SEC Division of Examinations Announces its 2021 Examination Priorities and Fiscal Year 2020 Results

Stroock & Stroock & Lavan LLP

On March 3, 2021, the Securities and Exchange Commission’s (the “Commission”) Division of Examinations (the “Division”), formerly known as the Office of Compliance Inspections and Examinations, announced its 2021 examination priorities, its ninth annual rundown of areas of potential risk to investors and the U.S. capital markets.[1] While the Division continues to focus its review on many of the same risk areas as in prior years, including an emphasis on investor protection through compliance items, fiduciary duties and potential conflicts of interest, this year’s examination priorities include an emphasis on recent developments and market trends. This includes operational resiliency in the face of the Covid-19 pandemic and new, emerging risks related to environmental, social and governance (“ESG”) concerns and climate change. As in past years, the Division also briefly touched upon the results of its fiscal year 2020 examinations and their overall impact.

2021 Examination Priorities

In announcing its 2021 examination priorities, the Division maintained its focus on the areas of retail investors, information security, financial technology, registered investment advisors (“RIAs”), broker-dealers, mutual funds, municipal advisors, and market infrastructure, as well as anti-money laundering programs and London Inter-Bank Offered Rate (LIBOR). The Division clearly continues to prioritize the protection of retail investors, weaving this priority into its stated areas of focus for RIAs, broker-dealers, and mutual funds – with emphasis on the standards of care owed to investors. The specific sources of risk and potential conflicts like the calculation of fees, the security of investor assets, the sufficiency of investor disclosures, portfolio management and strategy recommendations, and operational, investment, and liquidity risk management are also given special attention. Concerns about emerging risks and security in remote working environments, and the threats posed by climate change, were stated priorities and were not limited to the areas of information and financial technology, but were also addressed as an area for potential high-risk investments by funds into sectors that would be particularly affected by such factors (including the risks to investors these investments pose). Recurring concerns about maintaining effective compliance procedures and processes were identified for almost all of the areas the Division focused on.

Set forth below is a detailed summary of the examination priorities the Division has identified for 2021. A full copy of the 2021 Examination Priorities Memorandum can be found here.[2]

Retail Investors, Duties and Conflicts

The Division highlighted the protection of retail investors, focusing on RIAs, broker-dealers, and dually-registered or affiliated firms, and the investments and services these firms market to investors, and identified the primary tools for investor protection as the Form CRS Relationship Summary (“Form CRS”), Regulation Best Interest, and the Interpretation Regarding Standard of Conduct for Investment Advisers (“IRSC”).[3] Both broker-dealers and RIAs are required to provide retail investors with a brief customer or client relationship summary with information about the firm under Form CRS. The standard of care under Regulation Best Interest requires broker-dealers and associated persons to act in the best interest of their retail investors when making an investment recommendation. The Division plans to examine whether broker-dealers have a reasonable basis to believe a recommendation is in the investor’s best interests, the evaluation of alternative strategies, the assessment of costs and fees and their impact on the recommendation process, and the internal processes to identify and address conflicts of interest, among other factors. The Division also will continue to examine similar factors when focusing on RIAs in their compliance with the duties of care and loyalty established by the IRSC.

The Division emphasized the financial incentives that might cause these conflicts of interest, highlighting firm recommendations for specific types of accounts, strategies, products, and securities, the existence of revenue sharing agreements, and fee calculation methods. Specifically, the Division will focus on recommendations provided to seniors, including recommendations and advice made by entities and individuals targeting retirement communities, teachers, military personnel, and individuals saving for retirement.[4] When reviewing fees and expenses, the focus will be on: “(1) advisory fee calculation errors, including, but not limited to, failure to exclude certain holdings from management fee calculations; (2) inaccurate calculations of tiered fees, including failure to provide breakpoints and aggregate household accounts; and (3) failures to refund prepaid fees for terminated accounts.”[5] Specific “retail-targeted investments” will be examined for proper disclosures and compliance obligations, with the Division specifically highlighting mutual funds, exchange-traded funds, municipal and other fixed income securities, and microcap securities as particular products of concern when it comes to ensuring proper investor disclosure.

