SEC Division of Examinations pronounces 2021 examination priorities
Securities Enforcement Alert
On March 3, the Division of Examinations (Division) of the Securities and Alternate Fee (SEC) introduced its 2021 Examination Priorities. Revealed yearly for the final 9 years, the priorities are designed to supply securities business contributors with perception into the Division’s risk-based method to examinations and the areas it at the moment believes current potential dangers to buyers and the US capital markets. The 2021 launch highlights 9 areas:
- Retail buyers, together with seniors and retirement savers
- Info safety and operational resiliency
- Monetary know-how and innovation, together with digital belongings
- Anti-money laundering (AML)
- London Inter-Financial institution Supplied Charge (LIBOR) transition
- Registered investments advisers (RIAs) compliance packages and funding firms
- Dealer-dealer monetary accountability and buying and selling practices and municipal advisors
- Market infrastructure (clearing companies, exchanges, and switch brokers) and
- Regulating the regulators: examinations of the Monetary Business Regulatory Authority (FINRA) and Municipal Securities Rulemaking Board (MSRB).
The priorities record is prefaced with a message from the Division’s management staff and an introduction providing additional perception to the Division’s work and strategic course. Set forth under is our abstract and key takeaways.
Management message and introduction
As a preface to the priorities record, the Division included a management message and introduction that highlighted a number of key info and insights:
- In mild of the challenges attributable to the COVID-19 pandemic, the Division early on pivoted to concentrate on essentially the most urgent dangers, which included whether or not registered companies’ enterprise continuity plans have been up to date, operational, and efficient and addressing elevated cybersecurity dangers dealing with companies and buyers. Within the Division’s view, the monetary markets’ operations and techniques typically continued to work as designed throughout the pandemic, with exchanges, clearing companies, RIAs, broker-dealers, and different market contributors adapting to important distant work and persevering with to function largely with out incident. Cybersecurity dangers – particularly an elevated use of ransomware and credential stuffing – stay a priority, and the Division reminded market contributors of its latest threat alerts and report on these matters.
- Regulation BI and Kind CRS are an necessary focus of the Division. The Division reminded market contributors of its 2020 threat alerts and its December 2020 Assertion on Current and Upcoming Regulation BI Examinations (mentioned under.)The Division additionally highlighted its Dealer-Supplier and Alternate (BDX) program, by means of which the Division coordinates with different SEC Divisions and FINRA to develop examination supplies. BDX can be engaged on examination supplies for security-based swaps.
- Tradition and tone on the high stay a key focus of the Division. It identifies hallmarks of an efficient compliance program as energetic engagement in most agency operations, early involvement in necessary enterprise developments, and educated and empowered Chief Compliance Officers with the authority and sources to develop and implement insurance policies and procedures.
- Regardless of the pandemic, the Division accomplished 2,952 examinations, a couple of 4 p.c lower from the prior fiscal yr. This included analyzing 15 p.c of 13,900 RIAs. The examination program coated 100 fund complexes, 330 broker-dealers, over 110 exchanges, and 90 municipal advisors and switch brokers. The Division issued greater than 2,000 deficiency letters and made greater than 130 referrals to the Division of Enforcement to this point.
- The Division is adjusting course in FY 2021 to answer market occasions, for instance dangers relating to the wide-spread compromise of generally used community administration software program and “meme” inventory exercise. To reply to new and rising threat areas extra successfully, the Division has created the Occasion and Rising Dangers Examination Crew (EERT).The Division will leverage the EERT “to proactively have interaction with registered companies and different market contributors about rising threats and present market occasions and shortly mobilize to supply experience and sources to the SEC’s regional workplaces when important issues come up.”
- The examination program stays grounded within the Division’s 4 pillars: selling compliance, stopping fraud, figuring out and monitoring dangers, and informing coverage.
