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SEC Publishes 2015 Examination Priorities

On January 13, 2015, the Securities Exchange Commission (“SEC”) published the 2015 examination priorities for the Office of Compliance Inspections and Examinations (“OCIE”).  The OCIE protects investors through administering the SEC’s nationwide examination and inspection program for registered entities, such as broker-dealers, transfer agents, and investment advisers, among other organizations.[1]  Generally, OCIE staff promotes compliance with the federal securities laws through outreach, publications, and examinations designed to improve compliance, prevent fraud, monitor risk, and inform future SEC policy.

The OCIE publicizes its examination priorities to foster self-governance and increased compliance by its member firms.  The SEC establishes its annual examination priorities after consulting with the five Commissioners, senior staff from the SEC’s eleven regional offices, the SEC’s policy-making and enforcement divisions, the SEC’s Investor Advocate, and other regulatory agencies.

This year, the OCIE’s examination priorities will focus on three “thematic areas:”

  1. Examining areas of importance to retail investors, including sales practices, information, advice and products offered to investors saving for retirement.
  2. Assessing issues relating to market risks; and
  3. Using the SEC’s resources to analyze data to uncover illegal activity, such as excessive trading and penny stock, pump-and-dump schemes.

Aside from these three thematic areas, the OCIE announced it will continue to examine the following: newly registered municipal advisors; investment companies that the SEC has not yet examined; proxy advisory service firms and how those firms make recommendations for proxy voting, as well as disclose potential conflicts of interest; fee and expense structures in private equity firms; and transfer agents, especially those involved with microcap securities and private offerings.

I. The SEC’s Examination Priorities With Respect to Retail Investors

Citing the shift from employers offering their employees defined benefit pensions to defined contribution plans, the SEC expressed concern regarding the risks facing retail investors planning for retirement.  More so than ever before, retail investors have the opportunity to invest in alternative investments, such as private funds, illiquid investments, and structured products intended to generate higher yields in a low-interest rate financial climate.  The OCIE established six examination initiatives to assess the risks these products pose to retail investors.

  1. Fee Selection and Reverse Churning: The OCIE found that financial professionals serving retail investors are increasingly choosing to operate as an investment adviser or under a dual registration, rather than solely as a broker-dealer.  This affords industry professionals the opportunity to choose from many different types of fee structures.  The OCIE will focus on whether the fee structure offered is in the best interest of the client from the inception of the agreement and all times thereafter.
  2. Sales Practices: The OCIE will monitor registered representative’s sales practices, looking for improper recommendations in transferring retirement assets from employer-sponsored defined contribution plans, to other investments and accounts, which potentially carry greater risks or fees.
  3. Suitability: The OCIE will evaluate recommendations to invest retirement assets into complex structured products, examining what due diligence is conducted, what disclosures are made, and whether such recommendations are consistent with existing suitability rules.
  4. Branch Offices: The OCIE will focus on the analytical measures used by registered entities to determine whether branch offices or registered representatives are deviating from a firm’s home office compliance practices.
  5. Alternative Investment Companies: The OCIE will continue to assess funds that offer alternative investments and use alternative investment strategies. In its assessment, the OCIE will consider: i) leverage, liquidity and valuation practices; ii) internal controls, including corporate governance, compliance departments, and back-office operations; and iii) the marketing practices of alternative investment companies.
  6. Fixed Income Investment Companies: The OCIE will examine the compliance policies, disclosures and trading controls of mutual funds that have significant exposure to increased interest rates.

 II. The SEC’s Examination Priorities With Respect to Market Risk

To promote fair, orderly and efficient markets, the OCIE announced that its 2015 examinations will focus on four initiatives designed to address systemic risks:

  1. Large Firms: The OCIE will collaborate with the Division of Trading and Markets and the Division of Investment Management to monitor U.S. broker-dealers to assess risk and maintain early awareness of any events that could affect the industry.
  2. Clearing: The OCIE will continue to conduct annual examinations of all systemically important clearing agencies,[2] taking a risk-based approach in collaboration with the Division of Trading and Markets.
  3. Cyber-security: The OCIE will continue last year’s initiative to examine cyber-security compliance and controls, but will also include examining transfer agents.
  4. Potential Routing Conflicts: The OCIE will examine whether firms are prioritizing trading venues based on payments for order flow that potentially conflict with the firm’s best execution duty to its customers.

 III. The SEC’s Use of Resources to Uncover Illegal Activity

The OCIE’s use of data analytics has uncovered past violative conduct.  This year, OCIE will continue to utilize its analytical capabilities to detect potentially illegal and fraudulent activity through four initiatives:

  1. Recidivist Representatives: The OCIE will continue to investigate representatives that have past histories of misconduct, as well as the firms that employ those representatives.
  2. Microcap Fraud: The OCIE will continue to examine broker-dealer firms and transfer agents for activity that suggests they may be involved with pump-and-dump schemes or other market manipulation schemes.
  3. Churning or Excessive Trading: The OCIE will examine data obtained from clearing brokers to identify potential churning or excessive trading.
  4. Anti-Money Laundering (“AML”): The OCIE will continue to examine AML programs with a concentration on firms that have not filed suspicious activity reports or filed such reports late. Additionally, the OCIE will examine those broker-dealers that provide customers direct access to markets from higher risk jurisdictions.

While the 2015 examination priorities went into great detail regarding specific areas of investigation, the OCIE did not intend the details to comprise an exhaustive list.  The OCIE specified that information learned from other sources, such as tips, complaints, and law enforcement or regulatory referrals may alter the focus of their examinations.

Lax & Neville LLP has extensive experience in the financial services industry. Please contact our team of experienced attorneys for a consultation at (212) 696-1999.

[1] While the OCIE examines exchanges and self-regulatory organizations as well, the SEC’s 2015 Examination Priorities did not address examination priorities for those organizations.

[2] As defined under the Dodd-Frank Wall Street Reform and Consumer Protection Act.