Private Fund Advisers, Robo-Advisers, ETFs Among SEC, FINRA Exam Priorities for 2017

In January, U.S. financial market regulators released their annual preview of what the industry can expect in the year ahead. Both the Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) issued their respective 2017 examination priorities for the year ahead.

Many of the areas outlined for ongoing or additional scrutiny in the coming year will directly affect the alternative investment sector. As a result, private fund advisers and securities firms should be aware of the areas due for regulators’ scrutiny in order to review and/or update their policies and procedures in these areas to ensure their compliance with the SEC’s and FINRA’s requirements.

SEC Priorities

In its 2017 examination priorities, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) outlined three general areas of interest:

1. Examining matters of importance to retail investors;
    
2. Focusing on risks specific to elderly and retiring investors; and
    
3. Assessing marketwide risks.

In addition, the SEC says it will allocate resources to examine private fund advisers, with a focus on conflicts of interest and disclosure of conflicts, as well as “actions that appear to benefit the adviser at the expense of investors.”

Each of these three broad spheres contains several specific items that would affect private fund advisers. As part of its objective of protecting retail investors, the SEC plans to examine registered investment advisers and broker-dealers that offer investment advice through automated or digital platforms, including “robo-advisers.” The examinations will focus on registrants’ compliance programs, marketing, formulation of investment recommendations, data protection and disclosures relating to conflicts of interest, as well as firms’ compliance practices for overseeing algorithms that generate recommendations.

The SEC will also expand its existing focus on registered investment advisers and broker-dealers using wrap fee programs, to ensure they are acting in accordance with their fiduciary duty and meeting contractual obligations to their clients. Specifically, examiners will focus on wrap account suitability, effectiveness of disclosures, conflicts of interest and brokerage practices. Wrap fees were highlighted in the SEC’s 2016 examination priorities, and the regulator brought charges against multiple firms for related violations in the past year, typically resulting in settlements in the six-figure range. Focus on “reverse churning,” or the practice of placing a client’s funds into a wrap program where very little trading is expected to occur, thus resulting in the client paying higher fees than it would in a standard advisory arrangement, will continue to be a priority.

Also of interest to private fund advisers is the expansion of the SEC’s Never-Before Examined Investment Adviser initiative to include focused, risk-based examinations of newly registered advisers and selected existing advisers that have never been examined by OCIE. In addition, the regulator will continue its use of analytics to identify individuals with a track record of misconduct and examine the compliance oversight and controls of investment advisers that employ such individuals, including those who have been subject to a regulatory action or barred from associating with a broker-dealer. Further, OCIE indicated that it will continue to focus on advisers that provide advisory services from multiple locations (i.e., multiple-branch advisers), due to the unique risks and challenges they perceive in such a structure.

Within the second area of interest, dedicated to protecting elderly and retiring investors, the SEC states it will examine the investment advisers to pension plans of states, municipalities and other government entities holding significant retirement assets belonging to U.S. employees. Large public pension plans placed extra scrutiny on their private fund holdings in 2016 as the trustees and beneficiaries of these pension plans questioned the value the pension plans received in return for the fees charged by the funds. The SEC will add to that pressure in 2017, specifically by examining how such advisers are managing conflicts of interest and fulfilling their fiduciary duty, as well as looking at sector-specific risks, such as pay-to-play, undisclosed gifts and entertainment practices.

The final sphere of the SEC’s examinations is its overall goal of maintaining fair, orderly and efficient markets, and in this area it will focus on structural risks and trends that may involve multiple firms or entire industries. Within that sphere, the agency has several specific examination areas of interest to private fund advisers. Specifically, it will continue its annual examinations of clearing agencies that have been designated as systemically important and for which the SEC is the supervisory agency under the Dodd-Frank Act. The SEC will also examine select broker-dealers, including market-makers and those primarily serving retail customers, to assess their compliance with their duty of best execution when routing customer orders for execution.

With respect to regulation systems compliance and integrity (“SCI”), the SEC will continue to scrutinize entities to determine whether they have established, maintained and enforced written policies and procedures reasonably designed to ensure their systems have the capacity, integrity, resiliency, availability and security to maintain operational capacity and promote maintenance of fair and orderly markets. Other areas of interest will include controls governing how systems record the time of transactions or events; how they synchronize with other systems, as well as collection, analysis, and dissemination of market data. The examinations will study entities’ enterprise risk management, including ensuring programs extend to all appropriate business units, subsidiaries and related interconnected infrastructure.

The SEC will also continue its ongoing oversight in the areas of cybersecurity, national securities exchanges and potential anti-money laundering activities.

Written under the direction of former chair Mary Jo White, the SEC’s 2017 priorities are expected to be carried out by recently nominated chair Jay Clayton. While some observers anticipate the new regime will seek to reduce Wall Street regulation that has been criticized as overly burdensome and a hindrance to growth, the scope and timeline of any such reforms remain uncertain and the agencies’ stated examination areas are likely to remain the key priorities for the immediate future.

FINRA Priorities

FINRA shares many of its 2017 regulatory and examination priorities with the SEC’s examination areas, such as a focus on cybersecurity, senior investors and anti-money laundering activities, with the overarching goal of ensuring adequate compliance, supervision and risk management practices.

However, its priorities also cover a range of additional activities. At the top of FINRA’s list for 2017 is firms’ hiring and monitoring of high-risk and recidivist brokers, including whether firms establish appropriate supervisory and compliance controls for such individuals. FINRA is strengthening this part of its activities by way of a recently established, dedicated examination unit to identify and examine high-risk brokers. It will also review firms’ internal supervisory procedures related to hiring and/or retaining statutorily disqualified and recidivist brokers, while also conducting ongoing examinations of branch office inspection programs and supervisory systems for branch and non-branch office locations, including independent contractor branches.

FINRA also indicated that it will be on the lookout for excessive and short-term trading of long-term products – including open- and closed-end mutual funds, variable annuities, and unit investment trusts – that may negatively affect clients’ returns due to the additional commissions, fees and other costs. The group will also pay particular attention to various operational risks, including cybersecurity preparedness and compliance with related regulations, supervisory controls testing, customer protection and segregation of client assets, compliance with SEC Regulation SHO, and testing for weakness in firms’ anti-money laundering and suspicious activity monitoring programs.

Finally, FINRA outlined its priorities to protect general market integrity. Specifically, examiners will focus on matters such as detecting and deterring manipulation; best execution obligations; compliance with the market access rule; and trading examination priorities, including the adequacy of alternative trading systems’ disclosures to customers, potential conflicts of interest, and evaluating whether floor brokers and upstairs firms are handling manual options orders in a manner consistent with their best execution obligations.

Significantly, FINRA will also conduct electronic, off-site reviews for the first time in 2017. As a supplement to its traditional on-site examinations, FINRA will make targeted and limited information requests to firms and review the responses off-site. This approach will be used only on a select group of firms that are not currently scheduled for a cycle exam in 2017.

The above areas will make up the core of the SEC’s and FINRA’s regulatory activities for the coming year; however, the regulators will continue to monitor for any new areas that may appear within the market and respond to any further developments using a risk-based approach. As a result, private fund advisers should remain vigilant for any additional statements and guidance from regulators in the months ahead.