Regulators’ Top Ten Problems List

Lehman Brothers is on the ropes, and other financial firms are reeling.

Lehman Brothers is on the ropes, and other financial firms are reeling. The Treasury Department and the Federal Reserve are busy. In fact, so are your regulators, from the states organizations to the SEC to FINRA. The areas of greatest interest to examiners can and do change with the times and market landscape. The auction-rate securities mess has been high on regulators’ list (how were ARS presented to retail investors?), as are customer privacy issues and those pesky pump-and-dump schemes.

All that stuff occasionally makes the front page, but what branch managers really want to know is: What will regulators be looking for when they visit your branch? In May, FINRA issued a document highlighting the year’s exam priorities and areas of potential focus called “Improving Exam Results.” (It is published every May.) The SEC also annually issues the “Top Ten Examiner’s Focus List,” designed to take the mystery out of the regulatory process. As a result, David Thetford, securities compliance principal analyst at Wolters Kluwer Financial Services, a compliance and risk management firm, says audits are essentially “open book exams.” All of the answers are there, he says, “Firms, supervisors and managers simply need to be prepared.”

Of course, just because an issue isn’t on a Top 10 list doesn’t mean it won’t be examined, Thetford stresses. “Compliance review should be a continual process. With the guidance of their firms’ compliance departments, managers should have adequate procedures in place that they can apply to changing focus lists.”

Several of the 15 focus areas listed in FINRA’s “Improving Exam Results” for 2008 aren’t really all that new. Issues like supervision and supervisory controls, anti-money laundering requirements, agency lending practices and disclosures, integrity of data reporting and outsourcing will likely always be critical focal points. But there are other areas regulators are beginning to scrutinize more carefully, Thetford says, in an effort to proactively address new potential problems. They include:

Protecting Senior Investors: “This has become an even greater priority as more baby boomers are becoming seniors,” Thetford says. FINRA reports there are more seniors investing in capital markets than ever before. A substantial number of them lack confidence in their investment knowledge, says FINRA, making them ripe targets for investments fraudsters. Their specific needs—and protection—must continually be addressed by firms in broker education, examination and enforcement programs.

Deferred Variable Annuities: “In 2002, the big issue was mutual funds,” says Thetford. “They received pretty intense regulatory attention that resulted in large fines to many firms all across the Street.” Variable Annuities are high on the list this year, he says. “They’re afraid these products are ripe for potential abuse. By focusing their attention there, they’re hoping to avert any trouble like the 2002 B-shares disciplinary actions,” he says.

Protecting Customer Information:
“Over the last year, the brokerage industry has continued to be a target for computer hackers who illegally access customer accounts,” he says. Firms must examine how they are protecting customer information and records. On September 11, the SEC announced that it had fined LPL $275,000 (without LPL admitting or denying guilt) for failing to do just that: properly protect clients’ identities from computer hackers.

Sales of New or Non-Conventional Products: FINRA says firms need adequate procedures for vetting new products that continually arrive on the market and may have complex features or risky characteristics. They should conduct adequate due diligence to understand the features of a product it allows its representatives to market. It all stems from the sub-prime lending crisis that has cost $500 billion worldwide, says Thetford.

Business Continuity Planning: As the 2007 California wildfires unfortunately reminded us, disaster often strikes without warning. FINRA wants firms to create and maintain business continuity plans, conduct annual reviews and update them as needed.

Inventory Valuations: As the credit markets seized up, validation of prices to third-party sources has become more challenging. Clients need to know the fair value of their holdings, and be on the alert for advisors overcharge fees based on overvalued holdings, Thetford says. This heightens FINRA’s desire to see firms strengthen their control over pricing integrity.
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Regardless of the market climate, many things remain constant in the audit process. As such, Nancy Lininger, a compliance consultant who heads The Consortium, a consulting firm, addresses how BOMs can prepare for them on a general level.

Audits begin with entrance interviews, wherein regulators speak to BOMs to get an idea of how the office is run. “They’re also trying to determine how the manager feels about authority,” Lininger says. This is the time to set a good “tone at the top,” she says. “Be cordial and treat them with respect. View them as people first—examiners second.”

If you seem organized and pull files out for them immediately, they’re more likely to scan them than to dig deeper, she says. Prep your reps to be polite and organized, too, she says. And, establish yourself as the “point person” between staff and the examiner. If files are requested, for example, the rep should hand that information over to the manager first. “You want a chance to see if anything is flagged and needs to be cleared up,” she says. “Then, you can pass it along to the auditor.” If auditors ask to speak to individual reps, managers should sit in, she says, to prevent any miscommunication.

As a manager, she says, you’re also entitled to an exit interview when the audit is over. This gives you another valuable opportunity to clear up any misconceptions or miscommunications.

And finally, she says, once the auditor leaves, fix the “quick and easy” problems right away. “You don’t need to wait for the deficiency letter to come back. This way, when it does, you can say, ‘We’ve already corrected that,’ and, for more complex issues, assure them plans to remedy them are already underway.”
Preparedness on the part of both manager and reps are key, Thetford concludes. “You never know when you’ll be audited, so keep things under control all the time. It’s also good business. By meeting the regulators’ requirements, you’re protecting the investor.”


1. Controls Over Securities Valuation
2. Controls Over Non-Public Information/Personal Trading/Code of Ethics
3. Dealing with Senior Investors
4. Compliance and Supervision
5. Portfolio Management
6. Brokerage Arrangements and Best Execution
7. Allocations of Trades
8. Performance Advertising, Marketing, and Fund Distribution Activities
9. Safety of Clients' and Funds' Assets
10. Information Processing and Protection (books and records, disclosures, and filings).
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