THE JOINT REGULATORY SALES PRACTICE SWEEP A Review of the Sales Practice Activities of Selected Registered Representatives and the Hiring, Retention, and Supervisory Practices of the Brokerage Firms Employing Them EXECUTIVE SUMMARY This is a report of the findings of the joint regulatory initiative involving the staffs of the Securities and Exchange Commission ("SEC" or "Commission"), the National Association of Securities Dealers, Inc. ("NASD"), the New York Stock Exchange, Inc. ("NYSE"), and the North American Securities Administrators Association, Inc. ("NASAA") (collectively, the "Working Group"-[1]-) to review the sales practice activities of selected registered representatives and the hiring, retention, and supervisory practices of the brokerage firms employing them. This review was commenced as a follow-up to the Commission's report entitled The Large Firm Project: A Review of Hiring, Retention and Supervisory Practices (the "Large Firm Project" or "Large Firm Report"). As described in more detail below, the registered representatives selected for review were identified based on specific criteria formulated by the Working Group and, therefore, the findings of this project should not be viewed as representative of all brokerage firms. The objectives of this joint initiative, referred to as the Joint Regulatory Sales Practice Sweep (the "Sweep") were to identify possible problem registered representatives, to review their sales practices, and to assess whether adequate hiring, retention, and supervisory mechanisms are in place. Where appropriate, the Sweep will result in enforcement action against these registered representatives and/or the firms employing them. The Working Group reviewed and analyzed data received from various sources to identify individuals who, based on their disciplinary and employment histories, appeared to warrant scrutiny during examinations. The criteria for identifying "profiled registered representatives" ("PRRs") was continuously refined and resulted in a combination of four different criteria being employed. After considerable scrutiny, 347 registered representatives were selected for review. The details of the selection process are described in further detail in the full report. The Sweep examinations encompassed a review of 101 different brokerage firms, primarily small- and medium-sized firms.-[2]- The examinations commenced in December 1994 and were generally completed by November 1995. The reviews consisted of on-site sales practice examinations of main and branch offices of the firms employing the PRRs,-[3]- including reviews of ==========================================START OF PAGE ii====== the PRRs' selling activities and interviews of the branch office managers (and, in some instances, other compliance personnel), and the PRRs themselves. Working Group examiners interviewed 230 PRRs during 179 branch office examinations. The findings from those examinations and the Working Group's recommendations are summarized below and discussed in greater detail in the full report. FINDINGS ù Some Firms Are Willing to Employ Registered Representatives With a History of Disciplinary Actions or Customer Complaints Of the 347 PRRs selected for review, approximately one-third had moved to at least one new brokerage firm since December 1994 despite a history of disciplinary actions or customer complaints.-[4]- Thus, some firms are willing to employ individuals with a history of disciplinary actions involving sales practice abuse or customer complaints. ù Many of the Branches Examined Utilize Only Minimum Hiring Procedures The review of hiring practices revealed that many of the branches examined appeared to conduct, before hiring, only the minimum review required by NASD and NYSE rules of a registered representative applicant's background, including those with a disciplinary history or a history of customer complaints. Such review is generally limited to examining the individual's Forms U-4-[5]- and U-5-[6]- (or reviewing the applicant's history on the Central Registration Depository, or "CRD")-[7]- and contacting the applicant's previous employers for the past three years. As discussed above, the significant movement of PRRs within the industry may be attributable, at least in part, to the minimal hiring procedures in place at some brokerage firms. ù One-Fifth of the Examinations Resulted in Enforcement Referrals and an Additional One-Fourth of the Examinations Resulted in the Issuance of Letters of Caution or Deficiency Letters Not including 104 registered representatives that were excluded from the review because they were already under investigation by the SEC or a self-regulatory organization ("SRO"), one-fifth of the Sweep's 179 examinations resulted in referrals for possible enforcement investigation.