SEC Staff Issues "ComplianceAlert" Letter, Alerting Compliance Officers to Deficiencies and Best Practices

24 July 2008 Publication
Author(s): Kathryn M. Trkla

Legal News Alert: Securities, Commodities & Exchange Regulation

The staff of the U.S. Securities and Exchange Commission (SEC) Office of Compliance Inspections and Examinations (OCIE) has issued a new ComplianceAlert letter, describing issues and practices that the staff has encountered in examinations of broker-dealers, investment advisors, investment companies, and transfer agents.1 The letter alerts compliance officers to both deficiencies and weaknesses that the staff has encountered in examinations as well as best practices in areas such as, but not limited to, personal trading by advisory staff and “free lunch” seminars offered by broker-dealers. The letter highlights some of the areas that SEC examiners focused on during examinations. The first ComplianceAlert was published in June 20072 and with this new ComplianceAlert OCIE staff hopes to help compliance officers proactively address issues.

OCIE staff continued to focus on “free lunch” seminars offered by broker-dealers, especially when targeted to senior citizens. In September 2007, Financial Industry Regulatory Authority (FINRA), North American Securities Administrators Association (NASAA), and the SEC issued a report3 about these “free lunch” seminars, and OCIE staff included in the ComplianceAlert a number of observations related to these seminars.

Examiners observed that seminars often were advertised as “educational” or “workshops,” and the advertisements did not mention investment products, although the actual goal of the seminars was to have attendees open new accounts. OCIE examiners observed that some firms had effective compliance and supervisory practices, including an effective compliance technique of requiring employees to send all seminar materials to the home office for review prior to an event. Another effective compliance technique was to provide supervisors with checklists to aid in the approval process for materials and seminars. However, examiners found that half of the firms used advertising and sales materials that might have been misleading or exaggerated. Many of these firms did not provide their sales material to FINRA for review. As a result, seminar attendees may not have understood that a presenter was biased in making recommendations. Additionally, sponsorship of seminars by a particular company with a financial interest in sales often was not clearly articulated.

Examiners found indications of possible fraudulent practices in 13 percent of their examinations, including potentially serious misrepresentations of risk and return, liquidation of accounts without a customer’s knowledge or consent, and sales of fictitious investments. Examiners also noted that 23 percent of their examinations revealed indications of unsuitable recommendations to purchase investments at sales seminars or following a seminar when an attendee opened an account. OCIE staff stressed in the letter that firms should closely supervise sales seminars.

The SEC and FINRA recently examined select large broker-dealer firms in their valuation and collateral management practices with respect to subprime related products. “Product control” is the verification of valuation by independent personnel. However, due to a lack of liquidity, firms were having an increasingly difficult time with valuation, and so relied more on modeled prices. Examiners noted deficiencies in this area as well as some best practices. Best practices noted at some firms included having the product control group use valuation processes that aligned to market conditions and keeping a data warehouse that could be used to ensure consistency.

Examiners performed a targeted review of broker-dealer subsidiaries of insurance companies and noted unsuitable recommendations and inadequate supervisory procedures as well as financial responsibility rule deficiencies. Examiners attributed the deficiencies to a lack of controls, stating that, in some cases, broker-dealers were managed by insurance industry personnel who lacked knowledge of the securities industry.

Some broker-dealers have designated their registered representatives as “solicitors” for an investment advisor. Examiners engaged in a targeted review of these firms and noted that although the solicitors were salesmen for the investment advisors, the solicitors also were providing investment advice to customers by guiding their choices of investment program and products. In some of these cases, there was no supervision of suitability of the advisory services and investment recommendations. Some of the firms appeared to use false or misleading sales literature, failed to have a principal indicate review and approval of materials, and/or failed to file sales literature with FINRA.

Examiners also conducted a risk-targeted examination of broker-dealers that recommend that customers finance the purchase of securities with a second or reverse mortgage on their homes. Many firms specifically prohibit registered representatives from recommending that customers take out loans to purchase securities. The recordkeeping and supervision for these activities was poor. The examiners also found problems with suitability with these practices.

Finally, examiners reviewed a sample of broker-dealer firms’ supervisory and compliance controls under an Office of Supervisory Jurisdiction structure. They found deficiencies in supervisory policies and procedures as well as in recordkeeping.

