U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
"Broker-Dealer Examination and Compliance Developments"
Remarks Before the National Society of Compliance Professionals
2006 NSCP National Membership Meeting


Mary Ann Gadziala

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

Washington, DC
October 19, 2006

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.

Thank you for inviting me to present my views on compliance from the perspective of the SEC examination program. The scope and coverage of topics being discussed at this conference are a clear demonstration that the industry is well aware of the many compliance challenges facing us in today's complex and dynamic capital markets. In general, the goal of our SEC examination program in the Office of Compliance Inspections and Examinations (OCIE) is to promote compliance in the securities industry and to detect and correct problems and wrongdoings. This morning I would like to cover three general topics that relate to these areas: first, enhancements to our examination program; second, the examination process; and third, some of our current examination focuses and concerns about potential compliance challenges.

I. Enhanced Examination Program

Over the past several years, we have enhanced our SEC examination program through increased risk-focusing and coordination, use of new procedures and improved technology, and increased training. We are also looking to firms to take a more proactive approach, anticipating potential problems and implementing controls to prevent violations. To achieve the latter goal we have encouraged firms to build strong, supervisory, compliance, risk management, surveillance, and internal audit programs. We have also encouraged firms to assess their conflicts of interests and other issues that may raise the potential for compliance problems. Conducting comprehensive compliance and risk management examinations and having discussions with firms on conflicts controls are some ways the SEC examination program is taking a more proactive approach. We have seen significant 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.

Another mechanism we are using to improve the effectiveness of our examination program is increased risk-focusing and analysis to anticipate potential compliance challenges. We now use 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 provides risk-focusing insights through continual monitoring of news and examination results and trends. For example, we monitor developments of new products and market trends, and also identify developing problems found during examinations. In addition to compiling risk-focusing information from our own examiners, we also receive compliance information from our Office of Investor Education and Assistance, trends and economic information relating to the capital markets from our Office of Economic Analysis, and information from the Divisions of Corporation Finance, Market Regulation, Investment Management, and International Affairs on issues they believe warrant examination review. OCIE uses the information to assist in setting goals and priorities for the examination program, deciding if sweeps on focused risk areas may be appropriate, providing information to the Commission on areas where interpretations or new rules may be valuable, providing recommendations for interpretations or investor education, and using the information to inform the Commission, the industry, and the general public of risks and concerns.

We are also enhancing our risk-focusing in selecting candidates for examination and scoping what we cover in examinations. Mechanisms we use for risk-focusing specific examinations are: information from prior examinations; enforcement actions; customer complaints; compliance reports; surveillance and trading information; financial reports; information from regulators, analysts and news reports; and tips we may receive from various sources. A relatively new procedure we have implemented with respect to our risk management examinations is to limit or adjust our examination scope (coverage) - thus, risk-focusing -- 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 as appropriate. 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. Utilizing all of these risk-focusing processes should assist us in more effectively spending our time and resources rather than conducting more time-consuming broad-based examinations, thus also reducing the burden on firms.

Coordination of examination work among securities regulators is another process that contributes to the effectiveness and efficiency of examinations for compliance with securities laws. Like you, we believe that coordination is essential to prevent unnecessary duplication of efforts and wasted resources. We also recognize that coordination begins within our own organization - the various groups in our SEC examination program.

As you know, the SEC has responsibility for the examination of broker-dealers, investment advisers, investment companies, transfer agents, clearing agencies, and the Self Regulatory Organizations ("SROs"). There are currently about 9,000 registered investment advisers, 990 fund complexes with over 8,000 mutual fund portfolios, and 6,100 registered broker-dealers with 170,000 branch offices and almost 660,000 registered representatives. There are also 550 SEC-registered transfer agents and 7 clearing agencies. 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. We also coordinate with other regulators having responsibilities in these areas.

Examination coordination among the SROs is performed under a Memorandum of Understanding signed in 1995 by the SEC, the SROs and the North American Securities Administrators Association. The MOU requires cooperation and coordination in examinations to "most efficiently and effectively oversee the financial, operational, and sales practice activities of broker-dealers, maintaining the highest level of examination oversight quality for the protection of investors, while working to eliminate any unnecessary and burdensome duplication in the examination process." Under the terms of 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 coordinated. SROs 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 as requested, and over the past year the SROs were more than 95% successful in coordinating. We have also worked with the NASD and NYSE to create a system to monitor exams being performed by each of the SROs and the SEC. This enables us to avoid unnecessary duplication of efforts and has been particularly helpful in our coordination with respect to sweeps and branch exams. Regional and national examination summits and joint training programs are also held to increase coordination and consistency.