-[8]- The potentially violative activity identified during these ==========================================START OF PAGE iii====== examinations included, among other things, excessive trading, unauthorized trading, failure to supervise, and improper registration of registered representatives or failure to update registration forms. In addition, another one-fourth of the Sweep's 179 examinations resulted in the issuance of a letter of caution or a deficiency letter,-[9]- noting violations and deficiencies not rising to the level of seriousness warranting enforcement investigation. The letters of caution and deficiency letters resulting from the Sweep examinations cited violations and deficiencies in varying degrees of seriousness. In the examinations resulting in enforcement referrals, letters of caution, or deficiency letters, inadequate supervision and deficient written supervisory procedures were the most common findings. These findings suggest that many firms' supervisory and compliance systems warrant improvement. ù Supervisors in Many of the Branches Examined Conduct Inadequate or No Routine Review of Registered Representatives' Customer Securities Transactions to Detect Sales Practice Abuses The examinations revealed that at many of the branches examined, supervisors conducted either inadequate or no routine review of the customer securities transactions effected by the registered representatives employed at the branch. This finding suggests that supervision of registered representatives' customer sales activity must be improved to aid in detecting and preventing sales practice abuses. ù Almost One-Half of the Branches That Engage in Some Type of Cold Calling Evidenced Cold-Calling Violations or Deficiencies The interviews of the branch office managers, PRRs, and other registered representatives selected by the examiners while on-site revealed that almost one-half of the branches examined engage in some type of cold-calling activity. Of the branches that engage in some type of cold-calling activity, almost one- half did not fully comply with the Telephone Consumer Protection Act of 1991 (the "Telephone Consumer Protection Act").-[10]- RECOMMENDATIONS These findings suggest, in our view, that firms must devote additional attention and resources to the prevention and detection of sales practice abuses by registered representatives. ==========================================START OF PAGE iv====== Based on the results of the Sweep, a number of areas relating to the prevention and detection of sales practice violations need improvement. In particular, we recommend improvements with respect to: (a) the hiring procedures for registered representatives, (b) the supervision of registered representatives, and (c) compliance with cold-calling requirements. Finally, the findings also suggest that the firms must be reminded about their obligations to properly supervise the activities of registered persons and that the Commission, the SROs, and the state securities regulators will continue to closely monitor during examinations firms' supervision whenever sales practice weaknesses, deficiencies, or apparent violations are detected. In light of the findings discussed above, the Working Group proposes the following recommendations. ù More Stringent Hiring Procedures for Registered Representatives In addition to reviewing an applicant's Form U-4 and Form U- 5, reviewing CRD, and contacting the applicant's previous employers, the Working Group strongly recommends as a "best hiring practice" that firms (or if delegated to one or more branches, the branch officer managers or other compliance personnel) discuss with all applicants the nature of the applicant's prior customers and the types of securities sold while associated with the prior employer; conduct a credit and financial check of the applicant; and obtain from the applicant, orally or in writing, explanations regarding any customer complaints and regulatory actions to determine the merit of each prior to hiring. Moreover, as recommended in the Large Firm Report, firms should include the compliance department and/or the legal department in applicant reviews and designate, above the branch manager level, an individual or committee to approve the hiring of any registered representative with a history of compliance problems. In addition, the SROs and state securities regulators should remind firms of their existing responsibilities under SRO rules and regulations and applicable state securities laws to adequately investigate before hiring each applicant's character, business repute, qualifications and experience and to maintain documentation of the steps taken in the hiring process, including the "best practices" described above. ù Special Supervision for Registered Representatives With a Disciplinary History The Working Group believes that registered representatives with a recent history of final disciplinary actions involving sales practice abuse or other customer harm warrant enhanced supervision by their firms. Firms that hire registered persons that have a history or pattern of customer complaints, ==========================================START OF PAGE v====== disciplinary actions, or arbitrations are responsible for imposing close supervision over these persons. "Normal" supervision is simply not enough; firms must craft special supervisory procedures tailored to the individual representative. If firms fail to establish such special supervisory procedures, SROs will consider whether it is necessary to amend their rules to specifically require these registered representatives to be placed under special supervision by the firm for a period of time. Moreover, if such an employee commits a sales practice violation during the period of special supervision, firms should recognize that securities regulators do and will continue to closely evaluate whether the firm itself should be subject to disciplinary action for a failure to supervise the registered representative. In addition, the Working Group recommends that a firm's compliance personnel perform a thorough review of a registered representative's customer account activity when that person is named, during a one-year period, in three customer complaints alleging sales practice abuse. The customer account activity of persons with fewer customer complaints or customer complaints over a longer period of time also should be reviewed as a matter of course. ù Branch Manager Compensation