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U.S. Securities and Exchange Commission

Speech by SEC Staff:
The Regulatory Focus on Broker-Dealer Legal and Compliance Issues


Mary Ann Gadziala

Associate Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission

Chicago, Illinois
June 7, 2007

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or the other members of the staff.


It's a pleasure to be here once again with the SIFMA Compliance and Legal Division to discuss issues of significance to all of us — broker-dealer legal and compliance issues. The topics I plan to cover include: enhancements to our examination program; examination priorities and challenges; and regulatory coordination. I hope we have additional time at the end of my presentation to hear some of your thoughts. We in the SEC examination program very much value your input and carefully consider your helpful suggestions in our ongoing efforts to evaluate and improve the effectiveness of our program.


I'll begin with some of the recent enhancements to our SEC examination program. These involve use of new procedures and improved technology, more open communications, and increased risk-focusing and coordination. We implemented changes to our oversight procedures for evaluation of SRO regulatory programs to increase the value of our inspection findings to SROs. We now more closely audit the specific work of the SROs, surveil for significant areas that may have been missed by SRO examiners, and determine underlying causes of concerns. We then work with the SROs to strengthen their programs. This should permit us to rely more on SROs for routine examination work, allowing us to focus on specific risk areas.

We are also looking to firms to take a more proactive approach, anticipating potential problems and implementing controls to prevent violations. We have encouraged firms to build strong supervisory, compliance, risk management, surveillance, and internal audit programs, and to assess their conflicts of interests and other issues that may raise the potential for compliance problems. A relatively new procedure we have implemented with respect to our risk management examinations is to limit our exam scope by leveraging off high quality, effective internal audit work performed by firms. Our reliance on the firm's own independent reviews will depend on whether examiners can become confident that effective independent oversight has been conducted and that the firm has taken meaningful corrective action. Based on this initial assessment, we might limit our review of areas effectively covered by internal audit at the firm and focus on high risk areas and areas not adequately covered by the firm's reviews. There has been quite a bit of progress at firms in building more robust programs in these areas and we hope this trend will continue as firms realize the benefits achieved from proactive and preventive efforts.

To provide more information to firms and promote greater understanding of the SEC examination program, we have included a number of descriptive and informative documents on the SEC website under the Office of Compliance section. These include: alerts (such as the recent reminder that firms be alert to imposters posing as SEC examiners); the examination brochure that describes our exam process; an overview of the SEC exam program with current issues and results; and the "Anti-money Laundering Source Tool" (providing a compilation of key AML laws, rules and guidance applicable to broker-dealers). The Website also provides information about a Hotline available to registrants who have a question, complaint, or concern about an SEC examination. For any of you interested, the hotline number is 202-551-EXAM and calls can be anonymous. We expect to continue to add to this website to keep the industry apprised of significant compliance issues, priorities, and general examination results. And I hope that seminars such as this and our participation in NASD compliance outreach programs are just the beginning of our overall compliance outreach to the industry.

Risk-focusing and analysis to anticipate potential compliance challenges continue to play an ever-increasing role in our examination program. We have a comprehensive risk assessment process to permit all examiners in our nationwide program to identify and prioritize risks to investors, registrants, and the markets. Examination staff also monitor developments of new products and market trends, and also identify developing problems found during examinations. We also receive economic, market, financial and investor complaint information from other offices in the SEC. We use this information to assist in setting goals and priorities for the examination program, deciding if risk-targeted examinations may be appropriate, providing information on areas where interpretations or new rules may be valuable, providing recommendations for investor education, and informing the Commission, the industry, and the general public of risks and concerns. Utilizing all of these risk-focusing processes should assist us in more effectively spending our time and resources, thus also reducing the burden on firms.


I will now turn to some of our current examination priorities. They include the following:

Supervision — Supervision continues to be a top examination priority for the SEC examination program.1 We are looking for written supervisory procedures that are complete, updated to keep pace with regulatory or business changes, and perhaps most importantly are followed. Branch office supervision is a growing challenge as the number of branch offices has escalated to over 172,000. Many offices are independent contractors, foreign branches, at remote locations, or have registered reps with disciplinary histories or producing branch managers, offering additional challenges. Outsourcing of more and more activities also raises supervisory issues.2

I'd like to take a moment to remind you of the SEC Division of Market Regulation's Staff Legal Bulletin No. 17. It discusses supervisory tools that are characteristic of good supervisory procedures. Among effective policies and procedures suggested are: conducting surprise inspections; considering centralized technology to monitor trading, funds transfers, and personal computers; including explicit delineation of the supervisory hierarchy with assignment of specific supervisory responsibilities, independence, and sufficient resources to implement those responsibilities; exercising caution about hiring registered reps with a disciplinary history and implementing a system of heightened supervision as appropriate; implementing special monitoring procedures for outside business activities of employees; and educating registered reps and customers. Although this SLB was published a couple of years ago, it is important to continue to keep it in mind for your supervisory and compliance programs.

