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STATUTORY DISQUALIFICATION REVIEW PROCESS
Audit No. 363
Overall, we found the Division of Market Regulation's (MR) review of applications seeking to enter or continue working in the securities industry was in compliance with SEC Rule 19h-1, promulgated under the Securities and Exchange Act of 1934 (Exchange Act). MR decisions on applications appeared appropriate and the process was thorough and effective.
To increase efficiency, we are recommending that MR consider limiting or discontinuing its review of applications based on offenses unrelated to the securities industry.
We are also recommending that MR enhance its application log, ensure it meets required time frames for reviewing applications, update its policies and procedures and consider eliminating its input of duplicative information into the Commission's Name Relationship Search Index (NRSI).
To help ensure consistency between the New York Stock Exchange's (NYSE) and National Association of Securities Dealer's (NASD) review processes, the Office of Compliance Inspections and Examinations (OCIE) commenced an inspection of the NYSE's statutory disqualification review program during our audit.
Commission officials generally concurred with the findings and plan to implement the report's recommendations.
OBJECTIVES AND SCOPE
Our objective was to evaluate whether MR's review process under SEC Rule 19h-1, promulgated under the Exchange Act, ensured that only appropriate statutory disqualification applications were approved. We also sought to identify possible enhancements to the review process.
During the audit, we reviewed a judgmental sample of 15 files maintained by the Division of Market Regulation (MR) of applications seeking entry or continuance in the securities industry. In addition, we examined other relevant documentation. We also interviewed Commission, NASD and NYSE staff. The audit was performed from September 2002 to March 2003 in accordance with generally accepted government auditing standards.
Persons (and broker-dealers)1 who have engaged in certain types of misconduct are subject to statutory disqualification under the Exchange Act and must undergo a Commission review under Rule 19h-1 to enter or continue working in the securities industry.2
A statutory disqualification constitutes an encumbrance to SRO membership, or participation or association with a member, but does not necessarily preclude an entity or person from participating in the securities industry.
A person becomes subject to a statutory disqualification if the person is enjoined temporarily or permanently from violating the securities laws by a court of competent jurisdiction; is barred or suspended from association with a broker-dealer by the Commission, the Commodities Futures Trading Commission, a self-regulatory organization (SRO) or foreign equivalent; or has been convicted of any felony or certain misdemeanors within the last ten years.
In 1990, the definition of statutory disqualification was amended to include non-securities related felonies. As a result, many persons now subject to statutory disqualification committed offenses unrelated to the securities industry (e.g., driving under the influence, possession or sale of a controlled substance, assault, manslaughter). The majority of MR's reviews now deal with such cases, referred to as "other felonies."
Under Rule 19h-1, a member firm willing to sponsor (i.e., employ) a person subject to a statutory disqualification makes an application to its member SRO (usually the NYSE or NASD) 3 for approval. If the SRO approves the employing firm's application, the SRO submits it to the Commission.4
MR staff review the materials submitted by the SROs and make a determination to approve or recommend against a proposed association. The determination is based on whether the approval is in the public interest and consistent with the protection of investors.5
MR determines whether the filing complies with Rule 19h-1 and considers the proposed supervision of the person applying, any subsequent disciplinary actions after the event giving rise to the statutory disqualification, whether the person complied with the provisions of the statutory disqualification, and the overall merits of the individual case. This determination is made on a case-by-case basis.
Typically, MR's review of statutory disqualification applications takes about 30 days and approval is normally granted. In some cases, however, MR requests additional information or recommends that additional controls be in place before approving an application.
If MR does not approve an application, it recommends that the Commission deny the proposed entry.6 MR last requested the Commission to take this action in the mid-1990s.
As a result of the Sarbanes-Oxley Act (effective July 30, 2002) persons found to have violated certain state securities and insurance regulations and banking laws are now subject to statutory disqualification. MR has held preliminary discussions with the SROs on this issue and is exploring how to incorporate the provisions of the Sarbanes-Oxley Act into the review process.
