OCIE to Prioritize Protection of Retail Investors in 2019 Examinations

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The SEC Office of Compliance Inspections and Examinations ("OCIE") will prioritize risks to retail investors in this year’s examinations. That concern is a distinguishing highlight of a new report summarizing OCIE assessments of regulatory issues, market risks and policy developments. OCIE’s conclusions are based on information derived from 2018 examinations, regulator concerns and public comments aired at OCIE outreach programs, as well as tips, complaints and referrals shared with the agency during past year.

Additional featured priorities include continuing risks and concerns related to fee disclosures, share class, and wrap fee programs, anti-money laundering, cybersecurity, digital assets, FINRA and MSRB operations, and issues of compliance by registrants involved in critical market infrastructure. In this article, we review the new report, contrast this year’s priorities with those of the past few years (See Bates Group’s year-to-year SEC OCIE priorities chart, below) and consider some implications so that firms might better prepare and, if necessary, adjust their compliance systems accordingly.  

Why the Report Matters: A Leadership Message

Primarily, the OCIE report serves as an information alert to market participants. Citations to a list of the OCIE’s oversight responsibilities (i.e. more than 13,200 investment advisers, 10,000 mutual funds and exchange traded funds, 3800 broker dealers, 330 transfer agents, 7 active clearing agencies, 21 national securities exchanges, 600 municipal advisors, FINRA, MSRB, the Securities Investor Protection Corporation, and the Public Company Accounting Oversight Board) serves as a not-so subtle reminder of the broad scope and reach of OCIE operations.

Similarly, OCIE leadership reminds us of how aggressive the organization can be. Reciting a list of year-over-year 2018 accomplishments, the report states that the OCIE completed over 3,150 examinations, (a 10 percent increase,) expanded coverage of investment advisers (a 17 percent increase,) increased examinations of investment companies (a 45 percent percent increase,) and conducted over 300 examinations of broker-dealers. The message is clear: firms must take these priorities seriously.

Changes in the Market: An Affirmation of the Risk-Based Approach

OCIE recognizes that the markets it oversees are changing rapidly. A number of metrics are used to make this point. As to investment advisers, OCIE notes a 5 percent increase in the number of registered investment advisers and approximately $84 trillion in assets under management by these advisers. More than 3,700 advisers have over $1 billion dollars in assets under management. The report states that over a third of the investment advisers manage a private fund; more than half have custody of client assets; almost two thirds are affiliated with other financial industry firms; and almost 12 percent provide advisory services to a mutual fund, exchange traded fund, or other registered investment company. As to the broker-dealer community, despite an overall decline, the OCIE reports that almost 100 new firms registered in 2018, about 10 percent were dually-registered as investment advisers, and broker-dealers operated more than 156,000 branch offices.

The OCIE states that it is responding to these market changes by (i) continuing to use a risk-based approach for examining registrants, and (ii) “increasingly leveraging technology and data analytics as well as human capital to fulfill its mission.” Generally, the risk-based approach includes a review of a registrant’s operations and the products it offers. The results are “examinations that address aspects of the SEC’s regulatory oversight, such as the disclosure of services, fees, expenses, conflicts of interest for investment advisers, and trading and execution quality issues for broker-dealers.” OCIE stated that its risk-based examinations are based on “four pillars: promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy.” On its increased reliance on technology, OCIE said it is “continually adding to and refining the expertise, tools, and applications that help identify areas of risk, firms that may present heightened risk of non-compliance, and activities that may harm investors.”

