Improving Examination Results
In a continuing 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 has identified the following areas of particular importance to the examination program.
Mutual Fund Share Sales Practices
Mutual funds offer various share classes that contain differing fee structures. NASD expects member firms that recommend a specific share class, such as A, B or C, to have conducted an analysis of the effects of the fee structure on the investor's return and to recommend the share class that is most advantageous for the customer. NASD also expects that member firms have adequate supervisory procedures and controls relative to breakpoints to make sure that investors are charged the correct sales loads on mutual fund transactions. Examiners will review mutual fund transactions to determine if recommendations of specific share classes are suitable and to determine if customers received the appropriate sales charge. View Notice to Members 02-85 and 03-47 for more important information about breakpoints.
Mortgage Proceeds Used to Finance Investments
NASD has noted a recent trend where customers were encouraged to mortgage their homes or other properties in order to generate cash to invest in securities products. Firms should be aware of the funding sources for investments, and to the extent mortgage proceeds are used to finance investments, the ability of the customer to make the mortgage payment should the securities investments not perform as expected. Examiners will be scrutinizing recommendations to customers to engage in this strategy and any advertisements, sales literature or other correspondence used by broker-dealers and affiliates in promoting or otherwise discussing the use of proceeds from mortgage financing as a source of funds to invest in securities products.
The PATRIOT Act requires that member firms have procedures to prevent and detect money laundering and terrorist financing. All member firms should have established anti-money laundering compliance programs, identified an AML compliance person to NASD, and initiated procedures to detect and report any suspicious activity through an SAR-SF. Effective October 1, 2003, member firms were required to have in place a written Customer Identification Program (CIP). Examiners continue to focus on AML supervisory systems to ensure that firms have implemented an adequate CIP to verify the identity of all customers who open accounts. Anti-money laundering remains an examination priority and substantive deficiencies in firm AML compliance programs and procedures may result in formal disciplinary action. View our AML Web page for more detailed guidance, including an AML Small Firm Template.
Variable Insurance Products
The complexity of variable insurance products coupled with the significant number of sales practice violations and supervisory failures continue to make this area a priority in our examination program. Examiners will continue to scrutinize replacements, overselling of enhanced riders, supervision of hypothetical illustrations, variable products within qualified plans, and market timing of sub accounts. View our Notice to Members 99-35: "The NASD Reminds Members Of Their Responsibilities Regarding The Sales Of Variable Annuities" and Notice to Members 00-44: "The NASD Reminds Members Of Their Responsibilities Regarding the Sale of Variable Life Insurance."
Heightened Supervision and Supervisory Controls
Regulators are increasing the focus on evaluating the supervisory systems and procedures for heightened supervision at the branch office level for representatives with a number of sales practice disclosures in CRD. View Notice to Members 97-19 for more important information. Our examiners are also highly scrutinizing the adequacy of supervision of producing branch managers and attendant conflicts. Examiners will be assessing the adequacy of regulated firms' supervision and supervisory controls.
Business Continuity Planning
NASD Rules 3510 and 3520 require firms to create and maintain business continuity plans (BCP) to use in the event of a significant business disruption. View additional information about BCP, including a small firm template.
Regulation SHO-Short Sales
Regulation SHO was effective January 3, 2005. The rule addresses: the marking of orders as long, short or short exempt; outlines the locate requirements for short sales of securities; and, imposes close out or pre-borrow requirements for short sales of threshold securities. Since this is a new regulation in an area where market abuses have been known to occur, our examiners will be reviewing for compliance with all aspects of the rule.
Gifts and Gratuities
NASD is examining the gifts, gratuities, and entertainment policies of firms. NASD Rule 3060 disallows a member or associated person to give or permit to be given anything of value in excess of $100 per individual per year where the gift or gratuity is in relation to the business of the employer of the recipient of the gift or gratuity. NASD is especially concerned about patterns of excessive gifts, which may improperly influence business decisions. Examiners will focus on the firm policies and procedures for supervising gifts and gratuities. The review includes examining firm internal controls and record keeping procedures as required by Rule 3060.
New Products and Non-Conventional Instruments
NASD is concerned about the number and nature of increasingly complex products that are being introduced to the market and geared toward retail investors. These new products raise suitability and supervisory concerns. Examiners will review the adequacy of firm due diligence procedures for reviewing and analyzing new products. In addition, examiners will review for policies that address the need to perform a product-level suitability analysis, customer-specific suitability analysis, ensure that promotional materials are fair, accurate, and balanced, implement adequate internal controls, and provide training to registered representatives selling the products.
