On March 3, 2021, the Securities and Exchange Commission’s Division of Examinations (EXAMS) (formerly the Office of Compliance Inspections and Examinations (OCIE) released its 2021 examination priorities.
Notably, while the majority of the examination priorities echo OCIE priorities from prior years, this year’s EXAMS priorities include a greater focus on climate-related risk and environmental, social, and governance (ESG) matters. This is consistent with the Commission’s increased emphasis on ESG matters in other contexts, as well as that of other regulators. This year’s priorities also include examinations relating to Regulation Best Interest (Reg BI) compliance, considerations relating to the impacts of the COVID-19 pandemic and a continued focus on complex products.
EXAMS’s leadership also calls out its newly operational Event and Emerging Risks Examination Team (EERT), which is tasked with enhancing the Division’s ability to identify and tackle emerging and exigent risks as they arise.
The examination priorities are organized around largely perennial themes, and we discuss each such theme below.
Retail Investor Protection, Including Seniors and Those Saving for Retirement
Consistent with prior years, EXAMS will focus on recommendations and advice given to retail investors, with a particular focus on seniors and those saving for retirement. The examinations will focus on registered investment advisers (RIAs), broker-dealers, and dually-registered firms, as well as investments and services marketed to retail investors (including but not limited to mutual funds and exchange-traded products, municipal securities and other fixed income securities, and microcap securities).
In its examinations, EXAMS will be assessing firms’ compliance with Reg BI and Form CRS. In this regard, EXAMS will consider whether broker-dealers are making recommendations that they have a reasonable basis to believe are in customers’ best interests. EXAMS will also evaluate policies and procedures for compliance with Reg BI and alterations made to product offerings in connection with Reg BI. Firms can expect enhanced transaction testing in this regard and questions from examiners relating to, among other things, recommendations of rollovers and complex product recommendations, assessment of costs and reasonably available alternatives, how sales-based fees paid to broker-dealers and representatives impact recommendations, and policies and procedures regarding how broker-dealers identify and address conflicts of interest.
RIA fiduciary duty examinations may be impacted by the Interpretation Regarding Standard of Conduct for RIAs that was released concurrently with Reg BI. With respect to fiduciary duty, EXAMS will continue to focus on:
- risks associated with fees and expenses (including, without limitation, advisory fee calculation errors, inaccurate calculations of tiered fees and failure to refund fees);
- advice with respect to complex products;
- best execution; and
- undisclosed or inadequately disclosed compensation arrangements.
Firms can also expect EXAMS to scrutinize how firms are complying with the recent changes to the definition of accredited investor when recommending and selling certain private offerings.
Information Security and Operational Resiliency
EXAMS will be focused on firms’ response to the pandemic and, in particular, whether firms have taken appropriate measures to:
- safeguard customer accounts and prevent account intrusions, including verifying an investor’s identity to prevent unauthorized account access;
- oversee vendors and service providers;
- address malicious email activities, such as phishing or account intrusions;
- respond to incidents, including those related to ransomware attacks; and
- manage operational risk as a result of dispersed employees in a work-from-home environment.
Fintech and Innovation, Including Digital Assets
EXAMS will continue to focus on Fintech and Innovation in 2021. In 2021, this focus will include a particular consideration of the implementation and integration of technology to facilitate compliance with regulatory requirements (referred to by EXAMS as “RegTech”).
In the digital asset space, substantially consistent with 2020 examination priorities, EXAMS will assess:
- whether investments are in the best interests of investors (in contrast, 2020’s priorities focused on pre-Reg BI suitability);
- portfolio management and trading practices;
- safety of client funds and assets;
- pricing and valuation;
- effectiveness of compliance programs and controls; and
- supervision of representatives’ outside business activities.
EXAMS will continue to focus on firms’ AML programs. Consistent with last year, EXAMS notes four areas of review:
- customer identification programs and SAR filing obligations;
- customer due diligence;
- compliance with beneficial ownership requirements; and
- timely and robust independent testing of AML programs.
EXAMS will use its examinations to engage with firms to assess their understanding of any exposure to the London Inter-Bank Offered Rate (LIBOR) and their preparations for the expected discontinuation of LIBOR. Examiners will be seeking information regarding impact assessments made with regard to the transition to an alternative reference rate in connection with both the firms’ own financial matters and those of their clients and customers.
Additional Focus Areas Involving RIAs and Investment Companies
EXAMS will, among other things, continue to conduct risk-based examinations, prioritize examinations of RIAs who have not been examined for a number of years, and prioritize examinations of RIAs that are dually registered as broker-dealers (or affiliated with broker-dealers).
Noting the increased popularity of sustainability focused and ESG conscious investment strategies, EXAMS will plan to focus on RIA practices with respect to these offerings (particularly in products that are widely available to investors). In this regard, firms and fund complexes can expect examiners to review the consistency and adequacy of the disclosures provided to clients regarding these strategies. In addition, EXAMS will determine the firms’ processes and practices match their disclosures, review fund advertising for false or misleading statements, and review proxy voting policies and procedures and votes to assess whether they align with the strategies.
EXAMS will continue to focus on advisers to private funds, with a particular emphasis on assessing compliance risk, liquidity and disclosures of investment risks and conflicts of interest. In examining RIAs’ practices with respect to private funds, EXAMS will review for, among other things:
- preferential treatment of certain investors by advisers to private funds that have experienced issues with liquidity;
- adequacy of disclosure and compliance with any regulatory requirements of cross trades; principal investments, or distressed sales; and
- conflicts around liquidity.
Firms can also expect EXAMS to focus on advisers to private funds that (i) have a higher concentration of structured products, or (ii) own portfolio companies that may have been materially impacted by recent economic conditions.
Registered Funds can expect EXAMS to focus on, among other things:
- valuation practices and reporting;
- disclosure, particularly as relating to areas that have experienced stress due to the pandemic;
- securities lending;
- compliance with exemptive relief (including for non-transparent actively managed ETFs); and
- data analytics practices and methodologies, liquidity risk management programs
While the 2021 examination priorities are in large part similar to those in recent years, this year firms can expect EXAMS to consider firms’ assessments of, and adjustments to, the impacts of the pandemic. Firms should also be prepared for examinations relating to Reg BI and Form CRS compliance. With regard to broker-dealers, this new compliance program obligation under Reg BI is the first time that a failure to have reasonable procedures and systems in place may result in a failure to supervise enforcement action without the Commission needing to establish underlying violations resulting from the lack of a reasonable program. Finally, the 2021 examination priorities re-emphasize growing regulatory interest on ESG strategies and disclosures, and firms should be prepared for there to be continued focus in this area.
Regulated firms are reminded that the examination priorities identified are not exhaustive and that EXAMS will continue to conduct examinations determined through a risk-based approach that includes analysis of an entity’s history, operations, services, products offered, and other factors. Additionally, once the new Commission Chairman is approved and sworn in, this will also present opportunities for adjustments to examination priorities, although the stated priorities appear to be largely consistent with some of the focus areas that have been articulated by the current nominee.
We are happy to assist you in preparing for and navigating regulatory examinations. For additional information on what to expect in upcoming examinations please see our recent webinar series.
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