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Speech by SEC Staff:
Compliance Through Crisis: Focus Areas for SEC Examiners and Compliance Professionals


Lori A. Richards

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

National Society of Compliance Professionals
National Meeting
Philadelphia, Pennsylvania
October 21, 2008

Good Morning. I’m very pleased to be with you here today at the National Meeting of the National Society of Compliance Professionals. I believe that this is the largest professional organization of compliance professionals in the securities industry, so you carry a lot of clout!

Before I begin, I am required to state that the views I express today are my own, and do not necessarily represent the views of the Commission or any other member of the staff.

This event and others like it are so important — they provide an opportunity to share information about cutting edge compliance practices, about emerging compliance risks, and about strategies to help establish strong compliance programs and instill a healthy culture of compliance. Your role as compliance professionals is critical in any market environment, but in today’s turbulent times, it is essential. Your job each day is to educate, to guide, to investigate, to test and sometimes to insist on adherence to the law and to the firm’s policies, and sometimes, to just say no! Your job is important in any environment, and it is just as or more important now.

The compliance function within firms is critical in helping to assure operations in compliance with the law, and it must continue to be fully and adequately resourced. While not profit centers, firms must remember that their compliance programs (and related legal functions, as well as the information technology programs that support a well-run compliance program) are essential to their operations — reductions in resources to these programs would be ill-advised. Securities firms cannot now afford to reduce vigilance in compliance.

In today’s environment, perhaps the most important thing you can do as a compliance professional is to remind firm employees of their obligations to investors — for an adviser, the fiduciary obligation to clients, and for a broker, the obligation to follow just and equitable principles of trade. These obligations must continue to motivate and inform the way that the firm interacts with clients, customers, and investors. In addition to this reminder, however, there are areas where you will want to pay particular attention to compliance obligations. I will describe some of those this morning. Finally, you cannot let slip the other ongoing compliance responsibilities that the firm has, I will describe some of these priority areas as well.

As I speak to you today, our markets are undergoing unprecedented change. Once large firms no longer exist, and others have been acquired or merged. Securities firms that once stood alone are now parts of large banks. A money market fund has broken a dollar, and the Treasury has implemented a new program to guarantee certain money market funds from loss and the government has taken unprecedented steps to buy troubled assets and shore up credit markets. These are sudden and significant changes, and while we won’t see their full impact for some time, today, in the securities compliance world, our work could not be more important.

It’s worth remembering, for all of us who work administering compliance programs under the securities laws, that the underlying tenets of the securities laws are quite simple and provide meaningful protections to every investor every day:

  • Companies publicly offering securities to investors must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing — enabling investors to make informed investment decisions.
  • People who sell and trade securities and provide investment advice — brokers, dealers, advisers and exchanges — must treat investors fairly and honestly, putting investors' interests first.

In the current credit crisis, the SEC has been aggressively working to police the markets, and to ensure that the “rules of the road” for public companies and market participants include full disclosure to investors and promote healthy capital markets. While a small agency (only 3,800 staff), the SEC packs clout through its experienced and dedicated staff. Addressing the extraordinary challenges facing our markets, the SEC has issued new regulations to strengthen capital markets and protections for investors, taken enforcement measures against market manipulation (including a landmark enforcement action against a trader who spread false rumors designed to drive down the price of stock), initiated examination sweeps, communicated with investors, and collaborated with domestic and foreign regulators around the world.

The SEC is an aggressive police force too — we bring hundreds of enforcement actions each year to protect public investors from fraud.  Indeed in just this last year, we brought more than 650 enforcement actions, more than the year before, involving all types of fraud that harm investors — corporate non-disclosure, ponzi schemes, insider trading, failures to value assets correctly, and other types of frauds. The protections of the securities laws are meaningful and have real consequences for investors. In just the last year alone, we returned over one billion dollars to harmed investors — making the protections of the federal securities laws mean something to those investors who have been defrauded.

And, in the Office of Compliance Inspections and Examinations, we are keenly focused on issues that present risk to investors. I wanted to highlight some of the areas that SEC examiners will be focusing on in the months ahead in our examinations of registered investment advisers, investment companies, and broker-dealers — and suggest that these are areas that you might focus attention on as well.

Let me start with the “landscape” because the sheer number of registered firms subject to our examinations impacts our actions quite directly. At the start of FY 2009:

  • There are approximately 11,300 registered investment advisers and 950 fund complexes with over 8,000 mutual fund portfolios (this is a highly transient population: approximately 1,200 advisers became registered and 750 de-registered in FY 2008).
  • There are approximately 5,600 broker-dealers, 174,000 branch offices, and 676,000 registered representatives (as more firms have consolidated, the broker-dealer registrant pool has declined slightly in recent years, while the number of branch offices has increased dramatically). And, there are approximately 410 SEC-registered transfer agents.

