SEC's Division of Examinations Issues 2021 Examination Priorities
The Situation: The U.S. Securities and Exchange Commission's ("SEC") Division of Examinations (the "Division") issued its 2021 examination priorities ("2021 Exam Priorities").
The Result: The 2021 Exam Priorities set forth a non-exhaustive list of key areas where the Division intends to concentrate its resources in 2021.
Looking Ahead: SEC registrants, including broker-dealers and registered investment advisers, should use the 2021 Exam Priorities as a resource in administering and improving compliance programs, and expect Division examinations to include the 2021 Exam Priorities.
On March 3, 2021, the U.S. Securities and Exchange Commission's ("SEC") Division of Examinations (the "Division"), formerly the Office of Compliance Inspections and Examinations, issued its 2021 Examination Priorities (the "2021 Exam Priorities"), detailing the nonexclusive areas on which it intends to focus its resources for examinations in the coming year. As in previous years, the 2021 Exam Priorities contain the broad thematic categories of retail investors, market infrastructure, the activities of the Financial Industry Regulatory Authority ("FINRA") and the Municipal Securities Rulemaking Board ("MSRB"), cybersecurity, and anti-money laundering ("AML") programs. This year, however, some areas of focus changed or were reorganized to highlight or expand upon particular areas the Division intends to target, including: (i) compliance with the newly implemented Regulation Best Interest ("Reg BI"); (ii) unique compliance issues related to the COVID-19 pandemic; (iii) operational resiliency and risks associated with climate change; and (iv) exposure to and preparations for the expected discontinuation of LIBOR.
Below is an overview of some of the more notable points discussed in the 2021 Exam Priorities.
The Division will continue to focus on retail investors, particularly senior investors and individuals saving for retirement, and will prioritize examinations of registered investment advisers ("RIAs"), broker-dealers, and dually registered or affiliated firms with respect to this class of investor. The Division also plans to assess investment products marketed to or intended for retail investors (e.g., mutual funds, exchange-traded funds ("ETFs"), fixed income (including municipal securities), and microcap securities (i.e., stock of companies that have a market capitalization of under $250 million)).
Because the compliance date for Reg BI was June 30, 2020, the Division will move away from assessing implementation of Reg BI and instead will assess compliance with Reg BI, prioritizing examinations of broker-dealers and RIAs to assess compliance with Client Relationship Summary filings ("Form CRS"). The Division will also assess Reg BI requirements related to complex product recommendations, sales-based fees, broker-dealers' policies, and procedures regarding conflicts of interest, as well as RIA risks associated with fees and expenses, best execution, and undisclosed or inadequately disclosed compensation arrangements, among other things. See Jones Day's July 2019 Commentary, "Final Rule on Regulation Best Interest Now Complete," for additional information about the SEC's adoption of Reg BI and Form CRS.
The Division will continue to prioritize cybersecurity, and will pay particular attention to whether firms have taken appropriate measures to safeguard customer accounts, oversee vendors and service providers, address malicious email activities, and manage operational risk, given the increase in remote operations in response to COVID-19 (e.g., controls surrounding online and mobile application access to investor account information, electronic storage of books and records, personally identifiable information maintained with third-party cloud service providers, and firms' related policies and procedures).
Operational Resiliency and Climate Change
In light of substantial disruptions to business operations due to COVID-19, the Division will continue examining registrants' business continuity and disaster recovery plans. Although it was not specifically listed as an examination priority, the Division notes that it will shift its focus to assess whether such business continuity and disaster recovery plans—"particularly those of systemically important registrants"—account for risks associated with climate change. The Division compared the scope of these examinations to the Division's post-Hurricane Sandy examinations. See Jones Day's March 2021 Commentary, "SEC to Review Climate-Related Disclosure: The Start of Things to Come," for additional information about how the SEC plans to enhance its focus on climate-related disclosure in public company filings.
