Tuesday, April 17, 2018

SEC officials outline priorities at annual compliance seminar

By Amanda Maine, J.D.

Staff members from the SEC’s Division of Investment Management and its regional offices in the Office of Compliance Inspections and Examinations’ (OCIE) National Exam Program and the Enforcement Division’s Asset Management Unit (AMU) discussed issues facing compliance personnel at the Commission’s 2018 Compliance Outreach Seminar.

IM priorities. Paul Cellupica, deputy director of Investment Management, directed seminar attendees’ attention to the Commission’s upcoming Open Meeting on Wednesday, April 18. The meeting will consider proposing rules and rule amendments aimed at addressing confusion among investors about services they receive from investment advisers and broker-dealers, Cellupica said.

The three proposal items on the meeting agenda are: (1) requiring registered investment advisers and broker-dealers to provide a brief relationship summary to retail investors; (2) establishing a standard of conduct for broker-dealers and associated persons when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer; and (3) issuing a Commission interpretation of the standard of conduct for investment advisers. Cellupica urged CCOs, particularly those of investment advisers or dually-registered advisers/broker-dealers, to give input on the proposals because their roles make them “uniquely situated” to do so.

Another IM initiative highlighted by Cellupica is reforming how the Division treats ETFs. The Commission’s approach to ETFs began in 1992 with an exemptive order, and since then all ETFs have had to rely on exemptive orders to launch. It is not ideal for such a big segment of the investment management market to operate under so many separate orders, Cellupica said, noting that there are at least 300 such orders. The Division is working on a recommendation to the Commission for a proposed rule to address inconsistencies among exemptive orders and allow new ETFs to launch without an exemptive order, Cellupica advised.

The SEC is subject to a congressionally-mandated rulemaking under the FAIR Act, which requires extending the Rule 139 research report safe harbor to investment fund research reports published by brokers and dealers regarding certain investment funds such as ETFs and business development companies. The current safe harbor, which provides that a research report published or distributed by a broker-dealer is not an offer to sell a security pursuant to an effective registration statement, currently applies only to broker-dealers’ reports on public companies, not reports on ETFs or BDCs, Cellupica explained. There is a grey area between fund research reports and advertising, and Cellupica encouraged input on this issue.

In the medium-to-long term, the SEC would like to revise its marketing and solicitation rules, Cellupica said. The current rules were adopted in 1961 before the age of social media. The anti-testimonial rule in particular makes it difficult for people to research and select investment advisers using social media like they would for other aspects of the market, such as restaurants or travel, he noted.

Enforcement. Dabney O’Riordan, co-chief of the Los Angeles Regional Office’s Asset Management Unit, outlined several of AMU’s priorities. One priority is the disclosure of conflicts of interest. AMU has witnessed the lack of disclosure of conflicts regarding fees, compensation that advisers receive from broker-dealers, products that generate higher fees than others, and transactions that were engaged in to the benefit of an affiliate of the adviser, she said.

Another priority for Enforcement’s AMU is addressing trade allocation issues, or “cherry-picking.” She noted that the SEC identifies this conduct through data analysis of trading records, and reminded firms that they have access to the same records. Cherry-picking conduct usually falls into one of three buckets, O’Riordan explained: when an adviser favors himself over his clients, when he favors certain clients over other clients, or allocation practices that are contrary to the disclosures provided to clients.

O’Riordan highlighted the SEC’s Share Class Selection Disclosure initiative, which was established in February. Under the initiative, advisers are encouraged to self-report conduct where they failed to make disclosures relating to the selection of mutual fund share classes that paid the adviser a 12b-1 fee when a lower-cost share class for the same fund was available to clients. Advisers have until June 12, 2018, to self-report this conduct to the Commission to receive favorable settlement terms, including avoiding the imposition of a civil penalty.

After the June 12 deadline, there is no guarantee that self-reporting firms will get the same favorable settlement terms under the initiative, O’Riordan warned. Firms that do not self-report run the risk that Enforcement will find out about it after June 12. O’Riordan observed that the SEC had recently brought three cases in one week against firms that had failed to disclose that they had charged improper fees, resulting in the return of $12 million to harmed clients. She added that firms should think about how they would explain to their client why they failed to self-report and then went on to get caught anyway.

OCIE. Kristin Snyder, co-national associate director of the SEC’s National Exam Program in the San Francisco Regional Office, drew attention to OCIE’s 2018 exam priorities, which were published in February. In the retail space in particular, OCIE will be focusing on disclosure of the costs of investing; electronic investment advice; wrap-fee programs; cryptocurrency, ICOs and blockchain; and municipal advisers and underwriters.

The National Exam Program will also be focused on the protection of seniors, Snyder said, highlighting the program’s Retirement-Targeted Industry Reviews and Examinations Initiative (ReTIRE). Under the ReTIRE Initiative, which was launched in 2015, the staff gathered information about the distribution and sales practices regarding account rollovers into individual retirement accounts. From the broad look taken at the beginning of the initiative, examination staff will be focusing on specific issues such as target date funds and whether the disclosures match up to how a portfolio is actually performing, fixed-income cross trades, and sales and marketing of variable insurance products to be launched later this year, Snyder said.

She also said that staff will be focused on never-before-examined investment advisers. If you’ve never been examined before, you’re now likely to be examined, she explained. This also includes examinations of new registrants, which will give OCIE an early opportunity to engage with newly-registered advisers.

Another priority area for the National Exam Program is mutual funds and ETFs. This has been driven by the growth of ETFs in particular, Snyder said. One area in this space includes ETFs that are following a custom index, which can create conflicts between the adviser and the index provider. Snyder observed that IM Director Dalia Blass had highlighted this potential conflict in a recent speech to the Investment Company Institute. The staff will also take note of ETFs that are close to liquidation or delisting to ensure that the risk disclosures to investors are robust, Snyder advised.