Our program is risk-based, which means that we seek to accord resources to those firms and issues that present the greatest risk to investors. Our overall examination plan consists of numerous complementary components: routine and periodic examinations of those advisers (about 1,000) that are considered “higher risk;” routine examinations of large broker-dealer firms to evaluate their internal controls; “oversight” examinations of broker-dealers to evaluate the SROs’ regulatory programs; cause exams based on indications of violations; “sweep” exams focused on particular risk areas; random examinations of lower risk advisers; and visits to newly-registered advisers. In addition to these types of examinations, we will also closely monitor the compliance activities and controls of certain large advisers and broker-dealers.

We’ve also sought to leverage compliance results from firms’ own compliance programs by encouraging firms’ own compliance professionals to be aggressive in assuring compliance with the securities laws. In the coming year, we will continue this work as well — we will continue our CCOutreach programs for chief compliance officers. Our National Seminar for adviser and fund CCOs is November 13, and we just announced that our National Seminar for broker-dealer CCOs, in coordination with FINRA, will be held on March 10, 2009. We will also continue to issue ComplianceAlerts that summarize results of recent examinations so that all firms can benefit from our insights into both what can go wrong, and also, what particular practices seem to help make things go right.

Our examination program includes focus areas and exam initiatives that are particularly critical in today’s market environment. While these are not new areas, they are timely now and examiners will be paying special attention to compliance in these areas. These areas include:

  • Portfolio management: recent losses may provide an impetus for portfolio managers to trade more aggressively than they should or to deviate from investment objectives in order to make up losses, and perhaps also to catch-up on performance-based fees. This is an area where compliance personnel should be active.
  • Financial controls, including compliance with net capital and customer control requirements by broker-dealers, as well as these firms’ risk management and internal control procedures. While the Division of Trading and Markets will no longer be supervising the holding companies of large broker-dealer firms — OCIE examiners will continue to focus attention on controls within the registered broker-dealer, which are intended to protect investors’ accounts with a broker-dealer. And, if you’re an adviser in precarious financial condition — you must disclose this fact to clients. This is an area where your focus is warranted.
  • Valuation, at all types of registrants, including controls and procedures for valuation of illiquid and difficult-to-price securities at all registrants. Reluctance to fair value or mark down prices cannot take precedence over the firm’s pricing procedures — investors and fund shareholders have a right to know the current value of their holdings. If you work for a broker-dealer that provides quotes or for an investment adviser or other user of broker quotes — be particularly alert to and look for the possibility of “accommodation quotes” — which don’t reflect prices at which the security could actually be sold. At its worst, this could be fraudulent conduct. A reminder too — under accounting rules (FAS 157), issuers must classify their assets within a hierarchy. For those assets valued by using a broker’s quote or a price from a pricing service — you should be sure that you understand whether the quote or price is based on actual transactions, reflects the willingness of the broker to trade at that price, or is based on a model or another methodology.  Among strong practices in this area are to require multiple sources of pricing information, and also to regularly go back and compare the actual prices realized on any sale to the fair values used: then, determine the reasons for any wide gaps and implement improvements in pricing processes. This is an area where your focus is needed now — be sure that your firm is implementing its controls and its oversight over pricing.
  • Sales of structured products by broker-dealers and advisers. Of special note — given that investors may be particularly looking for lower-risk investment products, examiners will focus on products marketed as being relatively “safe,” such as principal protected notes and other products, and will review the adequacy of disclosures concerning credit risk, liquidity, and investment risk. Conversely, investors may be looking to recoup losses, and may be more vulnerable to sales of high-risk, high-return products. You will want to focus on both types of products and make sure that representations are accurate and that your firm is treating investors fairly.
  • Controls and processes at recently merged or acquired firms, both advisers and broker-dealers. This is an area where compliance staff must be active — to help make sure that controls and processes do not fall through the cracks in a merged organization.
  • Money market funds, including, at a minimum, compliance with Rule 2a-7 regarding the creditworthiness of portfolio securities, shadow pricing, and compliance oversight — and more broadly, whether funds’ are stretching for yield and subjecting the fund to excessive undisclosed risk. We have examinations underway. The problems experienced by money market funds should be seen as cautionary for all managers and CCOs of money market funds.
  • Short selling and compliance with Regulation SHO and filings of Form SH. Examiners are also focusing on firms’ policies and procedures to prevent employees from knowingly creating, spreading, or using of false or misleading information with the intent to manipulate securities prices, and will be concluding a sweep of broker-dealers and hedge fund advisers in this area.

Beyond these specific compliance risk issues, in times of financial strain, people may act in uncharacteristic ways — in order to conceal losses, inflate revenues or profits, to stay in business or just to avoid delivering bad news. Examiners will be alert for indications of fraud and “acts of desperation” by individuals and firms that are under financial duress. As compliance personnel, however, you are much closer to the scene than we are — and you should be aware of and alert to the increased possibility that individuals under stress may take fraudulent or deceptive actions. Checks and balances are critical in this environment. You should insist on absolute compliance with policies and procedures, there should be no possibility of “suspending” compliance. And it would be timely for you to remind firm employees of your presence and make clear to every employee in the firm that no shortcuts will be allowed.

