This March, the Securities and Exchange Commission released its new report on its 2021 Examination Priorities (the "Report").22 The Report covers a broad spectrum of issues. This article focuses on areas of interest to the structured products industry.
The Division of Examination (the "Division") stated in the Report its continued desire to emphasize the protection of retail investors, and the Division will prioritize examinations of financial intermediaries such as registered investment advisers ("RIAs") and registered investment companies, broker-dealers and dually-registered or affiliated firms. These examinations will focus on investments and services marketed to retail investors.
REGULATION BEST INTEREST
The Division plans to expand the scope of examinations of Regulation Best Interest. While prior examinations focused on the implementation of Regulation Best Interest by broker-dealers, future examinations will evaluate the processes used for compliance and alterations made to product offerings, as well as question the recommendations made by broker-dealers to customers, including whether such recommendations are in the customers' best interests.23 Additionally, the Division will also conduct enhanced transaction testing by "evaluating firm policies and procedures designed to meet additional elements of Regulation Best Interest, the recommendation of rollovers and alternatives considered, complex product recommendations, assessment of costs and reasonably available alternatives, how sales-based fees paid to broker-dealers and representatives impact recommendations, and policies and procedures regarding how broker-dealers identify and address conflicts of interest."24
REGISTERED INVESTMENT ADVISER FIDUCIARY DUTY AND FORM CRS
The Division's restated its commitment to examine the fiduciary duties of care and loyalty that RIAs owe to their clients, and the Division will focus on, among other items:
- RIA advice on whether account or program types are in the best interest of the client;
- RIA disclosure of all conflicts of interests "which might incline RIAs—consciously or unconsciously—to render advice which is not disinterested such that their clients can provide informed consent to the conflict;"25 and
- Risks associated with "fees and expenses, complex products, best execution, and undisclosed or inadequately disclosed, compensation arrangements" and the risk associated with each.26
With respect to ensuring compliance with Form CRS, the Division plans to prioritize examinations of broker-dealers and RIAs.
FRAUD, SALES PRACTICES, AND CONFLICTS
Examinations will focus on conduct related to retail investors, with a particular emphasis on: "(1) seniors, including recommendations and advice made by entities and individuals targeting retirement communities; (2) teachers; (3) military personnel; and (4) individuals saving for retirement."27 The Division also plans to hone in on the following:
- Recommendations regarding account type, conversions, and rollovers;
- The sales practices used for each product type, including structured products;
- Whether broker-dealers are meeting their legal and compliance obligations when providing retail customers access to complex strategies;
- How firms are complying with recent changes to the definition of accredited investor when recommending and selling certain private offerings;
- Whether fees, expenses and revenue sharing arrangements are adequately disclosed, encompassing revenue sharing arrangements between a registered firm and issuer, service providers, and others, and direct or indirect compensation to personnel for executing client transactions; and
- Examination of RIA fee calculation will include: "(1) advisory fee calculation errors, including but not limited to, failure to exclude certain holdings from management fee calculations; (2) inaccurate calculations or tiered fees, including failure to provide breakpoints and aggregate household accounts; and (3) failures to refund prepaid fees for terminated accounts."
- RIAs operation and use of turnkey asset management platforms.28
The Division restated its commitment to monitor securities products that can pose increased risks to retail investors such as mutual funds and ETFs, municipal securities, microcap securities and other fixed income securities. With respect to mutual funds and ETFs, the Division will focus on:
- The incentives provided to financial services firms and professionals that may cause them to select a higher cost mutual fund when a similar lower cost option is available.
- "Financial intermediaries' recommendations and disclosures involving ETFs, including adequacy of risk disclosure, and suitability, particularly in niche or leveraged/inverse ETFs."29
With respect to municipal securities and other fixed income securities, the Division will examine broker-dealers, underwriters and municipal advisors in order to determine whether each is meeting their obligations under municipal issuer disclosure. The Division will further examine "broker-dealer trading activity in municipal and corporate bonds for compliance with best execution obligations; fairness of pricing, mark-ups and mark-downs, and commissions; and confirmation disclosure requirements, including disclosures related to mark-ups and mark-downs."30
With respect to microcap securities, the Division restated its commitment to deterring fraud and cited concerns over false claims made by these companies regarding the pandemic, to which the Commission responded to by suspending trading in various securities. The Division plans to hone in on:
- "Transfer agent handling of microcap distributions and share transfers;
- Broker-dealer sales practices and their consistency with Regulation Best Interest; and
- Broker-dealer compliance with certain regulatory requirements, including the locate requirements of Regulation SHO, penny stock disclosures under Rules 15g-2 through 15g-6 of the Securities Exchange Act of 1934, and the obligation to monitor for and report suspicious activity and other anti-money laundering obligations."31
FINANCIAL TECHNOLOGY (FINTECH) AND INNOVATION, INCLUDING DIGITAL ASSETS
The Division restates its commitment to staying updated on recent fintech innovations and plans to focus its efforts on:
- Implementation and integration of RegTech in firms' compliance programs
- Implementation of controls and compliance around the creation, receipt, and use of alternative data
- Examining digital asset market participants for: "(1) whether investments are in the best interests of investors; (2) portfolio management and trading practices; (3) safety of client funds and assets; (4) pricing and valuation; (5) effectiveness of compliance programs and controls; and (6) supervision of representatives' outside business activities."32
THE LIBOR TRANSITION
The Division intends to examine the risks of "market participants such as RIAs, broker-dealers, investment companies, municipal advisors, transfer agents and clearing agencies in order 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 the registrants' own financial matters and those of their clients and customers."33
22. This Report is available at: https://www.sec.gov/files/2021-exam-priorities.pdf. On December 17, 2020, the Commission renamed the Office of Compliance Inspections and Examinations (OCIE) the Division of Examinations.
23. See the Report at 20.
27. See Report at 21.
28. See Report at 22.
30. See Report at 23.
32. See Report at 26.
33. See Report at 27.
Originally published in REVERSEinquiries: Volume 4, Issue
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