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U.S. Securities and Exchange Commission

Speech by SEC Staff:
SEC Broker-Dealer Examination Priorities for the Year 2000

Remarks by

Lori Richards

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

Before the Securities Industry Association
Compliance and Legal Division

October 19, 1999

The Securities and Exchange Commission, 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 author's colleagues upon the staff of the Commission.

Good Afternoon.

I think you would all agree that this is a momentous time for the securities industry – Chairman Levitt has described the changes now underway and surely to come – as nothing short of revolutionary.

I wanted to begin my remarks today by quoting one thing he said in his Columbia University speech three weeks ago. He said that "no matter how much our markets change, markets of fairness, markets of integrity and markets of quality should not be the most investors hope for – but the very least they should expect."

For all of us in this room, whose job it is to ensure compliance, we know how important that focus on investor protection is. It underlies all that we do in ensuring compliance with the federal securities laws. Despite the whirlwind of rapid change in our markets – changes in how our markets operate, in market participants, and in the services and products offered to investors – our job remains the same – to ensure that investors are served by compliance with the law. For all of us in this room, during times of change, that's our compass, the navigating principle that governs all that we do.

I wanted today to highlight for you some of the areas that we have identified as particular priorities for SEC examiners for our examinations in the Year 2000. I have often said that, given all the areas we review during examinations, and all the issues we see, it's almost easier to describe the areas we are not prioritizing than those we are. That said, each year examination staff along with our other colleagues in the Commission, discuss examination findings and trends over the last year, look at new rules and at market developments, and identify those areas that we think warrant additional scrutiny by SEC examiners. The areas that we identify for closer scrutiny include those where compliance practices appear to be weak, areas where the industry has perhaps not fully implemented new Commission rules, or areas that have recently been the subject of enforcement cases. We also include areas where we think we need to learn more about practices in the industry, particularly where the activity or practice is new.

That said however, examiners have full authority to focus their examination on any area within the firm – perhaps areas where compliance controls appear to be weak or where past examinations have revealed problems or weaknesses. So while we have identified national priorities for examiners, our examination of your firm may focus on other areas unique to your firm.

I thought to be most helpful to you – because despite what you think, examiners really are there to help you by bringing to your attention areas that put your firm at risk – I would outline our exam priorities for the upcoming year, along with some of the things that I think challenge good compliance. It's my hope that this information will be useful to you in reviewing compliance practices and procedures in your own organizations.

Exam Program Priorities for 2000

Given the explosive growth in the number of retail investors using the net to trade stocks, we'll be continuing to look closely at firms that offer customers an on-line option. We expect to complete our examination sweep in this area and to provide the Commission with our findings. Overall, we're looking at:

  • capacity: how do firms' measure and monitor their operational capacity;

  • disclosures made to customers about systems slow-downs or shutdowns, how orders are executed, and the difference between limit orders and market orders;

  • IPO allocation procedures and how firms describe them to customers; and

  • suitability issues.

We have also undertaken a separate examination sweep of day trading firms. Chairman Levitt stated in his testimony on day trading that he is concerned that all day traders understand the costs and risks of engaging in this strategy; and that day trading practices comply with existing laws. Chairman Levitt also expressed concern about the promotion by some day trading firms of lending between day traders to cover margin deficiencies without fully disclosing all of the risks (practice called journaling). In our examinations, we've found problems in some firms in such areas as advertising, disclosure, the use of leverage, registration, and short sales. In particular, we're reviewing the unbalanced representations that some of these firms make to customers in their advertising and in training courses concerning the likelihood of profits. We're also concerned about these firms' intra-day capital positions, and with compliance with short sale and margin rules.

We (and the SROs) will also be looking at clearing firms that clear for day traders and their risk management and internal control systems for short sales and margin.

In the financial and operational area, we are going back to the fundamentals in some ways. We're redoubling our focus on net capital and customer reserve requirements, given problems that we've seen recently – including in day trading firms. One problem we're seeing is that firms have shifted some liabilities off their books and into an affiliate – expenses that should be booked by the broker-dealer.

