SEC, FINRA release 2016 exam priorities for asset managersFebruary 2016

Both the SEC and FINRA recently released their priorities for 2016 examinations and continue to ramp up their oversight efforts with the goal of protecting investors. It is important that asset management firms review and update their policies, procedures and business activities to reflect both sets of priorities so they can strengthen business practices and prepare for potential exams.

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2 SEC, FINRA release 2016 exam priorities for asset managers

SEC priorities

In its Examination Priorities for 2016, the SEC’s Office of Compliance Inspections and Examinations (OCIE) states that the “priorities reflect certain practices and products that OCIE perceives to present potentially heightened risk to investors and/or the integrity of the U.S. capital markets.1” The OCIE release provides guidance to investment advisers, broker-dealers, municipal advisers and transfer agents. It is designed to protect investors, assess market-wide risks and collect information on illegal activities via data analytics to identify signs of potential unlawful actions.

Protecting investorsProtecting retail investors and those saving for retirement continues as a priority in 2016, and the OCIE indicates this will likely continue in the future.

OCIE focus areas Topics

Retirement accounts managed by SEC-registered investment advisers and broker-dealers

• Reasonable basis for recommendations made to investors• Conflicts of interest• Supervision and compliance controls• Marketing and disclosure practices

Exchange-traded funds (ETFs)

• Compliance with applicable exemptive relief and other regulatory requirements under federal securities laws, as well as unit creation and redemption processes

• Sales strategies, trading practices and disclosures with a focus on excessive portfolio concentration; primary and secondary market trading risks; adequacy of risk disclosure; and suitability, particularly in niche or leveraged/inverse ETFs

Supervision of SEC-registered investment advisers and broker-dealers in branch offices • Potentially inappropriate trading through the use of data analytics

Fee selection and reverse churning by investment advisers and dually-registered investment adviser/broker-dealers that offer a variety of fee arrangements

• Recommendations on account types and whether they are in the client's best interests• Fees charged• Services provided• Disclosure of fee arrangements

Variable annuity sales• Suitability of sales • Supervision of sales• Adequacy of disclosures

Advisers to public pensions• Pay-to-play • Identification of undisclosed gifts and entertainment• Other key risk areas

1 SEC Office of Compliance Inspections and Examinations. “Examination Priorities for 2016,” Jan. 11, 2016. See https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf for details.

Market-wide risksTo maintain fair, orderly and efficient markets, the OCIE will look for structural risks and trends that may involve multiple firms or entire industries.

OCIE focus areas Topics

Cybersecurity • Implementation of cybersecurity procedures and controls

Regulation systems compliance and integrity • Written policies and procedures reasonably designed to ensure the capacity, integrity, resiliency, availability and security of any technology systems that relates to the U.S. securities market

Liquidity controls for advisers to mutual funds, ETFs, private funds and broker-dealers that have exposure to potentially illiquid fixed income securities

• Controls over market risk management, valuation, liquidity management, trading activity and regulatory capital

Clearing agencies • Regulatory compliance with provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act

Data analyticsThe OCIE has steadily increased its use of data analytics to analyze asset management firms and identify areas of weakness or illegal activity.

OCIE focus areas Topics

Recidivist representatives and the firms that employ them

• Firms that employ individuals with a history of misconduct• Compliance oversight and controls of firms after such individuals have been disciplined or barred from

a broker-dealer

Anti-money laundering programs• Clearing practices and history• Late or incomplete suspicious activity reports• Whether the number of suspicious activity reports is consistent with the business model

Broker-dealers’ anti-money laundering programs • Adequacy of the independent testing obligation• Extent to which firms consider and adapt their programs to current money laundering and

terrorist financing risks

Microcap fraud and market manipulation

• Broker-dealers and transfer agents operations that may support market manipulation schemes (e.g., pump and dump schemes)

• Broker-dealers' compliance with federal securities laws in publishing quotes for or trading securities in the over-the-counter markets

Excessive trading • Firms and representatives engaged in excessive or otherwise inappropriate trading activities

Product promotion • Potential suitability issues and breaches of fiduciary obligations arising from the use of new, complex and high-risk products

Other exam initiativesThe OCIE expects to allocate examination resources to some priorities beyond those described above.

