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SEC Sets Examination Priorities for 2013

The SEC's Office of Compliance Inspections and Examinations (OCIE) released its 2013 examination priorities for the National Examination Program (NEP). The NEP-wide examination priorities (that apply to nearly all SEC-regulated entities) are:

  • identifying market participants engaged in fraudulent or unethical behavior;
  • corporate governance and enterprise risk management, including how firms govern and manage financial, legal, compliance, operational and reputational risks;
  • monitoring how registrants mitigate conflicts of interest and disclose such conflicts to investors;
  • examining technology controls.

The NEP also identified several ongoing risks, emerging issues and policy topics specific to the Investment Adviser-Investment Company (IA-IC) Exam Program and Broker-Dealer (BD) Exam Program that will be focus areas in 2013.

Ongoing Risks for the IA-IC Program
Safety of Assets. Exams will focus on the measures taken by advisers to protect client assets from loss or theft, the adequacy of audits of private funds and the effectiveness of policies and procedures in this area. The SEC noted that recent exams have found a high frequency of issues relating to compliance with Advisers Act Rule 206(4)-2, the custody rule. See "SEC Issues Risk Alert and Investor Bulletin on Investment Adviser Custody Rule" in this update.

Conflicts of Interest Related to Compensation Arrangements. Examiners will review financial and other records to identify undisclosed compensation arrangements and the conflicts of interest they present. Examples of these activities include undisclosed fee or solicitation arrangements, referral arrangements (particularly with affiliated entities) and receipt of payment for services "allegedly provided to third parties."

Marketing/Performance. SEC staff will focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized and related disclosures and compliance with record-keeping requirements. The SEC noted that aberrational performance can be an indicator of fraudulent or weak valuation procedures or practices.

Conflicts of Interest Related to Allocation of Investment Opportunities. Where there is side-by-side management of accounts that pay performance-based fees (e.g., hedge funds) and accounts that do not pay performance fees (e.g., mutual funds), examiners will confirm that the adviser has controls in place to monitor investment decisions and conflicts of interest that may arise.

Fund Governance. Staff will confirm that advisers are making full and accurate disclosures to fund boards and that boards are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets and assessment of expenses or viability.

New and Emerging Issues for the IA-IC Program
Payments for Distribution in Guise. Examiners will focus on payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments and boards' oversight of the payments. According to OCIE, "these payments go by many names and are purportedly made for a variety of services, most commonly revenue-sharing, sub-TA, shareholder servicing and conference support." Examiners will assess whether such payments are made in compliance with regulations, including Rule 12b-1, or "whether they are instead payments for distributions and preferential treatment." A sweep to examine these types of payments kicked off in early March. The SEC has indicated it wants to gain a better understanding of what services are provided for the fees paid by advisers and funds.

Newly-Registered Advisers. The SEC intends to launch an examination initiative to establish a meaningful presence with the approximately 2,000 investment advisers that have registered with the SEC since early 2012. The vast majority of these new registrants are advisers to hedge funds and private equity funds. The nitiative will have four phases:

  • engage with new registrants;
  • examine a substantial percentage of the new registrants;
  • analyze the examination findings; and
  • report observations to the industry.

Dually Registered IA/BD. The IA-IC program will continue to expand coordinated and joint examinations with the BD program of dually registered firms and distinct broker-dealer and investment advisory firms that share common financial professionals. Examiners 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.

"Alternative" Investment Companies. In light of the growing use of alternative and hedge fund investment strategies in mutual funds, examiners will assess whether:

  • leverage, liquidity and valuation policies and practices comply with regulations;
  • boards, compliance personnel and back-offices are staffed, funded and empowered to handle the new strategies; and
  • the funds are being marketed to investors in compliance with regulations.

Policy Topics for the IA-IC Program
The IA-IC examination program for 2013 also includes several policy topics. Examiners are expected to look at:

  • money market funds, specifically whether funds are conducting stress tests to gauge their ability to maintain a stable share price based on hypothetical events;
  • compliance with exemptive orders; and
  • compliance with the pay-to-play rule that prohibits advisers from obtaining business from government entities in exchange for political contributions.

Ongoing Risks for the BD Program
Sales Practices/Fraud. Exams will focus on sales practices targeting retail investors, including:

  • affinity fraud or fraud targeting seniors;
  • unsuitable recommendations of higher yield products (e.g., municipal or corporate bonds);
  • outside business activities;
  • conflicts of interest; and
  • certain firms identified as recidivist or high-risk for potential misconduct.

Trading. Exam staff intends to address certain trading risk areas, with particular focus on high frequency trading, algorithmic trading, proper controls around the use of technology, alternative trading systems and order routing practices.

AML. The staff will identify firms that appear to have weak anti-money laundering (AML) programs, especially customer identification programs (CIP), suspicious activity identification and reporting deficiencies, and weak due diligence procedures regarding certain accounts.

Policy Topics for the BD Program
JOBS Act. Upon approval of a final rule pursuant to the JOBS Act, which creates a new exemption from registration under the Securities Act for qualified "crowd funding" transactions, the staff intends to conduct reviews of entities participating in the crowd funding business.

Sources: Examination Priorities for 2013, Office of Compliance Inspections and Examinations, February 21, 2013; Peter Ortiz, SEC Makes Distribution-Fee Exam Priority, Ignites, February 25, 2013; Sarah Lynch, SEC to Examine Fund Fees, Alternative Funds, Reuters, March 8, 2013.

Copyright © 2020 Godfrey & Kahn S.C.National Law Review, Volume III, Number 104


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Godfrey & Kahn has one of the Midwest's largest investment management practices, with a team of attorneys dedicated solely to investment management clients. Our team offers a wide range of experience and includes attorneys who have worked at the SEC, held senior executive positions at national and international mutual fund groups and served as in-house counsel to companies within the investment management industry. This broad experience gives us the insight and understanding necessary to advise clients in the United States and abroad on the complex issues faced by investment management...