On January 7, 2020, the U.S. Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) released its 2020 examination priorities. An annual announcement since 2013, the priorities release describes OCIE’s examination focus across its examination population: investment advisers, registered investment companies (“RICs”), broker-dealers, the Financial Industry Regulatory Authority, national securities exchanges, municipal advisers, and transfer agents.
In this alert, we focus on on the impact of the priorities on RICs.1 The 2020 priorities release offers less specific detail than the 2019 examination priorities release and OCIE’s November 2018 fund-focused examination initiatives, which touched on topics such as aberrational performance, custom-built indexes, exchange-traded funds (“ETFs”) with little secondary market trading volume and smaller assets under management, and allocations to securitized assets. Instead, the current priorities release describes the following three “short” focus areas:
- Third-Party Sponsored Trusts – This is a new focus area that concerns investment advisers that use third-party administrators to sponsor the funds managed by or affiliated with the adviser. Under these third-party sponsored trusts, the trust’s operations, infrastructure, and board of trustees are established outside the control of any one adviser, which leverages the trust to create the series fund(s) the adviser will manage. While the examination priority appears to be aimed more at the managing adviser, such third-party sponsored trusts may also be examined as OCIE works with individual advisers on this area.
- Never-Before Examined – With this recurring focus area, OCIE will continue to review funds that have never undergone an OCIE examination.
- Similarly-Managed Accounts – This is another recurring focus area, one in which OCIE reviews investment advisers to private funds that also manage a RIC with a similar strategy.
Outside of above, OCIE’s 2020 priorities release also discusses the following focus areas that may be factored into fund examinations:
- Transition from LIBOR – LIBOR is a widely used reference rate in financial instruments. OCIE “will be reviewing firms’ preparations and disclosures regarding their readiness, particularly in relation to the transition’s effects on investors” as an alternative reference rate is introduced and settled on.
- Fee Breaks – OCIE will review for “fund fee discounts that should be provided to investors as a result of policies, contractual or disclosed breakpoints.”
- Digital Assets – OCIE will continue to identify and examine SEC-registered market participants engaged in recommending and investing in digital assets. While RICs largely have not invested directly in digital assets, given, in part, prior SEC staff guidance, this area is still worth noting as the investment industry moves toward fuller investment in this space.
- ESG – Environmental, Social, and Governance (“ESG”) investment strategies are of particular interest to OCIE. In part, it is interested in the accuracy and adequacy of disclosures made to investors.
- AML – Funds’ anti-money laundering (“AML”) programs will be assessed for whether the funds “have established appropriate customer identification programs and whether they are satisfying their SAR filing obligations, conducting due diligence on customers, complying with beneficial ownership requirements, and conducting robust and timely independent tests of their AML programs.”
What’s interesting about the 2020 fund priorities is what is not mentioned – the Investment Company Act of 1940 liquidity risk management program rule – given, in part, that funds have been preparing to comply with this new requirement for more than three years and that the full compliance dates passed in 2019. The rule’s absence is also interesting given OCIE’s discussion of the recently adopted Regulation Best Interest ("Reg BI"), Form CRS, and two separate interpretations under the Investment Advisers Act of 1940 that will be focus areas during 2020. While OCIE is silent regarding reviews of funds’ liquidity programs in the priorities release, ACA would not be surprised to see such reviews during routine examinations this year or even to learn of a focused examination sweep on the topic. Thus, funds should ensure their liquidity programs are effective and compliant through their compliance program oversight and the direct oversight of the liquidity program by the liquidity program administrator.
Outside of the announced examination priorities, funds should also be aware of and consider the November 2019 OCIE risk alert focused on registered investment companies. The content of this alert can be broken into three parts:
- General Fund Compliance – The alert presents OCIE’s observations across the varied requirements of the fund compliance rule—for example, its observations on disclosures to investors, noted weaknesses in the initial and annual review process of approving a fund’s investment advisory agreement, and the fund code of ethics rule.
- Target-Date Funds – The alert describes OCIE’s review of 30 target-date funds, including “to” and “through” funds2, and noted deficiencies or weaknesses related to incomplete and potentially misleading disclosures in prospectuses and advertisements and to incomplete or missing policies and procedures.
- Money Market Funds – The alert also describes OCIE’s examinations of money market funds for compliance with rule amendments that came into force in October 2016. During its examinations, OCIE noted deficiencies or weaknesses with “eligible securities” and minimal credit risk determinations, the summary of significant stress-testing assumptions, compliance policies and procedures, and website and advertising materials.
The review of target-date funds and money market funds was also part of OCIE’s 2017 examination priorities.
In conclusion, we note that OCIE’s examination priorities highlight its assessment of risks and issues facing the SEC’s registrant population and that its risk alerts summarize common deficiencies or weaknesses found during examinations as well as point out practices it finds particularly positive so that registrants may learn and potentially enhance their own compliance programs. Funds should consider the information provided by OCIE in these documents as they implement their compliance program initiatives, risk inventory, and monitoring and testing for 2020.
How ACA Can Help
ACA offers compliance consulting services to RICs along with mock SEC examinations, compliance program reviews, and annual liquidity program assessments and other readiness reviews.
To learn more about how ACA can help enhance or strengthen your compliance program, please reach out to your ACA consultant or contact us here.
1 Given its greater focus on retail investors in the 2020 priorities, OCIE singles out “mutual funds” and “ETFs” in its discussion. ACA will use the more generic terms “fund” and “registered investment company” so as not to limit our remarks to the two product types named by OCIE.
2 Per OCIE’s risk alert, “a fund that is managed ‘to’ its target date (typically, the investor’s retirement date) tends to be more conservative by reducing the fund’s equity exposure over time to its most conservative asset allocation at the target date. In contrast, a fund that is managed ‘through’ its target date will typically reach its most conservative asset allocation years later.”