The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) announced the 2014 examination priorities (the “Announcement”) for its National Examination Program (the “NEP”). The priorities are organized according to the NEP’s four distinct program areas: (a) investment advisers and investment companies, (b) broker‑dealers, (c) exchanges and self-regulatory organizations, and (d) clearing and transfer agents. This article presents selected highlights of the examination priorities for investment advisers and investment companies.
Corporate Governance, Conflicts of Interest and Enterprise Risk Management. The NEP examination priorities include a number of topics that apply broadly across SEC registrant categories. Among these is an ongoing effort to meet with senior management and boards of entities registered with the SEC and their affiliates to discuss “how each firm identifies and mitigates conflicts of interest and legal, compliance, financial, and operational risks.” As described in the Announcement, “[t]his initiative is designed to: (i) evaluate firms’ control environment and ‘tone at the top,’ (ii) understand firms’ approach to conflict and risk management, and (iii) initiate a dialogue on key risks and regulatory requirements.”
Presence Exams. The SEC staff will continue its initiative to examine a significant percentage of the advisers newly registered as a result of the Dodd-Frank Act, with a focus on the following key areas: (1) marketing, (2) portfolio management, (3) conflicts of interest, (4) safety of client assets and (5) valuation. Indicia of broker-dealer status concerns, cited in 2013 speech by David W. Blass, Chief Counsel of the Division of Trading and Markets, is among the factors cited in the Announcement for prioritizing examinations of private fund advisers. The Announcement notes that as of September 30, 2013, over 200 presence exams had been completed and the Presence Exam initiative was on pace to meet its goal of “touching” 25% of newly registered advisers within two years.
Never-Before Examined Advisers. In a new initiative, the SEC staff will conduct “focused, risk-based examinations” of advisers that have been registered for more than three years but have not yet been examined by the NEP and are not part of the Presence Exam initiative.
General Solicitation Practices. Designated as one of the most significant of the NEP-wide initiatives is the review of general solicitation practices and the verification of accredited investor status in conjunction with reliance on newly adopted Rule 506(c) under the Securities Act of 1933. The staff “generally will review, monitor, and analyze the use of Rule 506(c); and will evaluate due diligence conducted by broker-dealers and investment advisers for such offerings.” (See this article in the July 23, 2013 Financial Services Alert for a discussion of Rule 506(c) and this article in that issue for a discussion concerning a coordinated initiative on the part of various branches of the SEC, including the Division of Enforcement, to analyze the market impact of, and market practices that develop as result of, permitting general solicitation in connection with private offerings under Rule 506(c).)
Marketing/Performance. The staff will review advisers’ claims about their investment objectives and performance. “For example, the staff will review and test hypothetical and back-tested performance, the use and disclosure of composite performance figures, performance record keeping, and compliance oversight of marketing.”
Adviser Conflicts of Interest. The Announcement cites the following specific types of potential conflicts of interest as focus areas in adviser examinations: (a) compensation arrangements, “with a particular focus on undisclosed compensation arrangements and their effect on recommendations made to clients,” (b) allocation of investment opportunities, (c) side-by-side management of accounts with performance-based fees and accounts with purely asset-based fees, and (d) risk controls and disclosure, particularly for illiquid investments and leveraged investment products and strategies.
Quantitative Trading Models. NEP staff will examine investment advisers that rely substantially on quantitative portfolio management and trading strategies and assess, among other things, whether these firms have adopted and implemented compliance policies and procedures tailored to the performance and maintenance of their proprietary models, including procedures that (i) evaluate if models are used to manipulate the markets, (ii) reasonably review models and their output over time, (iii) maintain required books and records, and (iv) maintain a current inventory of all firm-wide proprietary models.
Registered Funds. NEP staff will target some examinations at money market funds, with a particular focus on (1) the management of any potential stress events and (2) money market funds that exhibit “outlier behavior in some respect.” The staff will continue its review of payments made by advisers and funds to distributors and intermediaries, disclosures made to fund boards about these payments, and related board oversight. In addition, the staff will monitor the risks associated with changing interest rates and how they may affect fixed income funds and related risk disclosures, a topic also addressed in a January 2014 IM Guidance Update discussed elsewhere in this issue.