Improving Examination Results - April 2003
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 has identified the following areas of particular importance to the examination program in the coming year.
Mutual Fund Breakpoints
Mutual funds that are sold with front-end sales loads often offer investors the opportunity to pay reduced sales loads under a variety of circumstances. As set by the mutual fund, the breakpoint levels can be reached in a variety of ways, including aggregating investments in specified related accounts. As a result of recent and ongoing examinations, NASD and SEC staff are concerned that some member firms have not been charging investors the correct sales loads in many instances, particularly for mutual fund transactions involving letters of intent and rights of accumulation. Examiners will be carefully assessing member firms practices, supervisory procedures, and controls relative to breakpoints to make sure that investors are charged the correct sales loads on mutual fund transactions. View NASD Notice to Members 02-85 for more important information.
Net Capital and Customer Protection Rules
Net Capital and Customer Protection Rule violations are among the most frequently found violations in NASD's routine examination program. Regulators have recently noted an increase in the assumption of liabilities by parents and affiliates of member firms. This practice, coupled with decreases in member firm revenues, makes maintaining adequate levels of minimum net capital more important now than ever. Examiners will continue to scrutinize member firm compliance with the Net Capital and Customer Protection rules, and will also focus on expense sharing agreements and the booking of liabilities.
The PATRIOT Act requires that member firms prevent and detect money laundering. All member firms should have established their anti-money laundering compliance programs. Further, NASD's AML rule was amended to require that the AML compliance person be identified and contact information provided to NASD by December 31, 2002. The requirements for member firms to identify and file suspicious activity reports (SARs-SF) went into effect December 31, 2002. When the customer identification rule is final and the implementation date has passed, we will also be focusing on this area. Anti-money laundering will remain an examination priority in order to determine industry compliance with these important rules, and to assist member firms in meeting their obligations. View our AML Web page for more detailed guidance, including an AML Small Firm Template.
Business Continuity Plans
Member firms should have established risk management procedures addressing all aspects of their businesses, prudent financial controls, and well thought-out business continuity plans. NASD and the NYSE have proposed rules requiring that firms have adequate business contingency plans. A new examination focus in 2003 will be on ensuring business contingency planning for events causing significant business disruption.
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.
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. NASD and the NYSE have proposed rules requiring member firms to have internal controls in this area. Continued 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. Examiners will be assessing the adequacy of member firms' supervision and supervisory controls. View our January 28, 2002 Member Alert regarding customer address changes and use of post office boxes.
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. View our Notice to Members 99-35: "The NASD Reminds Members Of Their Responsibilities Regarding The Sales Of Variable Annuities."
Member firms must ensure that the sales of hedge funds and funds of hedge funds comply with all relevant NASD and SEC rules, particularly those related to suitability. Hedge funds are complex investment vehicles, which are often risky and lacking in transparency. Consequently, many investors, especially retail investors, may not understand the risks associated with investing in hedge funds and funds of hedge funds. Given these considerations and the fact that certain hedge funds are for the first time being offered to a broader investor segment, NASD considers it essential that members reach an initial determination about the suitability of such funds to any retail investors before performing an individual suitability assessment. Members also must ensure that any promotional efforts of hedge funds or funds of hedge funds are fair and balanced. Finally, members must properly supervise and train all associated persons selling these products to ensure that associated persons comply with applicable securities laws. View NASD Notice to Members 03-07 for more important information.
Frequently Found Violations Update
Books and Records Requirements (SEC Rules 17a-3 and 17a-4, and NASD Conduct Rule 3110) (Updated: 04/03/03)
Violation: SEC Rule 17a-3 requires members to keep certain books and records, including an itemized daily record of the receipt and delivery of securities, and the receipt and disbursement of cash and other debits and credits. The record must include the date of the receipt or disbursement of the securities, cash or credits; the certificate number of the securities; the name and amount of the securities received or disbursed; the name of the person who received the securities or to whom the securities were delivered; and the account for which each transaction was effected. Members frequently fail to maintain an adequate record of the receipt or delivery of securities by failing to note the date of receipt of the securities, the date of disbursement of the securities, or to whom the securities were disbursed.
Why this is a problem: When a member fails to maintain these records, its books and records are not in compliance with the SEC's books and records rules, or NASD's books and records rule, NASD Conduct Rule 3110. Complete books and records are a critical tool for managing the business, assuring appropriate supervision, and ultimately for protecting investors.