Examiners routinely review member firm internal communications to identify possible "red flags", violative conduct, and potential conflicts of interest at member firms. Internal communications can be in various forms, including email, instant messaging, and hard copy memoranda. All of these records are required to be maintained pursuant to SEC Rule 17a-4, and member firms must be able to produce the records for regulatory inspection.
Anti-Money Laundering (NASD Rule 3011)
Violation: NASD Rule 3011 requires member firms to develop and implement a written anti-money laundering program reasonably designed to achieve and monitor the member's compliance with the requirements of the Bank Secrecy Act (31 USC 5311 et seq) and the implementing regulations promulgated there under. Among other things, under 3011(c) the program requires members at a minimum to provide for independent testing for compliance to be conducted by member personnel or by a qualified outside party. Members frequently fail to comply with the independent testing requirement, either by not conducting a test at all or by not conducting an independent test.
Why this is a problem: NASD Rule 3011 has been in effect since April 23, 2002. The requirement to test has been in effect since that date. Therefore, any firm that has not conducted a test, regardless of its size and type of business, is in violation of the rule. Members that have not tested their program and its implementation to this date or that have tested the program but have not done so using an independent person may have an inadequate program thereby putting their firm at risk for money laundering resulting not only in NASD action, but also subjecting their firm to potentially serious civil and criminal liability.
The solution: All members are required to conduct an independent test of their AML program periodically based on the firm's business and associated risk. The person conducting the test should not be the AML Compliance Officer, otherwise involved in the day-to-day implementation and monitoring of the firm's anti-money laundering program, or reporting to the AML Compliance Officer. A person who is responsible for any part of the implementation of the AML compliance program of the firm would not be considered independent for purposes of conducting the test. For more information about AML, please see our online Issue Center page for Anti-Money Laundering.
Registration Requirements (Article IV, Section 1 of the NASD By-Laws, Article V, Section 2 of the NASD By-Laws, and Article V, Section 3 of the NASD By-Laws)
Violation: Article IV, Section 1 of the NASD By-Laws, Article V, Section 2 of the NASD By-Laws, and Article V, Section 3 of the NASD By-Laws require member firms to maintain accurate registration information including outside business affiliations on all forms filed with the NASD's Central Registration Depository (CRD). This includes, but is not limited to accurate and timely filings of Form U4, Form U5, and Form BD. It also requires firms to disclose various changes in business such as the type of business it is approved to conduct, branch offices, and status of current or previous associated persons. Members frequently fail to update this information within thirty (30) days as prescribed by the rule.
Why this is important: If this information is not kept current or properly disclosed, NASD may not have current regulatory information on the status of current and previous associated persons. Moreover, accurate and current information about firms helps NASD better assess whether, for example, firms are in compliance with membership agreements. Similarly, in conducting risk assessments, focusing examinations, and planning examination schedules, NASD considers information about the firm that is contained in various regulatory filings.
The solution: All members are required to keep their registration information up to date. All information, with regard to hiring status of associated persons, branch offices, and approved business practices, must be submitted and updated in a timely fashion. For more information about monitoring for compliance with registration and disclosure requirements, please see our online Web CRD Late Filing Fee Report. This report shows whether a firm submitted U4 and U5 filings in the required time frame. Provided on a monthly basis, the report assists in assessing and monitoring compliance with reporting obligations under NASD's by-laws and rules. The report allows member firms to download report data directly into Microsoft Excel and receive automatic notifications when updated reports are available.
Books and Records Requirements (SEC Rules 17a-3 and 17a-4)
Violation: SEC Rules 17a-3 and 17a-4 require member firms to make and keep current certain books and records relating to their business, including records "reflecting all assets and liabilities, income and expense and capital accounts." Expenses relating to the business of a broker-dealer, which results in payment owed to a vendor or another party, are considered liabilities of the broker-dealer for net capital purposes and should be recorded as such.
This violation was identified as a frequent violation in the last installment of this publication; however, certain members continue to fail to accrue certain liabilities, such as audit and legal expenses, adverse awards in arbitration proceedings, and other unsecured liabilities.
Why this is a problem: If expenses and liabilities are not properly recorded, the books and records of the broker-dealer may not accurately reflect its performance and financial condition, artificially inflating its profitability, causing it to appear to be in capital compliance when it is not, and possibly disguising improper activities.