Fintech and Innovation
Expanding on last year's priorities, the Division will continue to focus on developments in the fintech area. In addition to focusing on compliance issues related to digital asset securities, electronic investment advice, and the use of "alternative data" (data gleaned from non-traditional sources) to provide services to clients, the Division will focus on the use of technology to facilitate compliance with regulatory requirements in firms' compliance programs, sometimes referred to as "RegTech." The Division will also continue to examine market participants engaged with digital assets. See Jones Day's March 2021 Commentary, "SEC's Division of Examinations Reiterates Focus on Digital Asset Securities," for additional information about the Division's February 26, 2021 Risk Alert on digital asset securities.
Examinations of broker-dealers and registered investment companies for compliance with their AML obligations under the Bank Secrecy Act continues to be a priority for the Division. The Division will evaluate whether regulated entities are complying with requirements related to filing of suspicious activity reports, performing due diligence on customers, satisfying beneficial ownership obligations, and conducting independent assessments of their AML programs on a timely basis. See Jones Day's January 2021 Commentary, "Major U.S. Anti-Money Laundering Reforms Become Law," about significant reforms to U.S. AML laws that Congress recently enacted.
Following up on its June 2020 Risk Alert announcing its intent to examine registrants on their preparation for the expected discontinuation of LIBOR and the transition to alternative reference rates, the Division specifically listed the discontinuation of LIBOR as an examination priority in the 2021 Exam Priorities. The Division will examine registrants to assess their understanding of any exposure to LIBOR, their preparations for the expected discontinuation of LIBOR, and the transition to an alternative reference rate, in connection with registrants' own financial matters and those of their clients and customers. See Jones Day's June 2020 Commentary, "SEC Staff Announces Examination Initiative on LIBOR Transition Preparedness." Among the specific topics prudent registrants will be prepared to address are the following: the impact of the LIBOR transition on asset valuations and models, suitability determinations for fixed-income offerings materially impacted by the transition, and the registrant's understanding of the governing agreements underlying their LIBOR-linked investments.
RIAs and Investment Companies
The Division will continue to review the compliance programs of RIAs, prioritizing examinations of RIAs that have not been examined for a number of years or have never been examined. Compliance program elements that the Division will focus on include, among other things, the appropriateness of account selection, portfolio management practices, custody and safekeeping of client assets, best execution, fees and expenses, business continuity plans, and valuation of client assets for consistency and appropriateness of methodology. The Division will also continue to prioritize examinations of RIAs that are dually registered as, or are affiliated with, broker-dealers, or have supervised persons who are registered representatives of unaffiliated broker-dealers.
The Division will pay particular attention to RIAs' disclosures (e.g., whether disclosures match the RIAs' actual strategies), processes and practices, advertising, and proxy voting policies and procedures and votes related to ESG products, such as mutual funds and ETFs, as well as qualified opportunity funds. Notably, the SEC has had a recent emphasis on ESG (e.g., the creation of the new role of Senior Policy Advisor for Climate and ESG and a new Enforcement Task Force focused on climate and ESG issues).
Registered Funds, Including Mutual Funds and ETFs
In reviewing registered investment companies, the Division will focus on funds' compliance programs and governance practices, with a focus on disclosures to investors, valuation, SEC filings, personal trading activities, and contracts and agreements. In focusing on valuation of registered funds, the Division will review funds for their investments in market sectors that experienced, or continue to experience, stress due to COVID-19 (e.g., energy, real estate, or products such as bank loans and high yield corporate and municipal bonds).
The Division will prioritize examinations of mutual funds and ETFs that have not previously been examined or have not been examined in a number of years. The Division will focus on actively managed ETFs, as well as mutual funds' liquidity risk management programs, particularly in light of COVID-19. The Division also emphasizes that it will review money market funds' compliance with stress-testing requirements, website disclosures, and board oversight.
