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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Key Issues in SEC Examinations of Broker-Dealers


Lori A. Richards

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

Before the Legal and Compliance Division, Securities Industry Association
Union League Club
New York, N.Y.
September 17, 2002

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 other members of the staff.

Good afternoon. It's a pleasure to be with you again. I'd like to thank the SIA's Legal and Compliance Division for asking me to speak, and thank the SIA for continuing its many initiatives to ensure communication and dialogue among legal and compliance professionals.

The events in our markets today -- the collapse of large public companies, the volatility in the markets, the public's unease with securities analysts -- prove to all of us just how important legal and compliance professionals are in the securities industry. Your work has never been more critical. You must be proactive and aggressive in helping ensure that your firms conduct business in the right way, in a manner that meets not only the requirements of the law, but also meets public and investor expectations. As Chairman Pitt said when he addressed the Legal & Compliance Division at its annual meeting earlier this year: "[c]ompliance and legal functions are "bread and butter" functions of a firm, and must be adequately staffed and resourced." He went on to say that:

"I applaud all of you for your efforts in making sure that you, and the business people you oversee, answer to the demands of conscience. You are important transmitters of corporate culture. Businesses have cultures and most of the disasters that find their way to us have their roots in a cultural pathology within the business. Compliance people are the ones who insist that things be done the right way, and by doing so, you spread values throughout your enterprise."

It's clear that we as regulators strongly support your efforts and want to ensure that the compliance function is healthy, strong, well-resourced and respected within securities firms, and within the securities industry.

I wanted to talk with you today about some of the areas we are focusing on now in our examinations of broker-dealers. It's my hope that you will use this information to make certain that your firm's compliance and internal controls in these areas are strong.

Sales Practices

A continuing focus for SEC examiners is on retail sales practices - unauthorized trading, suitability, disclosure of risks, costs and fees, churning and switching. We've placed particular emphasis on reviewing sales practices for particular products that are new or are popular with retail investors -- mutual funds, variable annuities and limited partnerships, and in the coming months, securities futures products.

We're continuing our examination sweep of firms selling variable annuities. Fundamentally, we're concerned that investors don't understand the complexities of this product. More complex products require that registered representatives spend more time explaining them to customers. With "bonus variable annuities," we're worried that this product is being inappropriately recommended to customers to switch from one similar annuity to a bonus annuity, that has a larger payment for the registered representative but may not be beneficial for the customer, because of the customer's investment timeline, age, or investment objectives. We are concerned that many firms we've examined have not implemented sufficient safeguards to prevent this conduct. We're also continuing to conduct examinations of branch offices, since sales practice violations occur most often in branches -- last year we conducted a large number of exams of retail branch offices, many for cause and unannounced. You can expect that these examinations will continue.

Let me add a thought here on a related topic -- we often conduct these cause examinations as a result of receiving complaints from investors. While we follow up on these complaints by conducting examinations, you must also make sure that your firm is responsive to the complaints of your customers in a timely and appropriate way. Our Office of Investor Education and Assistance asks that when they send copies of the complaints they receive to you for your firm's response (to the SEC and to the customer), that you do so within 30 days. Being responsive to your customer's questions and their complaints is an important part of your obligation to serve their interests.


The first thing examiners are going to ask you in a sales practice exam is what your system of supervision is -- and in particular, not only how you ensure that problem trades are detected, but more importantly, how you ensure that inappropriate trades never take place.

We have recently initiated a series of special examinations to review the overall compliance systems of a number of large broker-dealer complexes. That is, we are looking at all compliance procedures and their implementation at all broker-dealers in a complex. These examinations focus on a top-down evaluation of the effectiveness of the broker-dealer's supervisory systems, as well the implementation of those procedures. We're focusing on the firm's compliance culture -- is compliance a high priority within the firm's overall organization? Are sufficient staff and other resources allocated to ensure complete oversight? Is surveillance adequate, particularly at branch offices? Finally, how are complaints and compliance issues recorded and, thereafter, resolved?

While examiners have only just begun this series of examinations, I hope that when the examiners come calling on your firm, you will be prepared to demonstrate that your compliance and supervisory controls are strong.

Another special focus area right now for examiners, both SEC and SRO examiners, is evaluating supervisory procedures to ensure that firm personnel cannot misappropriate customer assets. The NYSE has also proposed new rules requiring members to have internal controls in this area. We have looked at the Frank Gruttadauria matter, in which a Cleveland registered representative stole millions of dollars from his customers, as a textbook case of what none of us want repeated. Examiners will be reviewing what I think should be very basic compliance procedures to prevent theft of client funds and securities:

  • how do you handle checks to and from customers?
  • how do you handle customer changes of address, particularly to P.O. boxes?
  • how do you handle customer authorizations for withdrawing or transferring funds?
  • what are your controls over the sending of account statements?
  • does someone other than the registered representative follow up with customers in response to unusual account activity?
  • do you have adequate supervision over producing branch managers?

Firms must do all they can to protect against theft by employees, and having good front-end supervisory and compliance procedures is the key.

