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SEC Takes Aim at Products and People

The Securities and Exchange Commission’s division tasked with keeping watch over the nation’s investment advisors and broker-dealers is paying closer attention to the marketing of popular investment products and plans to track which firms hire employees with a history of misconduct.

The new areas of focus were announced last month in the SEC’s annual examination priorities from the Office of Compliance Inspections and Examinations. An SEC exam typically involves a request for documents and trading data and a series of onsite interviews that could last weeks. Potential problems can be forwarded to the SEC’s enforcement division for legal action.

The SEC said it would concentrate on the same three themes as last year: protecting retail investors and those saving for retirement, watching for marketwide risks, and beefing up its data analytics capabilities.

But the agency will be especially looking at firms’ liquidity controls, the behavior of public pension advisors and the marketing of variable annuities and exchange-traded funds (ETF), it said. ETFs are similar to mutual funds, but can be traded at any time, opposed to just at the end of the day. Some ETFs dropped more than 30 percent in just a few minutes in late August, a far greater dip than the losses in their underlying assets, spooking investors and regulators.

“There’s always a flavor of the year, which is usually a reaction to what happened in the past,” said Erwin Shustak, managing partner at Shustak Reynolds & Partners.

His firm advises some of the more than 800 SEC-registered investment advisors in the area.

“You think these ETFs will mirror a major index like the S&P 500, but some are fairly exotic and risky,” he said. “The SEC is concerned people are hearing ETFs and thinking plain vanilla mutual funds. It’s an appropriate response.”

Exams into ETF investments will likely center around how much information advisors presented to their clients and how risky the products were, according to Shustak.

Cybersecurity Concerns

The SEC priority list also mentioned the agency was increasing its focus on cybersecurity protections, including the resiliency of backup and primary data centers and whether computer infrastructure is geographically diverse. As part of its data analytics push, the SEC said it would identify individuals with a track record of misconduct and the firms that employ them, especially when registered investment advisors take on employees that have been barred from a broker-dealer.

The aim, according to securities firm Jacko Law Group managing partner Michelle Jacko, is to create a complete risk profile for investment firms. Advisors offering traditional products may not seem overly risky at a glance, but if they have a track record of hiring employees with a history of misconduct, that would significantly increase the chances of an SEC exam, she said.

“It’s not just the products you’re selling, it’s the people you employ,” she said. “It’s not something they’ve concentrated on before.”

Scrutinizing Issuers

The SEC’s guidelines are not the only thing securities lawyers are looking toward for hints on how the agency may behave this year. Pete Adams, a litigation partner at Cooley LLP, primarily represents issuers, not investment advisors or broker-dealers, and deals with the SEC’s Division of Enforcement, which doesn’t have an annual priorities release. But late last year, the agency accused audit firms BDO and Grant Thornton in two separate cases of ignoring red flags when auditing companies’ finances.

“The cases were against the firms, not just individuals, which is relatively rare, but consistent with the division’s focus on financial reporting,” Adams said. “They really want to make sure issuers are properly recognizing revenue and have the appropriate controls.”

The SEC brought 807 enforcement cases last year, including at least one against a San Diego firm. The agency accused Paul Lee Moore and Coast Capital Management of raising $2.6 million from clients and spending more than $2 million on travel, retail goods and pornographic websites. He used the rest of the money to pay back earlier clients in a Ponzi scheme, according to the SEC. The agency said Coast Capital had never registered with the SEC or any state regulator as an investment advisor.

Moore pleaded guilty in a parallel criminal case and was sentenced in December to five years in prison and ordered last month to pay $1.7 million in restitution.

A record 507 of last year’s actions were independent cases, which Jacko said signaled more attention on technical violations.

“That’s telling me their focus is not just on going after advisors for investment protection where an investor has been harmed, but they’re looking at internal controls,” she said.

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