RIAs to Private Funds
Examinations of RIAs to private funds (e.g., private equity, real estate, hedge, and venture capital funds) will focus on liquidity and disclosures of investment risks and conflicts of interest, in addition to other key areas applicable to operations of private funds such as information security, business continuity, and ESG. These examinations will also focus on RIAs to private funds that have a higher concentration of structured products, such as collateralized loan obligations and mortgage-backed securities, and RIAs to private funds where "recent economic conditions" may have materially impacted the portfolio companies owned by the private fund (e.g., real estate-related investments). Other areas of focus will be preferential treatment of certain investors, cross trades, principal investments, distressed sales, and conflicts around liquidity, such as fund restructurings.
Broker-Dealers and Municipal Advisors
In addition to the Division's emphasis on broker-dealer compliance with Reg BI mentioned above, the Division's broker-dealer examinations will focus on a number of other areas, including compliance with: (i) SEC Rule 15c3-3 under the Securities Exchange Act of 1934 ("Exchange Act"), as amended ("Customer Protection Rule"), which requires broker-dealers to periodically calculate the net amount of cash owed to customers and deposit that amount into a segregated Reserve Account; (ii) Exchange Act Rule 15c3-1 ("Net Capital Rule"), which requires broker-dealers to maintain at all times adequate liquid resources to satisfy customer claims; and (iii) Rule 606 of Regulation NMS, which requires broker-dealers to disclose order routing information. Highlighting today's zero commission environment, the Division will continue to examine broker-dealers' use of payment for order flow, and will also focus on market maker compliance with Regulation SHO (short sales of securities) as well as the operations of alternative trading systems. In light of COVID-19, the Division also may examine broker-dealer funding and liquidity risk management practices.
The Division will focus on the potential impacts of COVID-19 on municipal advisors and their clients, and whether municipal advisors adjusted their practices as a result of the pandemic. The Division will also evaluate municipal advisor compliance with obligations relating to their fiduciary duty to clients, conflicts of interest, documentation of the scope of engagement with clients, among other things. Further, the Division will examine whether municipal advisors have relied on temporary (and now-expired) exemptive relief related to Form MA filing requirements and direct placements of municipal securities, both enacted due to the pandemic. See Jones Day's June 2020 Alert, "Temporary Exemption From Broker Registration for Municipal Advisors," for more information on the temporary exemption permitting direct placements of municipal securities without broker-dealer registration.
Clearing Agencies and National Securities Exchanges
The Division will conduct examinations of clearing agencies, other entities exempt from registration as clearing agencies, and national securities exchanges, particularly emphasizing areas impacting the infrastructure of the securities markets (e.g., liquidity risk management, the effect of the LIBOR transition, and cybersecurity). The Division will also assess clearing agency and national securities exchange compliance with SEC Regulation Systems Compliance and Integrity's ("Regulation SCI") requirement to implement and enforce written policies and procedures intended to ensure, among other things, that the regulated entity's technology systems can maintain its operational capabilities.
The Division will continue to examine transfer agents' core functions, such as the timely turnaround of items and transfers, recordkeeping requirements, and safeguarding of funds and securities. In light of COVID-19, the Division will also focus on transfer agents' business continuity and disaster recovery plans, as well as their cybersecurity infrastructure. The Division intends to examine transfer agents that service microcap or municipal bond issues, blockchain or online crowdfunding portals, or engage in significant paying agent activity.
Three Key Takeaways
- Because topics identified in the 2021 Exam Priorities often become the subject of SEC investigations and enforcement actions, the 2021 Exam Priorities are a good reminder for broker-dealers, investment advisers, and other SEC-regulated entities to review their existing policies, procedures, and practices to determine where enhancements and additional attention may be needed.
- Broker-dealers should pay particular attention to subject matter areas identified in the 2021 Exam Priorities as they review their sales practices and policies and procedures to ensure compliance with current regulatory requirements, namely those areas relating to retail investors and Reg BI, the LIBOR transition, the Customer Protection Rule, the Net Capital Rule, order routing and payment for order flow disclosures pursuant to Rule 606 of regulation NMS, activities involving digital asset securities, and liquidity risk management practices.
- Registered investment advisers, including those to private funds, should particularly focus their regulatory and compliance reviews on funds in market sectors that experienced, or continue to experience, stress due to COVID-19, ESG-focused products, and liquidity events.
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