UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION Securities Exchange Act of 1934 Release No. 38174 / January 15, 1997 Administrative Proceedings File No. 3-9223 ------------------------------- : ORDER INSTITUTING In the Matter of : PUBLIC PROCEEDINGS, : MAKING FINDINGS, AND Royal Alliance Associates, Inc.: IMPOSING REMEDIAL SANCTIONS _______________________________: I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that administrative proceedings be instituted pursuant to Sections 15(b) and 19(h) of the Securities Exchange Act of 1934 ("Exchange Act") against Royal Alliance Associates, Inc., a broker-dealer registered with the Commission. In anticipation of the institution of these proceedings, Royal Alliance has submitted an Offer of Settlement that the Commission has determined to accept. Solely for the purpose of these proceedings, and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings contained herein, and prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R. 201.1 et seq., Royal Alliance by its Offer of Settlement consents to the entry of the findings and the imposition of the remedial sanctions set forth below. Accordingly, IT IS ORDERED that proceedings pursuant to Sections 15(b) and 19(h) of the Exchange Act be, and hereby are, instituted. II. On the basis of this Order and Royal Alliance's Offer of Settlement, the Commission makes the following findings: A. THE RESPONDENT Royal Alliance, a registered broker-dealer, has supervisory responsibility for approximately 2,700 registered representatives in approximately 1,500 offices. Approximately 385 of these offices are designated as offices of supervisory jurisdiction, of which approximately 49 are one-person offices. The 1,500 offices are supervised by registered principals who are referred to as "managing executives." Some of the managing executives are also separately registered with the Commission as investment advisers. In addition, some managing executives, like the two former managing executives discussed here, perform financial services ==========================================START OF PAGE 2====== through their own corporations or "DBAs." B. SUMMARY This matter arises from Royal Alliance's failure adequately to supervise two managing executives who constituted one-person branch offices in Greensboro, North Carolina and Cocoa Beach, Florida, with a view to preventing violations of Section 17(a) of the Securities Act of 1933 ("Securities Act"), Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder. Royal Alliance lacked adequate supervisory and compliance procedures and failed adequately to implement the procedures that were in place with respect to its Greensboro and Cocoa Beach offices. Further, Royal Alliance failed effectively to delegate its responsibilities with respect to the supervision of the Greensboro and Cocoa Beach managing executives. As a result, Royal Alliance failed adequately to supervise the activities of its one-person offices in Greensboro and Cocoa Beach. C. THE MANAGING EXECUTIVES' VIOLATIONS The managing executives in Royal Alliance's Greensboro and Cocoa Beach offices engaged in violations as described below. 1. GREENSBORO, N.C. Between November 1989 and March 1993, the managing executive of the Greensboro office transferred funds among approximately 50 of his customers through various deceptive means, including the use of separate entities, as more fully described below. When the scheme ended, 14 of the managing executive's customers had suffered losses of about $600,000. Some customers actually profited, because the managing executive transferred more money to them than he diverted from them.-[1]- On at least four occasions, the managing executive obtained funds from customers by forging their signatures on third party checks. He also solicited customers to purchase fictitious CDs, bonds, and other securities, and then instructed the customers to issue checks payable to him or his DBA rather than to Royal Alliance. The managing executive deposited all these funds, which totalled approximately $650,000, into a bank account maintained in his own name. Thereafter, the managing executive used the majority of the funds to pay dividends or to make distributions to his customers, thereby giving them the false impression that their "investments" were successful. On 140 occasions, the managing executive also improperly transferred approximately $950,000 among accounts controlled by a ---------FOOTNOTES---------- -[1]- Royal Alliance has agreed to pay $615,000 to certain customers in connection with the settlement of a class action law suit involving the Greensboro managing executive's conduct. ==========================================START OF PAGE 3====== money market fund. He accomplished this by forging letters of instruction to the money market funds and directing the transfer of funds between customer accounts. The managing executive guaranteed the forged signatures with a signature guarantee stamp that Royal Alliance provided to him as a registered principal. In addition, on more than 12 occasions, the managing execu- tive diverted checks from some of his customers to other custom- ers in amounts of approximately $500,000. He accomplished this by receiving checks from customers made out to Royal Alliance and writing on the face of the checks the account numbers of customers to whom he wanted the funds diverted. The managing executive knew that Royal Alliance's independent clearing firm, in accordance with its own policies, would credit the check to the customer whose account number appeared on the face of the check. The managing executive excessively turned over IRA accounts of at least 16 customers by partially liquidating variable annuities in the accounts and then repurchasing the same annuities. This activity generated approximately $67,000 in gross commissions and caused approximately $80,000 in unnecessary withdrawal and surrender fees. Finally, the managing executive distributed false confirmations to investors to conceal his misappropriation and diversion of customer funds. He also fabricated and distributed to many of his customers periodic account evaluations that misrepresented the financial condition of their accounts, creating the appearance that the investments were genuine and income-producing. Many customers relied on these evaluations instead of the statements provided by Royal Alliance and other financial institutions. 