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The Friday List: 2020 Examination Priorities

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

Both FINRA and the SEC OCIE staff recently released their 2020 examination priorities.  Today’s list summarizes their 10 most significant concerns for investment managers and broker-dealers.   New areas this year include Regulation Best Interest, digital assets and cash sweep programs. Some longtime favorites include anti-money laundering, best execution, and retail sales practices.  Compli-pros should use these letters to prepare their compliance programs and exam readiness.

10 Most Significant 2020 Examination Priorities

  1. Compliance programs. OCIE’s overriding concern is assessing whether compliance is actively engaged in firm operations and whether the CCO is knowledgeable and empowered.  FINRA wants firms to evaluate the “state of their compliance, supervisory and risk management programs.”
  2. Regulation Best Interest. Both OCIE and FINRA warn firms to implement new procedures and processes to comply with Regulation Best Interest, including Form CRS, and related interpretations.
  3. Retail Sales Practices. OCIE wants firms to re-consider disclosure, sales practices and conflicts of interest when advising retail clients.  FINRA adds supervision and focuses on certain products such as private placements and variable annuities.
  4. Revenue Sharing. The regulators have serious reservations about advisers who have a financial interest in the products they recommend.
  5. Information Security. Firms need to assess systems, technology governance, and testing to ensure the protection of clients’ personal information.
  6. Trading Practices. FINRA will target market manipulation practices, mark-ups/mark-downs, short sales, short tenders, and TRACE reporting.
  7. Digital Assets. OCIE worries that firms may not understand the differences between digital assets and more traditional products.  The examination staff will review suitability, trading, custody, valuation, and supervision.
  8. Anti-Money Laundering. Both regulators expressed concerns about how broker-dealers comply with their anti-money laundering obligations.
  9. Cash Sweep. FINRA wants firms to consider how they communicate features and options and how the programs operate.
  10. Best Execution. Always a perennial favorite, FINRA will focus on routing decisions, odd-lots, and options.

SEC Examinations to Focus on Compliance, Reg BI, and Retail

 

The SEC’s Office of Compliance Inspections and Examinations (OCIE) will focus on compliance programs, retail investors, and Regulation Best Interest according to its 2020 Examination Priorities Letter.  OCIE will investigate whether the CCOs are knowledgeable and empowered and whether they are actively engaged in firm operations.  OCIE will prioritize reviewing dually registered firms, advisers that use sub-advisers, and ESG advisers.  OCIE will also spend significant resources ensuring that firms follow Regulation Best Interest, deliver the new Form CRS, and observe the new Advisers Act fiduciary interpretations.  OCIE will scrutinize disclosures, fees, conflicts, and suitability related to recommendations of funds, ETFs, and other products to retail investors.  Other topics in the Letter include information security, robo-advisers, digital assets, and series trusts operated by third-party administrators.  OCIE warns that the priorities listed “are not exhaustive and will not be the only issued OCIE addresses in its examinations.”

The year is only a week old, but don’t blame compli-pros if they’re already exhausted.  Even before the year started, compliance professionals faced a mountain of new work because of Regulation BI and Form CRS.  Next comes a massive 28-page priorities letter with dozens of new “ToDos.”  We recommend that senior management seriously consider a budget increase for the compliance team.   

SEC Official Warns Firms Not to Shortchange Compliance

In a recent speech, the Director of the Office of Compliance Inspections and Examinations, Peter Driscoll, admonished firms who do not adequately resource the compliance function. Calling compliance officers “partners,” Mr. Driscoll lauded their role on the “front lines” of regulatory compliance. Mr. Driscoll said that he could not “underscore enough a firm’s continued need to assess whether its compliance program has adequate resources to support its compliance function.” OCIE is concerned “when we hear directly from industry participants and read press reports that compliance resources and budgets are being cut or are not keeping up with firms’ risk profiles.” He stressed the importance of compliance as equal to other key business lines, critical to the success of the overall business in its role to protect the trust of clients, investors, and customers.

We have observed OCIE staff specifically ask about compliance resources and spending during examinations. Based on various research studies and our own empirical experience, firms should benchmark to spend at least 5% of revenue on compliance resources including personnel and technology. Of course, the actual spending should vary depending on the complexity and size of the business.

OCIE Warns of Transfer Agent Failures to Safeguard Assets


The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert citing transfer agents for deficient safeguards and lost securityholder procedures.  Reporting on 75 transfer agent examinations over three years, OCIE observed misappropriation of shareholder funds and theft of physical certificates, inadequate account reconciliation processes, commingling of funds, and failures to secure physical access.  OCIE also observed failures to adequately search for lost securityholders including neglecting to send written notices.  OCIE recommends heightened policies and procedures, fund segregation, frequent reconciliations, locked vaults, video cameras, periodic audits, and controls around lost property.  OCIE published the Risk Alert “in order to encourage TAs to review and strengthen their applicable policies, procedures, and controls related to their paying agent operations.”

This is the regulatory warning shot for transfer agents.  Expect sweeps and enforcement actions to follow.  This Risk Alert also puts registered funds and their Boards and CCOs on notice that they should consider oversight procedures. 

The Friday List: Top 10 OCIE Priorities for 2019

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

Christmas came early this year as the SEC’s Office of Compliance Inspections and Examinations (OCIE) released its 2019 priorities, which in prior years came out in January or February.  OCIE has expanded its activities under the new Administration, boasting that it completed over 3,150 exams during the past year.  OCIE increased investment company exams by 45% and reviewed 17% of investment advisers, making good on its prior commitment to double adviser exams.  The Exam Priorities letter is long (12 single space pages) and covers many topics.  To help synthesize the data, we offer the Top 10 OCIE Priorities for 2019:

 

Top 10 OCIE Priorities for 2019

  1. Fees and Expenses:  OCIE will review disclosure and calculation of fees charged to clients.
  2. Portfolio Management: The staff will scrutinize how firms allocate investment opportunities and whether assets are managed according to stated investment objectives.
  3. New Advisers: OCIE continues to focus on never-before examined advisers and advisers that have not been examined in many years.
  4. Mutual Fund Share Classes:  The SEC will focus on which mutual fund share classes are recommended and whether reps have a financial incentive.
  5. Wrap Fee Programs: Firms must monitor wrap programs to make certain that the bundled fee is the best deal for clients.
  6. Affiliated Products/Services:  OCIE will examine the use of affiliated services or products for undisclosed conflicts of interest.
  7. Senior Investors:  The regulators are concerned about unsuitable recommendations to senior investors and supervision of reps.
  8. ETFs: The staff has prioritized ETFs with custom indexes, limited secondary market trading, and risky assets.
  9. Digital Assets: Concerned about the volatile cryptocurrency markets, the SEC remains vigilant about the sale, trading, and management of digital assets.
  10. Cybersecurity: OCIE wants firms to identify and manage cybersecurity risks including devices, governance, and policies and procedures.