OCIE focus areas Topics

Newly-registered municipal advisers • Compliance with recently adopted SEC and Municipal Securities Rulemaking Board rules

Private placement offerings involving Regulation D of the Securities Act of 1933 or the Immigrant Investor Program • Legal requirements regarding due diligence, disclosure and suitability

Never-before-examined investment advisers and investment company complexes

• Compliance programs• Investment advisory contracts• Advertising and distribution of fund shares• Valuation of portfolio assets and NAV calculation

Advisers to private funds• Fees and expenses • Controls and disclosures associated with side-by-side management of performance-based and purely

asset-based fee accounts

Transfer agents, including examining transfer agents providing paying-agent services for their issuers

• Timely turnaround of items and transfers, record keeping and record retention• Safeguarding of funds and securities• Paying-agent services, focusing on the safeguarding of security-holder funds

4 SEC, FINRA release 2016 exam priorities for asset managers

FINRA priorities

FINRA also recently issued its 2016 Regulatory and Examination Priorities Letter.2 Similar to the OCIE’s priorities, key FINRA examination areas include culture, conflicts of interest and ethics; supervisions, risk management and controls; liquidity; sales practices; financial and operations controls; and market integrity.

Culture, conflicts of interest and ethicsFINRA describes culture as the “set of explicit and implicit norms, practices, and expected behaviors that influence how firm executives, supervisors and employees make and implement decisions in the course of conducting a firm’s business.” Because of culture’s central role in how business is conducted, FINRA is formalizing its assessment of firm culture to better understand how it affects a firm’s compliance and risk management practices, while continuing to focus on conflicts of interest and ethics.

FINRA focus areas Topics

The frameworks that firms use to develop, communicate and evaluate conformance with their culture

• Whether control functions are valued within the organization• Whether policy or control breaches are tolerated• Whether the organization proactively seeks to identify risk and compliance events• Whether supervisors are effective role models of firm culture• Whether subcultures (e.g., at a branch office, trading desk or an investment banking department)

conform to overall corporate culture

Conflicts of interest and the fair and ethical treatment of customers • Mitigation actions

2 Financial Industry Regulatory Authority. “2016 Regulatory and Examination Priorities Letter,” Jan. 5, 2016. See http://www.finra.org/sites/default/files/2016-regulatory-and-examination-priorities-letter.pdf for details.

Supervisions, risk management and controlsCulture is closely aligned with supervision. FINRA will consider supervision generally and also how it specifically relates to conflicts of interest.

FINRA focus areas Topics

Conflict of interest management

• Incentive structures – Incentive structures and conflicts of interest within member firms’ retail brokerage business – Conflict mitigation processes regarding compensation plans for registered representatives – Approaches to mitigating conflicts of interest that arise due to the sale of proprietary or affiliated

products or products for which a firm receives third-party payments• Investment banking and research businesses

– Whether firms’ research analysts have inappropriate involvement in their investment banking activities – Whether investment banking personnel have undue influence on analysts

• Information leakage and controls to identify, minimize and mitigate information leakage within or outside a firm

• Supervision, control and validation of traders’ pricing of illiquid, Level 3 assets and whether positions are fairly valued

Technology infrastructure (including hardware, software and personnel)

• Cybersecurity – Cybersecurity risk management and assessment – Governance – Technical controls – Incident response – Vendor management – Data loss – Staff training – Confidentiality, integrity and availability of sensitive customer and other information – Ability of high-frequency and proprietary trading firms to protect their systems from

unauthorized access • Technology management

– Technology governance – Change management practices

• Data quality and governance – Data governance – Quality controls – Reporting practices

Outsourcing • Due diligence and risk assessment of vendors• Supervision of vendors

Anti-money laundering • How a firm monitors suspicious activity• High-risk microcap securities activity

LiquidityBecause liquidity management has been a contributor to firm failures and systemic crises, FINRA will continue to review the adequacy of firms’ contingency funding plans in light of their business models.