Investment Advisors and Mutual Funds
With regard to investment advisory firms, OCIE staff expressed concerns about internal compliance controls, particularly relating to employee trading and proprietary trading. Examiners found firms with incomplete or ignored codes of ethics, firms with employees who did not comply with personal trading reporting requirements, and firms that did not review reports for non-compliance with their own policies and procedures and/or with applicable regulations. Examiners did find firms with effective internal controls, compliance, and reporting procedures such as information barriers, watch lists, time-stamped order tickets, black-out periods, comparisons of pre-clearance forms to actual trading, and analysis of personal and proprietary trading for high percentages of profitable trades or exceptional returns. The staff also noted that effective compliance programs include compliance personnel who are actively involved in implementing the programs.

With regard to proxy voting and funds’ use of proxy voting services, OCIE examiners found that while most firms had the policies and procedures required for proxy voting, the policies and procedures at other firms were not accurate or not followed; some lacked accurate records of votes. Examiners also found weak board oversight of the use of proxy service providers and a lack of documentation that provided an assessment of the proxy service providers used. Some funds voted inconsistently with their policies, or failed to file the Form N-PX with a record of all votes cast. Lastly, they provided deficient disclosures or charged improper fees. OCIE staff did recognize the described processes to identify conflicts of interest, often relying on the chief compliance officer, proxy coordinator, or other advisory employee, “generally appear[ing] to be effective.”

OCIE staff also discussed the practice by some high-yield municipal bond funds of investing in difficult-to-value securities — those securities that might trade infrequently on the secondary market or not at all. OCIE examiners focused on portfolio composition, valuation, and transaction activity, and found that fund boards often would determine the fair value for net asset value purposes using pricing services. The examiners noted that high-yield funds did not disclose this as an increased risk to liquidity and valuation. They also found that because the pricing services relied on information from the funds’ management to value securities, a disclosure that the valuation was independent would be misleading. The staff noted as well that cross-trading between customer accounts could lead to mispricing, and could disadvantage one client over another.

OCIE staff discussed soft dollar practices of investment advisers. Examiners found that most firms were compliant with soft dollar rules and had effective policies and procedures, with the most common soft dollar arrangements involving research and trade execution assistance products and services. All of the firms examined reported that they had informal commission targets with the broker dealers providing the research services and that the targets were intended as guides, not firm commitments. Advisers documented efforts to seek best execution, and conducted periodic execution quality reviews. Most firms that relied on the Section 28(e) safe harbor had determined that the commissions paid were reasonable. However, in situations where a firm had not made such a determination and the value of the products received seemed higher than the instruments traded, examiners questioned whether a firm had overpaid. Examiners also investigated the reasonableness of commissions when an adviser had accumulated a large soft dollar credit value. Examiners who looked at disclosure of soft dollar arrangements generally found effective practices for compliance policies, procedures, and controls, including the practice of having the chief compliance officer approve, in advance, products and services obtained with soft dollars.

Transfer Agents
Lastly, OCIE examiners conducted examinations of transfer agents to understand the current practices with respect to “lost security holders.” When a security’s owner is “lost,” transfer agents must attempt to find the correct address and must conduct at least two searches for the holder at no cost to the holder. Further searches can be charged to the holder. The staff expressed concern that revenue-sharing can pose a conflict of interest when the transfer agent receives a part of the fee charged by third-party “search firms,” that some transfer agents refused to deal with security holders who tried to provide the transfer agent with the correct address, and that some search firms charged security holders fees for the free searches.

1 SEC Staff, ComplianceAlert (July 2008), available at

2 SEC Staff, ComplianceAlert (June 2007), available at

3 SEC, NASAA & FINRA, Protecting Senior Investors: Report of the Examination of Securities Firms Providing “Free Lunch” Sales Seminars (September 2007) available at

Legal News Alert is part of our ongoing commitment to providing up-to-the minute information about pressing concerns or industry issues affecting our securities, commodities, and exchange regulation clients and colleagues.

Please contact the following attorneys for additional information on this or other securities, commodities and exchange regulation-related matters:

Amy N. Kroll
Washington, D.C.

J. Craig Long
Chicago, Illinois

George T. Simon
Chicago, Illinois

Michael D. Wolk
Washington, D.C.


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