The solution: Members should prepare daily records of the receipt and disbursement of securities, noting the date of the receipt or disbursement of the securities, cash or credits; the name, amount and certificate number of the securities received or disbursed; the name of the person who received the securities or to whom the securities were delivered; and the account for which each transaction was effected. SEC Rule 17a-4 requires, among other things, that members maintain records, pursuant to paragraphs 1, 2, 3, and 5 of SEC Rule 17a-3, for a period of not less than six years, the first two years in an easily accessible place. For a complete reading of the rule refer to SEC Rule 17a-3. Members should also consult SEC Rule 15c3-1 to assess net capital implications and 15c3-3 to assess Customer Protection Rule implications when receiving and holding funds or securities.
Supervisory Obligations (NASD Conduct Rule 3010(a)(7))
Violation: Members are required to conduct an annual compliance meeting, either individually or collectively, with their registered representatives to discuss relevant compliance matters. NASD examiners frequently find that member firms do not adequately document these meetings. In most cases, there is no evidence that these meetings have actually occurred.
Why this is a problem: The annual compliance meeting is a valuable tool for assuring that registered representatives are mindful of firm procedures, supervisory obligations, and other important information relating to compliance. Firms must be able to demonstrate that each registered representative participates, at least once each year, in an interview or meeting at which compliance matters relevant to the particular representative are discussed.
The solution: Firms can avoid this problem by maintaining a record of each meeting that addresses:
WHEN and WHERE the meeting was conducted;
WHAT was discussed; and
WHO was in attendance. (See Notice to Members 99-45)
Internal Inspections (NASD Conduct Rule 3010(c))
Violation: Firms are required, at least annually, to conduct internal inspections of the businesses in which they engage and of each office of supervisory jurisdiction ("OSJ"). The purpose of these reviews is to assist the member in determining whether the supervisory systems and procedures are current and sufficient and that they are designed to assist in detecting and preventing violations of and achieving compliance with applicable securities laws and NASD regulations. NASD staff often find that, while a firm's written supervisory procedures require that these reviews be conducted, the procedures do not address how the reviews will be documented. Further, another common deficiency is that there is no documentation of the reviews.
Why this is a problem: It is often difficult for the staff to assess compliance with the rule in the absence of clear documentary evidence that the firm conducted the required reviews.
The solution: Members should retain a written record of the internal inspection of its businesses. The written supervisory procedures should indicate, specifically, how this is to be documented. This record should include what the member reviewed, when the review was conducted, and the results. Firms should also ensure that they include the review cycle for each branch office. (OSJs are examined annually.)
NASD Notice to Members 99-45 provides an explanation of the purposes underlying the different sections of Rule 3010 and provides guidance on complying with supervisory responsibilities.
Form U-5 Reporting (Article V, Section 3 of the NASD By-Laws)
Violation: Article V, Section 3 of the By-Laws requires every member to file a Form U-5 with NASD within 30 calendar days of termination of an associated person. NASD staff has noted a significant increase in the number of instances in which members fail to file their Forms U-5 or file them delinquently (a year after termination in some instances).
Why this is a problem: U-5 disclosures represent one of the most valuable sources of regulatory information concerning the employment status of associated persons for both firms, which should monitor this information for supervisory purposes, and NASD, in the discharge of its oversight responsibilities. Failure to file or timely file Form U-5 is a violation of Article V, Section 3 of the By-Laws.
The solution: Members frequently state that their failure to submit a Form U-5 was the result of being unaware of the 30-day requirement for filing. Member firms should regularly seek to remind appropriate personnel concerning their obligations to ensure that the Form U-5 is submitted within 30 days of the termination of an associated person.
The Use of Electronic Storage Media (SEC Rule 17a-4(f))
Violation: Firms are increasingly using electronic storage media to maintain books and records without notifying their designated examining authority (DEA) at least 90 days prior to use. By failing to notify NASD prior to the use of electronic storage media, members are not complying with SEC Rule 17a-4(f)(2)(i).
Why this is a problem: The examination staff cannot effectively examine the firm's books and records, particularly as it relates to the review of customer account statements, if it is unaware of the use of electronic storage media.
The solution: Members must notify their DEA at least 90 days prior to employing the use of electronic storage media.
In addition, other regulatory requirements are that the electronic storage media must:
- Preserve the records exclusively in a non-rewriteable, non-erasable format;
- Verify automatically the quality and accuracy of the storage media recording process;
- Serialize the original and, if applicable, duplicate units of storage media, and time-date for the required period of retention the information placed on such electronic storage media; and
- Have the capacity to readily download indexes and records preserved on the electronic storage media to any medium acceptable under the Rule, as required by the Commission or the self-regulatory organizations of which the member, broker, or dealer is a member.
In addition, for examination purposes, the member shall at all times have facilities available for immediate, easily readable projection or production of micrographic media or electronic storage media images and for producing easily readable images.
Questions about this communication may be directed to Lorraine Lee, of NASD Member Regulation, at (202) 728-8442.