Internal Controls

We have continued to conduct specialized reviews of firms' 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 first began this type of examination in 1995, and have expanded the number of these reviews each year since then. In light of the concentration of customer assets in the largest firms, we are examining large firms' internal controls on a regular basis.

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. Most often our internal controls examinations result in deficiency letters recommending that risk management be more comprehensive, more independent and timelier.

Where risk management (for the broker-dealer and other affiliates) is consolidated at the parent holding company level, we expect broker-dealers to make this information available to us. Our practice is to share the results of these reviews with our colleagues at the Federal Reserve, so that banking regulators will have a complete picture of the holding company including the broker-dealer, and can defer to the SEC as the functional regulator for the broker-dealer.

A new focus of these examinations is on operational risk, particularly on contingency planning for an emergency or a significant business disruption. In this regard, I note that there has been an enormous amount of focus on contingency planning by firms in the industry and by regulators. The SEC, the Federal Reserve Board, the Comptroller of the Currency and the NY State Banking Department recently issued a "Draft White Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System," which describes sound practices with respect to contingency planning. The SEC is seeking public comment on the scope and application of the sound practices, by October 31st.

And, as you may know, both the NASD and the NYSE have proposed rules requiring that firms have adequate contingency plans. Hopefully, by now your firms have conducted a comprehensive review of operations and have planned accordingly.

Money Laundering

The passage of the Patriot Act has given us all new roles and responsibilities to learn in a quick timeframe. The SEC has been working cooperatively with the securities self-regulatory organizations, as well as with the SIA, to help firms get educated and get started with their new anti-money laundering requirements.

Many provisions of the Patriot Act have already gone into effect, and you should expect SEC and SRO examiners to be reviewing your Patriot Act compliance as part of routine broker-dealer exams going forward. By now, all broker-dealers should have established their anti-money laundering compliance programs, including by: (1) adopting policies, procedures and controls specifically designed to detect and prevent money laundering; (2) designating a compliance officer; (3) initiating ongoing training for employees; and (4) providing for independent tests of the program.

Looking forward, you can expect that examiners also will be looking at your account opening procedures, which will be subject to new Patriot Act requirements as of October 26, 2002. These new rules require broker-dealers to: (1) verify the identity of any person seeking to open an account, to the extent reasonable and practicable; (2) maintain records of the information used to verify a person's identity; and (3) determine whether the person appears on any lists of known or suspected terrorists or terrorist organizations. In addition, we will also be reviewing your policies and procedures for suspicious activity reporting, and, after January 1, 2003, the implementation of your SAR reporting program. Finally, part of our exam protocol will include review of your due diligence procedures for correspondent accounts, especially for any shell banks.

As I have stated previously, we expect to work with you on your anti-money laundering compliance. Expect 'tough love.' That is, we will ask you questions and attempt to understand your program. We know one size doesn't fit all. But we will be citing firms in appropriate circumstances.

The IPO Process

Last month Chairman Pitt announced that the SEC had initiated a review of the IPO process, including the roles of issuers and underwriters in the price-setting process. Chairman Pitt called on the NYSE and the NASD to begin this review, stating his letter to the SROs:

"[In the 1990s], hot IPOs were heavily oversubscribed, and many investors were frustrated in their attempts to participate in the IPOs. Participation in these IPOs became immensely valuable for both underwriters and customers, inducing aggressive conduct to gain this business. As a result, serious questions arose about the price setting process and the allocation practices of the underwriters of some of these offerings. For example, to obtain IPO allocations some investors paid excessive commissions, or may have been induced to purchase shares in the aftermarket, distorting the market for these securities. In other cases, hot IPO shares may have been allocated to individuals for the purpose of obtaining investment banking business."

The Chairman noted in his letter that the SEC and the SROs continue to investigate possible violations of existing rules, and asked the SROs to undertake a broader review of the IPO process by convening a group of business and academic leaders to study the IPO process. One goal of this effort is to determine whether additional rulemaking is appropriate to strengthen the integrity of the offering process and to protect investors. IPO allocations are an area that you can expect examiners to continue to focus on in upcoming examinations.

Best Execution

We are continuing to focus on execution practices of broker-dealers and advisers. Over time, we've seen that firms are paying greater attention to conducting a "regular and rigorous analysis of execution quality" -- many firms have a formal process to evaluate execution quality -- they have designated committees, they review execution quality of various market centers, they have compliance staff review the process, and the analysis is well-documented.

Now retail order routing firms have a new tool to measure and monitor execution quality -- all firms should be using the new market quality data required to be provided by market centers under Rule 11Ac1-5. SEC examiners will want to see that firms are using this information to evaluate the quality of the markets to which they route orders and the quality of other alternative markets. We will be asking you if your routing decisions are consistent with the execution quality data you have available to you, and that you have, hopefully, carefully analyzed. Order routing decisions must be made based on the ability to get the best possible execution, not on order routing inducements.

Many firms are using "smart routing technology" that allows them to instantaneously route individual customer orders to the market posting the best price or best size (or both), with algorithyms that also factor in past fill rates and price improvement rates. Certainly, "smart routers" go a long way to ensuring that customers are getting the best possible price at any given moment during the trading day.