2. COCOA BEACH, FLA. The managing executive of the Cocoa Beach office also operated a one-person branch office of Royal Alliance, and conducted certain of his business activities through a DBA. He had come to Royal Alliance in November 1989 with several reported customer complaints concerning misrepresentations and unauthorized and unsuitable trading. Between July 1990 and July 1992, the Cocoa Beach managing executive misappropriated approximately $400,000 from ten of his customers.-[2]- He persuaded the customers to liquidate their investments in order to purchase certificates of deposit and mutual funds that did not exist. He instructed the customers to make their checks out directly to him or to his DBA, and then converted the funds to his own use. He used some of the funds to make periodic interest payments to the defrauded investors as ---------FOOTNOTES---------- -[2]- Royal Alliance has paid in excess of $450,000 to certain customers in the Cocoa Beach office in connection with the conduct described herein. ==========================================START OF PAGE 4====== part of a Ponzi scheme. To create the appearance that the investments were genuine, the managing executive distributed false periodic account evaluations to his customers. D. ROYAL ALLIANCE'S FAILURE TO SUPERVISE Royal Alliance failed to adopt, implement, and follow adequate supervisory and compliance procedures, and failed reasonably to supervise the Greensboro and Cocoa Beach managing executives with a view to preventing and detecting their separate violations of the law. 1. DEFICIENT SUPERVISION According to Royal Alliance's compliance manual, the compliance director, non-supervisory personnel in the compliance department, and a management committee shared the responsibility of supervising the managing executives. Although the compliance manual described eighteen duties for which the three parties were responsible, it failed adequately to assign the duties among the parties. In this matter the three parties did not carry out all of the supervisory functions that the compliance manual described, and they therefore failed to prevent the violations that occurred in the Greensboro and Cocoa Beach offices. 2. ANNUAL BRANCH EXAMINATIONS a. General The annual on-site inspection of more than 385 offices of supervisory jurisdiction formed an important part of Royal Alliance's compliance program. The examination system proved to be ineffective in detecting and preventing the violations of the Greensboro and Cocoa Beach managing executives. To prepare for a branch office inspection, each examiner was expected to review branch office examination reports, which were maintained in the compliance department at headquarters. These files included correspondence, customer complaints, and descriptions of any previous deficiencies. Each examiner also was required to confer with other Royal Alliance departments, such as those responsible for margin and licensing, to check for potential compliance issues. The examiners were expected to determine whether the managing executives had encountered disciplinary problems and, if so, to tailor their examinations accordingly. Moreover, the examiners were expected to review "production reports," which reflected the extent to which the managing executives had earned commissions from sales of stocks and bonds as opposed to packaged products, such as annuities and mutual funds. The branch office examination process relied to a large extent on the managing executives' responses to a checklist of questions. The examiners engaged in a review of such key documents as the sales log, the product cross index, and customer holding pages. In some instances, the examiners chose at random ==========================================START OF PAGE 5====== only five transactions for close audit. The examiner concluded the examination with a discussion of the deficiencies uncovered. The examiner thereafter prepared a follow-up letter about the deficiencies, which the Director of Compliance reviewed. The managing executives were required to take corrective action and respond to the deficiency letter within 30 days. Royal Alliance did not have an effective mechanism for verifying that the deficiencies were actually corrected. Often, the matter was deferred until the next year's annual examination. b. Examinations Did Not Detect Greensboro Fraud Despite Red Flags From 1990 through 1993, while the Greensboro managing executive was violating the law, Royal Alliance conducted annual examinations of his office. The examinations revealed only minor deficiencies. A Royal Alliance examiner performed an inadequate audit of the Greensboro office in April 1992. The examiner also failed to detect numerous deficiencies when he revisited the Greensboro office for his second audit in February 1993. In both 1992 and 1993, the examiner failed to follow procedures requiring him to review the managing executive's production runs. Consequently, the examiner failed to detect that the managing executive's sales log, product cross index, and customer holding pages did not reflect variable annuity, limited partnership, and mutual fund transactions. The omission of variable annuity, mutual fund, and limited partnership transactions from the books and records of the Greensboro office should have raised a red flag, since the managing executive derived most of his commissions by selling those products. During the 1992 exam, the managing executive admitted that he was not maintaining a signature guarantee log as Royal Alli- ance policy required. The examiner conducted ineffective follow- up questioning regarding the use of the signature guarantee. In fact, the managing