II. The Examination Process

I would now like to turn to my second topic - the examination process. All of our SEC examinations follow the same general process. This process is outlined in our examination brochure, which firms are given at the beginning of an examination. The brochure:

  • Describes the purpose for examinations and the examination process and provides some specific suggestions on communicating with SEC examiners and other SEC staff regarding the exam.
  • Points out what registrants can expect upon initial contact by the staff if the examination is announced or unannounced.
  • Describes how the "exit interview" process works.
  • Establishes the completion time of examinations as 120 days and indicates that the staff will contact the firm to discuss the status of the examination and likely schedule for completing the exam if the examiners are unable to complete their work within that time.
  • Provides registrants with information about the Examination Hotline, which can be reached at (202) 551-EXAM to express comments or concerns about examinations, either anonymously or by identifying yourself and the specific concern.
Many of these steps in the examination process are responsive to industry suggestions.

An "announced" examination will usually begin with a document request letter. More documents will most likely be requested throughout the process. If the exam is "unannounced", documents will be requested by exam staff upon arrival. It helps the examination process proceed smoothly and more quickly if you provide documents to the examiners as promptly as possible - perhaps piecemeal - if some documents will take longer to produce. You should also communicate with the examiner if you are unable to provide any documents by the due date or if you have questions or concerns. The request for information can be adjusted in situations where better, more precise, or more appropriate documents can be provided.

Upon arrival on-site at your firm, examiners identify themselves and present their SEC identifications. The examiners may conduct an initial interview asking questions about the firm and the activities to be examined. This information assists examiners in understanding the firm and its operations, and often assists examiners in determining the scope of the examination. The examiners may also ask for a walk-through of the firm's offices to gain an overall understanding of the firm's organization, flow of work, and control environment. Then the main process begins, which is the examination of the firm's books and records combined with meetings and consultations with firm personnel.

On the last day of the on-site visit, examiners will typically conduct an "exit interview" during which they will discuss the status of the examination and any outstanding information requests and, if appropriate, the issues identified during the examination to that point. The firm will be given an opportunity to discuss any of the issues that the examiners found and provide additional relevant information.

The examiners then return to the SEC offices to perform additional analyses. They may also contact the firm to ask clarifying questions or to request additional information. In formulating the findings of the examination, the examiners may consult with other staff within the SEC to ensure that the findings are consistent with Commission rules, regulations, and interpretations.

If work performed subsequent to completion of the on-site portion of the examination identifies issues in addition to those discussed during the exit interview conducted on the last day of the on-site visit, the examiners will contact the firm to discuss these additional findings. During this "final exit interview," the firm will be given an opportunity to discuss any of the issues that the examiners found and provide additional relevant information, such as a description of any actions the firm has taken or plans to take to address the issues identified. Cooperation during the exam and promptly providing complete and relevant information will assist in timely completion and an effective examination.

Once the examination is complete, the firm will be sent written notification. To the extent there are findings of weaknesses or concerns, these will be included in the written notification together with any of the firm's preliminary responses or information provided by the firm on corrective actions. Firms will be asked in the notification to formally address in writing any weaknesses or concerns, typically within 30 days. If special circumstances arise and you believe you will be unable to complete the response within the time requested, you should contact the examination staff or supervisor to request an extension. It is our expectation that with recent enhancements, our SEC examination process will be more effective, more efficient, and less burdensome, producing a more accurate result, using less time and resources - both by SEC examiners and firm personnel.

III. Examination Priorities and Challenges

Now I will turn to my third and final topic - some of our current examination priorities. These are in the general areas of supervision, sales practices, risk management, financial issues, and trading practices. They include the following:

  • Supervision - Supervision has long been a top examination priority for the SEC examination program and I expect it will remain on that list for a long time.1 One area of focus is ensuring that a firm's written supervisory procedures are complete, and updated to keep pace with regulatory or business changes. They also need to be followed by firm personnel. Large, high volume firms using manual monitoring processes may raise supervisory concerns. Branch office supervision is a growing challenge as the number of branch offices has escalated to about 170,000, and many offices are independent contractors or at remote locations, offering additional challenges. Outsourcing of more and more activities also raises supervisory issues.
  • Sales Practices - Suitability and disclosure are also high priorities for our examination program. One of our main joint examination initiatives with the states and SROs involves aggressive enforcement, targeted examinations, and investor education and outreach programs to protect seniors from investment fraud and sales of unsuitable securities. This was announced on May 8, 2006, by SEC Chairman Christopher Cox and North American Securities Administrators Association President Patricia Struck and is a significant collaborative effort among the SEC, the SROs, and a number of states. Almost 90 suitability examinations have begun in Florida, California, Texas, Arizona, North Carolina and Alabama - states with large retirement communities. We expect that many of our general sales practice and suitability exams in our program nationwide will key in on sales to senior citizens, as well. Rules relating to sales, suitability, and supervision are areas of focus.2 While we are still in the early stages of the examination process, we have already seen concerns with advertising and marketing materials, and have seen particular problems with the sale of variable annuities and equity indexed annuities.

    In addition to the suitability examinations with respect to seniors, there are also a number of products that we should all carefully monitor. The creation of new innovative products is, of course, a very good thing for investors and for our markets and economy. However, abuses in the sale, marketing and structuring of these products that can cause problems that harm not only investors but markets in those products. Some products that may raise compliance challenges include 529 plans, variable annuities, illiquid securities, and IPOs. And despite all the valuable work that has been done by regulators and the industry, we continue to find some firms that are not providing investors with appropriate breakpoint discounts on mutual fund purchases. There are other products, for example hedge funds and structured finance products, that 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.
  • Risk Management - Firms continue to make significant advances in risk management internal controls. However, there are still some areas where special attention might be directed. For example, it is a good practice for firms to continually monitor and update business continuity plans as appropriate to implement technological advancements and address new challenges, such as a potential pandemic. Making certain back office operations and compliance keep pace with sales and marketing new product is an area of focus. And firms should continue to monitor assignments and confirmations with respect to credit derivatives. Complex structured finance transactions (CSFTs) are another product that merits attention. CSFTs are an important segment of the international capital markets that experienced dramatic growth in recent years and have become increasingly complex.3 They may involve innovative financing techniques creating customized financing and investment products to suit financial needs of customers, making them unique, illiquid, and difficult to price. As such, 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. On May 9, 2006, the SEC together with the banking regulators issued a proposed revised "Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities." The Statement describes risk management principles that may help a financial institution manage and address risks. The comment period on this Statement has expired and the agencies are considering whether any changes to the Statement are appropriate in light of the comments. Other key risk management concerns include conflicts of interests and information security, particularly in view of increased instances of identify thefts.4
  • Financial Issues - Net capital deficiencies and inaccuracies in computing net capital remain among top findings from our examinations. Imposing adequate margin requirements on customers, particularly hedge funds and other significant or highly leveraged customers, is also an area of focus. You should also monitor developments in portfolio managing. We are also carefully monitoring alternative net capital computations of broker-dealers using methodologies incorporating the concepts of the Basel capital requirements with internal mathematical models as the underlying basis.
  • Anti-Money Laundering - Not only is the anti-money laundering program important in combating terrorist financing, but there always seem to be new rules and nuances to address the clever new activities of those who would abuse our financial system for nefarious purposes. Therefore, it remains an important area for all of us to monitor. Some items of particular focus this year include: on-line firms; shell companies and other vehicles that may be used to mask the true identity of customers; the "silo problem" - where key areas of the firm are not communicating and therefore significant AML issues may be missed; firms' relationships with foreign institutions; whether independent tests are timely, comprehensive, and conducted by a person with sufficient knowledge of anti-money laundering laws; adequacy and effective implementation of compliance programs; and whether each regulated entity is meeting its independent obligations under the PATRIOT Act.
  • 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. They are also key to understanding firm operations and activities. One major challenge is email communications. Under Rule 17a-4, firms are required to establish an adequate system for the retention of all records, including emails, relating to the firm's "business as such". It is important that all correspondence and records, including emails, be accurately maintained and accessible as required.
  • Trading Practices - Examinations continue to find instances of market timing in mutual funds, variable annuity products, and REITs. Best execution of transactions is also 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.

Looking over the horizon, it is my view that there are some potential challenges we can already anticipate. First, there is an ever increasing stream of new and complex products being offered. While marketing and sales seem to proceed promptly, it is a challenge to keep pace in the areas of operations, controls, compliance, and training. Structured product marketing and sales continue to escalate with a reported 500% growth in commodities-related structured products. There continues to be an increased focus on sales and marketing of securities products to senior citizens and those in the pre-retirement stage, where suitability and marketing must be carefully monitored. Changes in interest rates will impact home mortgages, home equity loans and fixed income products in ways that may not be expected by investors. As more and more activities are outsourced, firms will be challenged with maintaining appropriate controls and supervision. Technology continues to offer challenges - there are increasing volumes, increased rapidity of trades, more nonpublic customer information on potential trading that should be appropriately protected, and more sophisticated hackers and security breaches. Maintaining robust and flexible controls and continually monitoring and addressing risks are the best defenses against compliance problems and financial failures. And it is hard-working compliance professionals like all of you who I am sure will keep these as top priorities at all of your firms. Thank you.



Modified: 10/19/2006