Sales Practices — Suitability and disclosure are also high priorities for our examination program. One of our main collaborative examination initiatives with the states and SROs involves protecting seniors through aggressive enforcement, targeted examinations, and investor education and outreach programs. These efforts are intended to protect seniors from investment fraud and sales of unsuitable securities. Over 110 examinations are underway or completed covering firms in Florida, California, Texas, Arizona, North and South Carolina, and Alabama — all states with large retirement communities.3 While we are still in the early stages of assessing examination results, we have already seen some concerns with advertising, suitability, and supervision. Similar issues may merit consideration in connection with the investment of retirement funds.

There are also a number of products to carefully monitor because they may raise particular suitability challenges. Some of these products include 529 plans, variable annuities, CMOs, REITs, and mutual funds — where regulatory actions have resulted in the return of about $135 million to investors for "breakpoint" violations. There are other products, for example hedge funds and structured finance products, which are now being marketed in some firms to retail customers. As this develops, firms should be mindful of the unique suitability, supervision, and disclosure issues that apply to such products.4 Mark-ups on fixed income securities are also a priority, and firms may refer to the NASD debt mark-up policy published April 20, 2007 for guidance.5

Risk Management — Firms continue to make improvements in risk management controls. Among good practices are continually monitoring and updating business continuity plans to implement technological advancements and address new challenges, such as a potential pandemic and potential terrorist cyber attacks. Operational risks are a focus area — for example, making certain back office operations and compliance keep pace with sales and marketing new products. Other key risk management concerns include conflicts of interests and information security, particularly in view of increased instances of identify thefts.6 With respect to prime brokers, firms should be mindful of compliance, supervision and risk management related to their business with prime brokerage clients. Among areas of review are conflicts, procedures for protecting non-public information, extensions of credit, and best execution.

Complex structured finance transactions (CSFTs) may merit special risk management attention. CSFTs are an important segment of the international capital markets that experienced dramatic growth in recent years and have become increasingly complex.7 They may be subject to heightened risks — credit, market, risk modeling, operational, legal and reputational — imposing increased responsibility to properly manage risks and ensure activities are lawful. The SEC and the banking regulators on January 5, 2007, issued the "Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities." This statement is generally principles-based. Firms engaged in CSFT activities should consider adopting controls consistent with the risk management principles described in the Statement. This may assist in developing and maintaining robust and effective risk management programs.

Financial Issues — Net capital deficiencies and inaccuracies in computing net capital remain among top findings from our examinations. Firms should take care to ensure accuracy and adequacy of capital. This may be particularly relevant for firms employing part-time Financial and Operational Principals. Adequacy of margin requirements is a focus for highly leveraged customers. Developments in portfolio margining continue and firm controls should keep pace with these developments. Another OCIE exam priority is broker-dealers using alternative net capital computations incorporating the concepts of the Basel capital requirements with internal mathematical models as the underlying basis. You may also wish to review the amendments proposed by the SEC to the financial responsibility rules in March 2007. In addition to addressing emerging issues, they would require certain larger broker-dealers to document internal risk management controls established and maintained by the firm to assist in analyzing and managing risks of its business activities.8

Books and Records — Having accurate books and records is a key component of ensuring compliance with the law and having financial integrity and accuracy of financial statements. All correspondence and records, including emails, should be accurately maintained and accessible as required. As I am sure you are aware, SEC staff are in active discussions with the industry concerning requirements related to e-mail retention.

Trading Practices — Best execution of transactions is an examination priority as well as compliance with Reg SHO. Trading practices is another area where conflicts are a concern, particularly with respect to maintaining the confidentiality of nonpublic customer trade information. Information leakage is a top priority. Surveillance, physical separation, and adequate written procedures are relevant controls.

Anti-Money Laundering — AML compliance continues to be a priority for the SEC examination program. SEC examinations review: compliance programs; customer identification programs; suspicious activity reporting; and currency transactions and wire transfers, among other areas. Firms should also have controls to comply with the laws and rules administered by the Office of Foreign Assets Control (OFAC). These are generally economic and trade sanctions based on foreign policy and national security goals and impose strict liability with penalties that can be severe. Therefore, if examiners identify a weakness in your controls in this area, I strongly urge you to heed their warning and strengthen your controls.

On December 21, 2006, the SEC and Financial Crimes Enforcement Network (FinCEN) announced an information-sharing agreement with respect to AML enforcement and examination information. We expect that this agreement will lead to more effective identification, deterrence and prevention of terrorist financing and money laundering. This information sharing should also contribute to ensuring firms have more robust AML programs. Much has been accomplished in this critical area and it is important that we all continue to work together to make AML compliance efforts as effective as possible.

