Short Interest
A Summary of SEC Examination Priorities for 2013
By Ann Oglanian, Shealyn McGuire Sullivan, and David Thetford
Ann Oglanian is President and CEO of
ReGroup, LLC, a consulting firm that
provides strategic and tactical guidance to
investment advisers, private equity firms,
hedge funds, and mutual fund boards of
directors regarding business and regulatory
risk management.*
Shealyn Sullivan is a senior consultant at
ReGroup LLC.**
David D. Thetford is Wolters Kluwer
Financial Services’ securities compliance
principal analyst, the firm’s subject matter
expert in securities regulation, and editor
of this journal.***
O
n February 21, 2013, the National Examination Program
(“NEP”) of the Securities and Exchange Commission
(the “Commission”) published its examination priorities
for 2013, including those related to registered entities.1 Below is
a summary of the examination priorities related to investment
advisers, investment companies, and broker dealers listed in the
following categories: General Topics, Ongoing Risks, New and
Emerging Issues, and Policy Topics. The SEC document also
includes priorities for other registration types, such as transfer
agents and clearing agencies.
The NEP crafted their examination priorities based upon perceptions of their senior exam staff and management from the NEP’s
twelve offices of areas of heightened risk. They compiled the list
from a variety of sources, including information reported by registrants in required filings with the Commission, information gathered
through examinations conducted by Commission staff and other
regulators, and comments and tips received directly from investors
and registrants. The NEP cautions that the list is not exhaustive;
examinations will continue to focus on the actual business practices
of the registrant.
Practice Point: We incorporate this information provided by NEP
into annual reviews and use them to assist firms in adjusting the
focus on their compliance programs. Consider using this chart as
part of your annual review. For each NEP priority that is applicable
to your firm, add columns to the right of the chart below outlining
the tests you conduct, your findings, and any recommendations
for improvement.
©
2013, Ann E. Oglanian, Shealyn McGuire Sullivan, and David D. Thetford
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Short Interest: A Summary of SEC Examination Priorities for 2013
Investment Adviser–Investment Company
General Topics
These topics are areas of risk and examination priorities that the NEP believes apply to nearly
all registrants, including investment advisers, investment companies, and broker-dealers.
Fraud Detection and Prevention
Build upon existing quantitative and qualitative analytical tools that identify business
practices where there is greater opportunity for fraudulent conduct.
Encourage and solicit tips, complaints and referrals.
Corporate Governance and
Enterprise Risk Management
Meet with senior management and boards of entities and their affiliates to discuss
enterprise risk, including how firms govern and manage financial, legal, compliance,
operational, and reputational risks.
Assess the firm’s approach to Enterprise Risk Management.
Evaluate the firm’s tone at the top.
Initiate a dialogue on key risks and regulatory requirements.
Engage in “discovery” reviews to inform both examination policy and rulemaking efforts
and joint monitoring efforts with other regulators.
Conduct in-depth reviews of the manner in which registrants demonstrate and test the
readiness of their business continuity plans.
Conflicts of Interest
Examine the efforts of large/complex firms to document periodic evaluations of conflicts of
interest as part of their risk-assessment process, steps taken to mitigate the conflicts, the
sufficiency of disclosures made to investors, and how such conflicts are being addressed.
Examine the overall risk governance framework registrants use to manage conflicts.
Technology
Analyze the manner in which registrants leverage, supervise, and control technology,
specifically including:
Operational capability,
Market access,
Informational security,
System outages, and
Compromises to data integrity.
Enhance review of the registrant’s ability to demonstrate a clear understanding and
mitigation of operational information technology risk.
Assess the governance and supervision of technology systems.
Ongoing Risks
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“Ongoing risks” are those that the NEP believes pose inherent risk or threaten continued
reoccurrence.
Safety of Assets
Utilize a risk-based asset verification process to confirm the safety of client assets and
compliance with custody requirements.
Review:
The adequacy of audits of private funds,
Measures taken to protect client assets from loss or theft, and
The effectiveness of policies and procedures.
Focus on the extent to which new registrants:
Recognize situations in which they have custody,
Comply with Rule 206(4)-2 of the Advisers Act of 1940 (the “Custody Rule”), and its
“surprise exam” requirement,
Satisfy the Custody Rule’s “qualified custodian” provision, and
Follow the exception to the independent verification requirement for pooled investment
vehicles.
Conflicts of Interest Related to
Compensation Arrangements
Review financial records to identify undisclosed (or poorly disclosed) compensation arrangements including:
Undisclosed fee or solicitation arrangements,
Referral arrangements (particularly to affiliated entities), and
Receipt of payment for services allegedly provided to third parties.
