SEC’s 2020 Exam Priorities: Continued Focus on Investment Advisors

The Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) announced its 2020 examination priorities on January 7, 2020.

This is the eighth 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 advance announcement of exam priorities is intended to provide SEC-regulated entities insight into those areas that the agency 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.

This article addresses the 2020 exam priorities that are expected to have the most significant impact for investment advisers.

Background

With respect to registered investment advisers, OCIE is the primary and often the sole regulatory and supervisory entity applicable to this sector of the financial services industry. In its examination priorities announcement, OCIE noted that there has been significant growth in both the population of registered investment advisors as well as assets under the management of registered investment advisers. In the previous five years, the population of registered investment advisers has increased from approximately 11,500 to 13,475 with a corresponding increase in assets under the management of registered investment advisers, over this same period, from approximately $62 trillion to $84 trillion¹.

More than 3,700 advisers have greater than $1 billion in assets under management; approximately 36 percent provide advisory services to a private fund; greater than 55 percent have custody of client assets; and approximately 12 percent provide advisory services to a mutual fund or other registered investment company.

In 2019, the SEC examined approximately 15 percent of all registered investment advisers, a minor decrease from 17 percent in 2018, a statistic which the SEC noted reflects the impact of the approximately one-month suspension of SEC examination activity which occurred in early 2019 due to a lapse in government appropriations.

2020 Exam Priorities Focus and Challenges

OCIE has communicated that its 2020 exam priorities will include a focus on the compliance programs of investment advisers, never-before-examined investment advisers and not recently-examined investment advisers, as well as investment advisers to private funds.

In its examination priorities announcement, OCIE underscored several steps it has taken in recent years to expand its coverage of registered investment advisers. Such measures include enhancement of examination program efficiencies, through procedural and technological innovation, realignment of internal staffing to preserve and promote examination coverage of registered investment advisers and investment in staff, including the hiring of experienced subject matter experts and dissemination of training.

With respect to risks and challenges impacting OCIE’s examination program as it relates to registered investment advisers:

• OCIE disclosed in its exam priorities announcement that it has experienced challenges with respect to examination of non-U.S. registrants, including off-shore registered investment advisers. Specifically, offshore registered advisers are increasingly subject to foreign regulations governing data protection and privacy which restrict cross-border transfers of certain information including SEC required records necessary for inspection. These scenarios present a conflict of law (foreign regulations versus U.S. securities laws). OCIE is working on remedies to address these challenges, including seeking additional information from non-U.S. applicants for SEC investment adviser registration to ensure that these firms can comply with SEC inspection requirements.
• OCIE did identify as a “significant risk” that it may not have sufficient resources to keep pace with industry growth which could adversely impact its ability to achieve adequate examination coverage of registered investment advisers. OCIE noted that, without staffing increases that correspond with the growth in the registered investment adviser population and complexity, it is likely that its examination coverage rates for this sector will decline. OCIE described this risk as “concerning” and a focus of the SEC.

In its 2020 examination priorities announcement, OCIE emphasized that the selection of firms to examine and related scoped focus areas of an examination are determined through OCIE’s risk-based analysis. OCIE disclosed that it considers dozens of potential risk factors, including nature of products and services offered, whether certain higher risk products are offered, compensation and funding arrangements, changes in firm leadership, whether a firm has custody of client assets, past examination findings, and disciplinary histories of individuals associated and affiliated with the registrant. Of special interest to registered investment advisers, OCIE stated that it continues to be focused on conflicts of interest.

The 2020 exam priorities have been organized around eight themes:

1. Retail investors, including seniors and individuals saving for retirement.
2. Information security.
3. Financial technology (FINTECH) and innovation, including digital assets and electronic investment advice.
4. Additional focus areas involving registered investment advisers and investment companies.
5. Additional focus areas involving broker-dealers and municipal advisers
6. AML programs.
7. Market infrastructure.
8. Focus on FINRA and MSRB.

The 2020 exam priorities are thematically similar to the 2019 exam priorities but do reflect a more targeted focus on certain areas involving registered advisers.

This article will expand on the following exam priorities which are expected to have particular impact on investment advisers of private funds:

• Retail investors, including seniors and individuals saving for retirement.
• Information security.
• Financial technology (FINTECH) and innovation, including digital assets and electronic investment advice.
• Additional focus areas involving registered investment advisers and investment companies.

