AML)
- The London inter-bank offered rate (LIBOR) transition
- Additional focus areas involving registered investment advisers (RIA) and investment companies
- Additional focus areas involving broker-dealers and municipal advisors
- Market infrastructure
- Financial Industry Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB
The 2021 DOE examination priorities are similar to OCIE's 2020 priorities. DOE will continue to emphasize 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 and that there is tangible support for compliance at all levels of an organization."
DOE will continue to prioritize the examination of certain practices, products and services that it believes present heightened risks to investors or the integrity of the U.S. capital markets. DOE also will prioritize emerging risks including those relating to climate, environmental and social governance matters (ESG).
While the stated priorities drive many of DOE's examinations, they are not exhaustive. The selection of firms to be examined, and the related risk areas of focus are determined through DOE's risk-based analysis. DOE's risk-based approach results in examinations that are focused on key aspects of the SEC's regulatory oversight, such as products identified as having higher risk characteristics, compensation and funding arrangements, disclosures and representations made to customers, prior examination observations and regulatory history, examination history (if any), material changes in firm leadership, and whether the firm has custody of investor assets (custody).
DOE's examination program remains grounded on its four pillars: "promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy."
DOE 2021 Examination Priorities
(1) Retail investors, including Seniors and Individuals Saving for Retirement. DOE will continue to prioritize examinations of RIAs, broker-dealers, and investments and services marketed to retail investors. Examinations in these areas will focus on dually-registered firms, as more and more individuals rely on these financial intermediaries to gain access to the financial markets. DOE will focus on fees, expenses, complex products, best execution, and conflicts of interest. To protect retail investors, DOE will prioritize examinations to assess compliance with Regulation Best Interest (Reg BI), fraud, sales practices and conflicts, and retail-targeted investments.
- Standards of Conduct—Reg BI, adopted in 2019, established a new standard of conduct for broker-dealers, "to act in the best interest of their retail customers when making a recommendation of any securities transaction ..." This obligation is satisfied only if a broker-dealer complies with four component obligations: disclosure, care, conflict of interest, and compliance. DOE will expand the scope of examinations to assess compliance with Reg BI. DOE will examine whether broker-dealers are making recommendations they reasonably believe are in customers' best interests. DOE will examine RIAs to assess whether, as fiduciaries, they have fulfilled their duty of care and loyalty, and are providing advice in the best interests of their clients. DOE will focus on risks associated with fees and expenses, complex products, best execution, and undisclosed or inadequately disclosed compensation arrangements. DOE also will prioritize examinations of broker-dealers and RIAs to assess compliance with form CRS. Form CRS provides investors with a description of the relationship and information about the firm and must be filed with the SEC and posted on the firm's public website if it has one.
- Fraud, Sales Practices and Conflicts—Examinations will focus on appropriateness of advice to retail investors, particularly, seniors, teachers, military personnel, and individuals saving for retirement. DOE will focus on account type, conversions, rollovers, and sales practices. DOE will examine broker-dealers to assess whether they are appropriately providing retail customers with access to complex strategies. DOE also will focus on compliance with recent changes to the accredited investor definition when recommending and selling certain private offerings. DOE will review firms' conflicts of interest disclosures, including those related to fees and expenses. In particular, DOE will prioritize examinations of RIAs utilizing "turnkey" asset management platforms to assess whether such fees and revenue sharing arrangements are properly disclosed. DOE will review for (1) advisory fee calculation errors; (2) inaccurate calculations of tiered fees (including failure to provide breakpoints and aggregate household accounts); and (3) failure to refund prepaid fees for terminated accounts.
- Retail-Targeted Investments—DOE will prioritize examinations of mutual funds and exchange traded funds (ETFs), municipal securities and other fixed income securities, and micro-cap securities.