Overall, we found MR's review of statutory disqualification applicants to be in compliance with Rule 19h-1 provisions. MR's files were complete and contained documentation supporting its decisions, which appeared appropriate.
We are making several recommendations, as described below, to enhance the review process.
MR'S REVIEW OF "OTHER FELONY" APPLICATIONS
As stated in the Background, the majority of statutory disqualification applications are categorized as "other felonies" and are not related to the securities industry. To date, MR has never disagreed with an SRO's approval to allow a statutorily disqualified person convicted of an "other felony" to enter the securities industry. On occasion, however, MR has asked the SROs for additional information or has recommended that additional controls be in place before approving such applications.
MR staff said their review ensures that the SROs follow applicable policies and procedures, ensures that adequate supervisory controls are in place, and allows MR to assist the SROs with unique issues. Furthermore, MR staff contend that continuing to review "other felony" applications is currently more efficient than eliminating this review.
SRO staff said that MR's review of all statutory disqualification applications, including "other felonies," is valuable and assists them in developing proper responses. SRO staff also said that MR's input fosters communication between MR and the SROs.
On the other hand, the Commission has limited authority in responding to felony convictions unrelated to the securities industry. As a result, MR staff generally defer judgment to the SROs for determining, on a case-by-case basis, whether it is in the public interest to permit the proposed or continued association of such persons. In addition, MR's statutory disqualification workload is expected to increase as a result of the Sarbanes-Oxley Act (see Background).
At some point, MR may want to consider discontinuing or limiting its review of "other felony" applications. For example, persons subject to a statutory disqualification because of a Driving Under the Influence (DUI) or Driving While Intoxicated (DWI) felony conviction do not typically suggest a risk to investors. Furthermore, these applications constitute a large percentage of the "other felony" applications.
MR should consider limiting or discontinuing its review of "other felony" DUI and DWI applications.
LOG OF 19H-1 APPLICANTS
MR staff maintain a spreadsheet containing the name of each person or entity it reviews, the type of violation, the responsible SRO, the date the Commission received the filing and other descriptive information. We identified the following issues with this log:
- The column headings for the log were not clearly defined (e.g., one heading was labeled "X");
- Many abbreviations were not defined (e.g., "RR," "GSP", "GP/OP", "NAL", "W/D", "NOTIF/ii", "Re-Entry(ii)", "C", "W", and "P");
- Some applications categorized as "other felonies" were not identified as such;
- Information was not consistently recorded. For example, the names of persons recorded more than once were often recorded differently (e.g., Smith, J vs. Smith, John A). This procedure made it difficult to tell whether the log referred to the same person.7 Different abbreviations were also used to describe the same issue.
- Sometimes information was not entered into the log (e.g., final disposition, description of violation, application due date).
- Add an explanatory legend describing the meaning of each column heading and of the information in each column (including abbreviations);
- Correct inaccuracies, inconsistencies and omissions, as feasible (e.g., as discovered in the ordinary course of business)8; and
- Record information consistently (e.g., names and abbreviations) and completely.
Regarding MR's 19h-1 log, MR should:
MR does not record the date on which it considers an application complete. MR does however, record the dates when it receives an application and completes its review.9
The completion date for an application is important because under Rule 19h-1, MR usually has 30 days from this date to comment on or object to the SRO's approval.10 We identified two instances out of 15 in which MR did not meet the 30-day time frame.
To help ensure MR meets the 30-day time frame for comments, MR should record the date when it considers an application complete.
WRITTEN POLICIES AND PROCEDURES
We found MR's written policies and procedures to be satisfactory in most respects and in accordance with MR's review process. We identified the following issues:
- The policies and procedures do not provide MR with guidance on how to review entities (e.g., broker-dealers) subject to the statutory disqualification review process.
- In certain circumstances, MR consults with staff in other divisions such as the Division of Enforcement or Investment Management. The policies and procedures do not specify what events necessitate this consultation.