OCIE 2019 Priorities

SEC Examination Priorities Year-To-Year Comparison Chart

Legend

Bates Group has been tracking the OCIE examination priorities for the past five years (see year-to-year comparison above). The most distinguishing difference in OCIE’s announced priorities for 2019 is the elevation of concern for risk in the products and services sold to Main Street investors. As is apparent in the chart, refocusing on the retail investor allows for firms to reconsider how each of its compliance programs may affect that target audience. Here are a few of the particulars:

Retail Investors

The OCIE focus on the retail investor is consistent with the strategic direction the SEC has taken during the past year. (See here for additional Bates coverage on the SEC Final Strategic Plan.) The 2019 report states that the OCIE will focus examinations on the following categories, among others:  

• Disclosures related to the calculation of fees, expenses and other charges investors pay for products and services. The OCIE said it would select firms with practices or business models that may create increased risks of inadequately disclosed fees, expenses, or other charges. The OCIE stated further that it “will continue to evaluate financial incentives for financial professionals that may influence their selection of particular share classes,” and will pay particular attention to investment advisers that participate in wrap fee programs.
• Conflicts of interest - The OCIE was particularly concerned with (i) the use of affiliated service providers and products, (ii) securities-backed non-purpose loans and lines of credit, and (iii) borrowing funds from clients.
• Custody risks - The OCIE will examine firms for compliance with the Customer Protection Rule which ensures that assets are safeguarded and accurately reported, and prevents them from being used by broker-dealers as working capital.
• Senior investors and those saving for retirement, particularly the ability to identify financial exploitation. (See here for Bates’ review of risks associated with senior investors and to download our complimentary Elder White Paper.)
• Portfolio management and trading - the OCIE indicated that it will assess “whether investment or trading strategies of advisers are: (1) suitable for and in the best interests of investors based on their investment objectives and risk tolerance; (2) contrary to, or have drifted from, disclosures to investors; (3) venturing into new, risky investments or products without adequate risk disclosure; and (4) appropriately monitored for attendant risks.”
• Risks associated with mutual funds and exchange-traded funds - OCIE stated it will focus on risks associated (1) funds that track custom-built or bespoke indexes; (2) ETFs with little secondary market trading volume; (3) funds with higher allocations to certain securitized assets; (4) funds that underperform relative to their peer groups; (5) funds managed by relatively new advisers in the Registered Investment Companies (“RIC”) space; and (6) advisers that provide advice to both RICs and private funds with similar investment strategies. (See here for Bates’ considerations on a recent OCIE alert on mutual funds and ETFs.)
• Risks re: Microcap Securities - The OCIE will examine broker-dealers that sell stocks of companies with a market capitalization of under $250 million. The chief concern is with the risk of manipulative schemes, short sales and fraud concerning the publication of OTC equity security quotes

Other Highlights

The OCIE also reemphasized several examination priorities that had been highlighted in the past (see year-to-year comparison above). These include:

• Anti-Money Laundering (AML) - OCIE will examine broker dealers to determine whether their AML programs are in compliance with their regulatory obligations, “including whether they are meeting their SAR filing obligations, implementing all elements of their AML program, and robustly and timely conducting independent tests of their AML program. (Note: Keep an eye out for a new Bates Research publication on the top AML cases brought by regulators in 2018.)
• Cybersecurity - The OCIE will prioritize examination of compliance with cybersecurity rules in all of its examination programs. In particular, the OCIE will look to ensure the proper configuration of network storage devices, information security, governance, and policies and procedures related to retail trading information security.
• Digital Assets - The OCIE will “focus on portfolio management of digital assets, trading, safety of client funds and assets, pricing of client portfolios, compliance, and internal controls.”
• FINRA and MSRB - The OCIE will continue to monitor the regulatory oversight programs conducted by FINRA and the MSRB, including their operations, internal policies, procedure and controls. OCIE also stated it will review the quality of FINRA’s examinations of broker-dealers.
• Compliance and risk by certain registrants - For entities that provide services considered critical to the functioning of the capital markets, OCIE examiners will review transfer operations, including clearing agencies, exchanges and agents, recordkeeping and the protection of funds and securities. In addition, OCIE will examine internal audit and surveillance programs.

Conclusions

The OCIE warns that the highlighted priorities “are not exclusive” and that the scope of any given examination is the result of a firm specific risk based analysis. That said, the overall message of the report could not be clearer. For market participants under the scope of authority of the OCIE mandate: get every aspect of your compliance programs that cover retail investors in order. 

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