(2) Information Security and Operational Resiliency. Information security is critical to the operation of the financial markets and the confidence of its participants. Over this past year, the increase in remote operations in response to the pandemic has increased concerns about endpoint security, data loss, remote access, use of third-party communication systems, and vendor management. DOE will focus on whether firms have taken appropriate measures to (1) safeguard customer accounts and prevent account intrusions, including verifying an investor's identity to prevent unauthorized access; (2) oversee vendors and service providers; (3) address malicious e-mail activities; (4) respond to incidents, including ransomware attacks; and (5) manage operational risk due to dispersed employees in a work-from-home environment. DOE will review firms' business continuity plans and disaster recovery plans, with an emphasis on whether such plans address the risks associated with climate change. DOE also will review whether systemically important registrants are considering effective practices to help improve responses to large-scale events.
(3) Financial Technology (Fintech) and Innovation, Including Digital Assets. DOE's examinations will focus on the innovative and evolving ways firms provide financial services to their clients. For example, some firms are providing advice to clients through automated investment tools and platforms (often referred to as "robo-advisers") or through automated asset allocation. Examinations will focus on evaluating whether firms are (1) operating consistently with their representations; (2) handling customer orders in accordance with customer instructions; and (3) complying with trade recommendations made in mobile applications. DOE will examine whether firms are implementing appropriate controls around the creation, receipt, and use of data gleaned from non-traditional sources ("alternative data"). In connection with digital assets, examinations will assess: (1) whether investments are in the best interest of investors; (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 firm representatives' outside business activities.
(4) AML. The goal of DOE examinations in this area is to evaluate whether firms have adequate policies and procedures that are reasonably designed to identify suspicious activity and illegal money-laundering activities. To this end, examinations will focus on firms' compliance with AML obligations to assess whether they (1) have established appropriate customer identification programs; (2) are satisfying suspicious activity report (SAR) filing obligations; (3) conducting due diligence on customers; (4) complying with beneficial ownership requirements; and (5) conducting robust and independent tests of their AML programs.
(5) LIBOR Transition. The discontinuation of LIBOR could have a significant impact on financial markets and may present material risk to RIAs, broker-dealers, and other market participants. DOE will engage firms to assess their understanding of any exposure to LIBOR, their preparation for the expected discontinuation of LIBOR and transition to an alternative reference rate.
(6) Additional Focus Areas Involving RIAs and Investment Companies
- RIA Compliance Programs—DOE will focus on compliance programs of RIAs in core areas, including appropriateness of account selection, portfolio management practices, custody and safekeeping of client assets, best execution, fees and expenses, business continuity plans, and valuation of client assets for consistency and appropriateness of methodology. DOE will focus on whether those programs are reasonably designed, implemented, and maintained. DOE will prioritize examinations of RIAs that have not been examined for a number of years, RIAs that have never been examined, and new RIAs. Due to investor demand, RIAs are offering investors ESG conscious products and strategies. DOE will examine those products that are available to investors, such as open-end funds and ETFs, as well as those offered to accredited investors, such as qualified opportunity funds. DOE will review the adequacy and accuracy of disclosures relating to those products to make certain they are consistent with a firm's actual processes and practices. DOE will review advertising for false or misleading statements, and voting policies and procedures and votes, to assess whether they align with firm strategies. Also, DOE will prioritize examinations of RIAs dually registered or affiliated with broker-dealers to assess compliance risks, and conflicts of interest that arise from certain compensation arrangements, outside business activities, best execution, and prohibited transactions.
- Registered Funds, Including Mutual Funds and EFFs—DOE examinations of registered funds will focus on disclosures to investors, valuation, filings with the SEC, personal trading activities, and contracts and agreements. DOE will focus on funds' compliance programs and financial conditions, compliance with exemptive relief, including for newly created non-transparent actively managed ETFs. DOE will focus on mutual funds' liquidity risk management programs to determine whether they are reasonable designed to assess and manage funds' liquidity risk. DOE also will focus on money market funds' compliance with stress-testing requirements, website disclosure, and board oversight. DOE will prioritize examinations of mutual funds and ETFs that have not been examined previously or have not been examined in a number of years.
