On January 7, 2020, the U.S. Securities and Exchange Commission (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) released its 2020 Examination Priorities (“2020 Priorities”). While at first blush the themes appear consistent with and predictable from their 2019 priorities, on closer read OCIE has provided some new insights and some unexpected focus areas. The themes for the 2020 Priorities are: retail investors, information security, financial technology (“Fintech”) and innovation (including digital assets and electronic investment advice), several areas covering registered investment advisers and investment companies, anti-money laundering, market infrastructure (clearing agencies, national securities exchanges, alternative trading systems, transfer agents), and oversight of the Financial Industry Regulatory Authority and Municipal Securities Rulemaking Board programs and policies. OCIE also stressed the challenges it faced in light of last year’s government shutdown and resource constraints, as the Division of Enforcement did in its 2019 Annual Report (see our analysis here), and the challenges in examining non-U.S. advisers due to limits that foreign data protection and privacy laws may place on cross-border information transfers. In this post, we analyze the highlights in and our takeaways from the 2020 Priorities.
- Examination “risk factors”. OCIE takes a risk-based approach in selecting potential exam candidates and developing the scope of exams. The 2020 Priorities, for the first time, provide some insight into the criteria that OCIE considers in its risk assessment process. OCIE noted that it considers dozens of factors, but highlighted certain “high risk products”, compensation and funding arrangements, prior examination observations and conduct, disciplinary history of associated individuals and affiliates, change in leadership or other personnel, and whether the adviser has custody of investor assets. We think “high risk products” are likely to include those implicating the industry’s transition away from LIBOR, which OCIE referenced elsewhere in the 2020 Priorities, and advisers would be well-served to review their compliance with remediation following prior exam findings or disciplinary events in light of these factors.
- Resource Constraints and Non-U.S. Advisers. Exams of non-U.S. advisers are resource-intensive for OCIE and, similar to functions performed by other SEC divisions, require coordination with other regulators to mitigate the associated burdens. The 2020 Priorities cited as a particular challenge examining advisers subject to local data protection regimes that may restrict them from sharing books and records. Consistent with what we have heard from non-U.S. advisers, OCIE indicated that it seeks additional information from non‑U.S. applicants for adviser registration to ensure that these firms can comply with the Advisers Act inspection requirements. Although OCIE acknowledged that this issue reflects a conflict of laws, it did not identify particular jurisdictions where the conflict exists or what information or commitments would satisfy its concerns in light of that conflict.
- Retail Investors: Standards of Conduct. Last year, the SEC issued a final interpretation and adopted a final rule addressing the duties owed by advisers and broker-dealers to their clients, specifically its release interpreting the Advisers Act fiduciary duty and Regulation BI establishing a new “best interest” standard for broker‑dealers (see our analysis here). These changes will require regulated entities to make changes to disclosures, marketing materials and compliance programs. OCIE will prioritize examining implementation of Regulation BI and the content and form of new Form CRS, and expects to continue to focus in adviser examinations on compliance with the fiduciary duty release. Registrants are encouraged to submit questions to the SEC’s Inter-Divisional Standards and Conducts Implementation Committee when developing changes in materials or compliance programs to comply with these new standards. We expect to see compliance with the fiduciary duty guidance, Form CRS requirements and Regulation BI increasingly cited in deficiency letters.
- Investment Adviser Focus Area: Private Funds. Consistent with the SEC’s priorities under Chairman Clayton, private funds, which typically are not offered to retail investors, have not been a recent focus of OCIE. The 2020 Priorities, however, highlight a focus on advisers to private funds “that have a greater impact on retail investors”. OCIE identified a few specific examination areas: controls to prevent the misuse of material, non-public information, conflicts of interest such as undisclosed or inadequately disclosed fees and expenses and the use of affiliates to provide services to clients. Notably, and consistent with the fiduciary duty guidance, OCIE did not define “retail investors” or provide clarity on the factors that would place a private fund adviser in the “greater impact on retail” category. OCIE provided only one example – advisers that advise separately managed accounts side-by-side with private funds – but also indicated that examinations will include a focus on advisers to private funds that also manage a registered investment company (“RIC”) with a similar investment strategy. Fund sponsors should take this as a sign that the SEC will take a broad view of “retail”, to include indirect retail investors such as pension plans and similar institutional investor beneficiaries.
- Investment Adviser Focus Area: Never Before and Not Recently Examined Advisers. The 2020 Priorities stressed that OCIE will focus on examinations of advisers that have never been examined, including new registrants, and advisers whose last examination was a number of years ago. Whether this is more than a shot across the bow for these advisers remains to be seen, since the only area identified for exam focus was whether compliance programs have been appropriately adapted in light of any substantial growth or change in business model. One area highlighted in the investment adviser theme that could be ripe for exams is disclosure practices around environmental, social and governance (ESG) investment strategies.
- Fintech. The 2020 Priorities expanded and added more granularity to this theme. Exams will focus on risks posed by so-called “alternative data” that drive investment decisions, such as biometric or geolocation data. Two notable focus areas are robo‑advisers and digital assets. For robo-advisers, the 2020 Priorities cited issues such as SEC registration eligibility, cybersecurity, marketing practices, adequacy of disclosure and compliance programs. For digital assets, OCIE identified new focus areas for 2020 of investment suitability and supervision of employees’ outside business activities.
- Information Security. Cybersecurity remains a focus for OCIE, but as part of a broader priority of information security, including information security governance and retail trading information security. Particular focus areas will include: governance and risk management, access controls, data loss prevention, vendor management (particularly with respect to cloud-based storage providers), staff training, incident response and resiliency, which OCIE highlighted in a risk alert last year on SEC’s Regulation S-P (see our analysis here).
Within its themes, OCIE indicated it will continue to focus on several expected areas: disclosure of fees and expenses, custody, mutual funds and exchange-traded funds, transfer agents, Regulation SCI entities and anti-money laundering. Finally, OCIE listed the eight risk alerts it published since issuing its 2018 priorities, which cover: cash solicitation, RICs, electronic messaging, transfer agent custody, Regulation S-P, safeguarding customer records and information in network storage, advisers’ disclosure of conflicts and principal and agency cross trading issues. We would expect to see these areas pursued in enforcement investigations in the coming year as a result. Similarly, OCIE noted that examinations led to more than 150 enforcement referrals in the prior fiscal year, and anticipates more to come. We take these statistics to serve notice of continued active coordination between OCIE and the Enforcement Division.
 This post was prepared with the assistance of Law Clerk Veronica Joubert.