We've also seen an increase in books and records problems caused by the integration of accounting systems or the introduction of new bookkeeping systems. In several instances, when firms tried to move to a new system, they have had significant problems reconciling outstanding balances, and in some cases the amounts out of balance have been extremely large. With the increase in broker-dealer mergers and acquisitions, we've seen an increase in this type of problem. As firms try to quickly integrate systems, problems result. Moreover, some firms have failed to promptly report massive reconciliation problems to regulators.

We will also continue our focus on reviewing firms' internal controls and risk management systems. As you may know, the SEC along with the NYSE and the NASDR issued a joint statement in July outlining our approach to these examinations and listing some examples of sound control practices, and some of the weak controls we saw as well. We believe that focusing on internal controls over trading, credit, liquidity and internal audit is appropriate for large organizations where we couldn't possibly review every aspect of their business. We want to have assurance that the firm has sound controls such that we can have confidence in its systems between examinations. We look for active oversight of risk parameters by senior management; we look at internal audit and funding, liquidity and credit controls. And we look at physical security and operations. For those of you Section 20's, you'll recognize that this approach is very similar to that used by bank regulators. We think that reviewing internal controls, along with financial/operational and sales practice compliance provides sound examination coverage.

Best execution has been and will continue to be a priority area for us. We have been reviewing, at this stage, selected broker-dealers' order routing practices against the general guidance provided in the Order Handling Rules and staff interpretations. We're also conducting a separate review of advisers' compliance with their best execution obligations. In general we're finding that firms "regular and rigorous review of the execution quality likely to be obtained in various markets" is neither rigorous nor regular enough. Although our examinations are ongoing, I want to sum up some guidance in this area. In general:

  • A broker-dealer must actively seek execution quality information from different market centers and carefully analyze that information before making order routing decisions.

    • What is execution quality information? It may include the likelihood of price improvement, the speed of execution, and the likelihood of execution for limit orders.

  • The firm's analysis should be done on a regular basis – generally quarterly, and, like your compliance with any legal obligation, you should document it, including your analysis of the factors you considered.

    • You can't allow order routing inducements, like payment for order flow; equity interests in market centers; or reciprocal order flow arrangements, to interfere with your duty of best execution.

  • Merely hiring an outside execution quality evaluation service does not necessarily constitute "regular and rigorous" examination. You need to actually direct your order flow in a manner that is consistent with your analysis of execution quality likely to be obtained.

Price improvement opportunities for customer orders should be a key factor in order routing decisions. The Commission has stressed that "[w]here material differences exist between the price improvement opportunities offered by different market centers, these differences must be taken into account by the broker-dealer" Broker-dealers tell us that while price improvement is one important factor in execution quality, speed of execution is also important. The Commission has stated that the "traditional non-price factors affecting the cost or efficiency of executions also should continue to be considered" as part of your "regular and rigorou" review. So, if speed of executions is important to you and your customers, you should be evaluating speed, along with price improvement and other factors. When we come in to do an examination, we will want to see documents that evidence your review.

As of this month, we have completed (with the NYSE and the NASD) Year 2000 reviews of the largest firms. In the next few months, we are prepared to examine firms that either report or have other indications of Year 2000 problems, and we have specially-trained Y2K examiners who work exclusively on these issues.

Turning to sales practices, we will continue to examine branch offices looking for supervisory weaknesses and resulting sales practice problems. As you may know, the NASDR is implementing a branch office exam program as well – we intend to ensure that in particular, the small one-man-shops are adequately overseen. I would say that while we always examine some number of branch offices each year, we are increasingly visiting branch offices to review sales practices and supervision. Firms with strong compliance programs don't wait for customer complaints to bring problems to the forefront – but have methods to regularly verify compliance.

We are continuing to focus on sales of mutual funds and variable annuities and the disclosure of costs and fees, switching and suitability compliance. In particular, we're looking at the suitability of fund sales given their various fee structures A, B and C shares. As I'm sure you know, we're looking for the adequacy of supervisory procedures for switching and suitability compliance. We have brought enforcement cases in this area recently and there may be more to come.

We are also continuing to review information barriers – exploring links between broker-dealer analysts' research and recommendations and the firm's underwriting and trading areas. We would like to update guidance provided by the NASD and the New York Stock Exchange in this area in 1991.