FINRA focus area Topics

Liquidity • Adequacy of firms’ contingency funding plans• Adequacy of high-frequency trading firms’ liquidity planning and controls

6 SEC, FINRA release 2016 exam priorities for asset managers

Sales practicesSales practices for specific types of investments or investors may be examined closely.

FINRA focus areas Topics

Suitability and concentration • Policies and processes that govern monitoring for excessive concentrations• Suitability determinations for recommended transactions or investment strategies

Seniors and vulnerable investors • Suitability and concentration issues• Recommendations regarding high-cost products

Sales charge discounts and waivers• Volume discounts or sales charge waivers for products such as mutual funds, unit investment trusts,

nontraded real estate investment trusts (REITs) and business development companies (BDCs)• Sales charge waivers

529 College Savings Plans • Recommendation of specific share types • Fee and expense structures

Private placements, the JOBS Act and public offers

• Private placement suitability, disclosure and due diligence• Public offering clearance by FINRA• Nontraded entities (e.g., REITs, BDCs and direct participation programs)• Prices for new bond sales and secondary market trading• Procedures for reviewing outside business activities

Financial and operations controlsFINRA wants to ensure controls are in place to lessen certain risks.

FINRA focus areas Topics

Market-maker net capital exemptions

• Exemptions from the SEC’s net capital requirements for broker-dealers• Whether the firm has consistently complied with the SEC’s net capital requirements for broker-dealers• Whether firms are engaged in bona fide market making and permissible hedging transitions under the

Net Capital Rule

Exchange-traded funds • Processes used to measure and monitor the impact of overnight counterparty risk• Accuracy of net capital computations

Fixed income prime brokerage

• Settlement practices for fixed income trades• Practices used to disaffirm trades, including the legal documentation that supports the

settlement process• Financing practices for fixed income when extensive leverage is offered

Internal audit

• Processes for identifying and prioritizing risks• Interactions between the audit committee and the board • Involvement of internal audit in committees and major projects• Audit plan execution• How issues are tracked through resolution• Whether internal audit deficiencies are incorporated into business risks

Client onboarding• Credit worthiness and the impact of trading strategy on credit worthiness• Projected liquidity usage arising from client trading practices• Estimated margin lending requirements

Transmittal of customer funds

• Controls used to review and monitor transmittals from customer accounts to: – Third-party accounts that would result in a change of beneficial ownership – Outside entities – Locations other than a customer’s primary residence – Firms’ registered representatives

Market integrityFINRA continues to focus on maintaining the integrity of financial markets.

FINRA focus areas Topics

Vendor Display Rule • Firm’s use of the Vendor Display Rule when providing quotation information to customers

Market access • How firms identify and address potential misconduct using information in new monthly FINRA equity manipulation compliance report cards

Fixed income

• Fixed income order handling, markups and related controls• Wash sales• Marking the close• Trading ahead• Alternative trading systems

Regulation SHO• Supervisory processes that ensure compliance with the net-flat or net long position requirements of Rule

204 of Regulation SHO• Adequacy of authorized participant controls on exchange-traded product redemption orders

Cross-market and cross-product manipulation • Coordinated equity and options market activity designed to create momentary artificial prices intended to affect the settlement prices of related products

Audit trail integrity• Potential audit trail issues not typically detected through routine compliance sweeps, including late

reporting of Trade Reporting and Compliance Engine-eligible and municipal securities and errors in the equity audit trail

ContactsMichael C. PatanellaAudit Partner and US Asset Management Sector LeaderT +1 212 624 5258E michael.patanella@us.gt.com

Kristina VieniLeader, Special Attestation Reporting Solution Group Metro New York/ New England Market TerritoryT +1 212 542 9612E kristina.vieni@us.gt.com

ConclusionRegulatory scrutiny is increasing, so now is the time to get your house in order, especially if you have not been through an examination. The SEC and FINRA examination priorities should serve as important building blocks to conduct your annual review of policies, procedures and business activities. Self-identifying and correcting deficiencies will be extremely useful in avoiding an investigation, examination or enforcement action. If you have any questions, please contact one of the Grant Thornton LLP professionals listed here.

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