Improving Examination Results - April 2004
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 Share Classes
Mutual funds offer various share classes that contain differing fee structures. NASD expects regulated 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 issued an investor alert entitled "Understanding Mutual Fund Classes". NASD has also made available a mutual fund fee calculator.
Late Trading and Market Timing of Investment Company Products
In response to the widely reported incidents in the mutual fund industry, NASD continues its focus on the late trading and impermissible market timing of mutual funds and other investment company securities. Late trading is the purchase or redemption of an investment company security after the close of business but at a price set at the close of business. This violates the forward-pricing provisions of the Investment Company Act of 1940 and is illegal. Market timing is typically described as the frequent and quick trading in and out of an investment company security done with the intent to capitalize on stale prices. This frequent trading is not illegal per se but since most investment company prospectuses discourage or bar such trading, it is a violation of NASD rules for an associated person or broker-dealer to circumvent these restrictions. View Notice to Members 03-50 for more important information.
Mutual Fund Breakpoints
NASD will continue to carefully assess 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. As part of this review, examiners will also be reviewing for mutual funds that offer NAV transfer programs and other sales discounts available to investors. In these situations, customers who liquidated a fund with a sales charge can reinvest in a new fund without incurring an additional sales charge. Examiners will review transactions to make sure that customers received the appropriate sales charge. View Notice to Members 02-85 for more important information.
In addition, examiners will be reviewing the accuracy of the NASD Breakpoint Assessments submitted by broker-dealers as well as the other assessment related requirements. Examiners will also look to ensure that all refunds were promptly made to customers. For more information refer to Notice to Members 03-47 and NASD's Web Site.
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.
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. In October 2003, NASD issued Notice to Members 03-63, which discussed SEC interpretations on expense-sharing agreements. NASD regulated firms were to be in compliance with the new requirements by December 1, 2003. Examiners will continue to scrutinize broker-dealer 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 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 in 2004 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."
Fee Based Accounts
NASD will focus on the use of fee-based accounts by member firms to determine whether they are being used appropriately. Before opening a fee-based account for a customer, a member must do an analysis of the appropriateness of such an account given the customers expected level and type of trading. Additionally, a member should perform periodic reviews of its customers' fee-based accounts to determine whether the fee structure continues to be appropriate, taking into consideration the level of the customer's trading and any changes to the customer's investment plan, among other factors. View Notice to Members 03-68 for more important information.
Heightened Supervision and Supervisory Controls
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 the implementation of 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.
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 broker-dealers to have internal controls in this area. Examiners will be assessing the adequacy of regulated firms' supervision and supervisory controls. View our January 28, 2002 Member Alert regarding customer address changes and use of post office boxes.
NASD is examining the soft dollar activities of regulated firms to determine, among other things, compliance with the requirements necessary to take advantage of the Section 28(e) safe harbor. Examiners will also focus on abuses in the use of soft dollars by broker-dealers.
NASD is examining the suitability and disclosures to customers with respect to the sale of 529 college savings plans by NASD regulated firms. Among other things, examiners will focus on instances where customers were sold 529 plans sponsored by a state other than their home state, and the fees being charged for such purchases. NASD will also continue to review to ensure members selling 529 plans are properly registered with the MSRB, and that they have the properly registered principals.
Frequently Found Violations Update
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 its 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. Members frequently 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 fraudulent activity.
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.
Continuing Education Requirements (NASD Rule 1120)
Violation: There are two parts to this Rule, a Regulatory Element and a Firm Element.
Regulatory Element: 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. A person's initial registration date shall establish the cycle of anniversary dates for purposes of this Rule. The Rule permits firms to deliver the Regulatory Element computer-based training on firm premises (In-Firm Delivery), rather than have these persons take the training at a test center. Firms must revise their written supervisory procedures to include procedures to comply with Rule 1120's specific requirements regarding supervision, delivery sites, technology, administration and proctoring. NASD examiners often find that member firms have not adequately updated their supervisory procedures to take into account the In-Firm Delivery of the Regulatory Element and also that firms have not ensured that inactive registered persons are not performing activities that required an active securities registration.
Firm Element: 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. If a firm's analysis establishes the need for supervisory training for people with supervisory responsibilities, the firm must include this training in its training plan.