Finally, we are continuing to focus on firms that underwrite and sell microcap securities. While many salesmen have moved off the telephone and onto the net, we're still focusing on the firms that bring these microcap stocks out, and are continuing to find fraud in various forms – including selling private placements for issuers secretly affiliated with the firm, unregistered branch offices housing previously disciplined reps, and various types of misrepresentations concerning the future profitability of the securities.

Compliance Challenges

So, that's a sketch of the areas we will be focusing on in broker-dealer examinations in the next year. I'd like to turn now and discuss some of the challenges to compliance that I see. I think the most common problem we see – in varying degrees of seriousness – is the deviation from the firm's own procedures. The firm's written procedures and its actual practice sometimes don't match up.

This can have serious results – the firm itself may not be aware of what its employees are actually doing; the actual practice may have repercussions in other areas of the firm; the actual practice may deviate from the firm's disclosures to investors; and finally, the actual practice may violate the law.

Let me give you an example. Last fall, we conducted a series of examinations focused on broker-dealer credit policies with respect to hedge funds. We reviewed firms' written policies governing the extension of credit. At one firm, when we discussed the policies with personnel in the credit department, we learned that credit exposure was reviewed using a far different technique, that extensions of credit were not actively monitored and were routinely increased. None of these actual practices conformed with the firm's written policies. The result was that the firm was not really aware at senior levels of the credit that was being extended, and the credit was not matched against the customer's transaction activities in other areas of the firm.

This is one example, but as I said, we see deviation from firms' written policies fairly often and in all areas within firms.

How does this happen, and relatedly, how do you guard against this?

First, I think the written policy has to make sense. It has to be understandable – not only in its application, but in its purpose. People down the chain must understand and appreciate the importance of the policy underlying the procedure.

Second, there must be regular oversight of whether the procedure is being implemented. Humans being what we are, if a procedure seems nonsensical and you know you are unlikely to be detected if you deviate from it, you're going to create your own way of doing things. Some people do this with fraudulent intent, but far more often, individuals who deviate from policy have no devious or nefarious purpose – they are just trying to find an easier way to do things. The way to guard against this happening is, I think, to make sure your policies are clear, and that people are educated about why they are important. There also have to be oversight checks and balances to ensure that the policies are being implemented effectively, and there must be some sort of sanction for those who deviate from them.

Another overarching challenge to good compliance is a lack of resources. As well-intentioned as you may be, you can't do a good job unless you are fully equipped to do so. That means that firms must devote adequate resources both to hiring, training and keeping good people, and to automation. You know better than I do probably, how automated exception reports have helped you do your job. And you probably know that having someone capable, who has the time to review those reports, is imperative.

There are a small number of firms that don't care about compliance. These firms' compliance directors are such in name only, and their only real concern with compliance is how to avoid getting caught. These aren't the firms I'm talking about now. I'm talking about firms that truly want to have good compliance, but that have not yet fully budgeted the money necessary to do so.

If you work for a firm that fits this profile, educate the firm's principals about the need for long-term commitments to fund your area. Compliance is at least equal to, and in my opinion more important than, the most significant profit-center within the firm. What good will a profit-center be, when the firms' reputation is damaged by bad press, poor customer relations, or lawsuits from customers or from regulators?

Finally, another serious challenge to good compliance is being too complacent. Even if you've got the most sophisticated compliance program, you need to always be looking to improve it. New technology allows us to constantly improve our systems. In addition, as your firm changes – changes in its business structure, changes in personnel, mergers and growth – you need to ensure that your compliance is dynamic and keeps pace with changes in the firm.

Industry events like this one are important because hopefully, while you are here, you will have the opportunity to talk with fellow compliance and legal staff to compare the compliance systems and techniques and learn about new compliance methods being developed by other firms.

So there you have it. You're equipped with a profile of our examination priorities for the next year and I've described my view of some of your challenges to good compliance. I hope you agree with me that despite the changes in our markets now underway, our navigating principle is the same as always – to do our best to ensure that investors are protected by sound compliance.

Thank you.