The 2021 priorities embrace the next 9 areas:
- Retail buyers, together with seniors and retirement savers The Division will proceed to prioritize examinations of RIAs, broker-dealers, and dually registered or affiliated companies as increasingly more people depend on these monetary intermediaries to achieve entry to the monetary markets. Key areas embrace Regulation Greatest Curiosity (Reg BI); fraud, gross sales practices, and conflicts of curiosity; and securities merchandise that pose elevated dangers when marketed to retail prospects.
- Regulation BI Regulation Greatest Curiosity (Reg BI) and Kind CRS stay entrance and middle of the Division’s priorities. The Division famous the intensive work that it did in 2020, culminating in a December 2020 assertion on latest and upcoming examinations. The Division intends to broaden the scope of 2021 examinations to concentrate on particular necessities of the regulation and conduct enhanced transaction testing to find out whether or not broker-dealers have successfully applied their written insurance policies and procedures. Examination parts could embrace continued analysis of agency insurance policies and procedures and alterations to agency product choices; consideration of prices in making a advice; processes agency personnel have used to make suggestions to new prospects (eg, rollovers); analysis of the processes agency personnel have used to suggest complicated merchandise; and analysis of the processes used to establish and tackle conflicts associated to suggestions. The Division will assess documentation on these matters together with whether or not there may be documentation of how related individuals contemplate prices in making suggestions. The Division famous that it’s going to replace its processes to implement 2019’s Regulation Greatest Curiosity, which requires broker-dealers and their representatives to behave in one of the best curiosity of retail prospects when making a advice of any securities transaction or funding technique involving securities with out putting their monetary or different pursuits forward of the pursuits of the retail buyer. Prior examinations centered on the processes that broker-dealers relied upon to implement the regulation. Examinations now will concentrate on assessing compliance with Regulation Greatest Curiosity in apply, by assessing whether or not broker-dealers have an inexpensive perception that suggestions are in a consumer’s greatest curiosity based mostly on particular circumstances, in addition to by means of transaction testing. The Division can even proceed to evaluate whether or not RIAs have fulfilled their duties of care and loyalty in serving one of the best pursuits of their shoppers, based mostly on their shoppers’ goals. This can embrace assessing charges and bills, the complexity of merchandise, greatest execution practices and whether or not compensation preparations are adequately disclosed. The Division can even prioritize examination of broker-dealers and RIAs to evaluate compliance with Kind CRS. RIAs should present Kind CRS to retail buyers, which describes the connection and gives details about the agency. The shape should even be filed with the SEC and posted on any publicly obtainable web site maintained by the agency.
- Fraud, gross sales practices, and conflicts The Division emphasised the important significance of offering the disclosures required by federal securities legal guidelines, together with these associated to charges and bills and conflicts of curiosity. Examinations will concentrate on the appropriateness of suggestions and recommendation supplied to retail buyers, with a specific emphasis on (1) seniors, together with suggestions and recommendation made by entities and people concentrating on retirement communities; (2) lecturers; (3) navy personnel; and (4) people saving for retirement. Areas of focus embrace suggestions relating to account kind, conversions, and rollovers, in addition to the gross sales practices utilized by companies for varied product sorts, resembling structured merchandise, exchange-traded merchandise, actual property funding trusts, personal placements, annuities, digital belongings, municipal and different mounted earnings securities, and microcap securities. The Division can even study broker-dealers to evaluate whether or not they’re assembly their authorized and compliance obligations when offering retail prospects entry to complicated methods, resembling choices buying and selling, and complicated merchandise. The Division can even concentrate on how companies are complying with the accredited investor definition when recommending and promoting sure personal choices. One other space of focus will likely be companies’ disclosures relating to their conflicts of curiosity, together with these associated to charges and bills. A selected space of precedence would be the examination of RIAs working and using turnkey asset administration platforms, which give RIAs with know-how, funding analysis, portfolio administration and different outsourcing providers. Examinations will assess whether or not such charges and income sharing preparations are adequately disclosed. The workers additionally will overview for: (1) advisory price calculation errors; (2) inaccurate calculations of tiered charges, together with failure to supply breakpoints and mixture family accounts; and (3) failures to refund pay as you go charges for terminated accounts.