In addition to these focus areas, OCIE examiners will also be focusing on other compliance risks, and so too must you. We cannot afford to pay less attention to any of these issues. Let me describe several of these areas:

  • Suitability and appropriateness of investments for clients: Examiners will focus on whether securities recommended and investments made for clients and funds are consistent with disclosures, the client’s investment objectives and any investment restrictions, and with the broker or adviser’s obligations to clients to only recommend securities that are suitable or appropriate. We’ll focus in particular, on how firms are interacting with their senior customers and clients. We’ll also focus on structured products and other complex derivative instruments, variable annuities, niche ETFs, managed pay-out funds, and 130/30 funds.
  • Disclosure: Examiners will focus on ADVs, performance advertising, marketing, fund prospectuses and any other information provided to clients. This is a good time for you to review your firm’s disclosures to investors and shareholders. Make sure that any steps the firm has taken in recent days or weeks to deal with the credit crisis are consistent with the firm’s disclosures. Examiners will be specifically looking at how the firm represents its participation in Treasury’s money market guarantee program, the existence of SIPC coverage, and at advertised performance figures. Consider your disclosures as your “Constitution” — even in a crisis, it’s your governing document, and it must match your practices.
  • Controls to prevent insider trading: We’re focusing on the adequacy of policies and procedures, information barriers, and controls to prevent insider trading and leakage of information including the identification of sources of material non-public information, surveillance, physical separation, and written procedures. Controls to prevent insider trading should be strong in any environment.
  • Trading, brokerage arrangements and best execution: We’ll be looking at whether brokerage arrangements are consistent with disclosures, whether the firm seeks best execution, and whether soft dollars are used appropriately (consistent with disclosures), Reg NMS and direct market access arrangements. We will particularly scrutinize the use of an affiliated broker-dealer or any undisclosed relationships with a broker-dealer for excessive commissions, kick-backs and other conflicted relationships. Your best execution committees will want to particularly review execution quality in current markets.
  • Proprietary and employees’ personal trading: This is a basic part of any compliance program — when we find weaknesses in this area, it makes us wonder about the firm’s commitment to addressing other conflicts of interest. This is not an area to be overlooked.
  • Undisclosed payments: Examiners are looking for compensation or payment arrangements that may be part of revenue-sharing, or other undisclosed arrangements with third parties. These payments may be made to increase fund sales or assets under management (such as fund networking fees and payments by advisers to broker-dealers for obtaining space on the firms’ recommended adviser list). Undisclosed payments may also involve misappropriation of adviser/fund/broker-dealer assets by, for example, creating fictitious bills and expense items, or receiving kick-backs from a service provider.
  • Safety of customer assets: Examiners will look at whether brokers, funds and advisers have effective policies and procedures for safeguarding their clients’ assets from theft, loss, and misuse. This is a good time for you too to assess controls in this area. Make sure that advisory clients’ money is with a qualified custodian and review prime brokerage relationships. You may want to ensure that the process for sending account statements to clients has controls to ensure that the account statements cannot be intercepted or falsified. Examiners will also continue to focus on controls for compliance with Regulation S-P with respect to customer information.
  • Anti-money laundering: Examiners will look at whether funds and broker-dealers are complying with obligations under the securities laws, the Patriot Act and Bank Secrecy Act to have effective policies and procedures to detect and deter money-laundering activities, whether these policies and procedures are regularly tested for continued effectiveness, and whether actual practices are consistent with the policies and procedures.
  • Compliance, supervision, and corporate governance: While this is the last item I’ll list, it’s the most important — because it underpins all the other compliance responsibilities that firms have. In the coming year, examiners will focus in particular on supervisory procedures and practices at large branch offices of broker-dealers and at advisory branch offices, on supervision and controls over traders, whether funds have appropriately-constituted boards and have considered required matters (e.g., fair value procedures), and whether firms have implemented effective internal disciplinary processes. Also, we’ll examine: firms that advertise themselves as allowing maximum independence to registered representatives; for abuses in transferring customer accounts as registered representatives move to new firms; supervision of producing branch managers; bank broker-dealer branches; and the adequacy of firms’ testing to detect unsuitable or aberrant trades.

For advisers and mutual funds, in that this is the fifth year of both the Compliance Rule and our CCOutreach efforts for adviser and fund CCOs, we hope to see improvements in firms’ compliance programs, and in particular, that significant deficiencies were identified promptly and corrected appropriately by firms.

* * *

These are challenging times, no doubt. The SEC has been and will continue to guard the interests of investors. Industry compliance professionals too play an indispensable role in fostering and assuring investor protection and the integrity of our markets. As I said at the outset, I think that the first thing that you might do in the current environment is to is to remind firm employees of their obligations to investors — for an adviser, the fiduciary obligation to clients, and for a broker, the obligation to follow just and equitable principles of trade. These obligations must continue to motivate and inform the way that the firm interacts with investors.

I have shared with you today some of the issues that SEC examiners will be focusing on in the coming months — and these are areas where I hope you too will focus your attention. Finally, you cannot let slip the other ongoing compliance responsibilities that the firm has, and I have described some of these priority areas as well.

I hope this information will be helpful to you in your work, and I look forward to continuing to work with you to help improve and assure strong compliance practices in the securities industry.

Thank you.



Modified: 10/23/2008