2018 Exam Priorities of the SEC and Commonly Issued Deficiencies
By Joanna Conte, CPA, Partner, Assurance Services, Alternative Investment Group
On February 7, 2018, the Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) announced its 2018 examination priorities.
This is the sixth year that OCIE has published its exam priorities in a continuing effort to provide transparency about its activities. While additional priorities may be identified based on OCIE’s ongoing findings and risk assessments, the announcement of the exam priorities in advance is intended to provide SEC-regulated entities with insight into those areas that the SEC believes warrant attention and constitute the most effective use of examination resources.
In the preface, OCIE noted that its work is based on four “pillars”: promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy. It further noted that the exam priorities are developed based on consultation with examination staff as well as other key constituencies outside of the exam program, including financial and compliance professionals, accountants, attorneys, and market participants.
This article addresses the 2018 exam priorities that are expected to have the most significant impact on investment advisers and includes a discussion of OCIE’s 2018 Risk Alerts and the most frequently identified deficiencies uncovered during the 2018 exams completed to date.
How Many Investment Advisers have Historically been Selected for SEC Examination?
In 2017, the SEC examined approximately 15 percent of all federally registered investment advisers (2,100), a 46 percent increase from 2016 and nearly double the 8 percent examined in 2012.
OCIE has communicated that its 2018 exam priorities will include a focus on never-before-examined investment advisers, including those which are determined to have elevated risk profiles.
How does the SEC Determine its Exam Priorities?
OCIE was guided by the following principles:
- Exams are risk-based. OCIE’s risk-based strategy includes a process for setting priorities, criteria for selecting examination candidates, and determination of exam scope. The size of the securities industry in relation to OCIE resources necessitates that OCIE select registered firms for examination based on areas that have been identified to pose the greatest risk to investors.
- Exams are data-driven. Data analytics are fundamental to numerous aspects of the exam program, including risk assessment, scoping, planning, and execution. In particular, OCIE has been focusing recently on the application of quantitative analysis to review regulatory filings and trading activity, which assists OCIE in the identification of potential non-compliance with the securities laws.
- Exams are transparent. In addition to the annual publication of its exam priorities, OCIE issues periodic Risk Alerts which are aimed at promoting compliance by sharing the most frequently cited deficiencies arising from various examination initiatives.
- Highest and best use. OCIE resources include its staff as well as data and technology. Since resources are limited, deployment is always based on the goal of maximizing of investor protections.
- Innovation and new technology. This principle embraces OCIE’s use of technology to enhance the efficiency and effectiveness of its exams, as well as the necessity for OCIE to review the impact of new technology on the securities industry. This includes attention to new investor risks that may be introduced by the employment of new technology, including cybersecurity risks.
What are the SEC’s 2018 Exam Priorities and which Priorities are Anticipated to have the Biggest Impact on Investment Advisers?
The 2018 exam priorities have been organized around five themes, as follows:
- Retail investors, including seniors and those saving for retirement.
- Compliance and risks in critical market infrastructure.
- Focus on FINRA and municipal securities rule-making board (MSRB).
- Anti-money laundering programs.
This article will expand on the following exam priorities that are expected to have particular impact on investment advisers:
- Retail investors, including seniors and those saving for retirement.
Exam Priority: Retail Investors, including Seniors and those Saving for Retirement
While this exam priority promotes a focus on Main Street investors, it also has applications to advisers of private investment funds.
Advisers of private investment funds should be aware of the following areas which were highlighted by OCIE in the 2018 exam priorities:
Disclosure of the costs of investing. This includes the disclosure and calculation of fees, expenses, and other charges paid by investors. It also includes disclosure of potential conflicts of interest, including other compensation the investment adviser may receive, such as compensation resulting from transactions with affiliates. Examiners will review that expense calculations are consistent with the disclosures provided to investors.
- The SEC is particularly interested in conflicts of interest that might incentivize an investment adviser to recommend higher-cost or riskier products or services to investors.
- For fees that are based on asset values, examiners will review whether assets are valued in accordance with investor agreements, disclosures, and the firm’s policies and procedures.
- The SEC will also focus on private fund advisers that manage funds with a high concentration of clients investing for the benefit of retail investors, including non-profit organizations and pension plans.
