On February 21, 2013, the National Examination Program (NEP), which is administered by the Securities and Exchange Commission's (SEC) Office of Compliance Inspections and Examinations (OCIE), published its examination priorities for 2013, highlighting the NEP's primary areas of focus for the coming year. The NEP addresses market-wide priorities, as well as priorities for each of the NEP's four distinct program areas: (i) investment advisers and investment companies; (ii) broker-dealers; (iii) clearing and transfer agents; and (iv) market oversight. In publishing its examination priorities, the NEP staff is alerting investors and registrants to specific regulatory issues that the staff perceives to have heightened risk.
This alert examines the NEP initiatives applicable to all market registrants, provides more specific guidance with regard to the Broker-Dealer Examination Program and incorporates information distributed at the most recent SIFMA Compliance and Legal Society Annual Conference. The NEP's examination priorities with regard to investment advisors, investment companies, clearing and transfer agents, and market oversight are beyond the scope of this alert.
Generally, the NEP staff believe that fraud detection, corporate governance and enterprise risk management, conflicts of interest and technology issues represent the primary risk areas that apply to nearly all market registrants. While the NEP examinations are tailored to each particular registrant, these issues are the most significant examination initiatives of the coming year.
1. Fraud Detection and Prevention
Recognizing that trust is integral to the healthy operation of the nation's capital markets, the NEP staff will continue to focus on identifying registrants engaged in fraudulent or unethical behavior. In its "risk-based" approach, the NEP will continue to utilize and enhance its quantitative and qualitative analyses to identify market participants engaged in fraud, as well as tips, complaints and referrals from investors, registrants and other parties to target registrants for examination.
2. Corporate Governance and Enterprise Risk Management
The NEP staff will continue to meet with senior management and the boards of entities in order to understand the firm's approach to enterprise risk management. Of particular interest is how a firm governs and manages financial, legal, compliance, operational and reputational risks. The NEP staff intends to hold discussions with firm management in order to:
Understand the firm's approach to enterprise risk management;
Evaluate the firm's "tone" at the highest levels of management; and
Initiate a dialog on key risks and regulatory requirements.
The ultimate goal of these discussions is to provide the NEP staff an opportunity to assess a firm's overall risk management practices. Additionally, the disruptions brought about by Hurricane Sandy exposed gaps in certain registrants' business continuity plans, and the staff is continuing to identify the overall impact of the hurricane on certain entities' operations. Thus, examinations are not directed just at a firm's regulatory compliance but also the methodology by which the firm complies.
3. Conflicts of Interest
A continuing key focus of the NEP's examination priorities is how well a firm handles conflicts of interest. Failure to eliminate or properly mitigate conflicts of interest is a leading indicator and cause of regulatory issues for individuals, firms and even the entire market. Due to its dynamic nature and the extensive affiliations common to this industry, conflicts are constantly arising and changing. To address this issue, the NEP staff will focus on specific conflicts, steps registrants have taken to mitigate conflicts and the sufficiency of disclosures to investors. In carrying out its corporate governance assessments, NEP staff will also look at a firm's risk management framework for dealing with and managing conflicts on an ongoing basis.
Because technology continues to revolutionize the operation of capital markets, the NEP staff recognizes the importance of staying current on new trading technologies. A firm's use of technology not only enables novel trading practices but also directly affects the firm's ability to manage its practices, risks and continuity of service. To that end, in 2013, the NEP staff may conduct examinations on the governance and supervision of a firm's information technology systems for topics such as operational capability, market access and information security. With regard to information security, the staff will focus on the risks associated with system outages and data integrity compromises. Additionally, while it is not covered in the Priorities Letter, on March 8, 2013, the SEC published proposed Regulation SCI that would supersede the current Automation Review Policy. We anticipate that this will be an ongoing priority for the SEC.
BROKER-DEALER EXAMINATION PRIORITIES
The Broker-Dealer Program applies a "risk-targeted" approach to focus the program and select broker-dealers for examination. In making this selection, the staff will be taking into account: (i) the risks and activities of individual broker-dealers; and (ii) the risks identified in the course of regional risk assessment efforts. The topic and scope of an examination is tailored to each particular broker-dealer, taking into account that registrant's business activities. Additionally, a review of a broker-dealer may involve the activities of related entities registered in multiple capacities (i.e. investment advisor, transfer agent, etc.) that act in concert with the broker-dealer. While no two examinations will be exactly alike, the Priorities Letter identified several areas of particular interest:
1. Fraud in Connection with Sales Practices
Broker-dealer examinations will continue to target fraud in connection with sales practices regarding retail investors, including:
Affinity fraud or fraud targeting seniors;
Unsuitable recommendations of higher yield products;
Improper supervision and due diligence processes regarding higher yield products;
Activities and products on the periphery of registered entities, such as activities that the registrant claims is beyond the Commission's jurisdiction;
Conflicts of interest that are not appropriately mitigated; and
Certain firms identified as high-risk or recidivist.
2. Trading Practices and Capital
While the nature of trading risks evolves with the development of new technology and market practices, the NEP staff will focus on the risks associated with high-frequency and algorithmic trading, proper controls around the use of technology, alternative trading systems and order routing practices. Additionally, the NEP staff will be conducting exams of clearing firms with multiple correspondents engaging in high- frequency/high-volume trading, focusing on their internal controls for managing intraday liquidity and intraday net capital.
