Liquidity Controls, Cybersecurity, ETFs Among OCIE’s 2016 Exam Priorities
Expect the SEC’s Office of Compliance Inspections and Examinations to scrutinize new areas like liquidity controls and exchange-traded funds in the coming year, while at the same time moving its focus in areas like cybersecurity to a new phase.
OCIE last week, in what has become an annual ritual, issued its annual examination priorities. This year’s list is the fourth consecutive one from the SEC division. It makes its priorities known so that "registrants will use this information to inform the evaluation of their own compliance programs in these key areas," said OCIE director Marc Wyatt.
Twenty priorities were listed in all. In addition to liquidity controls and ETFs, new areas OCIE will examine include public pension advisers, product promotion and variable annuities, the SEC said. Aside from cybersecurity, a perennial hot button, existing focus areas that will continue to draw OCIE attention will include fee selection, reverse churning and microcap fraud.
The new areas of focus "are extremely important to investors and financial institutions across the spectrum," said SEC chair Mary Jo White. "Through information sharing and conducting comprehensive examinations, OCIE continues to promote compliance with the federal securities laws to better protect investors and our markets."
"The 2016 exam priorities list is a must-read document for every chief compliance officer," said Ropes & Gray counsel David Tittsworth. "It is very helpful to have an understanding of what issues are at the top of the SEC’s examination program. While I would advise all investment advisers to take a very close look at OCIE’s priorities, I would particularly recommend that ETFs, advisers handling retirement accounts, and private funds pay particularly close notice."
"No one should be surprised to see that OCIE plans to look at liquidity controls at firms with exposure to fixed income securities, particularly mutual funds, ETFs and private funds," said Willkie Farr partner James Burns. "This emphasis is in keeping with the regulatory program the agency commenced last spring, recent speeches by the chair and various commissioners, and the general effort by the agency to show that it is policing these markets with an eye toward avoiding potential structural or systemic issues."
"If this year’s examination priorities list was a movie, its title would be ‘We Will Continue to . . . ,’" said Stradley Ronon partner Lawrence Stadulis. "And like all exciting movies, this one has a few surprises." As an example, he noted that "OCIE states that it will ‘assess the compliance oversight and controls of investment advisers that have employed such individuals after they have been disciplined or barred from a broker-dealer.’ While nothing prohibits advisers from continuing to employ these individuals absent an applicable bar, the staff presumably is concerned that they may continue raising disciplinary concerns in their capacity as investment adviser employees."
In disclosing its priorities, OCIE did not just provide a list of topics. Rather, perhaps in an attempt to show how it arrived at the priorities, it said that it organized them around "three thematic areas," just as it did last year. The three areas are:
Protecting retail investors and investors saving for retirement. This "will likely continue to be a focus for the forseeable future," OCIE said.
Assessing market-wide risks. "The SEC’s mission includes not only protecting investors and facilitating capital formation, but also maintaining fair, orderly and efficient markets," the division said. "We will examine for structural risks and trends that may involve multiple firms or entire industries." Left unsaid but perhaps behind this theme was the perceived ever-present threat from organizations like the Financial Stability Oversight Council that it may take action, including within the SEC’s traditional turf, to prevent systemic risk.
Using data analytics to identify signals of potential illegal activity. OCIE made clear that it will continue its use of data analytics from examinations and regulatory filings "to identify registrants that appear to have elevated risk profiles."
Here’s a rundown of some of the areas OCIE expects to examine this year:
Liquidity controls. "We will examine advisers to mutual funds, ETFs and private funds that have exposure to potentially illiquid fixed income securities," OCIE said in its announcement. Examinations will include "a review of various controls in these firms’ expanded business areas, such as controls over market risk management, valuation, liquidity management, trading activity, and regulatory capital." Sidley Austin counsel Kara Brown noted this examination focus is indicative of the SEC’s ongoing "focus on capital risk and systemic risk it has had since the financial crisis."
Cybersecurity. This one is not going away, and the SEC said as much, noting that in September 2015 it launched its second initiative to examine advisers’ and broker-dealers’ cybersecurity compliance and controls. "In 2016, we will advance these efforts, which include testing and assessments of firms’ implementation of procedures and controls." Burns noted that, in regard to cybersecurity, "the difference is that OCIE will approach this year’s exams with a broader set of examples and deeper awareness, informed by the extensive reviews that have taken place in recent years that will influence how they evaluate registrants. In some cases, deficiencies will have been noted in the past and so some firms will have to be prepared to describe for OCIE how they have addressed these issues."
Exchange-Traded Funds. OCIE will examine ETFs to ensure they are compliant with applicable exemptions, as well as with other regulatory requirements, and will review their unit creation and redemption process, the agency said. In addition, "we will focus on sales strategies, trading practices, and disclosures involving ETFs, including excessive portfolio concentration, primary and secondary market trading risks, adequacy of risk disclosure, and suitability, particularly in niche or leveraged/inverse ETFs." "The SEC is trying to get a better understanding of what is going on with ETFs," said Morgan Lewis partner John McGuire. "My hope is that they are just trying to learn more about how they operate." But he said he is concerned that the agency may place undue burdens on those whose investment strategy may have changed from what it was when they filed their exemption application.
Fee selection and reverse churning. The focus here is on dually registered advisers/broker-dealers that offer retail investors a variety of fee arrangements, such as asset-based fees, hourly fees, wrap fees and commissions. "Reverse churning" refers to the SEC concern that broker-dealers, used to earning commissions, who become advisers and charge an annual management fee, will not do much work in order to collect that compensation. "We will focus on recommendations of account types and whether the recommendations are in the best interest of the retail investor at the inception of the arrangement and thereafter, including fees charged, services provided, and disclosures made about such arrangements."
Public pension advisers. Advisers to municipalities and other government entities can expect to be examined, with examiners "focusing on pay-to-play and certain other key risk areas related to advisers to public pensions, including identification of undisclosed gifts and entertainment."
Private fund advisers. OCIE is not letting up here, saying it will "maintain a focus on fees and expenses and evaluating, among other things, the controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts." Brown noted that "OCIE, while continuing to focus on private funds, may shift the focus from private equity to more liquid strategies."
Private placements. These placements, including offerings involving Regulation D of the Securities Act of 1933, will be evaluated to determine "whether legal requirements are being met in the areas of due diligence, disclosure and suitability," OCIE said.
Never-before-examined advisers and investment companies. OCIE said it will "continue conducting focused, risk-based examinations of selected registered investment advisers and investment company complexes that we have not yet examined."