United States: SEC And FINRA Issue Guidance On Broker-Dealers’ Branch Office Internal Inspections

Introduction

In a move that highlights regulatory cooperation, the SEC's Office of Compliance Inspections and Examinations ("OCIE") and the Financial Industry Regulatory Authority ("FINRA") jointly issued to the broker-dealer community guidance ("Joint Guidance") on the best practices that firms should consider using in their internal inspections of branch offices.¹ These suggestions, while not intended to be exhaustive, provide a road map of the regulators' conception of a robust inspection program. Of particular note, the Joint Guidance encourages firms to tailor their branch office inspection programs based on an assessment of the relative risks specific to each branch. A firm that follows these best practices likely enhances its ability to demonstrate that it maintained reasonable supervisory policies and procedures, even if deficiencies or violative conduct are later discovered.

The Joint Guidance could be viewed as a directive to member firms to apply additional staff, technology and supervisory attention to the inspection function at a time when firm compliance and audit resources are already being stretched. The challenge for broker-dealers will be to determine which of these practices to incorporate into their inspection regimens, taking into account the nature of the firms' businesses and the attendant risks, as well as judgments regarding resource allocation.

Effective Branch Office Inspections

An effective branch office inspection program is a key element of a firm's supervisory system, as well as an important aspect of its risk management strategy. A broker-dealer's responsibility to supervise its associated persons is a core feature of the federal securities regulatory scheme. A failure to reasonably supervise persons subject to a broker-dealer's supervision exposes a firm or supervisor to potential liability under Sections 15(b)(4)(E) and 15(b)(6)(A) of the Securities Exchange Act of 1934, as well as NASD Rule 3010. In order to increase the likelihood that a broker-dealer will be able to avail itself of the good faith defense provided under Section 15(b), or more generally to demonstrate reasonable supervision to OCIE and FINRA, firms would be well-served to consider implementing some of the practices, as outlined in the

Joint Guidance, that the regulators' examination staffs have identified in well-executed internal inspection programs. These include:

• tailoring exams to the risks specific to each branch's business;
• determining the frequency of exams based on risk, and conducting branch office exams at least annually;²
• performing a significant number of exams on an unannounced basis, thereby reducing the risk that documentation might be hidden, altered, or destroyed;
• deploying appropriately senior and experienced branch office examiners who understand the business and have the ability and authority to challenge branch office personnel; and
• adopting procedures to avoid economic or other conflicts of interest between an examiner and the branch or associated persons he is examining.

The Joint Guidance also suggests that branch offices should be monitored for changes to business practices, product mix, or personnel that increase the relative risks presented by the branch; that branch inspections should be conducted by persons with adequate knowledge and experience to properly assess the activities at the branch; and that the inspections should be overseen by senior management, such as the Chief Compliance Officer. The Joint Guidance notes that associated persons' outside business activities should receive close scrutiny, as such activities present an increased opportunity for improper conduct, as well as a risk that customers will mistakenly believe the outside business is part of the member's business. The regulators also have identified certain business lines as presenting heightened risk, and thus requiring more frequent or unannounced visits, including structured products, variable annuities, and private or unregistered offerings. An additional concern is the hiring of personnel with disciplinary histories, and the Joint Guidance reminds firms that heightened supervision of branch offices that employ such persons may be necessary. Other recommended practices include periodic assessments of appropriate delineation of supervisory responsibilities, and thorough documentation and investigation of customer complaints.

OCIE and FINRA also suggest certain effective practices relating to the inspection process itself, including the use of comprehensive checklists that identify trends from prior inspections and internal reports, and the tracking of corrective action taken by branch managers.

It should be noted, however, that the Joint Guidance cautions that adoption of any or all of these practices does not amount to a safe harbor, nor does it guarantee a finding of a reasonable supervisory system.

OCIE and FINRA Examination Priorities

In addition to providing guidance on steps that member firms can take to enhance their own inspection programs, the Joint Guidance suggests that both OCIE and FINRA intend to focus on the effectiveness of a firm's branch office inspection program during an examination, with particular attention paid to the branch offices with the highest risk profiles. In evaluating the efficacy of a member firm's inspection program, OCIE and FINRA examiners are likely to be particularly interested in reviewing the firm's supervisory procedures regarding customer accounts, especially involving sales of retail products. Examples of other areas of anticipated focus include the servicing of accounts by income-producing managers; policies and procedures relating to the handling of money or physical securities, as well as transmittals of funds; validation of changes in customer address or other account information; and the firm's testing of its own policies and procedures. The Joint Guidance further explains that examiners will continue to assess how a branch office inspection program addresses other priority compliance concerns, such as advertising and communications with the public, the handling of customer complaints, and the use of unauthorized electronic devices or social media.

Common Deficiencies in Inspection Practices

OCIE and FINRA also provide a useful list of practices that regulators associate with deficiencies in the integrity of the branch inspection process. Broker-dealers should consider using this list to evaluate their own practices. For example, the Joint Guidance cautions against using generic, "check the box" exam procedures for all offices, having inexperienced staff perform the audits, and failing to devote sufficient time and resources to the inspection process.

The Joint Guidance also warns against failing to provide a written inspection report, reminding members that under NASD Rule 3010(c)(2), each branch office inspection must include a written report that includes testing and verification. Further, the regulators recommend that the report note any deficiencies, areas of improvements, and action plans. Firms would be prudent, however, to adhere to such plans for corrective actions because otherwise they could be deemed "red flags" that the firm discovered but failed to remedy.

Conclusion

The Joint Guidance includes an inventory of best practices for effective branch office supervision. Some of the practices highlighted by the regulators might be difficult or costly to implement readily, such as the implementation of a comprehensive compliance database, but each firm should evaluate the guidance in light of its own specific circumstances and make appropriate enhancements to its supervisory programs. In contrast, some of the practices endorsed by the release are relatively straightforward and could be implemented by firms for 2012 branch office inspections, such as the use of unscheduled examinations and experienced inspection staff. What is not expressly stated in the Joint Guidance, but should be a consideration for firms as they review their internal processes, is that increasing the effectiveness of self-review will likely allow firms to uncover issues at an earlier stage, and thus prevent increased exposure if such issues were to come to light at a later date. Moreover, as outlined above, implementing the methods endorsed by the Joint Guidance should go far in helping a firm demonstrate that it maintained a reasonably designed and appropriately tailored compliance program.

Footnotes

1 See National Examination Risk Alert, Vol. 1, Issue 2, Nov. 30, 2011 and FINRA Regulatory Notice 11-54, Branch Office Inspections, Nov. 30, 2011.

2 NASD Rule 3010(c) establishes the required schedule for examinations. The Joint Guidance highlights as a best practice conducting examinations for certain branches more frequently than the minimum required under the rule. The Joint Guidance also refers to the list of factors in NASD IM-3010-1 as supplemental considerations in determining the scope and frequency of branch office inspections.

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