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News January 19, 2015 Issue

OCIE 2015 Exam Priorities: Reverse Churning, Alternative Funds, Cybersecurity

It’s not really a new year until the SEC’s Office of Compliance Inspections and Examinations issues its examination priority list and, for those who might use that standard, 2015 began on January 13.

That’s when OCIE issued its Examination Priorities for 2015. The third annual list is a streamlined version compared to the previous two. With five pages and 19 specific priorities, it is a slimmer and perhaps less-intimidating document than the 2014 list, which came in at 11 pages and 39 specific priorities, or the 2013 version,at 13 pages and 45 specific priorities.

While it will come as no surprise to advisers who have been SEC watchers during the past 12 months to see cybersecurity and alternative funds among OCIE’s exam priorities, given the attention the agency has paid to these areas in the past year, perhaps more surprising will be the inclusion of never-before-examined investment companies, reverse churning, proxy advisory service firms, and private equity fees and expenses, none of which were listed as 2014 priorities.

"In-house counsel, compliance officers and executives should not see this five-page document as reflective of all OCIE examination priorities for the next 12 months," cautioned Nixon Peabody counsel Bradley Mirkin. "To the contrary, this non-exhaustive document reflects the Commission’s current assessment of areas of ‘heightened risk.’ That assessment may and undoubtedly will change before the next set of priorities is published in January 2016."

Adviser and broker-dealer sections gone

Gone from the list are sections titled for advisers, broker-dealers or other types of firms. The OCIE staff instead divided its priorities among four categories:

Protecting retail investors and investors saving for retirement. Th SEC is concerned that retail investors are being offered products and services "that were formerly characterized as alternative or institutional, including private funds, illiquid investments and structured products." Many of these products are geared toward sophisticated investors and the agency wants to make sure that average retail investors are protected.

  • Assessing market-wide risks. These are structural risks that involve multiple firms or entire industries. One of these areas is large firm monitoring, with OCIE saying that it, along with the Division of Trading and Markets, and the Division of Investment Management, will "monitor the largest U.S. broker-dealers and asset managers for the purpose of assessing risks at individual firms and maintaining early awareness of developments industry-wide."
  • Using data analytics to identify signals of potential. This broad area is unlike the two above, in that it refers not to adviser or broker-dealer activity, but instead to how the SEC will use its increasingly sophisticated analytics capabilities and staff to parse data. "OCIE will use these capabilities to focus on registrants and registered representatives that appear to be potentially engaged in illegal activity," the staff said.
  • Other priorities. These are topics that the OCIE apparently feels do not fit neatly into the first three categories, and include areas like municipal advisers, proxy services, and fees and expenses charged to private equity funds.
  • One reason for no longer having separate sections for advisers and broker-dealers, said Mayer Brown attorney Adam Kanter, may be that "lines in the industry are blurring as firms dually register or otherwise take on additional responsibilities." The new version also may simply represent a better-edited document, with the understanding that the priorities listed apply wherever the SEC finds them, he said. Finally, two categories that accounted for a number of additional priorities in previous lists – exchanges and SROs – were excluded from this year’s list. They will be addressed separately, the OCIE staff said.

    The decision to eliminate separate sections for advisers, broker-dealers and other firms should not be taken to mean that the SEC is paying less attention to those areas, or that issues regarding advisers or broker-dealers are any less of a priority. Rather, advisers and broker-dealers will simply need to see if their activities fall within the new categories listed – and in many cases, they will.

    The examination priority list helps advisers, broker-dealers and other securities firms prepare for upcoming exams by revealing the agency’s own focus. "We share our annual exam priorities to promote compliance," said OCIE director Andrew Bowden. "We have observed that when we share our areas of focus, many industry participants independently review their controls in the areas we have identified."

