The SEC’s Office of Compliance Inspections and Examinations (OCIE) and FINRA have released their 2017 examination priority letters, highlighting areas of examination focus for the year. Given that there are many common concerns, this article summarizes both letters, highlighting topics common to both investment advisers and broker-dealers, followed by topics specific to investment advisers and, finally, those specific to broker-dealers.

FINRA CEO Robert Cook notes that a common thread through their priorities is a focus on the “blocking and tackling” issues of compliance, supervision and risk management. Likewise, many of OCIE’s priorities have been the subject of Risk Alerts or priority letters in recent years. OCIE stresses that their exam program is “data-driven and risk-based” and incorporates extensive data analytics to identify industry practices and registrants that appear to have elevated risk profiles.

OCIE continues to shift resources from broker-dealer to investment adviser examinations, and saw a slight uptick in advisers examined in 2016. Due to the transfer of resources, OCIE will enhance its oversight of FINRA, assessing the quality of its exam program. In addition, OCIE will focus on money market funds’ adoption of new liquidity rules and oversight over market participants such as the exchanges, clearing agencies and transfer agents.

In 2017, FINRA will introduce electronic, off-site reviews of selected risk areas to supplement its on-site cycle examinations. They also intend to publish a summary report outlining key findings from examinations in selected areas.

 

Areas Common to Investment Advisers and Broker-Dealers

Annual ReviewElectronic Investment Advice

Given the rise in automated or digital platforms to provide investment advice, OCIE will examine firms offering such services, whether the automated tool is client-facing (often called a “robo-adviser”) or supports a financial professional in the investment program (“quantitative model”). This is a new focus area in 2017, and examinations will look at compliance programs, marketing, investment recommendations, data protection and compliance oversight of the algorithms that generate recommendations.

Recidivist Representatives and their Employers

Both OCIE and FINRA are focused on advisers and broker-dealers that hire individuals with a track record of misconduct. Examinations will focus on the controls in place to oversee and supervise such individuals. In September 2016, OCIE issued a Risk Alert regarding the supervision practices at investment advisers and called attention to individuals with a history of disciplinary events, including those that have been disciplined or barred from a broker-dealer. FINRA established a dedicated unit to identify and examine brokers who may pose a high risk to investors.

Branch Offices

In December 2016, OCIE issued a Risk Alert regarding investment advisers with multiple branches and operations geographically dispersed from a main office. In it, OCIE announced the launch of the Multi-Branch Adviser Initiative to examine such investment advisers to determine the effectiveness of compliance programs.

Likewise, FINRA evaluates firms’ branch office inspection programs and supervisory systems for branch and non-branch offices, including independent contractor branches. Advisers and broker-dealers with branch offices should ensure that their compliance programs and supervisory systems provide the necessary oversight and control.

Senior Investors

In 2013, OCIE and FINRA published the National Senior Investor Initiative, highlighting trends and practices identified during exams to assist firms in considering their policies and procedures in this area.  The regulators will continue to examine how firms manage interactions with senior investors, including the ability to identify potential financial exploitation of seniors. Specifically, FINRA will focus on microcap fraud schemes targeted at senior investors. In addition, OCIE will continue its multi-year ReTIRE initiative, focusing on investment advisers and broker-dealers and the services they offer to investors with retirement accounts, including recommendations and sales of variable insurance products and sales and management of target date funds. Examiners will review controls surrounding cross transactions, particularly with respect to fixed income securities.

Wrap Fee Programs

OCIE intends to expand its focus on investment advisers and broker-dealers associated with wrap fee programs, building on previous exams of wrap fee program sponsors and the investment advisers to such programs. OCIE will examine whether investment advisers are meeting their fiduciary duty, suitability, effectiveness of disclosures, conflicts of interest and brokerage practices, including best execution and trading away from the sponsor firm.

Operations

Cybersecurity.  Cybersecurity threats remain one of the most significant risks an organization faces, and the regulators intend to assess procedures and controls a firm has in place to protect its infrastructure and client data. There is no “one-size-fits-all approach,” and firms are expected to assess their individual risks and implement appropriate programs. Firms with branch offices should also consider controls in those branches, especially independent contractor locations.

Anti-Money Laundering.  FINRA and OCIE will examine broker-dealers to determine whether AML programs are tailored to a firm’s specific risks, how firms monitor for suspicious activity and how firms meet their suspicious activity reporting requirements.

