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 broker-dealers. Selected highlights of the examination priorities for investment advisers and investment companies were covered in the January 21, 2014 Financial Services Alert. Additionally, in a recent letter to its member firms (the “FINRA Priorities Letter”), FINRA set forth its regulatory and examination priorities for 2014, which in many cases overlap or are otherwise consistent with the NEP’s 2014 examination priorities. The FINRA Priorities Letter was discussed in the January 21, 2014 Financial Services Alert.
The NEP examination priorities include a number of topics that apply broadly across SEC registrant categories, including:
Corporate Governance, Conflicts of Interest and Enterprise Risk Management. The staff will continue 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.”
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).)
Retirement Vehicles and Rollovers. The staff noted that during changes in employment or when entering retirement investors are faced with decisions as to how to manage retirement plan assets held in their former employer’s retirement plan, including whether to roll assets over into an IRA or into a retirement plan offered by the new employer. The staff noted the potential conflicts of interest faced by investment advisers and broker-dealers that may have an incentive to recommend one option over another, and stated that, among other things, the staff will be examining broker-dealers and investment advisers for possible improper or misleading marketing and advertising, conflicts, suitability, churning, and the use of potentially misleading professional designations when recommending the movement of assets from a retirement plan to an IRA rollover account in connection with a customer’s or client’s change of employment.
Broker-Dealer Examination Priorities
The NEP examination priorities also include a number of topics that apply specifically to its Broker-Dealer Program. Among the priorities identified for the Broker-Dealer Program are:
Sales Practices Fraud – Retail Investors. The staff will conduct examinations designed to detect and to prevent fraud and other violations in connection with sales practices to retail investors, including (a) affinity fraud targeting seniors and other groups, (b) micro-cap fraud and pump and dump schemes, (c) unsuitable recommendations of higher yield and complex products (including the adequacy of due diligence with respect to such products), and (d) unregistered entities engaged in the sale or promotion of unregistered offerings or other unusual capital raising activities.
Supervision. The staff will focus on broker-dealers’ supervision of: (i) independent contractors and financial advisors in “remote” locations and large branch offices, (ii) registered representatives with significant disciplinary histories, and (iii) private securities transactions.
Trading. The staff will focus on market access controls related to, among other things, erroneous orders; the use of technology with a focus on algorithmic and high frequency trading; information leakage and cyber security; market manipulation involving practices such as marking the close, parking, fraudulent stimulation of demand (spoofing), and excessive markups and markdowns. Additionally, the staff will examine trading activity for abuses of the bona-fide market making exception to Regulation SHO, and will examine relationships between broker-dealers and Alternative Trading Systems (“ATSs”).
Internal Controls. The staff will assess the standing, authority, and effectiveness of key control functions, including (1) liquidity, credit, and market risk management practices, (2) internal audit, (3) valuation practices, and (4) compliance.
Financial Responsibility. The staff will review for compliance with the customer protection and the net capital rules with a focus on assets collateralizing large concentrated customer debit balances and the liquidity of firm inventory.
New and Emerging Issues and Initiatives. The staff also identified other new and emerging issues and initiatives which it will examine, including: (1) whether firms are appropriately applying the Market Access Rule to their proprietary trading, as well as the adequacy of books and records maintained by broker-dealers that provide market access through master/subaccount arrangements; (2) whether registered representatives are recommending that customers accept buyback terms offered by insurance companies related to the repurchase certain variable products that have guaranteed income and/or death benefits and, if so, whether such recommendations are suitable and what types of disclosure are made to the customer; and (3) issues related to the structure of, and quality of execution of transactions, in the fixed income markets.