Preparing for the SEC’s examination priorities in 2014


How you should prepare
Additional risks, issues and policy matters not discussed here may result from market developments, new information learned from exams or other sources, and coordination with regulators. Awareness of SEC focus areas and other areas as they arise gives you a roadmap to review and address areas that need attention to ensure they meet the standards for best practices.


In 2014, the SEC continues to emphasize registrants’ responsibilities to protect markets and customers through strong corporate governance, enterprise risk management and effective internal controls.

Beyond catching violators, the SEC is working to “make sure newly registered private fund advisers are aware of their obligations” and to “promote investor-oriented business practices,” said SEC Chair Mary Jo White at a recent speech before the Managed Funds Association.  She described the exams as “focused” and “shorter in duration and more streamlined than typical examinations.” These brief, risk-focused exams of advisers registered for more than three years and as yet not examined by the National Examination Program (NEP) have resulted in more referrals for further action than in previous years. 

In addition to new laws and regulation and retirement vehicles and rollovers, four NEP-wide areas to monitor and address include the following1:

1.    Fraud detection and prevention

This includes targeting fraudulent, unethical practices, such as scams, theft and unfair advantage, that adversely affect investors and erode trust in the markets. Accounting fraud cases tend to be built on performance benchmarks that do not follow standard accounting principles, such as acquisition accounting, capitalized versus non-capitalized expenses, reserves, revenue recognition and valuation.

2.    Corporate governance, conflicts of interest and enterprise risk management
Senior management and boards will need to be able to explain how they identify and mitigate conflicts of interest and enterprise risk, such as legal, financial and operational compliance. Compliance manuals need to be reviewed annually, focusing on policies, procedures, practices and risk matrices to assess advisers’ compliance with the Investment Advisers Act of 1940 (Advisers Act), and coverage of any relevant issues raised in recent SEC actions or NEP Risk Alerts.

3.    Technology
Systems governance and supervision, operational capability, systems security and disaster preparedness are among the hot spots for 2014. Particularly important will be to ensure that data security systems and procedures are up-to-date in light of the challenges financial institutions face.

4.    Dual registrants
Registrants that are both broker-dealers and investment advisers, as well as affiliated advisers and broker-dealers, must mitigate risk that the firm will not increase revenue at the expense of customers.
Iphone on business newspaperProgram area-specific initiatives
Among the program’s issues and business practices targeted to prevent the highest risks to investors and preserve the integrity of the market, certain issues predominate; some trigger further examination. Two programs of interest are the Investment Adviser/Investment Company (IA-IC) Program and the Broker-Dealer (B-D) Program.

Core issues that seem to dominate the IA-IC Program include the following areas:

  • Portfolio management: Safety of assets and custody; need to ensure compliance with the “custody rule”/Rule 206(4)-2 under the Advisers Act, which includes verifying that assets exist and failing to realize that an adviser has custody of assets
  • Conflicts of interest inherent in certain investment adviser business models:
    • Compensation arrangements for the adviser, with a particular focus on undisclosed compensation arrangements and their effect on recommendations made to clients
    • The allocation of investment opportunities
    • Controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts
    • Risk controls and disclosure, particularly for illiquid investments and leveraged investment products and strategies
    • Higher-risk products or strategies targeted to retail (and especially retired or elderly) investors
  • Marketing/performance: Particularly the accurateness and completeness of advisers’ claims about their investment objectives and performance

There are several new and emerging issues for the IA-IC Program; two significant ones are:

Quantitative trading models

Advisers will be assessed on fulfilling their fiduciary and contractual obligations to clients, as well as the processes they have in place for monitoring wrap fee programs recommended to advisory clients, related conflicts of interest, best execution, trading away from the sponsor and disclosures. The SEC staff will examine investment advisers with substantial reliance on quantitative portfolio management and trading strategies, and assess, among other things, whether these firms have adopted and implemented compliance policies and procedures.

Presence exams
Data from the SEC’s upgraded in-house technology and tools and presence exam observations confirms that never-examined businesses, particularly hedge funds and private equity funds, will want to ensure and document that they are maintaining organizational controls. The SEC announced that in 2014 it will expand its successful presence exam initiative beyond its original target of 15–25% of the nearly 1,600 newly registered private fund advisers.  

The core risks of the B-D Program include:

  • Sales practices/fraud: Detect and prevent fraud and other violations in connection with sales practices to retail investors
  • Supervision: Focus on broker-dealers’ supervision of independent contractors and financial advisers in “remote” locations and large branch offices, registered representatives with significant disciplinary histories, and private securities transactions
  • Trading: Focus on areas such as erroneous orders, use of technology, data leakage and market manipulation
  • Internal controls: Assess the standing, authority and effectiveness of key control functions
  • Financial responsibility: Review for compliance with customer protection and net capital rules, with a focus on assets collateralizing large concentrated customer debit balances and the liquidity of firm inventory
  • Anti-money laundering (AML): Review clearing and introducing firms to assess AML programs

One significant emerging issue is the SEC Rule 15c3-5 (Market Access Rule) exam. Staff will examine that firms are applying the Market Access Rule to their proprietary trading, as well as the adequacy of books and records that provide market access through master/subaccount arrangements.

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