Share Class Selection

As discussed in its July 2016 Risk Alert, OCIE will continue to review conflicts of interest and other factors influencing the selection of a particular share class of a mutual fund. Investment advisers making such recommendations should ensure that they are upholding their fiduciary duty to clients in the selection and that conflicts of interest are fully disclosed in the firm’s ADV. Broker-dealers should also be diligent to ensure that investors are purchasing the lowest cost share class available.

Municipal and Public Pension Advisers

Advisers to state and local governments and their pension plans have specific risks, including restrictions on political contributions, gifts and entertainment, as well as compliance with Municipal Securities Rulemaking Board (MSRB) rules. Advisers should also ensure that they are properly registered with the MSRB and that municipal advisor representatives pass FINRA’s new Series 50 exam as necessary.

 

Investment Adviser Areas

Private Funds

As in years past, OCIE will continue to examine private fund advisers, with a focus on conflicts of interest, the disclosure of those conflicts and actions that appear to benefit the adviser at the expense of investors.

Never-Before Examined Investment Advisers

OCIE is expanding its “Never-Before Examined Adviser” initiative, as described in their 2014 letter, to include focused, risk-based examinations of newly registered advisers as well as existing advisers that have never been examined by OCIE.

ETFs

OCIE’s attention with respect to exchange traded funds lies in two areas. First, they will examine sales practices and disclosures involving ETFs, in particular the suitability of a broker-dealer’s recommendation to purchase ETFs with niche strategies. In addition, OCIE will review ETFs for compliance with applicable exemptive relief and the unit creation and redemption process.

 

Broker-Dealer Areas

Sales Practices

Product Suitability and Concentration.  FINRA continues to observe instances where firms recommend unsuitable products to customers, including situations where the customers do not understand important product features. FINRA will review how firms conduct suitability reviews, including the supervision of that process. FINRA will also review the controls firms use to monitor for excess concentration in client accounts.

Trading Practices.  FINRA will evaluate firms’ ability to monitor for short-term trading of products designed for long-term investments, such as mutual funds, variable annuities and unit investment trusts.  Such trading may result in increased costs to clients.  Firms should consider whether their supervisory systems can detect activity intended to evade automated surveillance for excessive switching activity.

Outside Business Activities and Private Securities Transactions.  FINRA will continue to examine a firm’s procedures with respect to a registered person’s outside business activities and private securities transactions.

Electronic Communications.  FINRA reminds firms of their supervisory and record retention obligations with respect to social media and other electronic communications. A firm must capture and retain all business-related communications in such a way that the firm can review them for inappropriate conduct.

Operational and Financial Risk

FINRA has identified a number of operational and financial risk management issues. For example, it will evaluate whether a broker-dealer has an effective liquidity risk management plan, including sufficient sources of funding, rigorous stress testing and contingency plans. It will also review firm’s implementation of the new margin requirements under Rule 4210 for covered agency transactions.

Operationally, FINRA will review how a firm tests its internal supervisory controls. It has observed weaknesses in data quality, record retention and disclosure delivery. Firms with significant increases in the scope or scale of their business or compliance system conversions should review their processes. In addition, FINRA will review a broker-dealer’s compliance with Regulation SHO regarding short sales.

FINRA will also review a firm’s controls and supervision to protect customer assets, including segregation procedures. It has observed that some firms engage in transactions designed for no other purpose than to reduce their asset segregation requirements under the rules.

Market Integrity

Ensuring market integrity is critical and a number of initiatives have been identified in this area. OCIE and FINRA stress the duty of broker-dealers to seek best execution when handling or routing transactions. Firms should also ensure that payment for order flow disclosures are complete and accurate. FINRA also will review compliance with the market access rule, exams of alternative trading systems and continuation of the Fixed Income Securities Surveillance Program, Tick Size Pilot and the Audit Trail Reporting Early Remediation Initiative.

 

Conclusion

While OCIE and FINRA may not have introduced many new focus areas this year, their continued focus on the topics addressed should direct investment advisers and broker-dealers to ensure that their compliance programs remain effective. Further, this list is not exhaustive and the regulators will likely identify new risk areas throughout the year. Firms should continue to advance their compliance programs, finding better ways to improve their analytical capabilities and focus on identifying and mitigating risks.

 

NOTE: The SEC Exam Process will be one of the key content tracks of Ascendant’s upcoming conference on April 3-5. During the course of the conference, we’ll take you through a typical SEC exam journey, highlighting the lessons we’ve learned in the field alongside compliance teams just like yours. We’ll go through all essentials, from how to respond to the SEC’s information requests, to handling the in-person interactions, to the exit interview and responding to a findings letter. For more information, view our agenda by clicking here, and registration information by clicking here.

Written by: Matt J. Calabro