- Retail-targeted investments The Division can even prioritize the next retail focused investments:
- Mutual funds and ETFs – The Division will concentrate on monetary intermediaries’ suggestions and adequacy of threat disclosures involving ETFs, notably in area of interest or leveraged/inverse ETFs. It can additionally proceed to prioritize the examination of incentives supplied to monetary providers companies and professionals that will affect the share class choice.
- Municipal securities and different mounted earnings securities – The Division will concentrate on broker-dealer buying and selling exercise in municipal and company bonds for compliance with greatest execution obligations; equity of pricing, mark-ups and mark-downs, and commissions; and affirmation disclosure necessities.
- Microcap securities (market capitalization beneath $250 million) – In 2020, the Fee suspended buying and selling of a number of securities as a consequence of issues concerning the adequacy and accuracy of knowledge within the market concerning the issuers, together with issues associated to testing and therapy of COVID-19.The Division will proceed to watch microcap points, together with switch agent dealing with of microcap distributions and share transfers; broker-dealer gross sales practices and their consistency with Regulation Greatest Curiosity; and broker-dealer compliance with sure regulatory necessities, together with the find requirement of Regulation SHO, penny inventory disclosure guidelines, and the duty to watch for and report suspicious exercise and different AML obligations.
- Info safety and operational resiliencyThe Division continues to view info safety as important to the operation of the monetary markets and the boldness of market contributors; the impression of a breach in info safety could have penalties effectively past the compromised agency. The Division additionally famous elevated issues about, amongst different issues, endpoint safety, information loss, distant entry, use of third-party communication techniques, and vendor administration as firms transitioned to distant work in response to the pandemic. As such, the Division will overview whether or not companies have taken applicable measures to (1) safeguard buyer accounts and forestall account intrusions, together with verifying an investor’s identification to stop unauthorized account entry; (2) oversee distributors and repair suppliers; (3) tackle malicious e-mail actions, resembling phishing or account intrusions; (4) reply to incidents, together with these associated to ransomware assaults; and (5) handle operational threat on account of dispersed staff in a work-from-home surroundings, together with administration of the usage of on-line and cell functions.
As well as, the Division will concentrate on analyzing registrants’ preparation for climate-related enterprise disruptions. Just like the work completed by the Division and different regulators following Hurricane Sandy in 2012, the Division will assess whether or not registrants, notably systemically necessary registrants, preserve enterprise continuity and catastrophe restoration plans that account for the rising bodily and different related dangers related to local weather change.
- Monetary know-how and innovation, together with digital belongingsWith innovation in monetary know-how persevering with to develop at a speedy tempo and remodeling buyer interactions, the Division expressed its dedication to staying knowledgeable about how such know-how impacts registrants and buyers. The Division acknowledged modern and evolving providers, such offering recommendation to shoppers by means of automated funding instruments and platforms (“robo-advisers”) or companies providing automated asset allocation, fractional share purchases, personalized portfolios, and cell functions. Examinations will concentrate on evaluating whether or not companies are working constantly with their representations, whether or not companies are dealing with buyer orders in accordance with buyer directions, and overview compliance round commerce suggestions made in cell functions. Examinations can even concentrate on the usage of know-how to facilitate compliance with regulatory necessities (RegTech).
The Division additionally acknowledged that different information (information gleaned from non-traditional sources) is more and more being utilized by companies, together with advisers to non-public funds and mutual funds, as a part of their enterprise and funding decision-making processes. Examinations will embrace analyzing whether or not companies are implementing applicable controls and compliance round such info.
