SEC Division of Examinations Publishes 2021 Examination Priorities | Practical Law

SEC Division of Examinations Publishes 2021 Examination Priorities | Practical Law

The SEC's Division of Examinations published its annual examination priorities for 2021.

SEC Division of Examinations Publishes 2021 Examination Priorities

Practical Law Legal Update w-029-9778 (Approx. 9 pages)

SEC Division of Examinations Publishes 2021 Examination Priorities

by Practical Law Corporate & Securities
Published on 04 Mar 2021 • USA (National/Federal)
The SEC's Division of Examinations published its annual examination priorities for 2021.
On March 3, 2021, the SEC's Division of Examinations (Division) published its examination priorities for 2021. The priorities generally reflect practices, products, and services that the Division believes may present heightened risk to investors and the integrity of the US capital markets. The Division's 2021 priorities span over nine topics:

Retail Investors

The Division will again emphasize the protection of retail investors, particularly seniors and those saving for retirement. The Division plans to conduct examination initiatives related to:
  • Standards of Care.
  • Fraud, sales practices, and conflicts.
  • Retail-targeted investments.

Standards of Care

In 2021, the Division will:
  • With regard to Regulation Best Interest:
    • expand the scope of examinations that focus on specific requirements of Regulation Best Interest, including those that require broker-dealers to have a reasonable basis to believe that recommendations are in retail customers' best interests; and
    • conduct enhanced transaction testing to examine whether broker-dealers have effectively implemented their written policies and procedures (for more information on the expanded scope of Regulation Best Interest examinations, also see Legal Update, SEC Plans to Conduct More Focused Regulation Best Interest Examinations in 2021).
  • Continue to focus on risks associated with fees and expenses, complex products, best execution, and disclosure of compensation arrangements.
  • Prioritize examinations with broker-dealers and investment advisers to assess compliance with Form CRS.

Fraud, Sales Practices, and Conflicts

Against the backdrop of the standards of care discussed above, examinations will focus on:
  • Recommendations and advice given to retail investors, with particular focus on:
    • seniors, including recommendations and advice made by entities and individuals targeting retirement communities;
    • teachers;
    • military personnel; and
    • individuals saving for retirement.
  • Recommendations regarding:
    • account type, conversions, and rollovers; and
    • sales practices used by firms for various products (such as structured products, exchange-traded products, REITs, private placements, annuities, digital assets, municipal and other fixed income securities, and microcap securities).
The Division will also review firms' disclosures regarding their conflicts of interest, including those related to fees and expenses. In particular, the Division will prioritize the examination of investment advisers operating and utilizing turnkey asset management platforms, and whether associated fees and revenue sharing arrangements are adequately disclosed.
In addition, when reviewing fees and expenses, the Division will review for:
  • Advisory fee calculation errors.
  • Inaccurate calculations of tiered fees.
  • Failures to refund prepaid fees for terminated accounts.

Retail-Targeted Investments

The Division will also continue to prioritize examinations of certain securities products that pose elevated risks when marketed or sold to retail investors, including:
  • Mutual funds and exchange traded funds (ETFs).
  • Municipal securities and other fixed income securities.
  • Microcap securities.

Information Security and Operational Resiliency

Given the increase in remote operations in response to the COVID-19 pandemic, the Division will review whether firms have taken appropriate measures to:
  • Safeguard customer accounts and prevent intrusions.
  • Oversee vendors and service providers.
  • Address malicious email activities, such as phishing or account intrusions.
  • Respond to incidents, including those related to ransomware attacks.
  • Manage operational risk as a result of dispersed employees in work-from-home environments.
In particular, the Division will also focus on:
  • The controls surrounding online and mobile access to investor account information.
  • The controls electronic storage of books and records and personally identifiable information maintained with third-party cloud service providers.
  • The firms' policies and procedures to protect investor records and information.
In addition, in light of the substantial disruption to normal business operations in 2020, the Division will again be reviewing business continuity and disaster recovery plans. However, the Division will shift its focus to whether such plans account for the growing physical and other relevant risks associated with climate change. The scope of the examinations will be similar to the work of the Division and other regulators following Hurricane Sandy, with a heightened focus on the maturation and improvement to these plans since then.

Fintech and Innovation

The Division remains committed to staying informed about the rapid developments in financial technologies, methods of capital formation, market structures, and investor interfaces, including the use of new sources of data that may drive investment decision-making. Division examinations will focus on:
  • Evaluating whether firms are handling customer orders in accordance with customer instructions, and reviewing compliance around trade recommendations made in mobile applications.
  • The implementation and integration of technology to facilitate compliance with regulatory requirements (RegTech) in firms' compliance programs.
  • The implementation of appropriate controls and compliance around the creation, receipt, and use of data gleaned from non-traditional sources (alternative data).
In addition, the Division will continue to examine SEC-registered market participants engaged with digital assets, assessing:
  • Investment suitability.
  • Portfolio management and trading practices.
  • Safety of client funds and assets.
  • Pricing and valuation.
  • Effectiveness of compliance programs and controls.
  • Supervision of employee outside business activities.
For additional Division guidance relating to examinations and digital asset securities, see Legal Update, SEC Division of Examination Issues Risk Alert on Digital Asset Securities.

Anti-Money Laundering Programs

Division will continue to prioritize examining broker-dealers and investment companies for compliance with their anti-money laundering (AML) obligations, including whether they have established appropriate customer identification programs and are:
  • Satisfying their suspicious activity reports (SARs) filing obligations.
  • Conducting due diligence on customers.
  • Complying with beneficial ownership requirements.
  • Conducting robust and timely independent tests of their AML program.

