The US Securities and Exchange Commission's ("SEC") Office of Compliance Inspections and Examinations ("OCIE") released its 2020 examination priorities on January 7, 2020. A number of the 2020 priorities are continuations from the exam priorities for 2019 (some of which have been enhanced for 2020), and others have been informed by OCIE Risk Alerts or significant regulatory initiatives during 2019, such as the SEC's investment adviser fiduciary duty interpretation (see our 2019 Legal Update on this topic). As was the case in prior years, OCIE's examination priorities cover a broad array of SEC registrants, including investment advisers and registered investment companies, brokerdealers and transfer agents. However, this Legal Update focuses on the examination priorities for investment advisers and registered investment companies.
Before we turn to specific adviser and investment company examination priorities for 2020, we begin with a review of OCIE's approach in implementing its examination program, which itself indirectly includes guidance and warnings for registrants.
A Primer on OCIE's Examination Approach
Although OCIE's examination priorities often drive the scope and focus of its examinations as well as the registrants selected for examination, OCIE, overall, uses a risk-based approach to determine exam scope and focus as well as registrant selection. OCIE considers numerous factors in this approach, which may include:
- the products and services offered (including those products identified as being higher risk);
- compensation and funding arrangements;
- prior examination observations and conduct;
- disciplinary history of associated individuals and affiliates of a registered firm;
- changes in firm leadership or other personnel; and
- whether the firm has custody of client assets. In this regard, OCIE noted that in exams of registered investment advisers ("RIAs") that have custody of client funds or assets, OCIE prioritizes examination of the RIA's compliance with the custody rule.
Registrants should review these factors carefully in light of their own facts and circumstances, not only to evaluate their likelihood of examination, but also to evaluate their compliance programs and related policies and procedures for possible modifications. Registrants that have not been examined in the last few years or that have had a negative examination history, whose personnel have significant disciplinary histories, or that have had any enforcement history should be all the more prepared for an examination.
OCIE further identified certain key aspects of regulatory oversight for RIAs:
- the adequacy of the adviser's disclosures concerning services, fees and expenses, and
- the adviser's management and handling of conflicts of interest.
Notably, both of these subjects directly relate to the SEC's 2019 fiduciary interpretation and receive additional attention from OCIE in the specific exam priorities described below.
A Word About LIBOR
As an example of OCIE's ability to quickly pivot its exam focus to cover emerging and exigent risks, OCIE specifically called out the transition away from LIBOR. In this regard, OCIE warned that it will be reviewing firms' preparations and disclosures regarding their readiness and the transition's effects on investors. OCIE specifically encouraged registrants to evaluate their use of, and operational exposure to, LIBOR and their clients' exposure thereto, not just in contracts, but also in benchmarks and indices; accounting systems; risk models; and client reporting, among other areas. OCIE also warned that insufficient preparation could cause harm to retail investors and significant legal and compliance, economic and operational risks for registrants. OCIE will also closely track and evaluate the impact of the industry's transition away from LIBOR, which it calls a major risk theme affecting registrants.
In July 2019, SEC staff issued a joint statement regarding the LIBOR transition, providing guidance and expectations for registrants. Other federal and state regulators are asking questions about how their regulated entities are managing the transition and associated risks. UK regulators have been doing the same.
Examination Themes for 2020
Use of Third-Party Service Providers – OCIE observed that as registered entities' businesses have become more global, often this is coupled with an increased use of services and operations in the United States and abroad. OCIE also observed that registrants' use of third-party service providers and other vendors continues to increase, which can bring additional challenges and risks. OCIE will continue to focus on thirdparty risk management in FY 2020.
Enhanced risk in this respect raises the expectation that advisers have detailed due diligence procedures and use them to fully vet outsourced service providers, both at inception and as an ongoing proposition. Also, note that this examination focus is echoed a number of times in connection with other, more specific exam priorities, described below.
Foreign Registrants and Foreign Privacy Laws – OCIE admits that it has experienced challenges in examining non-US registrants due to local data protection and privacy laws. These challenges are growing along with the growing number of "off-shore" RIAs. Local privacy laws might conflict with US securities laws, SEC rules and registration forms, which require non-US RIAs to provide records to the SEC for inspection. In light of this conflict of law, OCIE is: (i) seeking additional information from non-US applicants for RIA registration to ensure that they can comply with these inspection requirements and (ii) continuing to work with both industry and regulatory counterparts in other countries.
Disclosures – OCIE emphasized the importance of disclosures, specifically those regarding: (i) fees and expenses; and (ii) conflicts of interest. OCIE also commented that registrants must effectively implement controls and systems to ensure that disclosures are made as required and that a firm's actions match those disclosures (emphasis added).
The importance of this examination focus is underscored not only by the recent adoption of Reg. BI (see our 2019 Legal Update), the Customer Relationship Summary and the fiduciary interpretation, but also the fact that disclosure generally and these specific disclosure subjects have served as the basis for numerous enforcement actions over the years.
Retail Investors: A Continued Focus
Generally – As in past years, OCIE will continue to focus on protecting retail investors, specifically seniors and investors who are saving for retirement. In this regard, OCIE stated that it will emphasize examinations of: retail investor intermediaries, such as RIAs and dual-registrants; and (ii) investments that are intended (whether by design or marketing) for retail investors, such as mutual funds and exchange-traded funds (ETFs), municipal securities, other fixed-income securities, and microcap securities.
OCIE stated that its examinations will focus on recommendations and advice given to retail investors, particularly: (1) seniors and (2) new for this year, teachers and military personnel. This focus will specifically include recommendations and advice made by entities and individuals that target retirement communities.
Higher-Risk Products – In addition, OCIE will focus on higher-risk products, such as securities issued in private placements and securities that involve new and emerging risk areas. In this regard, OCIE specifically cited securities that are complex or nontransparent, or that have high fees and expenses. OCIE also specifically referenced securities that are issued by an entity that is related to the registrant that is making the recommendation. In this regard, OCIE stated that its examinations will also focus on registrants' disclosures; supervision of outside business activities of its employees and associated persons; and related conflicts.
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