The Division plans to watch the evolution of digital belongings going ahead. Examinations of market contributors engaged with digital belongings will proceed to evaluate the next: (1) whether or not investments are in one of the best pursuits of buyers; (2) portfolio administration and buying and selling practices; (3) security of consumer funds and belongings; (4) pricing and valuation; (5) effectiveness of compliance packages and controls; and (6) supervision of representatives’ outdoors enterprise actions.
- AMLThe Division continues to spotlight the significance of AML necessities which might be used to detect and fight terrorist financing, public corruption, market manipulation, and different fraudulent behaviors. As such, the Division will proceed to prioritize examination of broker-dealers and registered funding firms for compliance with their anti-money laundering obligations. Particularly, the Division will assess whether or not companies have established applicable buyer identification packages and whether or not they’re satisfying their Suspicious Exercise Report submitting obligations, conducting due diligence on prospects, complying with useful possession necessities, and conducting strong and well timed unbiased exams of their AML packages.
- LIBOR transitionThe Division acknowledges that the discontinuation of LIBOR might current a fabric threat to many market contributors. As such, the Division intends to have interaction with registrants by means of examinations to evaluate their understanding of any publicity to LIBOR, their preparations for the anticipated discontinuation of LIBOR, and the transition to another reference charge, in reference to registrants’ personal monetary issues and people of their shoppers and prospects.
- Extra focus areas Involving RIAs and funding firmsThe Division will proceed to look at compliance packages of RIAs in a number of core areas, together with the appropriateness of account choice, portfolio administration practices, custody and safekeeping of consumer belongings, greatest execution, charges and bills, enterprise continuity plans, and valuation of consumer belongings for consistency and appropriateness of methodology. The Division will prioritize examination of RIAs that haven’t been examined for various years to evaluate whether or not their compliance packages stay efficient in mild of any progress or change in enterprise fashions in addition to RIAs which might be dually registered as broker-dealers.
The Division additionally notes that, as a consequence of buyer demand, RIAs have more and more started providing funding methods specializing in environmental sustainability. The Division will overview merchandise on this space to evaluate the extent to which they align with disclosures and adjust to promoting necessities; the Division can even overview proxy voting procedures and votes to evaluate whether or not they align with the technique. The Division additionally highlights the next merchandise for examination.
- Registered funds, together with mutual funds and ETFs: The Division intends to prioritize analyzing mutual funds and ETFs, the actions of their RIAs, and oversight practices of their boards of administrators for regulatory compliance and valuation points. With respect to valuation, the Division will overview for investments in market sectors that skilled, or proceed to expertise, stress because of the pandemic, resembling vitality, actual property, or merchandise resembling financial institution loans and excessive yield company and municipal bonds. The Division can even prioritize examinations of mutual funds or ETFs that haven’t beforehand been examined or haven’t been examined in various years, and can typically concentrate on funds’ compliance packages and monetary situation, notably the place funds have instituted advisory price waivers or sought exemptive reduction. As well as, the Division will concentrate on liquidity threat administration packages and liquidity classifications, to find out whether or not they’re fairly designed to evaluate and handle the funds’ liquidity threat and applicable in mild of the latest stresses available in the market because of the pandemic. The Division additionally intends to concentrate on cash market funds’ compliance with stress-testing necessities, web site disclosures, and board oversight.
- RIAs to non-public funds: The Division will proceed its concentrate on RIAs to non-public funds, noting that such funds typically have important investments from pensions, charities, endowments, and households. The Division will overview such RIAs for preferential therapy of sure buyers by advisers to non-public funds which have skilled points with liquidity, together with imposing gates or suspensions on fund withdrawals; portfolio valuations and the ensuing impression on administration charges; adequacy of disclosure and compliance with regulatory necessities for cross trades, principal investments, or distressed gross sales; and conflicts round liquidity, resembling adviser led fund restructurings, together with stapled secondary transactions the place new buyers buy the pursuits of present buyers whereas additionally agreeing to put money into a brand new fund. The Division can even concentrate on RIAs to non-public funds which have the next focus of structured merchandise, resembling collateralized mortgage obligations, which might be at the next threat of holding non-performing loans or materials impacts as a consequence of latest financial situations, resembling actual property associated investments.