3. Anti-Money Laundering
The NEP staff will seek to identify clearing and introducing firms with weak anti-money laundering programs, focusing on customer identification programs, suspicious activity identification and reporting deficiencies, and weak due diligence procedures. A broker-dealer's anti-money laundering program should adequately address these risks, especially where the firm takes on the accounts of another failed or expelled firm.
4. Exchange Act Rule 15c3-5 (The Market Access Rule)
Exchange Act Rule 15c3-5 requires broker-dealers to have risk controls in connection with their market access. The NEP staff will specifically focus on a firm's compliance with this rule, including:
The NEP staff believes that the master/sub-account structure is particularly susceptible to issues relating to money laundering, market manipulation, unregistered broker-dealers, excessive margin and inadequate minimum equity for pattern day traders. Ensuring Rule 15c3-5 compliance of firms that utilize this structure will be an examination priority in 2013.
b. Proprietary Trading
Because some firms are unaware that Rule 15c3-5 requires capital thresholds on proprietary trading and error accounts, the NEP staff is focusing on this issue this year. In particular, the staff is concerned with whether a firm's capital threshold methodology accounts for open quotes and quotes associated with
c. Supervision of Registrants' Technology System Controls and Governance
The NEP staff believes that effective technology systems and supervision personnel are integral to preserving customer confidence in the markets, noting recently observed technological problems that have caused significant losses and eroded customer confidence. These events raised questions as to the effectiveness of the risk controls required by Rule 15c3-5. To avoid similar losses in the future, broker-dealer examinations will increasingly focus on a firm's day-to-day compliance with technology and supervision requirements, as well as its risk management procedures.
d. Dual Registrants/Regulatory Coordination
Because of recent problems arising from certain broker-dealers that were dually registered as futures commission merchants, the Broker-Dealer Examination Program will continue to focus on ensuring compliance in this area. In its 2012 update, the OCIE noted that a significant number of cases were brought in 2011 as a result of referrals from the Division of Enforcement. These cases included those involving Ponzi schemes, material misrepresentations or omissions, undisclosed compensation or hidden fees and expenses charged to investors, false and/or inflated valuations and compliance controls. In 2013, the NEP staff will be increasing their coordination with the Commodity Futures Trading Commission and other Designated Examination Authorities.
5. Exchange-Traded Funds
Recent examinations have uncovered issues with exchange-traded funds, such as fails to deliver and compliance with Regulation SHO. In 2013, examinations will focus on these areas. Additionally, the NEP staff will continue to review the suitability of recommendations of leveraged or inverse exchange-traded funds to retail investors.
6. Policy Topics
In 2013, the Broker-Dealer Examination Program will focus on the following policy topics:
a. The JOBS Act
The Jumpstart Our Business Startups Act of 2012 (JOBS Act) makes a number of important changes to federal securities laws that are meant to ease and expand methods of capital raising by private companies. Among other things, the JOBS Act creates a new exemption from registration under the Securities Act for qualified "crowd-funding" transactions. Pending approval of a final rule covering these transactions, the Broker-Dealer Examination Program will review the compliance of firms engaging in the crowd-funding business.
b. Other New Regulatory Requirements
The NEP staff also anticipates the adoption of final rules applicable to municipal advisors, incentive compensation and security-based swap dealers. This year, the staff intends to conduct examinations for compliance with these rules, pending final adoption or compliance effective dates.
SIFMA ANNUAL COMPLIANCE AND LEGAL DIVISION ANNUAL CONFERENCE UPDATE
At the March 2013 SIFMA Compliance and Legal Division annual conference, the materials distributed as part of a panel discussion entitled "Examinations From the Regulators' Perspective," identified several items of interest to broker-dealers. In May 2012, senior OCIE staff outlined seven key findings of their 2011 broker-dealer examinations:
Problems in calculating the reserve formula and net capital;
Safekeeping customer funds;
Risk controls, compliance functions and internal audit;
Supervision, particularly relating to independent contractors;
Sales practices, suitability, misrepresentations, churning and unauthorized trading;
Order handling and execution; and
Underwriting and distribution issues.
Further, the panel handouts noted that the OCIE has changed its staffing model in two ways. First, it created specialized working groups for the following areas:
New and structured products;
Equity and market structure and trading practices;
Fixed income and municipal markets,
Microcap fraud; and
Marketing and sales practices.
Second, the new staffing model involves "project-based" exam teams, which allows for the use of examiners on an inspection based on expertise rather than from a single "branch" of examiners. Lastly, the panel handout materials noted that the OCIE and FINRA are reportedly working more closely on broker-dealer examinations than they have in the past. According to senior staff at both agencies, the SEC and FINRA are coordinating regularly and in some instances, the two are having daily discussions about broker-dealer risks.
The NEP provides all market registrants with a blueprint of its regulatory priorities for the coming year. While these priorities are not exhaustive, the NEP expects to allocate a significant portion of its resources through 2013 to the examination of the topics discussed in its examination priorities. Thus, broker-dealers should take heed of the policies and procedures that NEP staff perceives to warrant heightened scrutiny for regulatory compliance.