LIBOR Transition

The Division notes that the discontinuation of the London Inter-bank Offered Rate (LIBOR) could present a material risk for market participants. The Division will engage with firms through examinations to assess their understanding of any exposure to LIBOR, their preparations for the expected discontinuation of LIBOR, and the transition to an alternative reference rate.

Investment Advisers and Investment Companies

In addition to those referenced above relating to retail investors, the Division will have additional focus on certain areas involving registered investment advisers and investment companies.

Investment Adviser Compliance Programs

Division will continue to review compliance programs of investment advisers, prioritizing examinations of investment advisers that have not recently, or have never, been examined.
Areas of focus will include investment strategies focused on sustainability and related products that are widely available to investors. The Division will review:
  • The consistency and adequacy of disclosures to clients regarding sustainability strategies.
  • Whether firms' processes and practices match their disclosures.
  • Fund advertising for false or misleading statements.
  • Proxy voting policies and procedures and votes to assess whether they align with sustainability strategies.
The Division will also continue to prioritize examinations of investment advisers that are dually registered as, or are affiliated with, broker-dealers, or have supervised persons who are registered representatives of unaffiliated broker-dealers.

Mutual Funds and ETFs

The Division's examinations of mutual funds and ETFs will focus on disclosures to investors, valuation, filings with the SEC, personal trading activities, and contracts and agreements. The Division will prioritize examinations of funds that have not recently, or have never, been examined.

Investment Advisers to Private Funds

The Division will continue to focus on investment advisers to private funds and will assess compliance risks, with a focus on liquidity and disclosure of investment risks and conflicts of interest. Specifically, the Division will review for, among other things:
  • Preferential treatment of certain investors by advisers to private funds that have experienced issues with liquidity.
  • Portfolio valuations and the resulting impact on management fees.
  • Adequacy of disclosure and compliance with any regulatory requirements of cross trades, principal investments, or distressed sales.
  • Conflicts around liquidity.
The Division will also focus on investment advisers to private funds that:
  • Have a higher concentration of structured products.
  • Own portfolio companies that may have been materially impacted by recent economic conditions.

Broker-Dealers and Municipal Advisors

In addition to areas focusing on sales practices referenced above, broker-dealer examinations will focus on financial responsibility and risk management.

Broker-Dealer Financial Responsibility

Examinations of broker-dealers will continue to focus on compliance with the Customer Protection Rule and Net Capital Rule, including the adequacy of internal processes, procedures, and controls, and compliance with requirements for borrowing securities from customers. Due to COVID-19, examinations may also include an assessment of funding and liquidity risk management practices to assess whether firms have sufficient liquidity to manage stress events.

Trading Practices

The Division will also continue to examine broker-dealer trading practices, with a focus on:
  • Compliance with best execution obligations in a zero commission environment and amended Rule 606 order routing disclosure rules.
  • Market maker compliance with Regulation SHO.
  • The operations of certain alternative trading systems (ATSs) for consistency with their disclosures provided in Form ATS-N.

Municipal Advisors

In light of COVID-19, the Division will examine how municipal advisers have adjusted their practices, if at all. The Division will also examine whether municipal advisors have:
  • Met their fiduciary duty obligations to municipal entity clients.
  • Satisfied their registration, professional qualification, continuing education, and supervision requirements.

Market Infrastructure

Division plans to conduct examination initiatives related to:
  • Clearing agencies.
  • National securities exchanges.
  • Regulation Systems Compliance and Integrity (SCI) entities.

Clearing Agencies

Clearing agencies can expect their examination to focus on:
  • Compliance with the SEC's Standards for Covered Clearing Agencies and other federal securities laws applicable to registered clearing agencies.
  • Whether clearing agencies have taken timely corrective action in response to prior examinations.
  • Other areas identified in collaboration with the SEC's Division of Trading and Markets and with other regulators.
Areas of focus may include compliance, legal, recovery and wind down, margin, back-testing, settlement and operations, liquidity risk management, effect of the LIBOR transition, and cybersecurity and resiliency, among other things.

National Securities Exchanges

Examinations of national securities exchanges will focus on operations to monitor, investigate, and enforce member and listed company compliance with exchange rules and the federal securities laws, as applicable.

Regulation SCI Entities

The Division will continue to examine SCI entities to evaluate whether they have effectively implemented written policies and procedures required by Regulation SCI. In addition, Division will focus on:
  • IT governance.
  • IT asset management.
  • Cyber threat management/incident response.
  • Business continuity planning.
  • Third-party vendor management.
  • Whether SCI entities have taken appropriate action in response to past examinations.

Transfer Agents

Transfer agents can expect Division examinations to focus on:
  • Transfers, recordkeeping, and the safeguarding of funds and securities.
  • The requirement for transfer agents to annually file a report by an independent accountant concerning the transfer agency's system of internal accounting controls.
In light of the COVID-19 pandemic, examinations will also consider firms' business continuity and disaster recovery programs, as well as cybersecurity and account takeover precautions.
Examination candidates will include transfer agents that present the greatest possible risks to investors and investment channel, and will include transfer agents that:
  • Service microcap or municipal bond issues.
  • Use novel technological applications (such as blockchain).
  • Engage in significant paying agent activity.

Focus on FINRA and MSRB

FINRA

The Division will continue conducting risk-based oversight examinations of FINRA, inspections of FINRA's major regulatory programs and oversight examinations of FINRA's examinations of certain broker-dealers and municipal advisors in order to make recommendations to improve FINRA's programs, risk assessment processes, and future examinations.

MSRB

The Division will continue examining the effectiveness of MSRB's policies, procedures, and controls.