- Extra focus areas involving broker-dealers and municipal advisorsAlong with the Regulation Greatest Curiosity, the Division can even concentrate on the security of buyer money and securities, greatest execution, buying and selling methods, and the operation of different buying and selling techniques. The Division highlighted the next areas.
- Dealer-dealer monetary accountability: The Division will study whether or not broker-dealers meet their obligations to safeguard buyer money and securities in compliance with the Buyer Safety Rule and Internet Capital Rule. As well as, the Division acknowledged that examinations will assess compliance with necessities for borrowing securities from prospects. The Division can also assess broker-dealer funding and liquidity threat administration practices to evaluate whether or not companies have adequate liquidity to handle stress occasions.
- Dealer-dealer buying and selling practices: The Division will concentrate on greatest execution obligations in a zero-commission surroundings and compliance with the not too long ago amended Rule 606 order routing disclosure guidelines. The Division will proceed its prior initiative within the space of cost for order stream and its potential impact on order routing and greatest execution obligations. Examinations can even concentrate on market maker compliance with Regulation SHO, together with the foundations relating to aggregation models and find necessities. The Division can even study the operations of sure different buying and selling techniques for consistency with their disclosure necessities.
- Municipal advisors: The Division famous the impression of COVID-19 on many municipal issuers and can study the extent to which such issuers and municipal advisors have adjusted their practices in response to the pandemic. The Division can even study whether or not municipal advisors have met their fiduciary obligation obligations to municipal entity shoppers, in addition to their registration, skilled qualification, persevering with schooling, and supervision necessities and whether or not municipal advisors have relied on reduction from Kind MA annual replace submitting necessities, or the short-term dealer exemptive order allowing sure actions in reference to direct placements of municipal securities.
- Market infrastructureThe Division stays centered on entities that present providers which might be important to the functioning of the capital markets, together with clearing companies, exchanges, different buying and selling techniques, and switch brokers.
- Clearing companies: As required by regulation, the Division will conduct at the least one risk-based examination of every clearing company designated as systemically necessary and for which the SEC serves because the supervisory company. The Division will concentrate on (1) compliance with the SEC’s Requirements for Lined Clearing Businesses and different federal securities legal guidelines relevant to registered clearing companies; (2) whether or not clearing companies have taken well timed applicable corrective motion in response to prior examinations; and (3) different areas recognized in collaboration with the SEC’s Division of Buying and selling and Markets and different regulators. Examinations of registered clearing companies can also embrace evaluation of authorized, restoration and wind down, margin, back-testing, settlement and operations, liquidity threat administration, impact of the LIBOR transition, and cybersecurity and resiliency.
- Exchanges: The Division will concentrate on exchanges’ operations to watch, examine, and implement member and listed firm compliance with, as relevant, change guidelines and the federal securities legal guidelines.
- Regulation techniques compliance and integrity (SCI):SEC Regulation SCI requires entities resembling exchanges, clearing companies, FINRA, the MSRB, different buying and selling techniques, and sure different entities to determine, preserve, and implement written insurance policies and procedures designed to make sure that their system capability, integrity, resiliency, availability, and safety is sufficient to keep up operational functionality and promote honest and orderly markets. When sure occasions happen, these entities should take applicable corrective motion as quickly as fairly practicable and instantly notify the SEC. Areas of focus will embrace IT governance, IT asset administration, cyber menace administration/incident response, enterprise continuity planning, and third-party vendor administration, together with utilization of cloud providers.