    Specific priorities

    Following is a breakdown of OCIE’s individual examination priorities that would have the most effect on advisers:

    Fee selection and reverse churning. This comes from OCIE’s increased attention in recent months to dual registration, or brokers that choose to operate as an investment adviser rather than a broker-dealer (ACA Insight, 11/11/13). While broker-dealers receive commissions for each trade they make (raising the issue of churning, meaning making a lot of trades just to get the commissions), advisers get paid a fee regardless of how many trades are made. This creates the possibility that former broker-dealers will have a disincentive to trade (reverse churning), and simply charge fees to clients without much work to back it up. "It’s not that there’s anything fundamentally wrong with any specific type of fee arrangement," said Kanter. "It’s about whether, under the particular circumstances, they create an incentive to not act in the client’s best interest." The OCIE staff noted that when they find a variety of fee arrangements, "we will focus on recommendations of account types and whether they are in the best interest of the client at the inception of the arrangement and thereafter, including fees charged, services provided, and disclosures made about such relationships."
  • Alternative investment companies. The SEC has made little secret of its concern in regard to the mushrooming sales of alternative mutual funds – providing riskier private-fund type investments with many of the protections that mutual funds bring – to retail investors, who tend to be less sophisticated than private-fund investors (ACA Insight, 11/10/14). SEC Division of Investment Management director Norm Champ has spoken about them in at least three speeches, they were included in OCIE’s 2014 examination priorities, and were the subject of an agency sweep exam last year. OCIE said it would continue to assess funds offering these investments, "with a particular focus on (i) leverage, liquidity and valuation policies and practices; (ii) factors relevant to the adequacy of the funds’ internal controls, including staffing, funding and empowerment of boards, compliance personnel and back offices; and (iii) the manner in which such funds are marketed to investors."
  • Cybersecurity. Hardly a surprise, given the intense interest the agency took in the subject last year: sending a multi-page questionnaire to some firms, conducting a roundtable on the subject, and OCIE including it on its list of 2014 examination priorities (ACA Insight, 4/7/14). "In 2015, we will continue these efforts and expand them to include transfer agents," the OCIE staff said. The Commission may still be digesting the results of its questionnaire, suggested Mirkin, "as it has revealed nothing more than it will be continuing its 2014 efforts, other than expanding them to transfer agents. … It is unclear if the Commission is in a holding pattern, expanding the number of firms it is examining in cybersecurity, or widening the scope of those examinations. Regardless of the Commission’s present action (or inaction), based on the increasingly precarious threat landscape, firms should be making this one of their compliance priorities for 2015."
  • Never-Before-Examined Investment Companies. This is a new one. Apparently OCIE is going to take its new practice of examining never-before-examined advisers, begun last year, and expand it to investment companies. "We will conduct focused, risk-based examinations of selected registered investment company complexes that we have not yet
    examined," the OCIE staff said. Quite possibly, Kanter suggested, examiners who took part in the never-before-examined advisers initiative discovered practices that made them realize they should have been there years before, so they decided to do the same with investment companies.
  • Fees and expenses in private equity. Another new one. This most likely is an outgrowth of advisers to private funds that previously were not required to register now having to do so. Not only were many not used to SEC requirements, but the SEC, previously not that used to overseeing private funds, has become increasingly familiar with them, and has
    already uncovered a number of irregularities related to fees and expenses at private equity managers they have examined, Kanter noted. The OCIE staff said that, "given the high rate of deficiencies that we have observed among advisers to private equity funds in connection with fees and expenses, we will continue to conduct examinations in this area."
  • Fixed income investment companies. Also the subject of SEC interest during the past year, with the agency staff issuing a guidance update in January 2014 calling on firms to perform stress tests and more to ensure fund stability in the expectation of interest rate volatility (ACA Insight, 1/27/14). "With interest rates expected to rise at some point in the future, we will review whether mutual funds with significant exposure to interest rate increases have implemented compliance policies and procedures and investment and trading controls sufficient to ensure that funds’ disclosures are not misleading and that their investments and liquidity profiles are consistent with their disclosures," the OCIE staff said.
  • Proxy services. Somewhere, SEC Commissioner Daniel Gallagher must be smiling. In its listing of proxy services in this year’s priority list, OCIE staff said that it "will examine select proxy advisory service firms" – which is an interesting comment since a point made at an SEC 2013 roundtable on the subject was that there are only two main players in the field – "including how they make recommendations on proxy voting and how they disclose and mitigate potential conflicts of interest. We will also examine investment advisers’ compliance with their fiduciary duty in voting proxies on behalf of investors." Gallagher, in two speeches in 2013 and later, strongly advocated reform of how advisers work with proxy advisory services (ACA Insight, 12/16/13).
  • Other exam priorities listed that might affect advisers included how registered entities determine investment suitability for investors, branch-office deviation from home-office compliance practices, large-firm monitoring, and compliance of municipal advisers with the recently adopted SEC and Municipal Securities Rulemaking Board rules.