Improving Examination Results
In an effort to assist member firms' compliance efforts, NASD is issuing this regular communication, "Improving Examination Results." This document has two sections: "Examination Priorities" and "Frequently Found Violations," both of which relate to the Department of Member Regulation's routine examinations of firms. While each firm must establish its own compliance programs and supervisory procedures, we felt it may be helpful to share our overall priorities. This will permit firms to focus their efforts on issues that are particularly timely and be better prepared for regulatory examinations. We hope to alert firms to areas where we often see recurring problems and to offer some practical advice on how to avoid common pitfalls.
NASD believes that the following areas are of particular importance to the examination program in the coming year.
The recently adopted Anti-Money Laundering (AML) Rule (NASD Rule 3011) requires that firms establish and implement AML programs. The new and extensive obligations imposed by the PATRIOT Act and Rule 3011 are critical components in ensuring that the broker/dealer community responds to its obligations to detect and prevent money laundering. This area is an examination priority in order to assist member firms in meeting their obligations and to ensure that these obligations are being fulfilled. View our AML Web page.
Market volatility and the events of September 11, 2001, have highlighted the necessity that all member firms have in place a system of internal controls to ensure their long-term success. Member firms should have established risk management procedures addressing all aspects of their businesses, prudent financial controls, and well thought-out business continuity plans. In order to avoid breakdowns in the future, examination efforts will be focused on ensuring that firms have addressed these issues.
Analysts' Conflicts of Interest
Conflicts of interest are created when research analysts make recommendations regarding the securities of companies in communications to the public when the firms that employ the analysts have investment banking or other business relationships with the company or when the analysts own securities of the recommended company. To the extent that these conflicts affect the recommendations of the analysts, it compromises the integrity of the information flowing to investors and to the market place. Significant regulatory efforts are being devoted to reviewing these relationships at firms and statements that have been and are being made to the public. View our Analyst Recommendations Web page.
Branch Office Supervision
Sales practice violations by individual registered representatives are a continuing area of concern, many of which could have been prevented or detected through more diligent supervision. As such, regulators are placing an increasingly greater focus on evaluating the adequacy of supervision and supervisory procedures, particularly at the branch office level. Similarly, a high level of regulatory scrutiny is being directed towards the adequacy of supervision of producing branch managers and on registered principals working alone in independent offices.
The complexity of these products coupled with the significant number of sales practice violations and supervisory failures continue to make this area a priority in our examination program. (NASD Notice to Members 99-35: "The NASD Reminds Members Of Their Responsibilities Regarding The Sales Of Variable Annuities")
Written Supervisory Procedures (NASD Conduct Rule 3010(b))
Violation: Members are required to establish, maintain, and enforce written supervisory procedures (WSPs). One of the most common problems that NASD finds during examinations of firms is that written procedures adopted by the firms are inadequate. Although the product lines and procedural areas cited for inadequate procedures vary from firm to firm, frequently the general issue is that the procedure does not in fact describe what the firm will do to supervise the activity.
For example, in a recent examination the member's WSPs for Free-Riding and Withholding read: "Shares of new issues cannot be sold in violation of NASD Rule 2110." Another firm's procedures in the same area contained a similar prohibition and then reproduced all of IM-2110-1. Both procedures are inadequate.
Why this is a problem: These are not supervisory procedures. Rather they are compliance guidelines for the firm's employees.
The solution: Firms can avoid the problem by ensuring that their written supervisory procedures identify:
WHO is responsible for supervision
WHAT steps that person will take to ensure his/her firm is in compliance with the rule
WHEN the supervisory steps will be taken
HOW the supervision will be evidenced.
NASD Notice to Members 99-45 provides comprehensive and practical guidance for developing adequate WSPs.
Municipal Securities Trade Reporting (MSRB Rule G-14)
Violation: Municipal brokers and dealers are required to submit information about their municipal trades to the Municipal Securities Rulemaking Board (MSRB) in a timely and accurate manner, according to the formats and timeframes specified by the rule. Examinations of a number of introducing firms, however, have disclosed errors in trade reports, one of the most common of which is the reporting of trades under the identifier of the clearing firm, rather than that of the introducing firm. In some instances, reports are not submitted at all.
Why this is a problem: Introducing broker/dealers often rely on their clearing firms to submit reports of their municipal securities transactions. Notwithstanding any contractual relationships addressing this function that might exist between the firms, ultimate responsibility for municipal securities trade reporting rests with the firm that effected the trade, the introducing firm.
The solution: Introducing firms can avoid MSRB Rule G-14 violations by regularly reviewing the trade reports submitted by their clearing firms. The best way to do this is by registering to use the MSRB's Dealer Feedback Service. This free service allows introducing firms to download municipal transaction data submitted for them by their clearing firms to verify that it was submitted to the MSRB in a complete, timely, and accurate manner. Information about the Dealer Feedback Service is available from the MSRB's Web Site, www.msrb.org.