executive had abused the signature guarantee dozens of times, liquidating his customers' money market and mutual fund accounts without authorization. During the 1992 and 1993 inspections, the managing executive told the examiner that customer checks were being made payable to Royal Alliance and not to himself or to his DBA. Certain customer files, however, contained copies of checks made payable to the DBA or to the managing executive directly. During the 1992 inspection the examiner's random review of customer files included one file that contained some of those checks. Despite these red flags, the examiner did not request any further information from the managing executive regarding his DBA, nor did Royal Alliance have any procedure to request that information under these circumstances. c. No Heightened Supervision of Cocoa Beach Office ==========================================START OF PAGE 6====== Royal Alliance did not adequately review information in its files concerning the Cocoa Beach managing executive's personal financial condition and previous customer complaints. Information in the firm's files reflected that the managing executive had defaulted on a loan, which resulted in foreclosure proceedings. In addition, firm records showed that the managing executive earned minimal income from 1990 through the first six months of 1992 from Royal Alliance business. Royal Alliance did not make an adequate inquiry into what business actually supported the operations of the Cocoa Beach branch office. In June 1991 the NASD issued an advisory to Royal Alliance and the managing executive informing them that it was investigating matters contained in a previous employer's Form U-5 and amendments thereto, including customer complaints of fraud, unauthorized trading, and other sales practice abuses dating back to 1985 and 1986. The managing executive filed amended Forms U-4 that sought to refute the information in the U-5. Royal Alliance failed independently to verify the managing executive's disclosures and to communicate the information to the firm's supervisory personnel and compliance examiners. The branch office examiner did not consider the managing executive's history of customer complaints and financial problems when he conducted his examinations of the Cocoa Beach office. 3. INADEQUATE COMPLIANCE PROCEDURES-[3]- a. Signature Guarantees Royal Alliance also failed to implement procedures adequate to govern the managing executives' use of the signature guarantee stamp. Royal Alliance's policy required managing executives to maintain logs indicating which documents had been signature- guaranteed, and a separate file containing copies of the docu- ments. Royal Alliance's policy called for the branch office examiner to review the log during the annual audit. In effect, however, the examiner depended on the managing executive to identify the instances when he had used the signature guarantee. The managing executive of the Greensboro office avoided detection by omitting from the log any documents that bore an improper signature guarantee. b. Inadequate Review of Employment History and Financial Problems Royal Alliance lacked adequate procedures to monitor and follow up on supplemental disclosures contained in amendments to the managing executives' Forms U-4 and U-5. The firm also lacked adequate procedures to advise supervisory personnel and other ---------FOOTNOTES---------- -[3]- After Royal Alliance discovered the Greensboro managing executive's improper conduct in March 1993, it implemented procedures to enhance its supervisory and compliance systems. ==========================================START OF PAGE 7====== appropriate persons of disciplinary and financial problems concerning the managing executives. Consequently, Royal Alliance failed to identify that the Cocoa Beach managing executive required heightened supervision. III. In this matter the Commission has named only Royal Alliance, and not any individuals, for failure to supervise. The securities industry should be on notice, however, that where a firm employs branch offices made up of only one or two registered representatives and those individuals engage in misconduct, the Commission will, as it does for all firms, closely examine the responsibility of individuals charged with the duty to design and implement an adequate system of supervision. Many failure-to-supervise cases involve indicators of misconduct, or "red flags," that should immediately alert management to potential wrongdoing. In circumstances where a firm's compliance and supervision system is inadequate to discover the indications of problematic conduct, the personal responsibility for supervision cannot be fulfilled by a supervisor who is simply unaware of the indicators. As discussed above, Royal Alliance operates 1,500 offices with 2,700 registered representatives. Some 49 of these are one- person offices. Here, Royal Alliance's failure to scrutinize adequately the securities-related businesses of its registered representatives, which were conducted beyond the direct aegis of the firm, was a certain recipe for trouble. Further, Royal Alliance's practice of conducting a pre-announced compliance examination only once a year was inadequate to satisfy its supervisory obligations. Indeed, we harbor grave doubts that this practice would necessarily discharge the supervisory obligations of any firm that incorporates a structure in which smaller branch offices are operated by only one or two representatives. See, e.g., In the Matter of Consolidated Investment Services, Exchange Act Release No. 36,687 (Jan. 5, 1996) (Broker-dealer supervision of a small office run by a single registered representative inadequate without surprise inspections.) We do not here suggest that firms which employ offices consisting of one or two registered representatives cannot devise an adequate system of supervision, nor do we discourage such offices. We recognize that many smaller communities are well served by such arrangements and generally cannot support a large office. Nevertheless, such