- Switch brokers: Noting the important position of switch brokers within the settlement of securities transactions, the Division will study switch brokers’ core features together with well timed turnaround of things and transfers, record-keeping and retention, and safeguarding of funds and securities. The Division can even contemplate a agency’s enterprise continuity and catastrophe restoration packages, in addition to their cybersecurity measures and account takeover precautions, in mild of the COVID-19 pandemic. The Division has recognized switch brokers that current the best potential dangers to buyers and funding channels (ie, the place/how retail buyers usually tend to make investments), in addition to switch brokers that service microcap or municipal bond points, use novel technological functions (eg, blockchain or on-line crowdfunding portal functions), or have interaction in important paying agent exercise, as candidates for examination.
- Regulating the regulators: FINRA and MSRB The Division conducts risk-based oversight examinations of FINRA’s main regulatory packages in addition to oversight exams of FINRA’s examinations of sure broker-dealers and municipal advisors. From these observations, the Division makes detailed suggestions to enhance FINRA’s program, threat evaluation processes, and its future examinations. Final yr, the Division accomplished over 150 examinations of FINRA. The Division makes use of related processes with the MSRB.
In sum, the 2021 Priorities replicate the Division’s evaluation of dangers, points, and coverage issues derived from developments within the markets and within the regulation of these markets, info gathered throughout examinations and from ideas, complaints, and referrals, and coordination with different SEC Divisions and Places of work, in addition to different regulators. Our key takeaways are:
- Local weather and ESG dangers and the dangers posed by the rising digital asset business emerged as new priorities for the Division going into the 2021 examination season. Examiners will scrutinize companies’ local weather and ESG disclosures to evaluate whether or not disclosures are constant and adequately addressing areas of important import to buyers, whether or not companies’ inner processes and practices align with their disclosures, whether or not fund promoting is correct, and whether or not the voting insurance policies and processes align with acknowledged methods. Equally, examiners will scrutinize digital asset investments to make sure they’re serving buyers’ pursuits and sufficient controls exist to guard these pursuits.
- Expanded coordination efforts inside the SEC and with different regulators will proceed to permit the Division, FINRA, and others to conduct extra centered examinations on problems with key curiosity to the SEC.
- The Division’s December 2020 assertion on latest and upcoming Regulation BI examinations is a roadmap to what companies ought to count on and market contributors ought to overview it fastidiously. Corporations also needs to count on the Division to include information analytics as a part of its transaction testing because it assesses whether or not companies are actually appearing in one of the best curiosity of their shoppers. The transition interval for “good religion” efforts to implement Regulation BI is probably going over.
- There will likely be enhanced concentrate on how companies tackle potential market disruption points resembling those who emerged throughout latest unstable buying and selling occasions the place some buyers have been unable to have trades executed for a time frame.
- Perennial precedence repeats from previous years embrace info safety and operational resiliency, AML, and a seamless concentrate on retail buyers.
- There’s important consistency within the Division’s priorities for broker-dealers with these introduced by FINRA, together with Reg BI, AML, cybersecurity, mounted earnings markup disclosure, personal placements, and web capital and liquidity administration.
As in prior years, the Divisions record of priorities shouldn’t be seen as unique areas of focus. Examiners can – and can – discover different areas that they imagine pose dangers to buyers, together with new threat areas that will emerge on account of suggestions from the general public relating to potential exercise that will violate federal securities legal guidelines or in any other case hurt buyers, in addition to market or coverage shifts. “Our priorities replicate the sophisticated, numerous, and evolving nature of the dangers to buyers and the markets, together with local weather and ESG,” Division Director Pete Driscoll stated within the press launch saying the priorities. “On this unprecedented time, the Division is dedicated to persevering with to adapt examination processes and discover modern methods to boost the effectiveness of examinations and our risk-based method. Nonetheless, the bedrock of our examination program stays unchanged. The work we do, from examinations to publishing threat alerts and conducting outreach, serves our mission to advertise compliance and shield buyers.”
In case you have any questions relating to the 2021 Priorities, want help in making ready for a regulatory examination, or want to focus on your agency’s compliance and supervisory insurance policies and procedures, please contact one of many authors.