- RIAs to Private Funds—DOE examinations will continue to focus on advisers to private funds, recognizing that those funds have significant investments from pensions, charities, endowments, and families. Examinations will assess compliance risks, including a focus on liquidity and disclosures of investment risks, and conflicts of interest. DOE will review for preferential treatment of certain investors by RIAs that have experienced liquidity issues, including imposing gates or suspensions on fund withdrawals; portfolio valuations and the resulting impact on management fees; adequacy of disclosure and compliance with regulatory requirements of cross-trades, principal investments, or distressed sales; and conflicts around liquidity, such as adviser-led fund restructurings. DOE also will focus on advisers to private funds that have a higher concentration of structured products, such as collateralized loan obligations and mortgage-backed securities to assess whether the funds are at a higher risk for holding non-performing loans and having loans with higher default risk than that disclosed to investors.
(7) Additional Focus Areas Including Broker-Dealers and Municipal Advisors. In addition to Reg BI sales practices and retail targeted investments, DOE will focus on safety of customer cash and securities, best execution, trading activities, and the operation of alternative trading systems.
- Broker-Dealer Financial Responsibility—DOE examinations will focus on whether broker-dealers are safeguarding customer cash and securities in compliance with the Customer Protection Rule and the Net Capital Rule. DOE also will focus on compliance with requirements for borrowing securities from customers. In light of the pandemic, DOE may assess whether broker-dealer funding and liquidity risk management practices have sufficient liquidity to manage stress events.
- Broker-Dealer Trading Practices—DOE examinations will focus on (1) broker-dealer compliance with best execution obligations in a zero-commission environment; (2) compliance with recently amended Rule 606 order routing disclosure rules; (3) payment for order flow and its possible effect on order routing and best execution obligations; (4) market maker compliance with Reg SHO; and (5) operations of certain alternative trading systems.
- Municipal Advisors—DOE will examine (1) how municipal advisors may have adjusted their practices in light of the pandemic and its potential impact on municipal advisors and their clients; (2) whether municipal advisors have met their fiduciary obligations to municipal entity clients in disclosing and managing conflicts of interest and documenting the scope of their client engagements; and (3) whether municipal advisors have satisfied their registration, professional qualification, continuing education, supervision, and filing requirements.
(8) Market Infrastructure
- Clearing Agencies—DOE examinations will focus on (1) compliance with the SEC's Standards for Covered Clearing Agencies; (2) whether clearing agencies have taken appropriate corrective action in response to prior examinations; (3) other areas, including compliance, legal, recovery and wind down, margin, back-testing, settlement and operations, liquidity risk management, effect of LIBOR transition, and cybersecurity and resiliency.
- National Securities Exchanges—DOE examinations will focus on national securities exchange operations to monitor, investigate, and enforce member and listed company compliance with, as applicable, exchange rules and federal securities laws.
- Regulation Systems Compliance and Integrity (SCI)—DOE examinations will assess whether SCI entities have established, maintained, and enforced written SCI policies and procedures, as required, to strengthen the technology infrastructure of the U.S. securities markets. DOE will focus on IT governance, IT asset management, cyber threat management/incident response, business continuity planning, and third-party vendor management. DOE examinations also will focus on whether SCI entities have taken appropriate action in response to past examination findings.
- Transfer Agents—DOE will examine transfer agents' core functions, including timely turnaround of items and transfers, recordkeeping and record retention, and safeguarding funds and securities. In light of the pandemic, DOE examinations also will focus on firms' business continuity and disaster recovery programs, cybersecurity measures, and takeover precautions.
(9) FINRA and MSRB. DOE will conduct risk-based oversight examinations of FINRA with a focus on FINRA's major regulatory programs and the quality of its examinations of certain broker-dealers and municipal advisors. DOE will conduct risk-based oversight examinations of MSRB to assess compliance with MSRB rules and to evaluate the effectiveness of MSRB's policies, procedures, and controls.
DOE's 2021 priorities are not exhaustive and will not be the only areas on which it focuses. DOE's examination priorities reflect its assessment of certain risks, issues and policy matters arising from market and regulatory developments, information gathered from examinations and other sources, including tips, complaints, referrals, and coordination with other regulators. DOE's examinations, determined through a risk-based approach—both in selecting the entities to examine and in determining the risk areas to examine, enables it to be flexible and capable of covering emerging markets and exigent risks to investors and the marketplace as they arise.
Originally Published by The New York Law Journal, 29 April 2021
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