- The policies and procedures state that "MR generally has not required entities" (e.g., broker-dealers) "to submit to the review process. Instead, broker-dealers historically have otherwise addressed the statutory disqualification issue and its collateral consequences." This suggests, contrary to MR practice, that MR is not interested in filings from broker-dealers.
Additionally, the Sarbanes-Oxley Act will likely have a significant effect on the 19h-1 review process by increasing the types of incidents resulting in statutory disqualification.
MR should update its written policies and procedures, incorporating changes to address the above issues. Additionally, MR should incorporate into these policies and procedures any significant changes in program operations that result from the Sarbanes-Oxley Act, as feasible.
NAME RELATIONSHIP SEARCH INDEX
When MR completes its review of statutory disqualification filings, it enters selected information from each filing into the Commission's NRSI system. NRSI, among other things, identifies persons and companies who are subjects of investigations.
However, we found that limited or no information about the statutory disqualifications actually appeared in NRSI, due to a technical computer problem.
We also found that staff requiring information about entities subject to statutory disqualification (OCIE, Division of Enforcement, and the Office of General Counsel staff) obtained it from MR or the Central Registration Depository (CRD) 11 system maintained by NASD, rather than from NRSI. Thus, fixing the technical problem may not be cost-effective.
In consultation with affected offices, MR should consider discontinuing the entry of statutory disqualification filing information into NRSI.
OCIE'S EXAMINATION OF NASD
In 1999, OCIE completed an inspection of NASD's Statutory Disqualification Program. OCIE made recommendations to NASD regarding its statutory disqualification review program that we believe could also benefit the NYSE. For example, OCIE recommended that NASD interview individuals subject to a statutory disqualification during on-site examinations of member firms, visit any branch offices where an individual subject to a statutory disqualification is employed, and conduct unannounced examinations of member firms.
NYSE informed us that it conducts announced statutory disqualification reviews. OCIE has never inspected the NYSE's statutory disqualification review program. Such an inspection would help ensure that the NYSE incorporates recommendations made to NASD into its statutory disqualification review program, as appropriate.
During this audit, OCIE commenced an inspection of the NYSE's statutory disqualification review program. Therefore, we are not making a related recommendation.
1 Persons are most often subject to the statutory disqualification review process and Rule 19h-1 is primarily designed to deal with persons.
2 Entry applications include applicants seeking initial entry or re-entry into the securities industry as well as entry into a new job in the securities industry (e.g., changing to a broker from a trader). A continuance deals with persons seeking to remain in the same position, notwithstanding a statutory disqualification.
3 The NASD and NYSE make virtually all of the filings under Rule 19h-1. The NYSE generally submits filings for the NYSE/NASD dual members. Pursuant to agreements, the NASD handles filings for dual members of the Boston, Chicago, and Pacific Stock Exchanges, and the Chicago Board Options Exchange.
4 MR does not receive applications that were rejected by SROs. Rejected applicants, however, have the right to appeal directly to the Commission.
5 MR has delegated authority to make this determination.
6 MR does not have delegated authority to deny a proposed entry.
7 A person may be subject to the review process more than once, even if a new violation has not occurred (for example, when the person changes jobs).
8 Some information recorded in the 19h-1log several years ago may no longer be relevant. Therefore it may not be cost-effective to correct all errors.
9 In some cases applications are supplemented with additional information after they are filed. Therefore, the date MR receives an application and the date it is considered complete can be different.
10 In some cases, the Commission is required to issue an Order (e.g., when a person is barred from the securities industry). This determination is made upon reviewing the application. There is no statutory time frame on how long the Commission has to issue an Order and it typically takes more than 30 days.
11 The CRD is a computerized database containing information about the qualification, employment, and disclosure histories of most brokers, some investment advisers, their representatives, and the firms they work for. It contains more comprehensive statutory disqualification information than NRSI.