(Lexology) On January 7, 2020, the Securities and Exchange Commission (“SEC”) released its 2020 examination priorities, an annual report by the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) meant to apprise the public of the SEC’s activities and enforcement agenda based on potentially high-risk areas for investors and U.S. markets.
The issues in this year’s report reflect the agency’s concern that regulations and enforcement keep pace with the ever evolving market dynamics and financial technologies that characterize today’s securities markets. This also is the first OCIE annual report in the last five years articulating large-scale internal staffing concerns, and thus can be seen both as a rare cry for help, and evidence of a disconnect between the SEC and the Federal Government.
Updates on Key Priorities
Retail Investors
OCIE opened its 2020 priorities with an urgent call to shift additional staff and resources within the SEC to supervision of Registered Investment Advisors (“RIA”). Over the last five years, the number of RIAs has increased from about 11,500 to 13,475, with these firms’ assets under management increasing from about $62 trillion to $84 trillion. According to the report, while the total number of OCIE examinations stayed relatively consistent between 2018 and 2019, over 70% of 2019 examinations focused on RIAs. OCIE remarked that, given the industry growth and increased complexity involved in supervising RIAs, there was a “significant risk” its own examiners may not adequately be able to cover the RIA space without corresponding staffing increases.
Guided by its observation that registered entities are becoming more global, diverse, and dependent on third party services and operations, OCIE laid out its plan for strategic coverage of RIAs, focusing on these entities’ risk management for crucial third-party vendors, geopolitical events, information security, and the industry transition away from LIBOR. Because OCIE often has faced challenges examining the nearly 1,000 offshore RIAs, due to strict data protection and privacy laws, OCIE also is tightening its requirements for non-U.S. RIA applicants to require certification that the applicant will comply with inspection requirements of U.S. securities laws.
As in prior years, OCIE emphasized scrutiny of advice given to retail investors regarding high-risk products and retail-targeted investments, including mutual funds, ETFs, municipal securities and other fixed income securities, and microcap securities. This year, however, OCIE added teachers and military personnel, along with senior investors, to the category of retail investors most vulnerable to high-risk products. “High-risk products” include private placements and complex securities with high fees and expenses, or whose issuers are affiliated with the registered firm making the recommendation. OCIE specifically will examine RIAs’ execution of their fiduciary duty to provide advice regarding these products in their clients’ best interests and to adequately disclose risks and potentially problematic compensation arrangements when recommending these products.
OCIE also reminded broker-dealers of the upcoming compliance date for “Regulation Best Interest: The Broker-Dealer Standard of Conduct,” which is June 30, 2020. Adopted in June 2019, “Regulation Best Interest” requires broker-dealers, and associated persons of brokers or dealers, to act in the best interest of retail customers when making a recommendation of any securities transaction or investment strategy. OCIE warned that before the official compliance date, it will examine broker-dealers’ progress in implementing these new rules. Afterwards, OCIE will assess firms’ newly-implemented policies and procedures regarding conflicts disclosures, and the content and delivery of Form CRS, a document that must be provided to retail investors explaining their relationships with their financial professionals.
Information Security
OCIE continues to examine firms’ protection of clients’ personal financial information in a variety of mediums. This year, these mediums will include: data loss prevention through cloud-based storage, controls surrounding online and mobile access to customer brokerage accounts, and proper disposal of retired hardware containing sensitive information.
Financial Technology—Digital Assets and Electronic Investment Advice
OCIE will continue to monitor firms’ use of financial technologies to enhance services to investors and other service providers. With respect to digital assets, examinations will focus on the suitability of these investments, especially for retail investors who may not understand the risks of these products versus traditional investment vehicles.
OCIE also will examine the use of “robo-advisers,” or investment tools and platforms used by RIAs to provide investor services automatically. As with any traditional advisor, robo-advisers will be scrutinized for SEC registration eligibility, cybersecurity policies and procedures, marketing practices, adequacy of disclosures, and effectiveness of compliance programs.
Focus Areas Involving Broker-Dealers and Municipal Advisors
OCIE expressed particular interest in broker-dealers’ controls surrounding automated trading algorithms. Automated trading algorithms are computer programs that place trades using defined sets of instructions regarding timing, price, quantity, or any mathematical model, at a much faster speed than a human trader. As these programs are subject to SEC and FINRA rules regarding trading activity, OCIE will investigate broker-dealers’ development, testing, implementation, maintenance, and modification of the technology that implements them.
OCIE also will continue monitoring municipal advisors with a special eye towards fiduciary duty, fair dealing with market participant requirements, and disclosure of conflicts of interest. Professionals in the municipal securities space also should expect focus on compliance with the recently-effective MSRB Rule G-40, which prohibits municipal advisors from publishing false or misleading advertisements regarding their services.
AML Programs
Anti-money laundering (“AML”) is a longstanding priority for the SEC. Under the Bank Secrecy Act, financial institutions must establish AML programs with policies and procedures reasonably designed to verify the identities of individual customers and beneficial owners of legal entity customers, conduct due diligence on customers, and file Suspicious Activity Reports (“SARs”) with the Financial Crimes Enforcement Network to help fight terrorist financing, public corruption, and market manipulation.
In 2020, OCIE will examine broker-dealers and investment companies for compliance with these obligations, as well as whether they conduct meaningful independent tests of their AML programs.
Market Infrastructure
OCIE also highlighted four types of SEC registrants integral to market functionality that can expect examination in 2020 geared towards ensuring system integrity and functionality as well as risk management and controls that account for technological innovation. These include clearing agencies, national securities exchanges, Regulation SCI entities, and transfer agents.
Conclusion
The 2020 priorities are tailored to the SEC’s greatest concerns at this moment given current industry, market, technological, and global trends. For example, the SEC clearly is worried that without proper oversight, the growing RIA population will recommend investments in, or use of, new technologies that may be riskier than the average investor’s profile can tolerate, such as Blockchain and robo-advisers. Similarly, the SEC is acutely aware of the fact that transactions beyond U.S. borders now come within its jurisdiction more frequently, and is taking steps to expand the scope of its supervision. Notwithstanding these serious concerns, the SEC also is raising the alarm that it may not be able to meet its own supervision requirements.
Securities professionals – both domestic and international –not only should be mindful of these targeted priorities, but also the risks that may arise from inadequate regulatory oversight. 2020 stands to be an eventful year.
Sheppard Mullin Richter & Hampton LLP - Sarah E. Aberg and Kate Ross
