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Keynote Address by SEC Staff:
Furthering Good Compliance: Current Areas of Focus in SEC Examinations


Lori Richards

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

National Regulatory Services, 17th Annual Spring Compliance Conference

Miami Beach, Florida
April 8, 2002

The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the staff of the Commission.

Good morning.

It's a pleasure to be here with you this morning to talk about compliance. I'm especially pleased to have the opportunity to talk to an audience comprised of both broker-dealer and investment adviser compliance professionals. I think a joint conference like this is a great idea. While the laws and regulations that you administer may differ, at the core you are all securities compliance professionals with a common purpose — to ensure that your firm is meeting your obligations to best serve your customers.

Since this conference is the NRS's annual spring compliance conference, it seems appropriate to look ahead and see what is in store for the new year. I'd like to spend some time today sharing with you some of my thoughts on compliance and some of the changes in the SEC's examination program that we hope will further foster good compliance. Finally, I'll share with you the areas of our current examination focus — our "hot topics," so to speak. Hopefully, you'll take this information back to the office, share it with others, and make sure that your compliance program is the best that it can be.

The Importance of Good Compliance

Let me first start by saying that good compliance is critical to the health and well being of your firm. I believe that, simply put, what's good for investors is good for firms that do business for investors. Good compliance is simply good business. I know this concept isn't new to you. But, I think that it is important enough to bear repeating. As I have often said, one basic, fundamental way that you can maintain and bolster the health of your firm is by ensuring that your compliance and internal controls are first rate. Any firm in business for the long term has strong internal controls, and the opposite is also true — firms that fail often do so because of a lax control environment. A strong control environment is one which has controls designed to not only deter problems, but to detect problems. And naturally, once problems are detected, they are corrected right away. And, they are corrected in ways that are in the best interests of your customers.

I have stressed that you can achieve good compliance and internal controls only if you've implemented a sound infrastructure. What does that mean? Well, you must be proactive. You need to periodically review your systems, controls and people to ensure that they are first rate. Here are some key elements. Hire the best people you can. Needless to say, your compliance is only as good as the people carrying out those responsibilities. Once you have those people, you need to instill in them a mission of integrity and a culture of doing what's right. This is critical. Adopt written procedures, and clearly designate responsibility for implementation. Then, test your systems periodically to make sure they're working, as they should be. Also explore new ways of ensuring compliance. Technology can be very helpful in this regard. I highly recommend that you investigate how technology can work for your firm — whether it's the new "smart order routing" tools to aid in fulfilling the duty of best execution, or automated exception reports that indicate aberrant trades, or automated checklists that help in supervising the opening of new accounts — there are some innovative new automated compliance tools that are well worth investigating. I'm also really interested in the new on-line educational products that help ensure that staff are as proficient and knowledgeable as they can be.

None of this will help, of course, if you don't have adequate resources, whether its people power or automated compliance tools. You must devote adequate time and money to your compliance program — and enough of both to do the job and to do it right. Skimping on compliance can only hurt you and, ultimately, investors. Chairman Pitt cautioned firms about this just last month when he said that he was concerned about:

"the fate of legal and compliance personnel in firms trying to cut costs and improve the bottom line results. There is often a temptation to cut back, or skimp, on compliance assurance, on the theory that compliance and legal staff do not increase the bottom line. That view, of course, is terribly mistaken. Compliance and legal staff contribute to the bottom line in the most important way possible — they assure that their firms retain and improve their reputation, thus allowing their firms not only to remain in business but to continue to thrive in this unpredictable milieu. Cutting back on compliance is a sure-fire prescription for disaster and the erosion of public confidence."

I could not agree more! Cutting back or skimping on compliance controls is a sure recipe for failure.