BD/IA Examinations — A final examination priority I would like to mention where OCIE may focus more attention is conducting joint or coordinated examinations of dually registered, affiliated, and related broker-dealers and investment advisers. The businesses, interrelationships, and overlaps of personnel and operations make coordinated examinations more effective and less duplicative. I will say more about this when I discuss coordination later in my remarks.


That is a good segue into my next topic — regulatory coordination. Coordination of examination work contributes to the effectiveness and efficiency of examinations for compliance with securities laws. And it is essential to prevent unnecessary duplication of efforts and wasted resources. We recognize that coordination begins within our own organization. As you know, the SEC has responsibility for the examination of broker-dealers, investment advisers, investment companies, transfer agents, clearing agencies, and the SROs.9 While entities may be separately incorporated and registered and subject to different laws, they are often affiliated and their businesses frequently intersect. Large firms may perform multiple functions, have multiple registrations, have common revenue lines, and perform inter-related services. Best execution, valuation, brokerage commissions, sales practices, use of confidential customer trade information, and supervision all may cross registrant boundaries and require a more coordinated examination approach. In addition, where firms conduct regulatory responsibilities on a consolidated basis — such as business continuity planning, anti-money laundering, information security, and risk management — the examination program is making every effort to coordinate in all areas where the Commission has responsibilities.

The broker-dealer examination program has also initiated a monitoring and coordination pilot program now covering eight organizations. Under this program, exam staff collect and analyze available SEC, SRO and other regulatory information on all affiliated registered entities, as well as publicly available information and communications with firms. This is used to risk scope examinations and prevent unnecessary duplicative work. The usefulness of this approach on a pilot basis will assist us in determining whether to expand the program.10

For the past twelve years, examination coordination among the SROs has been performed under a Memorandum of Understanding (MOU) requiring cooperation and coordination. Under the MOU, the SROs ask firms with multiple SRO memberships if they choose to have all SRO examinations coordinated. That is, routine examinations by all SROs would be conducted at the same time and SROs would also agree upon the scope each will cover to prevent duplication. Since the time the MOU was first signed, the SROs have been quite successful in coordinating exams, with a 95% success rate in the past year. Regional and national examination summits and joint training programs are also held to increase coordination and consistency.

To further eliminate duplicative efforts, NASD and NYSE, in 2005, agreed to coordinate examination programs relating to anti-money laundering; research analysts; Regulation S-P; business continuity plans; monitoring of registered representatives subject to statutory disqualification; Regulation SHO; continuing education; supervisory controls; internal controls; and electronic communications.11 NASD and NYSE allocate responsibilities for these areas when conducting routine examinations so that only one regulator will be responsible for reviewing these areas at a particular firm. Of course, one of the most significant recent actions impacting regulatory coordination was the consolidation plan announced by NASD and NYSE Group on November 28, 2006. The plan calls for the formation of a new SRO that will be the private-sector regulator for all U.S. securities brokers and dealers. The new organization will consist of the approximately 2400 NASD and 470 NYSE regulatory personnel covering regulation, arbitration and related enforcement areas. This is expected to eliminate overlapping regulation, reduce inefficiencies and industry costs, and strengthen capital market competitiveness.


In conclusion, effective compliance and supervision is critical for investor protection and capital market stability and integrity. In my view, compliance challenges continue to grow. This can be attributed to many factors. Firms are merging and consolidating creating larger, more diversified, and more dispersed organizations. The number of branch offices of broker-dealers has been steadily escalating and firms are becoming more geographically diverse. The distance from the home office and the large number of offices can offer challenges to maintaining uniform, consistent, and complete compliance coverage. Products offered by firms as well as the customer base are becoming more diverse and more complex. If a firm sells products, then its registered reps should fully understand all the complexities and be able to convey them in an understandable way to the firm's customers. Recommended products must be suitable for the investor. The increased diversity of activities in which firms engage may raise potential conflicts. More and more confidential trade, financial and other information is available to firms and may be misused without appropriate controls. Unexpected events may raise business continuity challenges. As financial markets and products become more complex and as conflicts arise, extra attention may be necessary to promote compliance and ensure systems and controls are updated consistent with the new challenges.

I would like to leave you with one final thought — that the SEC recognizes the importance of strong compliance controls, cooperation, and useful leads. Cooperation was recently urged by Linda Thomsen, the SEC's Director of Enforcement, and I strongly echo her message. This was discussed by the Commission in the October 2001 Seaboard Report and confirmed in the January 2006 "Statement of the Securities and Exchange Commission Concerning Financial Penalties". The Statement provided that: "Effective compliance with the securities laws depends upon vigilant supervision, monitoring, and reporting of violations." It further stated that relevant legislative history noted the "importance of good compliance programs" in determining remedies. I hope you will all keep this in mind as you build strong compliance programs at your firms.

Again, I would like to thank you for giving me the opportunity to address your group and I look forward to a continuing dialog on compliance issues of significance to regulators, the industry, and investors. Thank you.



Modified: 06/14/2007