Annually, the Securities and Exchange Commission (SEC) determines and communicates to investors and SEC registrants the examination priorities that best will protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. This year’s priorities include several new
and emerging issues, as well as some ongoing risks, which I discuss below.
Preliminarily, the SEC’s examination priorities are published and effectuated through the
National Examination Program (“NEP”). NEP covers four distinct program areas: investment advisers and investment companies; broker-dealers; clearing and transfer agents; and market
oversight. NEP-wide initiatives, which apply to all registrants, include fraud detection and prevention and conflicts of interest. Regarding fraud detection and prevention, NEP has adopted a risk-based approach to targeting registrants, and utilizes both quantitative and qualitative tools to identify fraudulent and unethical behavior. The SEC, and NEP in particular, also encourages tips, complaints and referrals. Likewise, with respect to conflicts of interest, NEP reviews all registrants to ensure that if not eliminated, conflicts are properly mitigated and managed. NEP also reviews the sufficiency of disclosures regarding conflicts of interest made to investors.
Moving on to the examination program for investment advisers and investment companies (like mutual funds), NEP has identified five areas of ongoing risks. They are: safety of assets; conflicts of interest related to compensation arrangements; marketing and performance advertising; conflicts of interest related to allocation of investment opportunities; and fund governance. In terms of new and emerging issues for investment advisers and investment companies, NEP identifies several worth noting. One is the focus upon the growing use of alternative and hedge fund strategies in open-end (mutual) funds, exchange-traded funds (ETFs) and variable annuity structures. In particular, the SEC staff “will assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.”
Another major, new and emerging initiative relates to dually registered investment advisers and brokerage firms. There has been a “continued convergence”, and the SEC is concerned about “multiple conflicts” that this business model presents. The publication states, “Among other things, the staff will review how 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.”
Moving on to the examination program for brokerage firms, the sheer size of the broker-dealer program is noted: 4,600 registered broker-dealers, approximately 111 million customer accounts, over 160,000 branch offices, and over 630,000 registered representatives! Examinations thus are focused upon issues and practices that present the highest risk to investors and to the integrity of the market.
Beyond that, though, NEP identifies several ongoing risks that will be a focus for 2013 brokerage firm examinations. They are: sales practices and fraud; trading risks; capital and other financial risks; and anti-money laundering (“AML”). Regarding sales practices and fraud, the publication notes that an examination “frequently finds fraud” in connection with some of the following: affinity fraud or fraud targeting seniors; unsuitable recommendations of higher yield products such as municipal or corporate
bonds; outside business activities; failure to mitigate or disclose conflicts of interest; and a focus on firms identified as recidivists or high risk for potential misconduct.
There are two new and emerging issues related to broker-dealer examination priorities. One concerns ETFs. The examination program will continue to examine the suitability of leveraged and inverse ETFs.
Noteworthy is one new and emerging risk relating to transfer agents. Specifically, microcap securities and private offerings are a focus of the 2013 examination program -- both for transfer agent examinations and for broker-dealer examination programs. The reason for their inclusion in transfer
agent exams is that, “Transfer agents that service microcap securities, especially those involved in private offerings, may be used to facilitate the unregistered offering of restricted securities by allowing securities transfers that could circumvent existing rules or enable fraudulent schemes.” To counter that, SEC staff will review for effectively implemented formal written policies and procedures, and be on guard for conflicts of interest.
As one can see, there are many important examination priorities set for 2013. While not exhaustive, and while subject to change, investors should be pleased at the breadth and scope of the SEC’s /
NEP’s examination program for 2013.