arrangements necessarily entail greater supervisory challenges and the Commission requires firms organized in such a fashion, and individual supervisors at those firms, to meet the same high standards of supervision as at more traditionally organized firms. IV. Based on the foregoing, the Commission deems it appropriate ==========================================START OF PAGE 8====== and in the public interest to impose the sanctions specified in the Offer that Royal Alliance has submitted. Accordingly, IT IS HEREBY ORDERED that: A. Royal Alliance be, and hereby is, censured; B. Royal Alliance shall, prior to the close of business on the third business day following the issuance of this Order, pay a civil penalty to the United States Treasury in the amount of $50,000. The payment shall be: (a) made by United States postal money order, certified check, bank cashier's check or bank money order; (b) made payable to the Securities and Exchange Commission; (c) delivered to the Comptroller, Securities and Exchange Commission, 450 5th Street, N.W., Washington, D.C. 20549; and (d) submitted under cover letter which identifies Royal Alliance as Respondent in these proceedings, and the Commission's file number in these proceedings. A copy of the cover letter and money order or check shall be sent to Helaine Schwartz, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, mail stop 4-3B. C. Royal Alliance shall comply with the undertakings specified in its Offer as follows: 1. Royal Alliance undertakes to retain, within 30 days of the date of this Order, at its expense, an Independent Consultant not unacceptable to the Commission's staff. The Independent Consultant shall conduct a review of Royal Alliance's supervisory, compliance, and other policies and procedures designed to prevent and detect federal securities law violations of the nature involved in this matter. Royal Alliance shall cooperate fully with the Consultant and shall provide the Consultant with access to its files, books, records, and personnel as reasonably requested for the review. 2. At the conclusion of that review, which in no event shall be more than 120 days after the date of the Consultant's retention, the Consultant shall submit to Royal Alliance and to the Commission an Initial Report. The Initial Report shall address the adequacy of Royal Alliance's policies and procedures to detect and prevent federal securities law violations of the nature involved in this matter, and shall include the Consultant's recommendations thereon. 3. Within 30 days of transmittal of the Consultant's Ini- tial Report, Royal Alliance shall in writing advise the Consultant of the recommendations that it has determined to accept and the recommendations that it considers to be unduly burdensome. With respect to any recommendation that Royal Alliance deems unduly burdensome, Royal Alliance may propose an alternative policy or procedure designed to achieve the same objective or purpose. ==========================================START OF PAGE 9====== 4. With respect to any recommendation or proposal with which Royal Alliance and the Consultant do not agree, Royal Alliance and the Consultant shall attempt in good faith to reach agreement. In the event the Consultant and Royal Alliance are unable to agree on an alternative proposal, Royal Alliance shall abide by the recommendation of the Consultant. 5. Within 60 days of transmittal of the Consultant's Ini- tial Report, Royal Alliance shall in writing advise the Consultant and the Commission of the recommendations and proposals that it is adopting. 6. The Consultant shall complete the aforementioned review and submit a written Final Report thereon to Royal Alliance and to the Commission's staff within 270 days after the date of this Order. The Final Report shall recite the efforts the Consultant undertook to review Royal Alliance's supervi- sory functions, compliance mechanisms, and other policies and procedures, set forth the Consultant's recommendations and Royal Alliance's proposals, and describe how Royal Alliance is implementing those recommendations and propos- als. 7. Royal Alliance shall take all necessary and appropriate steps to adopt and implement all recommendations contained in the Consultant's Final Report. 8. No later than one year after the date of this Order, unless extended pursuant to paragraph 9, below, Royal Alli- ance shall submit to the Commission's staff an Affidavit setting forth the details of its efforts to implement the recommendations contained in the Consultant's Final Report and stating whether it has achieved compliance. 9. For good cause shown, and upon receipt of a timely application from the Consultant or Royal Alliance, the Commission's staff may extend any of the procedural dates set forth above. 10. To ensure the independence of the Consultant, Royal Alliance: (i) shall not have the authority to terminate the Consultant, without the prior written approval of the staff of the Division of Enforcement; (ii) shall compensate the Consultant, and persons engaged to assist the Consultant, for services rendered pursuant to this Order at their rea- sonable and customary rates; (iii) shall not, without prior written consent of the staff of the Division of Enforcement, enter into any legal, business, or other financial relation- ship with the Consultant, any firm with which he or she is affiliated or of which he or she is a member, or any person engaged to assist the Consultant in the performance of his or her duties under this Order, during the period of their engagements and for a period of two years following the completion of their duties described in this Order; and (iv) shall not be in and shall not have an attorney-client rela- ==========================================START OF PAGE 10====== tionship with the Consultant and shall not seek to invoke the attorney-client or any other doctrine or privilege to prevent the Consultant from transmitting any information, reports, or documents to the Commission or its staff. By the Commission. Jonathan G. Katz Secretary