The solution: All members are required to maintain their accounting records utilizing the accrual method of accounting. Therefore, all liabilities and expenses must be recorded when they are incurred. Accordingly, members should record audit expenses at the time the audit is conducted, even though an audit report has not yet been produced. Similarly, members should record arbitration awards at the time an award is made, even though the appeal process has not been exhausted and no judgment has been rendered. Finally, legal expenses and unsecured liabilities should be recorded at the time they are incurred. For more information about financial books and records, please see our online Interpretations of Financial and Operational Rules.
Continuing Education Requirements (NASD Rule 1120)
Violation: NASD continues to see violations of both the Regulatory Element and Firm Element of this Rule.
A registered person is required to complete the Regulatory Element on the occurrence of their second registration anniversary date and every three years thereafter. On each occasion, the Regulatory Element must be completed within 120 days after the person's registration anniversary date.
NASD examiners are finding that member firms fail to ensure that inactive registered persons are not performing activities that required an active securities registration.
The Firm Element of the Continuing Education Requirement requires that each firm comprehensively assess its own specific training needs and use the assessment to develop and implement a written training plan for its covered registered persons. The information derived from the needs analysis should become the primary basis for the written training plan. In developing the training plan, a firm should take into consideration the member's size, organizational structure, and scope of business activities, as well as regulatory developments and the performance of covered persons in the Regulatory Element. NASD staff continues to find that firms are not conducting a needs analysis of its training materials and therefore the material often does not accurately reflect the firm's current business.
Why this is a problem: For the Regulatory Element, a firm that has failed to ensure that inactive registered persons are not conducting activities that require an active securities registration not only violates Rule 1120 but such a failure may also be indicative of supervision problems.
For the Firm Element, if training materials are not kept current, examiners will not be assured that the firm's registered personnel are mindful of important information concerning, for example, new or amended rules and regulations applicable to the products and services offered by the firms, or to firms generally.
The solution: For the Regulatory Element, firms should ensure that they are maintaining a list of current inactive registered persons with periods of inactive status and are ensuring through adequate supervision that these persons are not permitted to perform activities that require an active securities registration.
For the Firm Element, firms must ensure and demonstrate through an updated written training plan that its registered personnel are being adequately trained in business that the firm is conducting. For more information about continuing education, please see our online resource, NASD and the Securities Industry Continuing Education Program.
Written Supervisory Procedures (NASD Conduct Rule 3010)
Violation: Members are required to establish, maintain and enforce an adequate supervisory system. The supervisory system will be composed of many different elements, both objective, such as regular reviews of specific areas of activity, and subjective, including placing competent, qualified, and experienced individuals in supervisory roles. Written supervisory procedures document the supervisory system that the member has established.
NASD examiners often encounter firms with procedures that do not include a description of the controls and procedures actually used by a firm to reasonably detect and prevent misconduct, but instead merely recite the rule requirements or firm policies.
Why this is a problem: Without an adequate supervisory system firms will not be able to properly supervise the business of their firms, supervise their associated persons, or be able to achieve compliance with applicable securities laws and rules. Having adequate written supervisory procedures will allow a firm to properly supervise its registered representatives, as they would be aware of the firm's procedures and compliance responsibilities.
The solution: Members should have written supervisory procedures that adequately address all activities in which the firm engages and that adequately describe what the firm will do to supervise the activity. A firm's written supervisory procedures would clearly state: (i) who: the identification of the principal responsible for conducting the subject procedure; (ii) what: a description of the specific procedure that is to be conducted by the supervisor; (iii) when: a statement as to when or how often the specific procedure is to be conducted; and (iv) how: a statement as to how the firm will evidence the fact that the procedure has been conducted.
For example, a supervisory system may include elements such as automated exception reports and surveillance programs that monitor for unusual trading activity in customer accounts. The firm's procedures would identify the supervisor who will monitor these reports, instruct the supervisor on which reports produced by the surveillance system the supervisor is to review, including a description of how often these reports would be reviewed, the steps to be taken if suspicious activity is discovered, and how to document the supervisor's oversight activities.
Members may avail themselves of a number of resources available on NASD's Web site that serve as job aids and tools to assist with compliance responsibilities. For example, templates, frequently asked questions with answers, web pages dedicated to specific regulatory topics, Notices to Members, and transcripts of educational preventive compliance workshops, and more, are available as resources for members. While there are a number of resources on NASD's Web site, we are providing a direct link to Notice to Members 99-45 considering that members frequently cite this Notice as highly valuable on the topic of supervision and compliance.
Questions about this communication may be directed to Lorraine Lee, of NASD Member Regulation, at (240) 386-4783.