Marketing/Performance
Focus on aberrational performance of registrants and funds.
Focus on the accuracy of advertised performance including:
Hypothetical and back-tested performance,
Assumptions or methodology used, and
Related disclosures and compliance with record keeping requirements.
Review changes in advertising practices related to the JOBS Act.
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Short Interest: A Summary of SEC Examination Priorities for 2013
Conflicts of Interest Related
to Allocation of Investment
Opportunities
Confirm that controls are in place to monitor the side-by-side management of performance-based fee accounts, such as certain private investment vehicles, and registered
investment companies, or other non-incentive fee-based accounts, with similar investment
objectives, especially if the same portfolio manager is responsible for making investment
decisions for both kinds of client accounts or funds.
Fund Governance
Confirm that the registrant is making full and accurate disclosures to fund boards.
Confirm that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets,
and assessment of expenses or viability.
New and Emerging Issues
“New and emerging” risks are those that the NEP believes require increased scrutiny due to
new circumstances, financial environments, new products and/or strategies, technological
advances, regulations, mergers, and general business practice changes.
New Registrants
Launch a coordinated national examination initiative designed to establish a meaningful
presence with these newly registered advisers, expected to run for two years and consisting
of four phases:
Engage with the new registrants,
Examine a substantial percentage of the new registrants,
Analyze examination findings, and
Report observations to the industry.
Prioritize examinations of private fund advisers where higher risks to investors may be
indicated.
Dually Registered IA/BD
Expand joint examinations with the Broker-Dealer Program of dually registered firms and
distinct broker-dealer and investment advisory businesses that share common financial
professionals.
Review how financial professionals and firms satisfy their suitability obligations when
determining whether to recommend brokerage or advisory accounts, the financial
incentives for making such recommendations, and whether all conflicts of interest are fully
and accurately disclosed.
Review dually registered firms’ policies and procedures to understand if such policies
and procedures provide guidelines for when a financial professional makes a securities
recommendation to a customer with a broker-dealer account versus an investment adviser
account.
“Alternative” Investment
Companies
Focus on the growing use of alternative and hedge fund investment strategies in open-end
funds, exchange-traded funds, and variable annuity structures.
Assess whether: (i) leverage, liquidity, and valuation policies and practices comply with
regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and
empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.
Payments for Distribution in Guise
Focus on the wide variety of payments made by advisers and funds to distributors and
intermediaries, the adequacy of disclosure made to fund boards about these payments, and
boards’ oversight of the same.
Assess whether such payments are made in compliance with regulations, including Investment Company Act Rule 12b-1.
Policy Topics
As part of the Commission’s ongoing efforts to gain a deeper understanding and knowledge of
specific practices or how previously adopted rules are being implemented by registrants, the
2013 NEP also includes what the Commission refers to as “Policy Topics”.
Money Market Funds
Review whether firms are conducting stress testing of money market funds as required Rule
2a-7 of the Investment Company Act, what factors they are considering in the stress testing, and the results of the stress testing.
Compliance with Exemptive Orders
Focus on compliance with previously granted exemptive orders such as:
Those related to closed-end funds and managed distribution plans, employee securities
companies, exchange-traded funds, and the use of custom baskets; and
Those granted to fund advisers and their affiliates permitting them to engage in coinvestment opportunities with the funds.
Compliance with the
Pay to Play Rule
Review compliance with the recently adopted Pay to Play rule, as well as assess the practical application of the rule.
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Short Interest: A Summary of SEC Examination Priorities for 2013
Broker-Dealer
General Topics
See the General Topics in Investment Adviser-Investment Company, above
Ongoing Risks
“Ongoing risks” are those that the NEP believes pose inherent risk or threaten continued
reoccurrence.
Sales Practices/Fraud
Affinity fraud or fraud targeting seniors.
Unsuitable recommendations of higher yield products (e.g., unsuitable recommendations of
municipal or corporate bonds), as well as improper supervision and due diligence processes
regarding those recommendations or those products.
Activities and products on the periphery of certain registered entities, such as outside business
activities or an affiliated entity that the registrant claims is beyond the Commission’s jurisdiction.
Conflicts of interest that are not appropriately mitigated, and are not clearly disclosed in an
understandable and timely manner.
Certain firms identified as recidivist or high-risk for potential misconduct.
