The Securities and Exchange Commission’s (SEC) Office of Inspections and Examinations (OCIE) released its 2020 examination priorities in January, identifying key areas of potential risk to investors and the capital markets. As in recent years, OCIE highlighted familiar risks like cyber security and anti-money laundering with a focus on protecting retail investors.
OCIE also identified a focus on registered investment advisers (RIAs) that have never been examined, and prioritizing standards of conduct for dual-registrants (RIA/Broker-Dealer). Also reprising priorities from 2019, OCIE will home in on mutual funds and exchange-traded funds. While OCIE’s priorities are meant as a broad overview for the securities industry, there were several topics or themes that will require more attention from registered funds and their advisers.
There were two notable OCIE statements:
- OCIE highlighted board oversight practices. While unlikely intended as a shot across the bow, it serves as a firm reminder of the board’s fiduciary role in protecting shareholders. Service providers and compliance professionals have frontline responsibility for serving shareholders’ interests, but boards are integral to the proper functioning of the compliance ecosystem. Thus, board members should be mindful of their oversight responsibilities, particularly regarding those tasks specifically entrusted to the board (e.g., 15(c) practices, valuation oversight, liquidity risk management oversight).
- OCIE will focus on RIAs that use “third-party administrators to sponsor mutual funds they are affiliated with or advise.” It is unclear what prompted OCIE to single out series trusts, but everyone should use the added scrutiny as an opportunity to demonstrate the value of independence – particularly regarding compliance professionals unaffiliated with advisers – and the efficiencies and broad-based expertise that a series trust affords. Not only do shareholders benefit from a series trust’s economies of scale, but the constellation of unaffiliated advisers (and their service providers) enables boards to foster best practices by promoting the top policies and procedures found among the group. In short, we view series trusts as a virtue, not a vice.
Priorities Directly Impacting Funds and their RIAs:
- Fee waivers, breakpoints. Given that mutual funds and ETFs are largely retail investment vehicles, OCIE will be looking closely at expenses that reduce shareholder capital invested. Expect scrutiny of contractual agreements requiring breakpoints and waivers. We also expect OCIE to make sure that disclosures accurately track language in board-approved contractual agreements.
- Revenue sharing. These arrangements, which are common in the retail space, present financial conflicts that should be disclosed. Revenue sharing has already been the subject of recent enforcement actions (following in the wake of the share-class initiative), so examiners will expect funds to be on clear notice that disclosures in this regard should be accurate.
- Best execution, fiduciary advice, and disclosure of conflicts. This flows from the adoption of Regulation Best Interest (Reg BI). But it also reflects a persistent focus on financial conflicts of interest. If an adviser is making money (or receiving some benefit) by virtue of its brokerage decisions, it should be disclosed. We expect that OCIE largely will be in information-gathering mode with respect to Reg BI implementation, helping guide registrants in becoming compliant before the June 30, 2020, deadline. By 2021, expect the bar to be raised higher, with possible enforcement actions on the horizon against any lax adopters.
- Third-party asset managers. OCIE will assess due diligence practices, policies, and procedures for oversight.
- ESG investing. The SEC is skeptical of Environmental, Social and Governance (ESG) descriptors, so advisers, asset managers, and investment firms should ensure that disclosures are detailed and accurately explain any ESG designation.
- Digital assets. There will be more focus on financial technology and digital assets, with areas of concern regarding security, pricing and valuation, and compliance controls. Some boards prohibit investing in cryptocurrencies, and funds investing in digital assets or using integrated blockchain technology will likely get extra attention. This may also include transfer agent services handling digital assets and blockchain ledgers.
- Similar strategy in private fund. Advisers managing both registered and private funds with a similar strategy will be scrutinized. OCIE will be looking for conflicts where one client benefits at the expense of the other. This may range from simple performance variances (cherry picking) and similar allocation practices, to more subtle cross subsidies, such as where a mutual fund pays for soft dollars that benefit a private fund with a similar strategy.
- Anti-Money Laundering. OCIE will examine whether funds (acting through transfer agents and broker-dealers) are conducting customer due diligence, complying with beneficial ownership requirements (including the customer due diligence rule), and testing the AML program.
- Cyber security. Picking up from last year’s guidance, OCIE examiners will look at network storage, access controls, vendor management, training, incident response, and resiliency. Most industry professionals spend a lot of effort and money focused in this area. But everyone should stay vigilant and harden their cyber defenses where possible as even a modest breach can cause lasting reputational harm even if there are no economic losses.
- Transfer Agents. OCIE will evaluate transfer agents’ core safeguarding, recordkeeping, and reporting functions. Among other things, OCIE also will examine compliance with obligations to search for lost securityholders and provide notice to unresponsive payees.
OCIE’s priorities reflect common weaknesses that examiners have observed or that they perceive as obvious potential weak spots. But those outlined should not be viewed as a checklist requiring selective attention, but rather suggest broad areas for compliance enhancements as part of comprehensive and continuous process for improving the compliance environment.
Brian Privor has more than 20 years of professional experience in asset management and securities regulation. He worked as Senior Counsel in the SEC’s Division of Enforcement, Asset Management Unit for seven years, leading a broad spectrum of investigations on violations of federal securities laws, and assisted in litigating enforcement matters in federal court and during administrative proceedings. He also spent a year as Senior Counsel to the Senate Judiciary Committee investigating financial crimes. Before that, Mr. Privor was an associate at Morgan, Lewis & Bockius, LLP, where he focused on corporate investigations, anti-corruption and anti-money laundering compliance, corporate governance, securities enforcement, and enforcement under various regulatory programs.
