SEC’s 2019 Exam Priorities: Focus on Investment Advisors
By Joanna Conte, CPA, Partner, Assurance Services, Alternative Investment Group
The Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) announced its 2019 examination priorities on December 20, 2018. In the past, OCIE has released its exam priorities in January or February, so the December announcement represented an acceleration of the historical timing.
This is the seventh 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 insight into those areas that the SEC believes warrant attention and constitute the most effective use of examination resources.
OCIE noted that its work continues to be based on four “pillars”: promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy. With respect to the focus on fraud prevention, in 2018 OCIE exams generated more than 160 referrals for enforcement and resulted in firms returning more than $35 million to investors.1
This article addresses the 2019 exam priorities that are expected to have the most significant impact for investment advisers.
Whom does OCIE oversee?
The SEC registrant base is comprehensive and far-reaching. It includes approximately 13,200 investment advisers, as well as 10,000 mutual funds and exchange traded funds; 3,800 broker-dealers; 330 transfer agents; seven active clearing agencies; 21 national securities exchanges; 600 municipal advisers; the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), the Securities Investor Protection Corporation, and the Public Company Accounting Oversight Board.
In 2018, the population of registered investment advisers increased 5 percent. More than 3,700 advisers have greater than $1 billion in assets under management; approximately 35 percent provide advisory services to a private fund; greater than 50 percent have custody of client assets; and approximately 12 percent provide advisory services to a mutual fund or other registered investment company.
Overseeing this diverse population of registrants are approximately 1,000 OCIE staff stationed in the SEC’s Washington D.C. headquarters and 11 regional offices.
How many investment advisers have historically been selected for SEC examination?
In 2018, the SEC examined approximately 17 percent of all registered investment advisers, an increase from 15 percent in 2017, and more than double the 8 percent examined in 2012.
OCIE has communicated that its 2019 exam priorities will include a focus on never-before-examined investment advisers, including those which are determined to have elevated risk profiles and those that have not been examined for a number of years and may have grown substantially larger or otherwise exhibited a new and heightened risk profile.
How does the SEC determine exam priorities?
OCIE has stated that exam priorities are 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. To this end, OCIE engages with senior management of registered entities to obtain insight into the changing markets and evolving risks to investors.
In further pursuit of transparency, promotion of compliance and open dialogue with its key constituencies, in 2018 OCIE sponsored, co-sponsored or participated in more than 100 “outreach events,” including national and regional compliance seminars. One such event was the National Compliance Outreach Seminar for Investment Advisers and Investment Companies, held on April 12, 2018, at the SEC’s Washington, D.C. headquarters with a live feed on the SEC’s website. The seminar included discussions of program priorities, fees and expenses, portfolio management trends, regulatory hot topics, cybersecurity and rulemaking. These outreach events help OCIE gather intelligence from its key constituencies and representatives of industry which informs OCIE’s examination priorities.
OCIE has communicated that it is 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 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 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 2019 exam priorities and which priorities are anticipated to have the biggest impact on investment advisers?
The 2019 exam priorities have been organized around six themes, as follows:
- Matters of importance to retail investors, including seniors and those saving for retirement.
- Compliance and risk in registrants responsible for critical market infrastructure.
- Select areas and programs of FINRA MSRB.
- Digital assets, including cryptocurrencies, coins and tokens.
- Anti-money laundering.
The 2019 exam priorities are thematically similar to the 2018 exam priorities.
This article will expand on the following exam priorities which are expected to have particular impact on investment advisers of private funds:
- Matters of importance to retail investors, including seniors and those saving for retirement.
- Digital assets.
Exam Priority: Matters of importance to 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 2019 exam priorities:
- Disclosure of the costs of investing. In its discussion of this 2019 exam priority OCIE states, “Every dollar an investor pays in fees and expenses is a dollar not invested.” This exam priority 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 to ensure that expense calculations are consistent with disclosures provided to investors.
- Conflicts of interest. OCIE is particularly interested in conflicts of interest that might incentivize an investment adviser to recommend higher-cost or riskier products or services to investors.
- OCIE has stated that it will give special attention to arrangements the adviser may have to utilize services or products provided by affiliated entities. Exams will focus on these arrangements, including the impact to investors and the sufficiency of disclosures of any resulting conflicts of interest.
- Mutual funds and exchange traded funds. OCIE has communicated an interest in advisers of registered investment companies (RICs) exhibiting certain attributes which OCIE believes contribute to an elevated risk profile. These attributes include funds managed by advisers that are relatively new to managing RICs and advisers that provide investment advice to both RICS and private funds that pursue similar investment strategies.
- Portfolio management and trading. Exams will address adviser practices for investment transaction execution, adherence of investments to investment objectives, disclosures and legal restrictions, and investment allocations.
- OCIE will review advisers’ practices for allocating investment opportunities to clients, including among registered investment companies and private funds that have similar investment strategies.
- Microcap securities. OCIE announced that it will continue examinations of broker-dealers involved in selling stocks of microcap companies, which it defines as companies with a market capitalization of under $250 million. OCIE focus areas will include reviewing for market manipulation (i.e., pump and dump schemes); compliance with Regulation SHO, which governs short sales; and compliance with Exchange Act Rule 15c2-11, which governs the submission and publication of quotations by broker-dealers for certain over-the-counter equity securities.
Exam Priority: Digital assets
Digital assets include 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.
With respect to registered advisers, OCIE expressed a special interest in cybersecurity practices by advisers with multiple branch offices and advisers that have recently merged with other advisers.
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.
Impact of U.S. government partial shutdown
The partial shutdown of the U.S. government, which commenced on December 22, 2018, and recently concluded (on a temporary basis, as of the writing of this article), appears to have halted or significantly reduced investment adviser exams during its duration. Just two days after OCIE announced its 2019 exam priorities, the shutdown began, instigating a lapse in appropriations to the SEC. In a shutdown operations plan posted on its website, the SEC stated that during the shutdown OCIE would not conduct non-emergency examinations and inspections. The SEC also suspended investigative work during the shutdown. During the shutdown, the SEC’s Division of Investment Management did not issue interpretive guidance or exemptive relief. The SEC continued to accept annual Form ADVs during the shutdown. There was some speculation within the investment management industry that the earlier timing of the release of the 2019 exam priorities, compared to prior years, was due to the anticipated shutdown and OCIE’s objective to disseminate the 2019 exam priorities prior to the commencement of the shutdown. It is unclear what kind of backlog in the exam program was created by the temporary moratorium on OCIE exams.
The SEC is making a concerted effort to increase the transparency of its examination programs. The publication of exam priorities serves to equip registrants with information that can be used to achieve compliance with securities laws. Furthermore, the dissemination of the exam priorities 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, focus areas and concerns, and to incorporate these insights into their compliance programs.
1. All statistical information cited in article is sourced from 2019 Examination Priorities published by the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations.