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Speech by SEC Staff:
The SEC Examination Program: Coordination and Priorities


Mary Ann Gadziala

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

New York, NY
February 7, 2006

Remarks before The Bond Market Association's Annual Legal and Compliance Conference

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.

I very much appreciate this opportunity to address the Bond Market Association. Your group has worked with us over the years on so many significant issues, and we hope you all continue to use the Association as a valuable resource to convey to us your ideas as well as any concerns you may have. It is only if we all work together and maintain an open dialogue that we can achieve the highest standards for maintaining investor protection and market integrity.

We in the Office of Compliance Inspections and Examinations are continuously evaluating and working to enhance our program. In my remarks, I would like to focus on some of our coordination efforts and examination priorities. Overall, the broad goals of our examination program are three-fold: to detect fraud and abuse; to foster a strong compliance and risk management culture in the securities industry; and to provide to the Commission useful information on the capital markets and industry business and practices to assist in informed decision-making.

Coordination and cooperation in the examination program are intended to avoid unnecessary duplication of efforts and regulatory burdens, use available information and technology as effectively as possible, promote the best use of scarce resources, and focus on areas of greatest risk to investors and markets. This is not an easy task, and it is a continuous process. Following my remarks on coordination, I will say a few words about specific areas of examination focus, particularly those that may impact the fixed income area.

Coordination begins within our agency. OCIE has responsibility for the examination of broker-dealers, investment advisers, investment companies, transfer agents, clearing agencies, and the Self Regulatory Organizations ("SROs"). Over the past several years we have increasingly integrated the work done in these areas. While entities may be separately incorporated and registered, and subject to different laws, their businesses frequently intersect. Large firms may perform multiple functions, have multiple registrations, and have common revenue lines. Broker-dealers are often registered as investment advisers. The SEC recently issued a new rule addressing the application of the Investment Advisers Act of 1940 to broker-dealers offering certain types of financial services. Broker-dealers may also use the services of investment advisers and may sell mutual funds; transfer agents maintain the records of stock transfers. Inter-affiliate transactions take place. Gifts and gratuities for inter-related services and revenue sharing also come into play. Best execution, valuation, brokerage commissions, sales practices, use of confidential customer trade information, and supervision all may cross registrant boundaries. In this environment, conflicts of interests may arise, and strong compliance programs as well as high ethical and business standards are imperative. Firms may also conduct regulatory responsibilities on a consolidated basis. These might include business continuity planning, anti-money laundering, information security, and risk management. In view of all this, individual registrants cannot be examined in isolation. We are therefore making every effort to coordinate examinations in all areas where the Commission has responsibilities. You should expect to see more joint examination work involving different registrants in an organization.

Another effort currently underway is a limited pilot program to monitor regulatory information about entire organizations. This may include examinations and other regulatory activity, news and market information, trading and surveillance information, financial reports, and customer complaint information. We are enhancing systems and using technology to collect and consolidate information. Updating and coordinating available information will not only assist us in more effective targeting of potential risks and scoping of exam coverage, but also will provide a full regulatory landscape of an organization rather than a piece-meal registrant-focused analysis.

Of course, our coordination efforts would not be complete without incorporating the work of the SROs and other regulators. The efforts I have mentioned also include the SROs and we are working diligently to combine our respective examination and other information to more fully coordinate securities examination activities and risk assessment activities. The work is ongoing, but substantial progress has been made and we will continue pursuing these coordination efforts.

It is noteworthy that we recently celebrated the ten-year anniversary of the original signing of the Memorandum of Understanding among the SEC, the SROs and the North American Securities Administrators Association. That 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." I'm sure you would agree this is a laudable goal. Pursuant to the MOU, the SROs have asked firms if they wanted all SRO examinations to be coordinated, and over the past year the SROs were more than 95% successful in conducting coordinated examinations where requested. Regional and national examination summits and joint training programs are also held to increase coordination. We expect to produce a more comprehensive assessment of the success of the MOU achievements for Commission consideration in the near future.

While coordination of securities oversight alone offers significant challenges, we are also coordinating our examination information with the bank regulatory agencies, CFTC, FinCEN and other relevant regulators. Recent joint banking regulator/SEC initiatives involved anti-money laundering, risk management for structured finance activities, and business continuity practices, among others. We are also working together with the Federal Reserve on a number of initiatives to share relevant examination information and coordinate risk assessment. We hope that the success of these endeavors will lead to further initiatives of this type.

Another aspect of our coordination and cooperation efforts involves the firms' internal compliance and control programs. Over the past decade, we have been examining risk management, internal audit, and more recently, compliance and legal control systems at firms. We have seen many of these programs mature and increase in effectiveness over the years. We expect to continue to focus on these areas to promote strong controls at firms, therefore lessening the occurrence of violations, financial losses, and fraud and abuse that must otherwise be addressed by our examiners.

We also have recently begun an initiative whereby we will leverage off high quality, effective internal audit work by firms. This new initiative should permit more effective and efficient SEC risk management examinations. Our increased use of our past examination work and 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. In such cases, we might limit our review of those areas and focus on high risk areas and areas not adequately covered by the firm's reviews. This should reduce the scope, length, and burden of our examinations. In order to incorporate this concept into our risk management examination process, we expect to enhance our reviews of the effectiveness and objectivity of the work of a firm's internal audit program.

