2018 SEC Examination Priorities: Cryptocurrency Joins Cybersecurity, Retail and Disclosure
The SEC’s Office of Compliance Inspections and Examinations on February 7 finally issued what advisory firms, investment companies, broker-dealers, attorneys, consultants and others in the asset management community have been waiting for since mid-January: its 2018 list of examination priorities. This year’s list was marked by two additions: a more polished presentation and the inclusion of cryptocurrency as a priority.
The securities industry, which has grown accustomed during the past four years with having OCIE issue its priority list in the first half of January, had to wait until the first half of the succeeding month this time. Now in its sixth year, the last time that the OCIE list was produced in February was in 2013, its first year of issue, and its absence in January this year was felt by advisory firms and others.
"I received inquiries from some folks during the past few weeks asking why the OCIE priorities document had not yet been released," said Ropes & Gray partner David Tittsworth. "This reflects the fact that the regulated community has become accustomed to receiving the report in order to understand OCIE’s priorities. The document helps to promote transparency by informing all registrants of what issues, activities, and practices OCIE has identified as priorities."
"As the markets continually evolve and the products and services available to investors adapt, OCIE remains committed in its risk-based examination program to prioritizing the interests of retail investors and examining those aspects of securities firms posing risks to investors and the proper functioning of our capital markets," said OCIE Director Pete Driscoll.
Despite the more polished delivery – four-color cover, a message from OCIE’s leadership team providing context and principles for the work examiners do, and photographs of key OCIE executives – there were only a few changes from the 2017 list. Among them were the inclusion of cryptocurrency and initial coin offerings as a priority, an increased emphasis on mutual funds and exchange-traded funds, the dropping of some previously included priorities (i.e., multi-branch advisers, money market funds, private funds), and some reorganization.
The polished, commercial feel of the presentation was "an attempt to turn the examination list into a different way of engaging with the industry by providing more context," said Shearman & Sterling partner Nathan Greene.
One of the reasons why so many topics from 2017 remain in the 2018 list may be nothing more than "institutional inertia," he said, meaning that each area of focus most likely has a champion or two within OCIE who has spent time examining advisers, and wants to make sure those topics continue to be priorities. Advisers should not fall into the trap of believing that if an area was dropped from a specific listing in the 2018 list that OCIE is no longer focusing on it. The examination agency may have simply incorporated that area into a larger area it plans to focus on.
The priorities listed "reflect certain practices, products and services that OCIE believes may present potentially heightened risk to investors and/or the integrity of the U.S. capital markets," OCIE said in its introduction. The 2018 priorities are organized around five themes:
Matters of importance to retail investors, including seniors and those saving for retirement;
Compliance and risks in critical market infrastructure;
FINRA and Municipal Securities Rulemaking Board;
Anti-money laundering programs.
Following are some of the priorities listed. Advisers, investment companies and broker-dealers are urged to review the actual examination priority list to gain the full scope of expected 2018 examination activity. It should also be noted that OCIE will not limit itself to the areas listed in its examination priority list. "The description of OCIE priorities is not exhaustive," it said. "Our staff will also conduct examinations focused on risks, issues, and policy matters that arise from market and regulatory developments, new information learned from examinations, or other sources, including tips, complaints and referrals, and coordination with other regulators."
"We will . . . pursue examinations of firms that provide products and services directly to (retail investors)," the OCIE staff said. "We will also focus on higher risk products as well as recent technological changes in how investment advice is delivered."
"Any investment adviser that has retail investors should examine the OCIE report carefully to ensure that its practices, disclosures, and activities place the interests of retail clients at the highest level," said Tittsworth.
Cryptocurrency, initial coin offerings, secondary market trading and blockchain. This is a new area for OCIE, given the large increase in investor interest here, which has resulted in an increase in the number of advisers and broker-dealers involved. "We will continue to monitor for the sale of these products, and where the products are securities, examine for regulatory compliance," OCIE said. "Areas of focus will include, among other things, whether financial professionals maintain adequate controls and safeguards to protect these assets from theft or misappropriation, and whether financial professionals are providing investors with disclosure about the risks associated with these investments, including the risk of investment losses, liquidity risks, price volatility and potential fraud."