The SEC's Examination Program: Our Role in Fostering Good Compliance

Now, let me turn to what's new in the SEC's examination program and how these changes might affect you. Let me first talk about how we perceive our role. The job of the SEC is to protect investors. In the exam program, we aid in this mission by conducting examinations of firms that do business with investors to ensure that they are in compliance with all applicable laws. In addition, I believe that examinations serve another role — they foster proactive private sector compliance. To that end, we both want to ensure that the compliance function is strong, well-resourced, and able to do its job.

As you know, during examinations, SEC examiners look for weaknesses and violations within your organization. In conducting our exams, we often find problems of varying degrees. These can range from record-keeping weaknesses, all the way up to significant conflicts of interest, frauds and manipulations. Remember, our mission is to protect investors and the examination process is one of the ways we do this. However, the examination process accomplishes something else, something we hope that you consider valuable. It helps you to identify potential weaknesses in your compliance practices, which, in turn, helps you to strengthen your compliance program. Believe it or not, many firms welcome our visits for this very reason (or so they tell us).

One of our primary goals is to get problems fixed quickly. We think that this should be your goal as well. We strongly believe that our examinations provide you with information you need to make changes and fix problems. One new development in our examination program designed to help you accomplish this goal is the use of exit interviews. When we find problems in our exams, it is now our policy to hold an exit interview with the firm. During an exit interview, the examiners will discuss their tentative conclusions about the problems they have found before they send a deficiency letter. The goal of this new policy is to provide you with information about problems we have detected as quickly as possible so that you can take immediate steps to correct problems. Ideally, you will have corrected all problems identified, and implemented measures to ensure that the problems don't reoccur, even before you receive our deficiency letter. We believe that investors are better protected and served if both of us take immediate action towards identifying and fixing problems.

We've recently made another change in our program — with respect to what's included in our deficiency letters. From now on, we'll send you a deficiency letter even if we make an Enforcement referral. This is in keeping with our goal to provide you with information about problems we have detected as quickly as possible so you can correct the problems right away.

As I hope I've demonstrated, we try to foster good compliance. Unfortunately, we can't be on the scene all of the time. But you are — you're there when things go wrong. And when things do go wrong and you discover problems, we sincerely hope you'll talk to us — and sooner rather than later. We really want to help you resolve problems — and resolve them quickly and in ways that benefit and protect investors. Recently, the Commission made clear our policy on cooperating with the staff in a Section 21(a) Report, (called In the Matter of Gisela de Leon-Meredith). I strongly urge you to read it. The report outlines the benefits of cooperating with the Commission by taking steps to protect investors, making them whole on any losses and assisting the Commission in resolving difficult problems.

We also expect candor and cooperation in the examination process. Most firms in the securities industry view our examinations as a normal part of doing business, not as an intrusion. If you and your staff view our examinations as a healthy check on operations, it's likely that the exam is going to go smoothly. I can't emphasize enough how important it is that you provide information to the examiners promptly and completely. And needless to say, you and your staff must be open and honest with examiners. On our part, as I said, we'll be forthcoming with you about any problems we see. Our goal is to establish a relationship of professional cooperation at all times.

Current Areas of Examination Focus

As you may know, each year we identify the areas that examiners will focus on during examinations. While each individual examination is tailored to the risks that exist at each individual firm examined, there are some areas of particular emphasis. If any of you are David Letterman fans, you're quite familiar with his Top 10 list. Well, we have a list, too — the top areas of interest for us in our examination program right now. While our list isn't funny, I hope that the significance of our list will make it much more memorable.