Information Security and Financial Technology

The Division emphasized the threat of cyber-attacks and the need for firms to proactively identify and address these risks, especially as these concerns have been amplified by the various remote working environments created by the Covid-19 pandemic, and the potential for similar disruptive situations that could be caused by environmental disasters. Specifically, reviews will focus on “whether firms have taken appropriate measures to: (1) safeguard customer accounts and prevent account intrusions, including verifying an investor’s identity to prevent unauthorized account access; (2) oversee vendors and service providers; (3) address malicious email activities, such as phishing or account intrusions; (4) respond to incidents, including those related to ransomware attacks; and (5) manage operational risk as a result of dispersed employees in a work-from-home environment.”[6]

Along a similar vein, the rapid development of technology offers firms new opportunities to expand their products and services in innovative ways, and examinations will focus on whether firms have successfully implemented new technology in assisting with their compliance programs, as well as ensuring compliance with firms’ collection, storage and use of alternative data.  Highlighting the growth of the digital asset market, the Division’s examinations of participants in this space will focus on: “(1) whether investments are in the best interests of investors; (2) portfolio management and trading practices; (3) safety of client funds and assets; (4) pricing and valuation; (5) effectiveness of compliance programs and controls; and (6) supervision of representatives’ outside business activities.”[7]

Anti-Money Laundering (AML)

The Division will continue to examine compliance with the AML requirements of the Bank Secrecy Act. This requires financial institutions to establish policies and procedures that will verify the identity of individual customers and beneficial owners of entity customers, perform customer due diligence, monitor for suspicious activity, and potentially file Suspicious Activity Reports with the Financial Crimes Enforcement Network.

LIBOR Transition

The Division intends to conduct examinations to help ensure a smooth transition away from LIBOR and ensure firms understand the change, and alternative reference rates, to prevent any adverse effects on investors.

RIAs and Investment Companies

Examination of RIAs will continue to focus on core compliance programs ensuring proper execution of typical items such as account selection, portfolio management, custody of client assets, calculation of fees and expenses, and valuation of assets, and whether these programs have been properly designed and implemented. Particularly, proper product strategies and accurate disclosures related to investor demand for investments with ESG components will be a focus of future examinations. RIAs that have never been examined or have not been examined for several years, as well as RIAs that are dually registered as broker-dealers and the unique risks posed by such firms’ dual business model, will be the primary focus of the Division’s examinations. 

The Division specified prioritizing examinations of mutual funds that have made investments in market sectors that experienced stress specifically due to the Covid-19 pandemic, such as real estate and energy, as well as funds that have never been examined or have not been examined in several years. Mutual funds’ liquidity risk management programs and whether they actually reasonably assess and manage risk, will also be a priority.

Advisers to private funds should also be aware that the Division will specifically prioritize certain issues, including preferential treatment to investors, portfolio valuations and the calculation of management fees, liquidity concerns, the risk of certain structured products and accurate disclosure of the risks of these products to investors, and proper compliance with general disclosure and regulatory requirements.

Broker-Dealers and Municipal Advisors

The Division emphasized its focus on (1) the responsibility of broker-dealers to hold customer cash and securities in compliance with the Customer Protection Rule and the Net Capital Rule, (2) compliance with best execution obligations in a zero commission environment, (3) compliance with Rule 606 regarding order routing, (4) market maker compliance with Regulation SHO, and (5) the operations of certain alternative trading systems for consistency with their disclosures provided in Form ATS-N.

The Division emphasized particular concern over how the pandemic has affected the finances of municipal issuers and how municipal advisors should prioritize timely and accurate disclosures, as well as typical requirements such as managing conflicts of interest, establishing the scope of client representation, and registration and professional qualification requirements.