Exam Priority: Retail investors, including seniors and individuals 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 2020 exam priorities:

• Fraud, Sales Practices and Conflicts.This exam priority includes the disclosure of fees, expenses, and other charges paid by investors. It also includes disclosure of potential conflicts of interest. The aim is to arm investors with information required to make better informed decisions. OCIE will evaluate whether registered investment advisers, as fiduciaries, have fulfilled their duties of care and loyalty. OCIE is particularly focused on elimination, or at a minimum full disclosure, of conflicts of interest (including fee and compensation-based conflicts) which could incentivize an adviser to dispense investment advice which is not in a client’s best interest.
• Retail-Targeted Investments. OCIE disclosed that it will focus on certain investment products which present with higher risk to investors. Higher risk may be the product of specific characteristics of those securities, market dynamics or an elevated concentration or placement with retail investors. These products include mutual funds and exchange traded funds, municipal securities and other fixed income securities and microcap securities. With respect to 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.
• Standards of Care. OCIE referred to several recently adopted SEC standards of care, including Regulation Best Interest, the Interpretation Regarding Standard of Conduct for Investment Advisers and the Form CRS Relationship Summary. With respect to registered investment advisers, OCIE noted that the Interpretation Regarding Standard of Conduct for Investment Advisers reestablished and expounded on certain elements of a registered adviser’s fiduciary duty with respect to its clients.

Exam Priority: Information security

The SEC will continue to devote attention to information security, including cybersecurity, in its exam program. Examinations are expected to prioritize governance and risk management, access controls, data loss prevention, vendor management, training, and incident response and resiliency.

With respect to registered advisers, OCIE expressed a special interest in mechanisms for protection of clients’ personal financial information.

Exam Priority: Financial technology (FINTECH) and innovation, including digital assets and electronic investment advice

In its discussion of this examination priority, OCIE observed that firms are increasingly utilizing new data sources, often referred to as “alternative data” and that this data has applications that may include influencing investment decision-making. OCIE intends to focus on firms’ use of these data sets as well as newly developed financial technologies as they relate to provision of services to investors.

With respect to digital assets, including cryptocurrency, Initial Coin Offerings (ICOs), secondary market trading, and Blockchain, OCIE intends to concentrate attention on investment suitability, portfolio management and trading practices, safety of client funds and assets, pricing and valuation, effectiveness of compliance programs and controls and supervision of employee outside business activities.

With respect to electronic investment advice, OCIE plans to focus on registered advisers that generate investment recommendations through automated investment tools and platforms (so-called “robo-advisers”). Attention will be placed on SEC registration eligibility, cybersecurity policies and procedures, marketing practices, adherence to fiduciary duty, including adequacy of disclosures and effectiveness of compliance programs.

Exam Priority: Additional focus areas involving registered investment advisers and investment companies

Registered investment advisers are the target of the following examination priorities discussed in the OCIE announcement:

• RIA Compliance Programs. OCIE noted that its interest will persist with respect to whether compliance programs of registered advisers are reasonably designed, implemented and maintained. Examiners will direct special attention to advisers offering novel types or emerging investment strategies, including strategies that promote sustainable and responsible investing. OCIE will also concentrate on advisers that are dually registered as, or affiliated with, broker-dealers, or have supervised persons who are registered representatives of unaffiliated broker-dealers.
• Never-Before and Not Recently-Examined Registered Investment Advisers. In addition to its recurring focus on never-before examined advisers, OCIE stated that it will also devote focused attention to advisers that were previously examined but have not been examined for a number of years “to focus on whether the registered investment advisers’ compliance programs have been appropriately adapted in light of any substantial growth or change in their business models.”
• Mutual Funds and Exchange Traded Funds. As retail investor exposure to these products increases, OCIE has developed a heightened interest in monitoring industry practices and regulatory compliance. Interest areas include registered advisers that use third-party administrators to sponsor the mutual funds they advise or are affiliated with, mutual funds or exchange traded funds that have not previously been examined and registered advisers to private funds that also manage a registered investment company with a similar investment strategy.
• Registered Investment Advisers to Private Funds. With respect to advisers to private funds, the examination priorities discuss that OCIE plans to evaluate compliance risks, including controls to prevent the misuse of material, non-public information and conflicts of interest, such as omitted or insufficient fee disclosures and the use of adviser affiliates to provide services to clients.

Conclusion

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 2020 Examination Priorities published by the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations.
2. “Custody Rule” refers to Rule 206(4)-2 under the Investment Advisers Act of 1940.