SEC Releases 2013 Examination Priorities for Investment Advisors

On February 21, 2013, the U.S. Securities and Exchange Commission (“SEC”) released its examination priorities for the 2013 calendar year. The priorities were published by the SEC’s Office of Compliance Inspections and Examinations and are intended to convey to investors and registrants the areas that the SEC perceives to be of greater importance and heightened risk. The priorities cover issues related to specific regulated businesses, such as registered investment advisors and registered investment companies, as well as the broader market.

 

Market-wide Priorities

In its release, the SEC pinpointed four areas where its staff would focus their examinations of market participants in general over 2013. The following list of enforcement priorities have market-wide applicability:

Fraud Detection and Prevention. Through a risk-based approach, the SEC will continue to seek to identify market participants engaged in fraudulent or unethical behavior. In addition to quantitative and qualitative tools, the SEC targets fraudulent behavior by encouraging tips and complaints from investors, registrants, and other parties.

Corporate Governance and Enterprise Risk Management. The SEC will continue to meet with senior management and boards of registered entities to discuss enterprise risk and, in particular, how entities manage various types of risk, including financial, legal, compliance, operational, and reputational risks. The SEC aims to (i) understand each firm’s approach to enterprise risk management, (ii) evaluate the “tone at the top” of a regulated firm, and (iii) initiate a dialogue on key risks and regulatory requirements. Additionally, the SEC staff will continue to conduct “discovery reviews” of registrants in order to improve examination policy, rulemaking efforts, and joint monitoring efforts with other regulators.

Conflicts of Interest. The SEC notes that conflicts of interest at registered entities are of particular importance to the Agency, given the extensive affiliations between broker-dealers, SEC registered investment advisors, registered investment companies, and clearing and transfer agents. The SEC will focus on certain specified conflicts of interest, the steps that firms have taken to mitigate such conflicts, the sufficiency of disclosures made to investors regarding these conflicts, and each firm’s overall risk governance framework to manage conflicts on an ongoing basis.

Technology. In its release, the SEC acknowledges the increasing complexity, interconnectedness, and speed driven largely by the advent of new and sophisticated technologies employed by registered investment advisers and other market participants. In light of recent market events and developments, the SEC may examine technology systems for operational capability, market access and information security, including risks of system outages and data integrity compromises.

 

Registered Investment Advisor and Investment Company Priorities

The scope of SEC examinations for registered investment advisors and registered investment companies will vary from registrant to registrant depending on the business practices of the particular investment advisor or investment company. The SEC will continue to prioritize its past areas of focus as the Agency continues to identify emerging areas of risk. The SEC will continue to focus on the following enforcement priorities related specifically to registered investment advisors and registered investment companies:

Safety of Assets. The SEC will continue to employ a risk-based, asset verification process to confirm the safety of client assets and compliance with custody requirements. The Agency will continue to pay particular attention to issues raised by the new custody Rule 206(4)-2 under the Investment Advisors Act of 1940, with a view to analyzing whether registered investment advisors are adequately addressing their responsibilities as custodians of their client’s assets, complying with the “surprise exam” requirement, and satisfying the “qualified custodian” provision of the rule.

Conflicts of Interest Related to Compensation Arrangements. Undisclosed compensation arrangements will be a focus when the SEC reviews the books and records of a registered investment advisor or registered investment company. The SEC will look for undisclosed fee or solicitation arrangements, referral arrangements, and receipt of payment for services provided to third parties.

Marketing and Performance. The SEC will focus on the accuracy of advertised performance, including the use of hypothetical and back-tested performance, methods used to calculate performance, and disclosures and practices related to recordkeeping.

Conflicts of Interest Related to Allocation of Investment Opportunities. The SEC will closely examine registered investment advisors who offer managed account programs that differ in terms of their management fee and performance fee arrangements. SEC examinations of registered investment advisors will focus on ensuring that the advisor has safeguards in place to monitor such accounts, particularly where the accounts have the same portfolio or are managed according to the same investment strategy.

Fund Governance. The SEC will concentrate on whether a registered investment advisor to an investment fund is making full and accurate disclosures to the fund’s board and that the fund’s directors are reasonably reviewing information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses.

 

In 2013, the SEC will also begin to prioritize the following areas during its examinations of registered investment advisors and registered investment companies:

New Registrants. As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, approximately 2,000 new investment advisors have registered with the SEC with the vast majority of the new registrants being advisors to hedge funds and private equity funds. The SEC plans to demonstrate a meaningful presence to the newly registered advisors over the next two years. The SEC will prioritize examinations of private fund advisors by focusing on those advisors where there are indicia of fraud or increased risk to investors relative to the rest of the registrant population.

Dually Registered Investment Advisors and Broker-Dealers. The SEC will continue to expand its coordinated and joint examinations for firms dually registered as investment advisors and broker-dealers, in addition to those distinct broker-dealer and investment advisory firms that share common staff. The SEC will focus on the methods by which financial professionals and firms satisfy their suitability obligations when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed. A dually registered firm’s policies and procedures will also be reviewed to determine whether the policies and procedures provide different guidelines when a financial professional makes a securities recommendation to a customer with a broker-dealer account as opposed to an investment advisor account.

Alternative Investment Companies. The SEC is focusing on the growing use of alternative investment and hedge fund strategies in open-ended mutual funds, exchange-traded funds, and variable annuity structures. The SEC release states that the SEC will specifically assess whether leverage, liquidity, and valuation policies comply with current regulations and whether a fund’s board of directors is adequately empowered to handle the advent of alternative investment and hedge fund strategies.

Payments for Distribution in Guise. The SEC has identified as an emerging risk the wide variety of payments made by registered investment advisors and funds to distributors and other intermediaries. The release states that these payments are most commonly for revenue sharing, shareholder servicing, and sub-transfer agent services. These payments will likely be subject to higher scrutiny to ensure that they are in compliance with applicable regulations.

 

The SEC also identified additional policy topics that it intends to prioritize in 2013. These policy topics include:

Money Market Funds. Recent Amendments to Rule 2a-7 of the Investment Company Act of 1940 require money market funds to periodically stress test their ability to maintain a stable share price under the certain hypothetical scenarios. The SEC will evaluate whether firms that manage money market funds are conducting stress testing and what factors these firms are considering in their stress tests.

Compliance with Exemptive Orders. The SEC will focus on compliance with previously granted exemptive orders to determine the effectiveness of such orders.

Compliance with the Pay to Play Rule. Recently, the SEC adopted the “Pay to Play” rule to ensure that registered investment advisors did not obtain business from the government in return for political contributions. The SEC will make compliance with the “Pay to Play” rule a priority in 2013 as the SEC reviews compliance with the rule and assesses its practical application.

The SEC’s complete examination priorities for 2013 are available on the SEC’s website at: http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2013.pdf

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