What Compliance Officers Should Expect from SEC Exams in 2014
If there is one thing that keeps compliance officers up at night, it is that dreaded message from the SEC, “We have decided to conduct an examination of your firm, and please do not treat this as an adversarial proceeding, rather we are here trying to learn about your firm, and we are here to help.” Hardly comforting given the many recent referrals from Enforcement, and the fact that Enforcement lawyers now routinely accompany SEC examiners to on-site inspections.
Recently, the SEC published its 2014 Examination Priorities giving broker-dealers and advisers guidance on areas of concern.
Examination Priorities for Both Brokers and Advisers
System-wide, the SEC will continue to focus on policies around fraud detection and prevention, corporate governance including the control environment and “tone at the top”, conflicts of interest, enterprise risk management, technology and supervision of IT systems. The SEC will closely examine dual registrants and incentives to firms when customers choose to open accounts at dual registrants as an advisory client or brokerage client. The SEC also will scrutinize how advisers and brokers are addressing new laws and regulations, and sales and marketing practices related to retirement products such as IRAs and 401(k) plans. These broad areas affect nearly every adviser and broker-dealer, and all firms should be prepared for an SEC exam in these areas.
Examination Priorities Specifically for Investment Advisers and Investment Companies
Adviser Core Risks
Still stung by the failure to detect Madoff, for advisers, the SEC will continue to examine custody of client assets and compliance with the custody rules, paying particular attention to advisers that fail to realize that they have custody through non-conventional methods such as check-writing authority or powers of attorney.
Another core risk for advisers is conflicts of interest in business practices such as best execution, soft dollars, and agency/principal transactions. Examiners will scrutinize undisclosed compensation arrangements, allocation of investment opportunities, controls and disclosure when an adviser manages both performance-based accounts and traditional fee accounts, valuation of illiquid securities and higher risk products that are sold to retail and elderly investors. The SEC will review the accuracy of advisers’ performance advertising. Advisers that have wrap-fee programs should expect a review of fiduciary duties and controls to monitor wrap fee conflicts of interest, best execution and trading away from the wrap sponsor. Finally, the SEC will continue to review disclosure and compliance issues related to payments by advisers to distributors, solicitors and other intermediaries.
Areas of Focus for New Advisers Including Hedge Fund and Private Equity Fund Managers
New advisers that have not been examined in the last three years, including hedge and private equity fund managers, should expect a visit from the SEC in 2014. The SEC plans to look closely at new advisers’ marketing and sales practices, portfolio management including compensation methodologies, conflicts of interest and safety of client assets, and valuation particularly with respect to hard-to-value illiquid securities and their relationship to portfolio manager compensation.
Increasingly Aggressive Examinations
There is little doubt that the market and regulatory failures of the Great Recession has led to increasingly aggressive and skeptical examinations by the SEC. This creates compliance and reputational risks for firms. The 2014 exam priorities, although quite extensive, nevertheless provide a helpful guide for compliance professionals in determining where to devote finite compliance resources.