Disclosure of the cost of investing. "Every dollar an investor pays in fees and expenses is a dollar not invested for his or her benefit," OCIE said. "Therefore, the proper disclosure and calculation of fees, expenses and other charges investors pay is critically important. It is also important for financial professionals to inform investors of any conflicts of interest that might provide incentives for the financial professionals to recommend certain types of products or services to investors, including any higher cost or riskier products." Expect examiners to review, among other things, whether fees are calculated and charged in accordance with the disclosures provided to investors; and fees charged to advisory accounts to determine whether assets are valued in accordance with investor agreements, disclosures and the firm’s policies and procedures. In particular, the OCIE staff said, examiners will seek to determine whether investors were placed in mutual fund share classes where they may be charged a higher sales load or distribution fee without the conflict of interest being disclosed; accounts where investment advisory representatives departed from the firm with a new IAR not assigned; and private fund advisers that manage funds with a high concentration of investors investing for the benefit of retail clients.
Cybersecurity. This has been, remains and is likely to remain a major examination focus for years to come, if only because online services, along with hackers, continue to become more sophisticated. "The scope and severity of risks that cyber threats present have increased dramatically," the examination agency said. "We are focused on working with firms to identify and manage cybersecurity risks and to encourage market participants to actively and effectively engage in this effort." Expect cybersecurity to continue being an examination priority. "Our examinations have and will continue to focus on, among other things, governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, and incident response," OCIE said.
Electronic investment advice. The concern over "robo-advisers" and other online interactions with clients has not abated. "We will continue to examine investment advisers and broker-dealers that offer investment advice through automated or digital platforms," OCIE said. "Examinations will focus on registrants’ compliance programs, including the oversight of computer program algorithms that generate recommendations, marketing materials, investor data protection, and disclosure of conflicts of interest."
Wrap fee programs. Under these programs, investors are charged a singled bundled, or "wrapped" fee based on a percentage of assets of advisory and brokerage services. "We will review whether investment advisers are acting in a manner consistent with their fiduciary duty and whether they are meeting their contractual obligations to clients," OCIE said. "Areas of interest will include whether (i) the recommendations to invest in a wrap fee program and to continue in the program are reasonable, (ii) conflicts of interest are disclosed in compliance with applicable regulatory requirements; and (iii) investment advisers are obtaining best execution and disclosing costs associated with executing trades through another broker- dealer."
Never-before-examined investment advisers. Given that only a relatively small percentage of advisers nationwide are examined each year, OCIE several years ago began making a point of focusing on those who have never been examined. That apparently is not going to change in 2018. According to the priority list, the SEC’s examination arm "will continue to make risk-based assessments and select those investment advisers for examination that have
elevated risk profiles."
Senior investors and retirement accounts and products. "We will continue to conduct examinations of investment advisers and broker-dealers that offer services and products to investors with retirement accounts," OCIE said. It specified that these examinations will focus on a number of things, including investment recommendations, sales of variable insurance products, and sales and management of target date funds.
Mutual funds and exchange-traded funds. These are the primary investment vehicles for many of today’s retail investors, OCIE noted in explaining why it is placing much of its focus here. "We will focus on mutual funds (i) that have experienced poor performance or liquidity in terms of their subscriptions and redemptions relative to their peer groups; (ii) that are managed by advisers with little experience managing registered investment companies, or (iii) that hold securities which are potentially difficult to value during times of market stress, including securitized auto, student, or consumer loans, or collateralized mortgage-backed securities." In addition to these objectives, OCIE said that it will pay attention to ETFs and mutual funds that seek to track custom-built indexes to review for any conflicts the adviser may have with the index provider, and the adviser’s role in selecting and weighting the index components.