Electronic investment advice. This refers to “robo-advisers” and advisers that offer investment advice through automated platforms, including the adviser’s oversight of computer program algorithms that generate investment recommendations.
Cryptocurrency, Initial Coin Offerings (ICOs), Secondary Market Trading, and Blockchain. OCIE noted that the number of investment advisers engaged in this space continues to grow. The SEC is particularly concerned with the increasing exposure of retail investors to these asset classes. Examiners will be focusing on whether advisers maintain adequate controls and safeguards to protect these assets from theft or misappropriation, and whether appropriate disclosures are provided to investors about the risks associated with these investments, including the risk of investment losses, liquidity risks, price volatility, and potential fraud.
Exam Priority: Cybersecurity
The SEC will continue to devote attention to cybersecurity in its exam program. Examinations are expected to prioritize governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, and incident response.
While cybersecurity is an area that has a pervasive impact on the securities industry, investment advisers are particularly impacted due to the increasing dissemination of electronic investment advice and the growth of investing in cryptocurrency and digital assets.
2018 Risk Alerts
As noted earlier, in addition to the annual publication of its exam priorities, the SEC’s OCIE issues periodic Risk Alerts which are aimed at promoting compliance by sharing the most frequently-cited deficiencies arising from its exam program.
The SEC has issued two Risk Alerts in 2018 to date as follows:
- Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers (Issued on April 12, 2018).
- This Risk Alert provides a list of compliance issues identified in deficiency letters, relating to fees charged by investment advisers. The Risk Alert notes that failure on the part of an investment adviser to adhere to the advisory and other fee terms disclosed in its Form ADV and other materials provided to clients may constitute a violation of the Investment Advisers Act of 1940 (the “Advisers Act”).
- The most frequently observed compliance issues related to advisory fees include:
- Fee-billing based on incorrect account valuations
- Billing fees in advance or with improper frequency
- Applying incorrect fee rate
- Omitting rebates and applying discounts incorrectly
- Disclosure issues involving advisory fees
- Adviser expense misallocations
- With respect to fee-billing based on incorrect account valuations, the SEC focused on fair valuation of investments. Specific issues noted in the Risk Alert were:
- Valuing assets using a different metric than that specified in the advisory agreement. One example provided was using the asset’s original cost to value an illiquid asset rather than valuing the asset based on its fair market value.
- Using the market value of assets at the end of the billing cycle, instead of using the average daily balance of that account over the entire billing cycle as specified in the advisory agreement.
- Including in the fee calculation assets excluded from the management fee by the advisory agreement, such as cash or cash equivalents, alternative investments, or variable annuities.
- Compliance Issues Related to Best Execution by Investment Advisers (Issued on July 11, 2018).
- This Risk Alert provides a list of compliance issues most frequently identified in deficiency letters, relating to best execution by investment advisers. The Risk Alert notes that the Advisers Act establishes a federal fiduciary standard for investment advisers. As a fiduciary, when an adviser has the responsibility to select broker-dealers and execute client trades, the adviser has an obligation to seek to obtain “best execution” of client transactions. Failure on the part of an investment adviser with respect to its best execution obligations may constitute a violation of the Advisers Act.
- The Risk Alert notes that, in directing brokerage, an adviser should consider the full range and quality of a broker-dealer’s services. This includes the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the adviser.
- The most frequently observed compliance issues related to best execution include:
- Not performing best execution reviews
- Not considering materially relevant factors during best execution reviews
- Not seeking comparisons from other broker-dealers
- Not fully disclosing best execution practices
- Not disclosing soft dollar arrangements
- Not properly administering mixed use allocations
- Inadequate policies and procedures relating to best execution
- Not following best execution policies and procedures
The SEC is making a concerted effort to increase the transparency of its examination programs. The publication of exam priorities and the issuance of Risk Alerts serves to equip registrants with information that can be used to achieve compliance with securities laws. Furthermore, the dissemination of this type of information increases the reach of the SEC’s exam program by enabling registrants that were not selected for examination to have access to the SEC’s priorities, observations, and findings and to incorporate these insights into their compliance programs.
The 2018 Risk Alerts, in addition to providing valuable information with respect to frequently cited deficiencies arising from the SEC’s exam program, reinforce and underscore the SEC’s adherence to its published exam priorities and its commitment to sharing information about OCIE’s activities.