Net Capital and Customer Reserve

Intentional and unintentional net capital and customer reserve violations are among the most frequently-identified problems in our exams. With declines in firm revenues, maintaining adequate minimum capital to conduct business is more important now than ever. No skirting the edges -- compliance with these rules is mandatory. And, we make enforcement referrals if we find serious or intentional violations. Clearly, this is an area that deserves your attention.

Analysts' Conflicts of Interest

Earlier this year, the SEC announced that it had commenced a formal inquiry into market practices concerning analysts. We are conducting the inquiry jointly with the NYSE and NASDR, and are cooperating with state securities regulators. We are focusing in this review on several things -- first, have analysts issued ratings that are fraudulent? I note that existing anti-fraud rules prohibit making statements that speaker knows not to be true -- that would be fraud, plain and simple. Second, are firms complying with the new rules adopted by the SROs and approved by the SEC in May? We are looking to see compliance with the new rules immediately as they go effective. Finally, we are reviewing whether additional rules may be appropriate.

In this regard, last month the SEC proposed a new rule -- Regulation Analyst Certification -- that would require research analysts to certify the truthfulness of their views in their research reports and in public appearances, and disclose whether they have received any compensation related to the specific recommendation provided in those reports and appearances. Proposed Regulation AC is just part of an ongoing process by the SEC, the NASD, the NYSE, and the states to address conflicts of interest faced by research analysts, which was initiated by a series of examinations by SEC staff beginning in 1999. Findings from these exams indicating serious conflicts of interest were described in our testimony before the House of Representatives last summer. As a result, the SROs adopted broad new rules designed to minimize and disclose analysts' conflicts of interests by analysts in their research reports. I also note that the Sarbanes-Oxley legislation requires additional rulemaking in this area.

I know that many of you are both dealing with regulators as we examine and investigate this issue, as well as implementing the new rules. I urge you also to be proactive, to review your own firms' practices for conflicts of interest and to adopt measures that control or prevent conflicts. There will be additional rules in this area, but there is no reason for you not to step ahead and take your own measures to assure your customers that your analysts are serving investors' interests.

Information Barriers

We are continuing to examine the policies and procedures that firms have adopted to prevent the misuse of non-public information, and we continue to find deficiencies in this area. In this context, one persistent complaint that we hear from buy-side traders is that information about their trades is getting out to others in the marketplace, who may be frontrunning their trades. I would caution that, while executing trades for customers necessarily involves finding the other side of the trade, if traders are providing non-public information about customers' trades absent this legitimate need, they may be engaging in insider trading.

I also note that in recent years the Commission has brought an increasing number of insider trading cases involving members of the securities industry. In my view, it makes sense for all firms to reexamine their procedures to prevent the misuse of non-public information to make sure they're airtight. This is an area that will continue to have our attention.

Regulation S-P and Identity Theft

We are reviewing for compliance with the new privacy rules -- Regulation SP. 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.

"Identity theft" is an issue that has touched many of us or those that we know. Thieves have been able to gain access to customers' personal information, and pretending to be the unwitting victim, have used the victim's good name and credit. This is often called "pre-texting," because the thieves obtain the information under a false pretext. Identity theft is one of the fastest growing crimes in America. Regulation S-P requires that firms have adequate safeguards to protect customer information from unauthorized access or use. As such, we are currently conducting a sweep of broker-dealers and investment company complexes to evaluate their policies and procedures for protecting customer records and information from people seeking to commit identity theft frauds.

Hedge Funds

By all reports, there has been a phenomenal growth in investments in hedge funds. These entities are not subject to reporting requirements or registration under the federal securities laws, so we have limited information about how they operate. Earlier this year, our Chairman announced that the SEC would commence a fact-finding investigation to evaluate:

  • incidents of fraud that we have seen with certain private investment funds, particularly hedge funds;
  • conflicts associated with managing these vehicles alongside mutual funds; and
  • marketing these vehicles directly and indirectly to retail investors.

SEC examiners are assisting in this fact-finding investigation, and will be seeking information from broker-dealers as part of this effort.

*  *  *  *  *

These are some of the key issues that our examiners are focusing on now. Armed with this information, I hope you'll go back to your offices and redouble your compliance efforts in these areas. Don't wait for us to send you a letter or arrive at your firm for an exam. As I said at the outset, be proactive and aggressive advocates for strong compliance within your firms. Your role has never been more critical. You must step up and exercise it.

Hopefully, you have time built into your programs to take a step back from your day-to-day compliance functions to conduct regular reviews (monthly, quarterly or annually) of your firm's compliance programs -- procedures, systems and staffing- - to ensure that the program is comprehensive, up-to-date, and working effectively. These reviews may help you make sure that you're on top of all issues, and have built the best possible program.

While we have high expectations of you, it's because of the importance of what you do. Please remember as you leave today that you, as compliance professionals and we, securities regulators, share a common goal in fostering and maintaining our capital markets as the fairest and most liquid in the world. Compliance is an important part of that equation. We must do all we can to reassure investors that our markets are fair and that their interests are paramount.

Thank you.




Modified: 09/18/2002