Market Infrastructure

The Division specified required examinations of “each clearing agency designated as systemically important and for which the SEC serves as the supervisory agency,” and detailed the focus of such examinations on: “(1) compliance with the SEC’s Standards for Covered Clearing Agencies and other federal securities laws applicable to registered clearing agencies; (2) whether clearing agencies have taken timely appropriate corrective action in response to prior examinations; and (3) other areas identified in collaboration with the SEC’s Division of Trading and Markets and other regulators,” with such areas potentially including compliance, legal, margin, settlement, LIBOR transaction, liquidity risk management and cybersecurity.[8]

Regulation Systems Compliance and Integrity (“SCI”) imposes requirements on specified entities to establish procedures that ensure their systems’ capabilities and security and their ability to maintain fair markets, namely through effective use of IT systems, services and security, as well as requirements to take corrective action and inform the Commission in response to certain events. The Division specified such entities as including “national securities exchanges, registered and certain exempt clearing agencies, the Financial Industry Regulatory Authority (“FINRA”), the Municipal Securities Rulemaking Board (“MSRB”), plan processors, and alternative trading systems that meet certain volume thresholds.”[9]

The Division emphasized it will continue to examine typical items of concern for transfer agents, such as transfers, recordkeeping, and asset security.  The Division also stated the continuation of oversight of FINRA’s operations and FINRA’s own examinations of broker-dealers, as well as continued examination of the effectiveness of MSRB’s policies and processes, which also informs the Division and FINRA’s own examinations.

Impact of 2020 Examinations

Set forth below are certain key impacts of the Division’s 2020 examinations:

  • A commitment of significant resources by the Division to verify investor assets and their valuation led to the Division verifying over 4.8 million investor accounts, totaling over $3.4 trillion in assets—an increase of more than 50 percent of investor accounts, and more than twice the value of assets verified in FY2019.
  • Successful identification of improperly calculated and charged fees resulting in firms returning more than $32 million to investors.
  • Numerous settled actions relating to issues such as improper disclosure of conflicts of interest, inflation of asset values and performance results, failure to supervise unsuitable investment recommendations to retail customers, and failure to report suspicious activity.

Summary of FY2020 Results

Set forth below are certain key highlights of the Division’s 2020 Fiscal Year Results:

  • The Division completed 2,952 examinations in FY2020, which is a 4.4% decrease from FY2019, a small decrease when considering the negative impact of the Covid-19 pandemic.
  • The Division covered 15% of RIAs in 2020.
  • In FY2020, the Division completed more than 100 examinations of investment company complexes, as well as conducting hundreds of outreach calls to both investment company complexes and RIAs to assess market impacts from the pandemic.
  • The Broker-Dealer and Exchange Program completed over 330 examinations of broker-dealers, over 110 examinations of national securities exchanges, and over 90 examinations of municipal advisors and transfer agents.
  • The FINRA and Securities Industry Oversight group completed over 150 examinations of FINRA, including inspections of critical FINRA program areas and oversight reviews of FINRA’s examinations.
  • The Clearance and Settlement Examination Program, working with the Technology Controls Program, completed 28 examinations of clearing agencies, nearly double the number completed in FY2019.
  • The Office of Risk and Strategy, which houses the registrations team, processed and reviewed over 50,000 filings from registered firms in 2020, including over 13,000 Forms CRS.

Emerging Areas of Risk and Examination

Much of the Division’s examination priorities emphasized recurring and known risk areas and typical areas of regulatory requirements and obligations. However, some areas were fleshed out by unique concerns such as disruptions to working environments in the wake of the Covid-19 pandemic and climate change, specifically as remote working environments posed increased risk of cyber-security threats. These risks are compounded by the increasingly rapid development of financial and security technology, which can be misused to the detriment of firm security and investor protection. Specific areas of emerging market and investor interest were also identified that may pose some additional considerations for firms when it comes to identifying types of risks and meeting their duties and obligations (mainly surrounding ESG initiatives, and how firms must balance increased investor demand for such products and investment strategies while balancing requirements such as accurate disclosure and making investment strategy recommendations.) 

[1]SEC Division of Examinations Announces 2021 Examination Priorities, SEC Press Release 2021-39 (March 3, 2021).

[3] 2021 Examination Priorities at 21.

[4] 2021 Examination Priorities at 21.

[5] 2021 Examination Priorities at 21.

[6] 2021 Examination Priorities at 24.

[7] 2021 Examination Priorities at 26.

[8] 2021 Examination Priorities at 32.

[9] 2021 Examination Priorities at 33.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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