Areas of Focus in Broker-Dealer Examinations

  • Sales Practices. A continuing focus for SEC examiners is on broker-dealers' retail sales practices — that is, we're looking for indications of unauthorized trading; failures to disclose risks, costs and fees; churning and switching. We've placed particular emphasis on reviewing sales practices for particular products, such as mutual funds and variable annuities — especially the sales of "bonus" variable annuities. We're also continuing to conduct examinations of branch offices, to review sales practices where they occur.
  • Supervision. One of the first thing examiners are going to ask you in a broker-dealer sales practice exam is what your system of supervision is. They are going to ask not only how you ensure that problem trades are detected but, more importantly, how you ensure that inappropriate trades never take place. A special focus area right now for examiners is evaluating supervisory procedures over producing branch managers. In particular, we're looking for independent supervision and compliance review of the activity of producing managers, by someone outside of the manager's chain of command.
  • We're also going to be reviewing what I think should be very basic compliance procedures to prevent theft of client funds and securities: Questions we'll be asking include:
    • how do you handle customer checks?
    • how do you handle customer changes of address, particularly to P.O. boxes?
    • how do you handle customer authorizations for withdrawing or transferring funds and?
    • does someone other than the registered rep follow up with customers in response to unusual account activity?
    We hope to see that your controls and supervision in these areas are sound.
  • Internal Controls. We have continued to conduct specialized reviews of broker-dealers' risk management and internal controls, evaluating the processes and procedures that firms use to measure and manage risks relating to trading, credit, liquidity and new products. We've been doing this for a number of years now. In light of the concentration of customer assets in the largest firms, we will be examining large firms' internal controls on a regular basis. A new focus of these examinations is on operational risk, particularly on contingency planning. What we're looking for in these exams is essentially a system of controls: written guidelines, a clear delineation of responsibility and independent and periodic oversight that the guidelines are being followed.
  • Money Laundering. Last spring, we initiated a joint exam sweep with the NASDR and the NYSE to review broker-dealers' anti-money laundering programs. We are concluding this sweep now. These exams have indicated to us that, while many firms have taken steps to adopt or to enhance existing programs, more must be done to be ready for full compliance with the Patriot Act. I remind you that Section 352 of the Patriot Act, which requires that all broker-dealers and investment companies have anti-money laundering compliance programs, goes into effect in exactly 16 days. SEC and SRO examiners will continue to work together to target firms for special examinations, and an anti-money laundering review will be a part of the routine exams conducted by the SROs.
  • Best Execution. We are continuing to focus on execution practices of broker-dealers. In particular, we'll be looking to see that firms are using the new market quality data required to be provided by market centers under Rule 11Ac1-5 in order to evaluate the quality of the markets to which they route orders and the quality of other alternative markets. We will also be looking at market centers' compliance with new Rule 11Ac1-5.
  • Net Capital and Customer Reserves. With declines in firm revenues, maintaining adequate minimum capital to conduct business is more important now than ever. Intentional and unintentional net capital and customer reserve violations are among the most frequently identified problems in our exams. And, I note that we make Enforcement referrals if these violations are serious or intentional.
  • Analysts' Conflicts of Interest. A year ago we conducted an exam sweep of sell-side analysts' relationships with investment banking departments within their firms, their personal ownership of the stocks in companies they cover, how firms monitored analysts' personal holdings, and the disclosure in research reports. Since then, the NYSE and NASDR have proposed broad new rules designed to address conflicts of interest by analysts. Shortly after the new rules become effective, SEC and SRO examiners will be conducting a second exam sweep to ensure that the new rules are being implemented effectively.
  • Limit Order Display. We will continue to focus on the Limit Order Display Rule, which requires the "immediate" display of customer limit orders that improve the price or the size of the quote.
  • Information Barriers. We are continuing to examine firms' information barriers — the policies and procedures that firms have adopted pursuant to Section 15(f) of the Exchange Act to prevent the misuse of non-public information. I also note that in recent years, the Commission has brought a number of insider trading cases involving members of the securities industry. In my view, it makes sense for all firms to re-examine their information barriers to make sure they're airtight.

