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February 22, 2013

OCIE Office Provides Priorities for 2013 Examinations

By Amy Leisinger, J.D.

On February 21, 2013, the National Examination Program (NEP) of the SEC's Office of Compliance Inspections and Examinations (OCIE) published its examination priorities for 2013. Together with representatives of other SEC divisions and offices, NEP considered information reported in SEC filings, examination data, and communications with other domestic and foreign regulators, as well as investors and industry participants, in setting the priorities, which address both issues that affect the financial industry as a whole and those that relate specifically to particular business models and organizations.

General areas of focus. According to NEP, potentially fraudulent practices and activities remain a primary focus of examinations. By using a risk-based approach to target examinations, NEP explained, the staff will be better able to identify market participants engaged in fraudulent practices. NEP noted that it encourages tips, complaints, and referrals from investors and industry participants to assist in discovery of potential threats.

According to NEP, management of conflicts of interest is crucial in avoiding regulatory issues. NEP noted that such conflicts often serve as an indicator of problems within a firm and that, as a result, they play a major role in decisions regarding which firms to examine and which issues to consider. Given the interconnectedness of the industry and increasing complexity of business operations, new conflicts arise regularly. NEP stated that, in its examinations, it will focus heavily on the measures taken to mitigate conflicts and the disclosures made to investors.

NEP further noted that market events over recent years have underscored how crucial it is for regulators to monitor trading technologies and consider their implications. As a result, in 2013, the number of examinations focused on information technology systems and their supervision may increase. The SEC needs to evaluate the risks associated with these systems to protect investors and to assist the industry in developing methods by which to manage these risks, NEP explained.

Investment advisers and investment companies. NEP noted that the scope of an investment adviser or investment company examination is generally limited to the issues presenting the greatest risk. In 2013, NEP anticipates that the issues will include: (1) safety of assets; (2) compensation-related conflicts of interest; (3) marketing and performance-based advertising; (4) concurrent management of fee-based and non-fee-based accounts; and (5) fund governance. To confirm the safety of assets and compliance with custody rules, NEP stated that it will use a risk-based asset verification process and will review registrants' efforts to protect assets from loss or theft and the adequacy of their audit processes. To assess risks related to compensation arrangements, the staff will review financial records to identify undisclosed compensation and referral arrangements and the conflicts of interest presented to ensure proper disclosure to clients. In evaluating marketing activities, NEP will focus on the accuracy of advertised performance, the methodologies used to develop the figures, and compliance with disclosure and recordkeeping rules. To address issues related to the side-by-side management of its performance-based-fee accounts and other non-incentive-fee-based accounts, the staff will confirm that the registrant has controls in place to monitor the inherent conflict, especially in cases where the same portfolio manager is responsible for both kinds of accounts. To ensure proper fund governance, NEP stated that examinations will focus on assessing the "tone at the top" and will confirm that advisers are making adequate disclosures to fund boards and that the directors are conducting reasonable reviews.

Regarding emerging issues facing investment advisers and their funds, NEP intends to launch a coordinated national examination initiative to evaluate new SEC registrants, including advisers to hedge funds and private equity funds, in an effort to establish a presence in the industry and research particular issues unique to these entities. NEP also plans to continue to expand coordination within the broker-dealer examination program to effectively address suitability obligations and other conflicts that face dually registered firms. The staff will also focus on the growing use of alternative and hedge fund investment strategies and will consider the propriety of, and compliance with rules regarding, distribution fees.

Broker-dealers. According to NEP, broker-dealer examinations also involve a risk-targeted approach, taking into account both the risks associated with individual broker-dealers and those identified in more general risk-assessment efforts. The staff anticipates that the primary focus areas for broker-dealers in 2013 will include: (1) sales practices and fraud; (2) trading risks; (3) capital and liquidity risks; and (4) anti-money-laundering programs. To address the issues surrounding fraudulent sales practices, the staff will focus on fraud targeting seniors, unsuitable recommendations of high-yield products, and unmitigated conflicts of interest. Given the dynamic nature of trading risks, the staff will focus on high-frequency trading, algorithmic trading, and proper supervision of the technologies used to engage in these activities. The staff also intends to focus on clearing firms' management of intraday liquidity risk, as well as intraday net capital and other financial risks. To evaluate firms that appear to have weak anti-money-laundering programs, the staff will focus on firms' assessments of their business practices and their implementation of the programs related to those risks.

NEP also stated that the staff will particularly focus on firms' compliance with the Market Access Rule, with particular attention to the potential risks associated with master/sub-accounts and proper controls relating to proprietary trading. According to NEP, the staff has also observed technology system errors and will evaluate the effectiveness of broker-dealers' controls and oversight over technology systems and related personnel.

SROs. OCIE's Office of Market Oversight is responsible for examining SROs and other entities, including national securities exchanges and the Municipal Securities Rulemaking Board, to evaluate their compliance with applicable federal securities laws and Commission rules. According to NEP, the staff will focus on evaluating the effectiveness of compliance programs across these entities and will examine equity exchanges to review their internal controls, rulemaking processes, and how order types are proposed, implemented, and monitored. The staff will also inspect recently registered exchanges, NEP explained.

Transfer agents. According to NEP, most transfer agents engage in three core activities: timely turnaround of items and transfers, accurate recordkeeping and retention, and safeguarding funds and securities. As a result, NEP stated, the staff will continue to focus on compliance and controls in these critical areas. In the area of recordkeeping and retention, the staff will specifically review policies and procedures related to business continuity, electronic storage, and third-party vendor access and security. According to NEP, the staff will also focus on transfer agents' customer service activities to verify that these entities are not providing investment advice such as would require registration with the SEC.

NEP expects that microcap securities will present additional risk in 2013, as they may be used to facilitate the unregistered offering of restricted securities or enable fraudulent schemes. In response to this risk, the staff will evaluate transfer agents' policies concerning microcap securities to ensure that they include acknowledgment of potential conflicts of interest and appropriate procedures to be followed when conflicts arise. According to NEP, the staff will also evaluate whether transfer agents have formal written policies and procedures to govern all of the securities they service, including new and hybrid products.

Clearing agencies. In July 2012, the Financial Stability Oversight Council designated the Depository Trust Company, the National Securities Clearing Corporation, the Fixed Income Clearing Corporation, and the Options Clearing Corporation as "systemically important" under the Dodd-Frank Act, appointing the SEC to serve as the agency to annually examine the entities.

As this year will be the first examination of these entities, NEP noted that it will use a risk-based approach to determine the policies, procedures, and associated internal controls to be reviewed and evaluated in collaboration with other regulators. To make these determinations, the staff will use the factors defined by the Dodd-Frank Act, including the operations of and the risks borne and presented by each individual designated clearing agency. NEP opined that regular interaction with the entities and other agencies, along with ongoing monitoring activities, will be beneficial when evaluating potential risks.

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