Trading
High frequency trading,
Algorithmic trading,
Proper controls around the use of technology,
Alternative trading systems, and
Order routing practices
Capital
Staff will review clearing firms with multiple correspondents engaging in high frequency/high
volume trading, focusing on:
The clearing firms’ internal controls for managing intraday liquidity risk, as well as
Assessing intraday net capital, and
Other financial risks.
AML
Identify clearing and introducing firms that appear to have weak anti-money laundering (“AML”)
programs.
Focus on the firm’s risk assessment of its business practices and implementation of the AML
program related to those risks, including risks associated with taking on the accounts of failed or
expelled firms.
New and Emerging Issues
“New and emerging” risks are those that the NEP believes require increased scrutiny due to new
circumstances, financial environments, new products and/or strategies, technological advances,
regulations, mergers, and general business practice changes.
Exchange Act Rule 15c3-5
(The Market Access Rule)
Focus on firms’ compliance with this rule, with particular attention to master/sub-accounts relations
and proper controls relating to proprietary trading. Particular areas of focus are below:
Master / Sub-Accounts
Potential issues related to money laundering activity, market manipulation, unregistered brokerdealers, excessive margin, and inadequate minimum equity for pattern day traders;
Also, adequacy of books and records maintained by broker-dealers that provide market access.
Proprietary Trading
Compliance with requirements around capital thresholds on proprietary trading, including
error accounts;
Compliance with requirements that these thresholds also encompass a methodology for
accounting for open quotes, taking into account quotes associated with market making
activities.
Supervision of Registrants’ Technology System Controls and Governance
Effectiveness of broker-dealers’ controls and oversight over technology systems and
supervision of personnel,
Adequacy of firms’ protocols to address systems that are acting counter to expectations, and
Robustness of firms’ risk management procedure.
Dual Registrants / Regulatory Coordination
The B-D Program will maintain its focus in this area in coordination with the CFTC, and
More broadly, the B-D Program is emphasizing stronger coordination among Designated
Examination Authorities.
Exchange-Traded Funds
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Suitability of recommendations of leveraged or inverse ETFs to retail investors.
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Short Interest: A Summary of SEC Examination Priorities for 2013
Policy Topics
As part of the Commission’s ongoing efforts to gain a deeper understanding and knowledge of
specific practices or how previously adopted rules are being implemented by registrants, the 2013
NEP also includes what the Commission refers to as “Policy Topics”.
JOBS Act
Conduct reviews of entities participating in the crowd funding business.
Other Regulatory
Requirements
Pending adoption of final rules, focus compliance with the new registration and related rules
applicable to municipal advisors as well as incentive compensation.
Conduct examinations for compliance with Security-Based Swap Dealers rules pending the final
adoption or compliance effective date for such rules.
ENDNOTES
* Ann Oglanian has over 20 years of professional experience in the financial services
industry. Formerly, she was the Managing
Director, General Counsel and Chief Compliance Officer for Montgomery Asset Management. Prior thereto, she was a partner in
the investment services practice group of
the Chicago-based law firm, Vedder Price,
where she represented a wide range of mutual funds, investment advisers, independent
fund directors and broker/dealers. Formerly,
Ann served as in-house counsel to Strong
Capital Management and Kemper Financial
Services. Ann is a member of the Editorial
Advisory Board of Practical Compliance &
Risk Management. Ann is a regular contributor to various investment industry periodicals
and a frequent speaker on a wide variety of
topics relating to leadership, enterprise risk
management, compliance, and ethics.
** Shealyn Sullivan provides expert guidance
to investment advisers on developing
strategic and tactically effective compliance
programs, conducts compliance reviews,
drafts regulatory documents, and advises
compliance officers and management teams
with respect to issues pertaining to developing
and maintaining compliance programs. She
has more than 19 years of financial services
industry experience both as a management
consultant and a compliance consultant.
Having worked with private/trust banking
firms, insurance/retirement firms, mutual
fund companies, registered investment
advisers, and hedge fund firms, her focus has
been on compliance, operations, marketing,
and product development. Shealyn earned
her BA from the University of Notre Dame
in South Bend, Indiana and her JD from
Suffolk University Law School in Boston
Massachusetts.
***David Thetford began his career in compliance
as a compliance examiner for NASD. He served
as a branch compliance manager for Morgan
Stanley, a regional supervisor of examiners for
Wachovia Securities, and as Chief Compliance
Officer for a small broker dealer specializing
in private equity. David is a retired U.S. Navy
Commander.
1
http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2013.pdf
This article is reprinted with permission from Practical Compliance and Risk Management for
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