Programs used to implement a member's training plan must, at a minimum, cover the following matters concerning securities products, services and strategies offered by the firm:
- General investment features and associated risk factors;
- Suitability and sales practice considerations;
- Applicable regulatory requirements; and
- With respect to registered research analysts and their immediate supervisors, training in ethics, professional responsibility and the requirements of Rule 2711.
NASD staff often finds 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. The training plan need not be very complex or lengthy, but it should clearly reflect the firm's business and the capabilities of its registered personnel.
Why this is a problem: For the Regulatory Element, if the firm has failed to update their written supervisory procedures to take into account the firm delivery, it is difficult for the staff to assess compliance with the rule. If a firm fails to ensure that inactive registered persons are not conducting activities that require an active securities registration, this is a failure and is 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, the sale of municipal securities and the regulatory requirements relating to compliance. Firms must be able to demonstrate through an updated written training plan that its registered personnel are being adequately trained in business that the firm is conducting.
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. Firms should also ensure that their Written Supervisory Procedures are updated with the requirements for In-Firm Delivery of the Regulatory Element in the instances where the firm is delivering the Regulatory Element on firm premises.
For the Firm Element, firms should ensure that they have an adequate training plan that clearly reflects the firm's business. A firm may use the preceding year's written training plan as a starting point; however it should consider recent training results and current training needs. The coverage and continuity of an established training plan can be enhanced through annually reviewing the Firm Element Advisory and the previous year's plan and needs analysis for appropriate updates and modifications.
The Reporting of Customer Complaints (NASD Conduct Rule 3070(a)(2))
Violation: Members are failing to notify NASD when the Firm is the subject of any written customer complaint involving allegations of theft or misappropriation of funds or securities or of forgery, a violation of NASD Conduct Rule 3070(a)(2).
Why this is a problem: Violations of Rule 3070(a)(2) may result in both formal and informal disciplinary actions. In addition, the failure to report customer complaints can lead to a Failure to Disclose or Failure to Update violation with respect to the appropriate amendments being made to the Firm's Form BD and the representatives' Forms U4 or Forms U5.
The solution: To comply with the NASD Conduct Rule 3070(a)(2), each member must promptly report to the Association when it is the subject of any written customer complaint involving allegations of theft or misappropriation of funds or securities or of forgery. Furthermore, each member must notify the Association no later than 10 business days after the member knows, or should have known, of the existence of any written customer complaint. The member or person associated with a member is also responsible for the prompt filing of any required amendments to Form BD, Form U4 and Form U5. In addition, each member is responsible for reporting statistical and summary information regarding customer complaints by the 15th day of the month following the calendar quarter in which the member receives the customer complaints. For more information see NASD Notice To Members 96-85.
Financial Reporting (SEC Rule 17a-5)
Violation: SEC Rule 17a-5 requires members to submit financial reports to their Designated Examining Authority (DEA) within certain prescribed time frames. For the majority of firms the DEA is NASD. Monthly and Quarterly Focus reports are due 17 business days following the month or quarter-end. Annual Audit reports are due 60 calendar days after fiscal year-end. Members are failing to submit their required reports or are not doing it on a timely basis.
Why this is a problem: NASD relies upon periodic financial reporting to carry out its National Examination Program (NEP) and other regulatory responsibilities including the enforcement of Financial Responsibility Rules (SEC Rules 15c3-1 and 15c3-3). Firms are required to maintain books and records that are current and accurate. They also must make timely submissions, which provide critical information for regulators who test for compliance and must ensure that firms are maintaining sufficient net capital to conduct a securities business. Failure to submit timely financial reports can subject the firm to disciplinary action including possible fines, suspension from conducting a securities business and expulsion from membership. In addition, as provided for in Schedule A of the NASD By-Laws, a fee is assessed of $100 for each day that the report is not timely up to a maximum of $1,000 per event.
The solution: Due dates for financial reporting are posted in advance on the web site to assist firms with monitoring and meeting deadlines. Schedule A, Section 4(l) also provides that, if a specific temporary extension of time to file the report has been granted, then the $100 per day assessment will not be made. However, any request for such a temporary extension of time must be submitted to NASD as least three-business days prior to the due date of the report.