SEC Releases National Examination Program Priorities for 2013

by BakerHostetler

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.[1] 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.

4. Technology

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.[2] We anticipate that this will be an ongoing priority for the SEC.


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:

a. Master/Sub-Accounts

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
market-making activities.

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.[3] 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.[4] 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.


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.[5] 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.[6]

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;
  • Valuation;
  • Equity and market structure and trading practices;
  • Fixed income and municipal markets,
  • Microcap fraud; and
  • Marketing and sales practices.[7]

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.[8] 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.[9]


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.

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.

© BakerHostetler | Attorney Advertising

Written by:


BakerHostetler on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at:

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.