SEC, FINRA Target ICOs, Cybersecurity, Secondary Market Trading in 2018 Examination Priorities

Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) recently released their respective 2018 examination priorities, providing a glimpse into their plans for the year to come.

Many of the areas they highlighted will directly affect the alternative investment sector, and private fund advisers and securities firms should pay particular attention to their activities in such areas. Investment managers should review and/or update their policies and procedures in these areas and in general ensure their compliance with the SEC’s and FINRA’s requirements.

SEC Priorities

The SEC’s Office of Compliance Inspections and Examinations’ (OCIE) 2018 examination priorities focus on practices, products and services it believes may present a “potentially heightened risk to investors and/or the integrity of the U.S. capital markets.” In addition to activities related to critical market infrastructure and the protection of retail investors, OCIE indicated that developments in the cryptocurrency and the initial coin offering (ICO) markets would be “of particular interest this year.” Where these products are securities, the SEC stated it would monitor them for regulatory compliance, with a focus on whether financial professionals maintain adequate controls and safeguards to protect these assets from theft or misappropriation, and whether financial professionals are “providing investors with disclosure about the risks associated with these investments, including the risk of investment losses, liquidity risks, price volatility, and potential fraud.” This continued regulatory focus on ICOs follows the SEC’s increased scrutiny of cryptocurrencies as the offerings surged in popularity during 2017.

The SEC’s examination priorities outlined five general areas of interest, many of which could affect private fund advisers:

• Compliance and risks in critical market infrastructure
• Matters of importance to retail investors, including seniors and those saving for retirement
• FINRA and the Municipal Securities Rulemaking Board (MSRB)
• Cybersecurity
• Anti-money laundering (AML) programs

With regard to oversight of critical market infrastructure, OCIE said it will “continue to examine entities that provide services critical to the proper functioning of capital markets.” This will include examinations of such firms as clearing agencies, national securities exchanges and transfer agents, with a particular focus on certain aspects of their operations and compliance with recently effective rules.

With respect to the priority of protecting retail investors, the SEC will focus on whether the retail investor’s investment professional makes the proper disclosure and calculation of fees, expenses and other charges investors pay. In addition, OCIE will be looking for adequate disclosure of any conflicts of interest that may push financial professionals toward recommending certain products or services, “including any higher cost or riskier products.” Further, examiners will focus on firms with practices or business models that could involve inadequately disclosed fees or other expenses, including “private fund advisers that manage funds with a high concentration of investors investing for the benefit of retail clients,” such as retirement accounts. Finally, the SEC will continue to make risk-based assessments and select for examination those investment advisers that have elevated risk profiles, which may include those that have never been examined, those that have not been examined in some time, and those that provide investment advice through automated or digital platforms, including “robo-advisers.”

The SEC’s priorities for 2018 also include oversight of FINRA, noting that the registered national securities association acts as a primary regulator of the vast majority of SEC-registered broker-dealers. As such, the SEC said it will focus on FINRA’s operations and regulatory programs, as well as “the quality of FINRA’s examinations of broker-dealers and municipal advisors that are also registered as broker-dealers.” With regard to the Municipal Securities Rulemaking Board, which regulates broker-dealers that buy, sell and underwrite municipal securities, while also regulating municipal advisers, the SEC will seek to “evaluate the effectiveness of select operational and internal policies, procedures, and controls.”

Cybersecurity has been an ongoing area of interest for the SEC in recent years, and that focus will continue in 2018. In response to the dramatic rise in the “scope and severity” of cyber risks, its 2018 examinations will continue to focus on, among other things, governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, and incident response. Fund managers should ensure their cybersecurity policies and procedures are in compliance and avoid common shortcomings.

Finally, with respect to AML programs, the SEC will continue to evaluate whether covered firms – such as broker-dealers and investment companies – are fulfilling their AML obligations. This will include, among other activities, compliance with the customer due diligence requirement, whether covered entities are taking reasonable steps to understand the nature and purpose of customer relationships, and taking steps to properly address risks. In addition, the SEC will monitor whether entities are filing timely, complete and accurate Suspicious Activity Reports and whether entities are conducting robust and timely independent tests of their AML programs.

FINRA Priorities

As for FINRA, many of its 2018 regulatory and examination priorities mirror many of the SEC’s examination areas, such as a focus on ICOs, cybersecurity and AML activities. FINRA lists several areas of ongoing inspection, such as fraudulent activities – including insider trading, pump-and-dump and Ponzi-type schemes, and micro-cap fraud schemes targeting seniors – and high-risk firms and individual brokers, which FINRA will continue to inspect for compliance in their remote supervision arrangements; supervision of point-of-sale activities, including individual broker accountability when using joint rep codes; and branch inspection programs.

FINRA also announced plans to launch report cards designed to assist firms with their compliance efforts in three areas:

• The Auto Execution Manipulation Report Card will focus on instances in which a market participant uses non-bona fide orders to move the national best bid or offer (NBBO).
• The Alternative Trading System Cross-Manipulation Report Card will examine the potential manipulation of the NBBO, which results in the modification of a security’s prevailing midpoint price on an alternative trading system crossing venue.
• The Fixed Income Mark-up Report Card will provide information to firms – including median and mean percentage markups for each firm – and the industry, which firms will be able to display based on certain criteria such as investment rating, product (e.g., corporate or agency) and length of time to maturity.

FINRA indicated it may add more products in the future and will review “whether and how firms make use of” the report cards.

Finally, FINRA highlighted several significant new rules currently scheduled to take effect in 2018, adding that it may discuss with certain firms the actions they are taking to meet their obligations under the rules, which include:

• FINRA Rule 2165: Financial Exploitation of Specified Adults (effective Feb. 5)
• Amendments to FINRA Rule 4512: Customer Account Information (effective Feb. 5)
• FinCEN’s Customer Due Diligence Rule: Firms have until May 11 to comply
• Amendments to FINRA Rule 2232: Customer Confirmations (effective May 14)
• Amendments to FINRA Rule 4210: Margin Requirements for Covered Agency Transactions (effective June 25)
• FINRA Rules 1210 through 1240: Consolidated FINRA Registration Rules (effective Oct. 1)

These areas will make up the core of the SEC’s and FINRA’s regulatory activities for the months ahead. However, the regulators warn they are not exhaustive lists and that they will continue to monitor for any new areas of concern that may appear in the industry 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.