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Why It's Time to Prep for SEC Exams

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The Securities and Exchange Commission’s exam priorities this year will include — for the first time — assessing how advisors are handling compliance related to the rapidly growing cryptocurrency market.

In releasing the exam list — which includes zeroing in on senior investor protections, fee disclosure, digital advice, cybersecurity, anti-money laundering, ETFs and the continued scrutiny of the Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board, the agency noted that not only is the crypto market exploding, but the number of advisors and broker-dealers “engaged in this space” continues to grow as well.

What’s the SEC going to look for in crypto compliance? The securities regulator says it plans to monitor the sale of such products, “and where the products are securities, examine for regulatory compliance.” SEC Chairman Jay Clayton told Senators in early February that from his vantage point, all Initial Coin Offerings are securities — and since none have registered with the Commission, they are illegal. (More on this later).

Financial professionals dealing in the crypto space will also be scrutinized on whether they’re maintaining “adequate controls and safeguards to protect these assets from theft or misappropriation,” the SEC’s Office of Compliance Inspections and Examination said, 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.”

Also, OCIE said examiners “will continue to prioritize our commitment to protect retail investors, including seniors and those saving for retirement,” focusing a close eye on products and services offered to retail investors, and the disclosures investors receive about those investments.

The group plans to conduct exams targeting “circumstances in which retail investors may have been harmed and reviewing whether financial service professionals have met their legal obligations,” according to OCIE Director Pete Driscoll.

AML Audits Amy Lynch, president of FrontLine Compliance, told me at press time in mid-February that her firm is seeing an uptick in SEC exams covering anti-money laundering audits, so she’s “not surprised” AML compliance is a priority this year.

What’s the SEC looking for in the AML realm?

In 2018, examiners plan to continue to focus on whether entities regulated by the agency are appropriately “adapting their AML programs to address their obligations,” with reviews looking for such things as “customer due diligence” and also determining whether the entities are taking “reasonable steps to understand the nature and purpose of customer relationships and to properly address risks.”

Advisors and broker-dealers must also show that they’ve been “filing timely, complete and accurate” suspicious activity reports, or SARS. Examiners will also evaluate whether these entities are “conducting robust and timely independent tests of their AML programs.” Scrutiny of variable insurance products also remains on the SEC’s radar as well, Lynch adds.

In focusing on senior investors, OCIE says exams will be conducted of investment advisors and broker-dealers that offer services and products to investors with retirement accounts, with those “exams drilling down on, among other things, investment recommendations, sales of variable insurance products, and sales and management of target date funds.”

OCIE also plans to examine investment advisor and broker-dealer “facilitation and involvement in retirement vehicles” that primarily serve state and local government employees and non-profit employees, including 403(b) and 457 plans.

One “glaring omission,” according to attorneys with the law firm Drinker Biddle & Reath in a February client alert, is that OCIE “does not discuss how the anticipated rulemaking by the Commission regarding the development of a fiduciary standard may impact its priorities.”

This may have likely been omitted, the attorneys say, because OCIE’s primary mission is to “conduct examinations to assess compliance with the current securities laws,” so it “would have been premature for OCIE to discuss views on some yet-to-be formulated SEC fiduciary standard.”

Still, the attorneys state, “OCIE is clearly prioritizing the protection of retail investors even more than in years past, which is consistent with the SEC Chairman’s public statements about prioritizing the protection of ‘Main Street’ investors.”

Focus on Fees As for retail investors, the attorneys point out that OCIE bluntly states: “Every dollar an investor pays in fees and expenses is a dollar not invested for his or her benefit.”

OCIE “further admonishes that the proper disclosure and calculation of fees, expenses and other charges investors pay is critically important,” the Drinker Biddle attorneys write in their alert. It further advises “financial professionals to inform investors of any conflicts of interest that might provide incentives for the financial professionals to recommend certain types of products or services to investors, including any higher-cost or riskier products.”

Sanjay Lamba, assistant general counsel for the Investment Adviser Association, adds that while SEC examiners “have always looked at fee and expense disclosures, this year’s priorities reflect an expanded focus on particular practices or business models relating to retail investors, including retail investors in private equity.”

Also noteworthy, Lamba says, is that SEC exam program increased its coverage of investment advisors, conducting more than 2,100 exams, “which is a 46% increase over the SEC’s prior fiscal year.”

Back to Crypto… During an early February Senate Banking Committee hearing, Clayton and Commodity Futures Trading Commission Chairman Christopher asked lawmakers to explore the SEC and CFTC’s oversight of the cryptocurrency market; the two regulators explained that they do not have direct oversight of the U.S.-based cryptocurrency trading platforms — which have elected to be regulated as money-transmission services, so legislation may be needed to expand their authority.

Clayton reiterated that to date no ICOs have been registered with the SEC, and the SEC also has not approved for listing and trading any exchange-traded products (such as ETFs) holding cryptocurrencies or other assets related to cryptocurrencies. “If any person today says otherwise, investors should be especially wary.”

Sen. Elizabeth Warren, D-Mass., probed Clayton on why ICOs have not registered with the agency, asking “how do we make them safer?” In 2017, Warren said, “companies raised more than $4 billion in ICOs. How many of those ICOs registered with the SEC?” Clayton responded: “Not one.” Warren queried further: “As of today, how many companies have registered for upcoming ICOs?” Clayton responded: “Not one.” Why? Warren asked.

“I don’t think the gatekeepers that we rely on to assist us to ensure our securities laws are followed have done their job,” Clayton said. “We’ve made it clear what the law is. As I’ve said many times, there are thousands and thousands of private placements that go on every year in the U.S. We want them to go on. We want people to raise capital, but we want them to do it right.”

What ICOs do, Clayton continued, “is they take the disclosure-like benefits of a private placement and then add to it the public general solicitation and retail investor promise of a secondary market without registering with us. And folks somehow got comfortable that this was new and it was OK, and it was not a security and just some other way to raise money. Well, I disagree.”

Said Warren: “So it is new, but it’s not OK, and it’s not another way to raise money?’ “Correct,” Clayton said. As for allowing ETFs and other retail investor-oriented funds to invest in cryptocurrencies, Clayton told the senators that a number of issues must be “examined and resolved” before the SEC will permit them.