On December 20, 2018, the U.S. Securities and Exchange Commission (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) released its 2019 Examination Priorities.  The six themes for this year’s priorities are:  retail investors (including seniors and those saving for retirement), compliance and risk in registrants responsible for critical market infrastructure (clearing agencies, transfer agents, national securities exchanges and Regulation SCI entities), oversight of the Financial Industry Regulatory Authority and Municipal Securities Rulemaking Board, digital assets, cybersecurity and anti-money laundering.  The only new theme for 2019 compared to 2018 is digital assets, which we take to imply a plan to more closely—and substantively—regulate investment advisers and broker-dealers involved with this asset class.  The 2019 priorities also more explicitly than the 2018 priorities describe specific practices that OCIE found concerning in examinations of those entities, many of which involved failure to adequately safeguard client assets and the adequacy of disclosures of conflicts of interest.  We expect to see a corresponding focus in Enforcement Division investigations and cases on these issues as a result.

Major changes or particularly notable areas in the 2019 priorities include:

  • Conflicts of Interest. This year, the theme of conflicts of interest permeated OCIE’s priorities, with OCIE noting that examinations would focus on policies and procedures addressing the use of affiliates as service providers, loans or lines of credit collateralized by securities in brokerage or advisory accounts, and borrowing funds from clients.  For these particular practices, OCIE will assess the adequacy of disclosures of risks to clients and conflicts of interest, and whether brokers or advisers are acting in a manner consistent with these disclosures. In framing its concerns, OCIE noted the long-standing fiduciary duty of investment advisers, but did not mention the standard of care applicable to broker-dealers that may engage in these practices.  Though the SEC has not yet finalized guidance and rules proposed earlier this year regarding these standards of conduct, the OCIE report nonetheless signals additional practices that the SEC may target as problematic if not adequately disclosed.
  • Digital Assets. As noted above, though there are a number of new priorities, the only new theme for 2019 is digital assets, and the significant interest in this asset class from retail investors has led to its prioritization by other divisions.  The reshuffling of the OCIE’s themes is unsurprising in light of Chairman Clayton’s statements that the SEC intends to hold gatekeepers accountable for fraud, manipulation and inadequate disclosures related to initial coin offerings.  OCIE’s focus on this area for 2019 continues that trend, and specific topics in OCIE’s examination priorities include portfolio management, trading, custody, pricing, compliance and internal controls of investment advisers and broker-dealers active in these businesses. The shift from the 2018 topics of disclosure of risks associated with investing in these assets and the adequacy of controls to protect them from theft or misappropriation suggests that OCIE plans a deeper dive into more traditional examination areas, such as whether investment advisers and broker-dealers are acting consistent with their disclosures and policies, whether they are treating clients fairly and equitably in these areas and whether they are complying with not only the spirit but also the letter of the relevant requirements in these areas.
  • Broker-Dealers Entrusted with Client Assets. Similar to the focus on safeguarding assets in the digital assets context, OCIE has included a new priority this year to examine select broker-dealers for compliance with the customer protection rule.
  • Fixed Income Order Execution and Electronic Investment Advice. These two areas are no longer priorities for 2019, although the priorities document is intended only to highlight key areas where OCIE intends to focus its resources.

OCIE made only incremental changes to the following priorities:

  • Disclosure of Costs of Investing. OCIE remains focused on examining fee arrangements, retaining proper disclosure and calculation of expenses as a “critically important” priority.  OCIE specifically identified two areas of continuing concern and focus following its 2018 examination findings—wrap fee programs and the recommendation of more expensive mutual fund share classes without adequate disclosure of conflicts of interest.
  • Mutual Funds and Exchange-Traded Funds. OCIE has retained its focus on mutual funds and exchange-traded funds.  OCIE  noted a focus in 2019 on advisers that provide advice to both registered investment companies (“RICs”) and private funds with similar investment strategies.  This may signal scrutiny in examinations on whether private funds, which typically provide higher compensation to advisers than RIC clients, receive favored treatment or investments more likely to generate higher compensation.  This focus may also evidence concerns with advisers that have retail investor bases and make available sophisticated strategies through RICs without adequate disclosure.
  • Cybersecurity. OCIE’s examinations will continue to prioritize cybersecurity in 2019.  The scope of focus, however, has sharpened over the last year to include the configuration of network storage devices, policies and procedures related to retail trading information security, and practices at investment advisers with multiple branch offices or that have recently merged with other investment advisers.
  • Transfer Agents. OCIE re-iterated its focus on examining transfer agents, particularly for transfers, recordkeeping, safeguarding of funds and securities, and internal accounting controls.  This year’s priorities list includes a clear focus on particular rules, in contrast to 2018’s list, which focused on transfer agents that serve particular market participants, namely microcap issuers and crowdfunding issuers.
  • Anti-Money Laundering. Anti-money laundering (“AML”) continues to be a focus for OCIE, although this year’s priorities appear to slightly de-emphasize this area by, for example, dropping a reference to this area as “an important and critical task” for the SEC. Substantive requirements for investment advisers have not changed since the Financial Crimes Enforcement Network (“FinCEN”) re-proposed a rule in 2015 that would impose AML obligations on investment advisers.

The SEC’s broad emphasis on protecting retail investors is evident not only in the OCIE’s priorities, but also in the SEC Enforcement Division Fiscal Year 2018 annual report.  As we noted in our review of the report, we expect that the Enforcement Division will focus on disclosures concerning fees and expenses and other misconduct that occurs in interactions between market participants subject to examination by OCIE and their retail investor clients—particularly in light of the Division’s Retail Strategy Task Force (the “Task Force”) created this year.  We believe the OCIE priorities provide a roadmap for the type of conduct likely escalate into enforcement actions or otherwise garner the attention of the Task Force.

Finally, OCIE framed their execution of the 2019 priorities as relying on four pillars.  The four pillars, which remain unchanged from 2018, are:  (1) promoting compliance, (2) preventing fraud, (3) identifying and monitoring risk and (4) informing policy.  The report, however, for the first time included statistics to illustrate how each pillar supports the OCIE’s mission and a retrospective review of particular OCIE initiatives and examination results from 2018 to demonstrate their effectiveness.  Of particular note is OCIE’s listing within the compliance pillar discussion of the five risk alerts it published since issuing its 2018 priorities, which cover:  best execution, advisory fees and expenses, initiatives focused on RICs, the cash solicitation rule, and electronic messaging.  We would expect to see these areas pursued in enforcement investigations and actions in the coming year as a result. Similarly, OCIE noted in its discussion of the preventing fraud pillar that examinations led to more than 160 enforcement referrals, which we take to serve notice that the active coordination between OCIE and the Enforcement Division is continuing.