The National Examination Program (“NEP”), headed by the U.S. Securities and Exchange Commission (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”), published its examination priorities for the first quarter of 2013. These focus areas, summarized below, set forth the risks, issues, and policy matters that have been identified as warranting particular attention in SEC examinations. The NEP identified issues that arise market-wide as well as those that arise specifically in the context of investment advisers and broker-dealers. The exam priorities are aimed at supporting the SEC’s mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formations.
The NEP has determined that the following market-wide exam priorities will be scrutinized:
Fraud Detection and Prevention. The NEP seeks to identify registrants engaged in fraudulent or unethical behavior. Fund managers should be prepared to have their compliance programs examined with respect to policies and procedures that address fraud detection and prevention.
Corporate Governance and Enterprise Risk Management. The NEP will meet with management and boards of entities registered with the SEC to discuss and examine how firms manage financial, legal, compliance, operational, and reputational risks. The objective of these discussions will be to understand the firm’s approach to enterprise risk management, evaluate the firm’s “tone” at the highest levels of management, and initiate a dialogue on key risks and regulatory requirements. In the wake of Hurricane Sandy, the NEP will pay particular attention to firms’ business continuity plans.
Conflicts of Interest. The NEP will examine the steps registrants have taken to mitigate conflicts, the sufficiency of disclosures made to investors, and the overall risk governance framework in place.
Governance and Supervision of Information Technology Systems. In light of the technological advances that are revolutionizing the securities regulatory industry, the NEP plans on examining firms’ operational capability, market access, and information security. This includes risks of system outages and data integrity compromises.
The NEP has also released exam priorities specifically applicable to investment advisers and broker-dealers. Targeted for examinations will be new registrants under Section 402 of the Dodd-Frank Act, dually registered investment advisers and broker-dealers, and firms that have been identified as recidivist or high-risk for potential misconduct.
Investment adviser exam priorities include:
Safety of Client Assets. The NEP plans to utilize a risk-based asset verification process to assess the safety of client assets and compliance with Advisers Act Rule 206(4)-2 (the “Custody Rule”). Advisers should expect a review of measures to protect client assets from loss or theft, the adequacy of audits of private funds, and the effectiveness of policies and procedures.
The NEP issued a risk alert on March 4, 2013 regarding significant deficiencies involving the Custody Rule, which is designed to protect advisory clients from the misuse or misappropriation of their funds and securities. Advisers should make sure that they appropriately recognize situations in which they have custody, comply with the rule’s “surprise exam” requirement, satisfy the rule’s “qualified custodian” provision, and follow the terms of the exception to the independent verification requirements for pooled investment vehicles. The NEP has had to order remedial measures spanning from amending written compliance policies to referrals to the SEC’s Division of Enforcement.
Conflicts of Interest Related to Compensation Arrangements. The NEP will examine financial records to identify undisclosed compensation agreements, such as solicitation arrangements, referral arrangements, and receipt of payment for services provided to third parties. Advisers should review such arrangements for conflicts of interest and be sure that they have been fully and clearly disclosed to clients.
Marketing and Performance. The NEP plans on scrutinizing marketing and performance advertising in search of fraudulent valuation practices, misleading advertising, inadequate disclosure, and noncompliance with recordkeeping requirements. The NEP also intends to evaluate changes to firms’ advertising practices under the JOBS Act. [hyperlink]
Conflicts of Interest Related to Allocation of Investment Opportunities. As a part of its review of portfolio management practices, the NEP will assess whether an adviser has adequate internal controls to monitor the side-by-side management of performance-based and non-performance-based fee accounts and detect and resolve conflicts. This is particularly important if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts.
Fund Governance. The NEP is interested in confirming that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews relating to contract approvals, service provider oversight, valuation of fund assets, and assessment of expenses or viability.
Broker-dealer exam priorities include:
Sales Practices Fraud. The NEP is particularly concerned about frequent findings of fraud in connection with sales practices regarding retail investors. Broker-dealers should expect to be examined for senior-targeted fraud; unsuitable recommendations of higher yield products; improper supervision and due diligence processes regarding those recommendations; activities and products on the periphery of certain registered entities; and the mitigation and clear and timely disclosure of conflicts of interest.
Trading. The NEP will conduct thorough examinations of certain trading risk areas, particularly high frequency trading, algorithmic trading, proper controls around the use of technology, alternative trading systems, and order routing practices.
Anti-Money Laundering Programs. The NEP will assess the adequacy of the firm’s AML program, with particular focus on customer identification programs, suspicious activity identification and reporting deficiencies, and weak due diligence procedures.
It is important to remember while the NEP expects to focus on these priorities, it will conduct additional examinations on issues that are not addressed here.