As a means to encourage and enhance supervisory vigilance, the Working Group believes that firms should consider adopting a policy of tying a component of a branch office manager's compensation to the manager's effective supervision of registered representatives. The Working Group believes that it would be a good practice for managers to be compensated, in part, for effective supervision and compliance efforts based on preventing, detecting, reporting, and correcting sales practice abuses and other customer harm. These supervision and compliance efforts may be evidenced by, for example, internal audit review of the branch, external regulatory review, and an assessment of arbitrations and customer complaints within the branch. ù Firm Supervisory Obligations In light of the findings with respect to inadequate supervision and supervisory systems, firms must ensure that they are fulfilling their supervisory obligations under SRO rules. In order to assist firms in this endeavor, the SROs should remind members about firms' supervisory obligations under SRO rules. Moreover, as part of the increased regulatory emphasis on evaluating the adequacy of supervision and supervisory systems, as discussed below, the Working Group believes that all regulators should place increased emphasis during examinations on determining whether firms have met these requirements. ù Cold-Calling Training and Supervision and Increased Regulatory Review and Enforcement ==========================================START OF PAGE vi====== Firms must ensure that they adequately train and supervise telemarketers and registered representatives who engage in cold calling. Firms that employ cold callers or whose registered representatives engage in cold calling must ensure that the firm element of the newly implemented continuing education program incorporates a cold-calling component.-[11]- Firms must ensure that they maintain a "do-not-call" list, establish procedures to add names to the list upon request, and provide a "do-not-call" list to all persons who cold call (or ensure that such persons have access to a copy of the list). Moreover, the Commission and regulators that conduct examinations will increase their focus on their regulatory review of cold-calling practices during sales practice examinations and on bringing disciplinary actions for violations in this area. To this end, SROs and the state securities regulators that conduct sales practice examinations should ensure that their examination modules incorporate a cold-calling review. SROs also should consider whether it is appropriate to add to their minor rule violation plans minor violations of SRO rules on cold calling. ù Increased Review During Examinations for Inadequate Supervision and Deficient Written Supervisory Procedures Given the number of examinations resulting in findings of deficient supervision, the Working Group recommends that during regulatory examinations, the Commission, the SROs, and those state securities regulators that conduct examinations increase their emphasis on evaluating the firm's supervision of its registered representatives. In particular, where a weakness, deficiency, or apparent violation is detected by examiners, examiners should determine whether supervisors reasonably carried out their responsibilities and whether such weakness, deficiency, or apparent violation is indicative of a defect in the firm's system of supervision, including its written supervisory procedures. ù Follow-Up Review of Firms That Were the Subject of Enforcement Actions To ensure that firms that have engaged in sales practice abuse do not repeat the offense, the Working Group recommends that the SEC and the appropriate SROs include in their annual examination priorities follow-up examinations of firms that have been the subject (or whose management have been the subject) of SEC or SRO enforcement actions involving serious sales practice abuses, supervisory breakdowns, or other egregious activity that harms customers within one year of the enforcement action. The Working Group also recommends that, as part of the overall sanctions imposed in enforcement actions, firms be required to prepare and submit to the appropriate regulator a report of the steps taken by the firm to address the abusive practices, including a follow-up review by the firm regarding its supervisory improvements following such actions. The ==========================================START OF PAGE vii====== improvements contained in this report will then be closely reviewed during follow-up regulatory examinations. CONCLUSION The findings of this Sweep and of the Large Firm Report suggest generally that, while many firms maintain satisfactory supervisory mechanisms, firms can and should improve and strengthen their hiring, retention, and supervisory practices. Consequently, this report contains specific recommendations aimed at improving brokerage firms' hiring, retention, and supervisory practices. Improvements by firms in these areas should, in turn, result in improvements in the prevention and detection of sales practice abuses. The Working Group believes that the implementation of these recommendations can greatly enhance the prevention and detection of sales practice problems, thereby protecting the integrity of the marketplace and the interests of the investing public. Moreover, members of the Working Group intend to continue to identify problem brokers and firms and to work toward enhancing existing supervisory and regulatory systems, and urge members of the securities industry to continue their efforts in improving their own supervisory systems.