Regulatory Element of Continuing Education (NASD Membership and Registration Rule 1120(a))
Violation: Registered individuals are prohibited from functioning in their registered capacities if they do not satisfy the Regulatory Element requirement within their 120-day window. NASD examiners frequently find that member firms permit registered individuals to function in a registered capacity despite being CE inactive. In some instances the firm states that it was not aware that the CE requirement had not been fulfilled. In other instances, firms have become aware that registered individuals are CE inactive but have allowed those individuals to continue functioning in a registered capacity.
Why this is a problem: CE requirements are an important means of assuring that registered persons keep abreast of current regulatory obligations. Failure to prohibit CE inactive registered individuals from acting in registered capacities, whether inadvertent or with knowledge, is a violation of the rule. Violations of this rule have resulted in both formal and informal disciplinary actions, depending upon several factors, including, length of time the CE inactive individual was permitted to function, the amount of income generated by the individual, the nature of the business conducted by the individual, the adequacy of the firm's WSPs and how they were implemented. Knowingly allowing a registered individual designated as CE inactive to function is a serious matter that could result in formal disciplinary action against the firm and/or the appropriate supervisors.
The solution: Proper use of the resources available through CRD to track compliance with the continuing education requirements will assist in preventing inadvertent violations. Members can affirmatively request e-mail notifications from CRD regarding their associated persons and can also check various CRD records on a regular basis to determine the CE status of their registered persons. NASD Notices to Members 01-07 and 01-17 provide information concerning Web CRD e-mail notifications regarding Regulatory Element Requirements and notifications of CE inactive registered individuals. NASD Notice to Members 01-35 also provides information concerning CRD CE requirement notification methods and provides information on Written Supervisory Procedures.
Books and Records (SEC Rules 17a-3 and 17a-4)
Violation: The SEC has consistently held that broker/dealers must maintain their books and records pursuant to the accrual basis of accounting. Thus, broker/dealers must record revenue when it is "earned," typically as services are rendered or when a security transaction has been completed. In addition, the broker/dealer must match expenses to the generation of revenue. For example, if commissions are earned in January, and the firm will pay a percentage of the commissions to its registered representatives in February, the expense and the related liability must be recorded on the firm's January financial statements. Some firms record commissions (and other recurring expenses like rent, utilities, telephone bills) when paid. Recording transactions when paid, as opposed to when the income is earned or the obligation to pay arises, is not consistent with the accrual basis of accounting, and is inconsistent with the SEC's requirement.
Why this is a problem: When a broker/dealer fails to accrue liabilities or expenses properly, its books and records are inaccurate and not in compliance with the SEC's books and records rules. Additionally, the inaccurate calculations may raise serious questions as to whether the broker/dealer is in compliance with the SEC Net Capital Rule.
The solution: Firms should take extra care to ensure that all financial activity is recorded on the firm's financial records accurately and timely, that is, in the month in which revenue is earned and obligations arise, regardless of when invoices are received. Precise accruals are often possible for items with a fixed monthly charge, such as rent or equipment lease payments. In other cases, reasonable estimates may be used, for example, to estimate a monthly phone bill. Estimates should be consistent with historical expenses where possible and adjusted for changes in service, e.g., additional phone lines or quotation terminals.
In addition, in some cases, a firm will enter into an expense-sharing agreement with a parent/affiliate where the latter agrees to pay for or provide certain services. For example, the parent/affiliate agrees to pay rent and provide office space to the broker/dealer. If the broker/dealer is legally obligated to the service provider or creditor, either directly or indirectly, a broker/dealer must record these expenses and accrue the related liabilities until it has received proof that the obligation has been paid by the parent/affiliate.
Form U-4 Reporting (Article IV, Section 1(c) of the NASD By-Laws and IM-1000-1)
Violation: The NASD By-Laws require every registered representative to keep their Form U-4 current at all times. NASD staff has noted an increase in the number of instances in which registered representatives fail to amend their Forms U-4 to reflect new information, including new home addresses, outside employment, and/or other material events, such as bankruptcies, regulatory actions, litigation, customer complaints, and convictions.
Why this is a problem: U-4 disclosures represent one of the most important sources of regulatory information for both firms, which should monitor this information for supervisory purposes, and NASD, in the discharge of its oversight responsibilities. Failure to update Form U-4 in a timely way will result in disciplinary action.
The solution: Registered representatives typically state that their failure to make disclosures on, or submit amendments to, Form U-4 was the result of either misreading a question or simply being unaware of the disclosure requirement. Member firms should regularly seek to educate registered representatives concerning their obligations to ensure that the Form U-4 is current at all times. A member firm can also take the lead in facilitating Form U-4 amendments when it learns that a registered representative resides at a new address.
Questions about this communication may be directed to Lorraine Lee, of NASD Member Regulation, at (202) 728-8442.