Protecting Retail Investors Through Examinations and Outreach

On April 29, 2019, Peter Driscoll, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), delivered a speech addressing the protection of retail investors.  In his speech, Driscoll discussed how OCIE’s examination priorities and core risk areas help the SEC achieve its investor protection goals. Driscoll also highlighted several areas where OCIE works to protect investors by conducting examinations and partnering with compliance professionals. Since OCIE is only able to examine a fraction of registered firms each year, it seeks other methods to inform and empower CCOs. OCIE believes that by being transparent regarding the deficiencies it frequently sees during examinations, it can help CCOs gain support from senior management.

OCIE examines areas of risk that might cause harm to retail investors. OCIE also looks closely at firms whose characteristics increase the risk of noncompliance and harm to retail investors. Driscoll focused on the following priorities and risk areas in his speech:

Fees, expenses, and related disclosures;

• Safeguarding client assets;
• Undisclosed conflicts of interests;
• Firms borrowing from clients; and
• Protection of seniors.

Driscoll also emphasized the critical role played by Chief Compliance Officers (“CCOs”) and compliance programs in protecting investors.

Fees, expenses and related disclosures

Investment advisors that fail to abide by their advisory agreements and disclosures increase the risk that clients will be over-billed. These firms may also be violating federal securities laws and their anti-fraud provisions.

Examiners closely review a firm’s disclosures to determine whether fees and charges are fully disclosed. Disclosures of fees and expenses are critical to an investor’s decision to hire a particular investment professional. Examiners will determine if the firm is assessing and collecting fees in a manner that is consistent with those disclosures.  Examiners will also look to see if advisors are accurately applying the correct fee rate, rebates, breakpoints and discounts. They will also make certain that advisors are refunding prepaid fees to former clients.

Among the deficiencies identified, examiners found that advisors sometimes valued a client’s assets using a different process than the one described in that client’s advisory agreement. For example, an advisor might utilize the market value of assets at the end of the billing cycle to calculate fees when the contract executed by the client stated fees would be based on the average daily balance of the account, or an advisor might . include assets in the fee calculation that were excluded per the terms of the advisory agreement.

Safeguarding of Client Assets

Surprise examinations and audits required by the Custody Rule (Rule 206(4)-2 of the Advisers Act) determine whether clients’ assets are protected from theft or misuse. To accomplish this, examiners focus on areas such as:

Custody of client assets;

• Misappropriation of investor assets; and
• Asset verification.

Examiners do not take firms’ documentation at face value and will look at the results of these audits as well as corroborating data from custodians.

Disclosure of conflicts of interest

Examiners review an advisor’s disclosures to determine if the firm has identified and disclosed material or potential conflicts of interest. Examiners have observed the following problems with such disclosures:

Recommending investments to clients without disclosing the advisor’s own interests in them, such as serving on a company board;

• Failing to provide adequate disclosure regarding how the advisor allocates investment opportunities among multiple clients with the same or similar investment strategies, or how the advisor allocates investment opportunities between itself and its clients;
• Recommending that their clients use affiliated broker-dealers or other service providers without fully disclosing the affiliation; and
• Recommending investment products without disclosing that the advisor receives additional compensation when those products are selected.

Mutual fund share class selection has been an OCIE priority since 2016. There have been a number of enforcement actions brought against advisors that had a financial incentive to recommend a particular share class. Of particular note, is the SEC’s recent share class  initiative, which required firms that recommended 12b-1 paying share classes without properly disclosing the associated conflicts, to self report.  As a result, many firms moved clients to a lower-cost share class and had to reimbursed clients the additional fees they paid by purchasing the more expensive share class.  These firms were also required to report this as disciplinary history on their Form ADV.   

Firms borrowing from clients & not disclosing all material facts

OCIE has seen many instances over the years where firms borrowed from their clients. This practice poses a risk to clients, because the advisor may not adequately disclose its financial condition or the potential benefits the loan will have for the firm. For example, firms may entice clients to invest in a growing business without disclosing the risks. Furthermore, OCIE has encountered firms that target seniors who mistakenly believe they are investing in a conservative and fixed-income investment, when, in reality, they may be investing in an unsecured note. When examiners observe these types of arrangements, they will ascertain whether all material risks, expenses and compensation have been adequately disclosed.

Issues that are important to seniors

OCIE continues to focus on protecting senior investors through its examinations and investor outreach efforts. OCIE recently conducted a review of over 200 advisors with a significant senior client base. The review was intended to:

• Develop an understanding of whether advisors with a significant senior client base had implemented policies and procedures to address the protection of senior investors; and
• Raise awareness and help influence behavior in a positive way through outreach events directed at senior investors.

Conclusion

OCIE’s examination priorities and core risk areas highlight the importance of having a strong compliance function.  OCIE’s goal is for all members of an advisory firm, not just compliance, to participate actively in the protection of investors. OCIE will continue to search for ways to strengthen the role of the CCO and to improve firms’ culture of compliance in order to protect investors. Examiners have found instances where competent CCOs are not empowered to fulfill their responsibilities. According to Driscoll, “An empowered CCO should have full authority to develop and enforce policies and procedures and be of sufficient seniority and authority within the firm to compel others – including others in senior management - to follow and enforce those policies and procedures.”

Driscoll stressed that firms must continue to assess whether their compliance programs are given sufficient resources. OCIE is concerned that compliance resources and budgets are being slashed and are not keeping up with firms’ risk profiles. He advised that firms should have a solid compliance culture, supported by a sincere “tone at the top” driven by senior management. Without that culture, the best compliance policies and procedures will not be effective. Strong CCOs and a culture of compliance help OCIE to deliver on the goal of investor protection. 

Driscoll’s speech can be found at https://www.sec.gov/news/speech/speech-driscoll-042919.

This article is not a solicitation of any investment product or service to any person or entity. The content contained in this article is for informational use only and is not intended to be and is not a substitute for professional financial, tax or legal advice.