Areas of Focus in Investment Adviser Examinations

  • Disclosures in Part II of Revised Form ADV. We are continuing to review Part II of revised Form ADV to make sure advisers are fully disclosing all important aspects of their operations, including any and all conflicts of interest inherent in their activities. We will also evaluate whether such disclosures are written in language that is easy for the average client to understand. And no legalese, please!
  • Performance Numbers. We are continuing to place special emphasis on reviewing advisers' performance claims. Making claims of good performance relative to benchmarks and peer group advisers continues to be an important marketing tool for many advisers. Because performance is perceived to be so important, some advisers have been willing to fudge the numbers or make representations of compliance with AIMR presentation standards that are false. It goes without saying that any representation to customers must be completely accurate.
  • Best Execution. We are also continuing to look at advisers' processes for placing orders for their clients' accounts. Among our objectives in this area is to determine if an adviser seeks to obtain best execution. We are also reviewing advisers' use of clients' funds for soft dollar abuses or undisclosed payments for client referrals.
  • Sales Practices and Suitability of Recommendations. We are equally concerned about investment advisers' "sales practices" and the suitability of recommendations they make. One of the areas that you can count on us to scrutinize is where an adviser who is also a registered rep of a broker-dealer or is dually registered as a broker-dealer, recommends that clients purchase "B" shares of funds. We want to make sure that the sale is appropriate in light of breakpoints and in relation to other classes of shares.
  • Preferential Treatment of Hedge Funds. An increasing number of advisers are permitting one or more of their portfolio managers to create and manage a hedge fund or other private equity fund side-by-side with the portfolio manager's management of a registered investment company or traditional separate accounts. During every inspection in which we find side-by-side management of hedge funds, we focus on how the adviser allocates securities and whether the adviser is managing all of its accounts appropriately.

Areas of Focus in Investment Company Examinations

  • Fair Value Pricing Procedures. We will be looking at the use of fair value pricing procedures, particularly any changes to fair value procedures adopted by fund boards to reflect the issues raised by the two valuation letters sent by the Division of Investment Management to the Investment Company Institute. In particular, funds should have procedures to handle the valuation of securities when significant subsequent events occur after the regular or early close of a market and the regular time a fund calculates its NAV.
  • Error Correction. We're reviewing the policies and procedures established by funds and their advisers to handle the correction of errors that may occur in the calculation of NAV.
  • Fund Governance Rules. We' reviewing for compliance with the new fund governance rules. Independent directors play a critical role in fund compliance. The new rules, which include new disclosure requirements, expand the role of independent directors. They are designed to enhance the independence and effectiveness of fund boards of directors and provide investors with greater information about fund directors.
  • Names Rule. We will also review for compliance with the recently adopted "names rule," Rule 35d-1 under the Investment Company Act — which is designed to ensure that the name of the fund reflects its portfolio investments and risks.
  • Money Laundering. The Patriot Act also imposes new obligations on mutual funds to create compliance programs and to verify the identity of shareholders. As these provisions become effective, SEC examiners will begin to review for compliance. Therefore, you should expect to see an anti-money laundering review as a part of the review of your fund.

Finally, in examinations of broker-dealers, funds and advisers, we'll be examining for compliance with Regulation S-P and reviewing firms' contingency planning efforts.

  • Regulation S-P. As you know, Regulation S-P, the SEC's new privacy rules, became effective last July. During our exams, we're placing particular focus on that part of the rule known as the "safeguard rule," which requires firms to have safeguards over the security of information. Our information technology staff are reviewing firms' information technology systems, including firewalls, encryption and other protections.
  • Contingency Planning. Finally, we're also reviewing firms' disaster recovery and back-up plans. That is, we are looking are firms' policies and procedures to consider the potential impact of disasters on the firm's operations, its ability to comply with regulatory requirements and how firms will continue to operate consistent with disclosures that have been made to clients.

These are the areas that SEC examiners are likely to focus on in examinations this year. I certainly hope you'll use this information to go back to your offices and double-check your compliance efforts in these areas.

Let me finish by wishing you a wonderful conference. All of the topics I've outlined this morning are going to be covered in the sessions here in the next few days. Remember, too, that you as compliance professionals and we, securities regulators, share a common goal — we both want to ensure that compliance is the best it can be.

Thank you.



Modified: 04/08/2002