Some factors SEC examiners may consider in assessing the quality of an internal audit program are: first, the adequacy of the audit universe - internal audit's assessment to determine the areas of risk, risk rankings, and the effectiveness of risk controls; second, incorporation of this information into the design and implementation of the audit plan; third, ensuring the firm's top management, which has overall responsibility for audit, is kept informed on audit issues; and fourth, the competence and objectivity of internal auditors and the effectiveness of their work.

Now let me turn to some of our examination priorities - the areas where SEC examiners expect to focus significant attention and resources. The conflicts areas I mentioned earlier remain on our radar screen. We also have focused in the fixed income area on mark-ups, with inter-dealer and retail mark-ups being a primary focus. As you know, NASD Rule 2440 requires members to buy or sell bonds at a price that is fair to the customer. Municipal Securities Rulemaking Board ("MSRB") Rules G-17 and G-30 require that a municipal securities dealer deal fairly with all persons and not engage in any deceptive, dishonest, or unfair practice. MSRB Rule G-18 requires fair and reasonable pricing in executing a transaction whether undertaken as agent for a customer or as a "broker's broker" on behalf of another broker-dealer. MSRB and NASD rules also require municipal securities dealers to maintain an adequate supervisory system and written procedures (MSRB Rule G-27 and NASD Rules 3010(a) and (b)).

A number of concerns have been raised in the inter-dealer area. For example, inter-dealer firms may provide certain bidding broker-dealers an unfair advantage through tips or information valuable to the outcome of the bidding process; firms might use a false cover bid to conceal the spread between the winning bid and the second place bid from the buying and/or selling broker-dealer; firms might charge excessive markups, which could be passed on to a selling broker-dealer and then to a retail customer.

A number of concerns have been raised in the retail area as well. For example, retail firms may charge excessive mark-ups, unfair prices, and/or engage in unsuitable transactions. Finally, with respect to both inter-dealers and retail firms, there are concerns about weak supervisory systems and inadequate books and records. These areas are currently under review by our examiners.

Improving bond market transparency has been a priority of Commission Staff for the past decade. In 1994, the Commission Staff obtained a commitment from MSRB to implement price transparency in the municipal securities market, and in 1998 the Debt Market Report led to the development of NASD's TRACE system for the corporate bond market. Recently, the MSRB and NASD implemented new phases of their transparency programs for the municipal and corporate sides of the bond markets, increasing the availability of near-real-time bond pricing data in the marketplace. This has enhanced the ability of regulators to surveil the bond markets for unfair pricing, illegitimate mark-ups and mark-downs, and other abusive practices. Excessive markups are an area of examination focus with respect to all fixed income sales. MSRB and TRACE surveillance information will assist us in identifying potential problems.

Another area being reviewed is payments for bond rating trips by broker-dealers. MSRB Rule G-20 restricts the value and frequency of gifts and gratuities that can be given by municipal securities dealers in relation to their municipal securities activities and Rule G-17, as I mentioned, requires fair dealing by municipal securities dealers. There is a concern that broker-dealers preparing new bond offerings may be violating these rules by paying excessive expenses for municipal officials to meet with rating agencies, with expenses then being passed on to ultimate bondholders as a cost of offering. Payments for bond rating trips, as well as the general provisions of MSRB G-37 and G-38, prohibiting "pay to play" are areas of focus for our examiners in the fixed income area.

Other examination priorities for 2006 include the following:

  1. Sales practices and supervision, covering:
    • general suitability examinations to identify sound and weak practices;
    • branch exams, particularly remote offices, independent contractors, and foreign branches;
    • products, including variable annuities, mutual funds, and bonds.
  2. Compliance, internal controls, and risk management, including:
    • consolidated supervised entities, particularly inter-affiliate transactions, unregulated material affiliates, and new products and businesses;
    • OTC derivatives dealers;
    • the largest institutional and retail broker-dealers with an increased focus on legal and compliance risks and controls.
  3. Net capital and customer reserves, with some focus on Rent-A-Finops, assumption of liabilities, customer versus capital investment, and the alternative capital calculation for consolidated supervised entities.
  4. Business continuity practices, including:
    • the Interagency White Paper for significant firms;
    • compliance by all firms with SRO rules and general BCP risk management.
  5. Anti-money laundering, including:
    • compliance programs, training, audits;
    • Suspicious Activity Reporting;
    • Customer Identification Programs;
    • broker-dealers with bank or insurance affiliates and online BDs;
    • Rule 312, including enhanced due diligence for accounts with foreign banks and foreign correspondent accounts.
  6. Back office operations and new products and services, particularly:
    • risk management for new products;
    • ensuring back office operations and controls keep pace with new product and business developments;
    • information security issues, including privacy, identity theft, computer viruses, and stolen information.
  7. Best execution and trading activities, including:
    • compliance with Sections 11 Ac1-5 and 6 and Reg SHO
    • use of customer trading information;
    • valuations;
    • information barriers.

These are only some of the examination priorities of the Office of Compliance Inspections and Examinations. Like our program operations, our priorities are also subject to continual review. Market changes, surveillance and trading information, new product developments, customer complaints, new rules and many other factors influence the coverage of our examination program and our priorities. Our program will no doubt continue to evolve. But I hope my remarks have given you a better understanding of our goals, our program, and our current priorities. Thank you.


Modified: 02/09/2006