Securities and Futures Regulatory Update
On May 15, 2012, Carlo V. di Florio, Director of the Securities and Exchange Commission’s (“SEC” or “Commission”) Office of Compliance Inspections and Examinations (“OCIE”), spoke at the SIFMA Compliance and Legal Society May Monthly Luncheon (“SIFMA Luncheon”). Mr. di Florio discussed two main areas: 1) overall changes and developments in the SEC’s compliance and examination program, and 2) findings from the 2011 exam year and priorities for the coming year in connection with the SEC’s national examination program. The following provides an overview of Mr. di Florio’s remarks at the SIFMA Luncheon.
Evolution of the OCIE’s National Exam Program
Mr. di Florio first discussed the continued evolution of OCIE’s structure and program. One of his priorities has been to move the compliance program from one conducted by 12 autonomous regions to a nationally integrated approach and toolbox. To that end, OCIE has developed a National Exam Program Policies and Procedures Manual. Along with the Manual, OCIE now has a Chief Compliance Ethics Officer and supporting committee. The goal is for the exam program to have a consistent approach and methodology so the experience does not differ, for example, from Chicago to New York. Mr. di Florio also cited better coordination within the SEC, including through the use of Regulatory Colleges, as well as with international regulators as part of a more cohesive exam program.
The addition of new staff with significant industry experience and specialized skills has also helped OCIE enhance its exam program. Mr. di Florio specifically cited the hiring of Julius Leiman-Carbia to head the broker-dealer team and Drew Bowden to lead the investment adviser and investment company exam area. Mr. Leiman-Carbia has worked at Goldman Sachs, JP Morgan, and Citigroup. Mr. Bowden also has extensive industry experience, most recently at Legg Mason.
OCIE also has hired a large number of staff with specialized skills, including PhD’s in math, computer science, and economic modeling. In addition, OCIE has been able to add staff with experience in trading, structured products, risk assessment and derivatives. These staff contribute to risk assessment, training, and the development of exam modules. Mr. de Florio noted that was important to strengthen specialization to support the staff’s generalists.
In addition to staffing, OCIE has evolved its method of data analysis from a manual process to an Oracle platform that allows more sophisticated data and risk analytics. Mr. di Florio identified the creation of three groups within OCIE as reflective of the program’s new level of specialization: (1) the Office of Risk Analytics and Surveillance, which will seek to identify firms and risk areas that should be of interest to examiners; (2) the Office of Data Analytics, which will be able to conduct further trading and data analytics once firms and issues have been identified; and (3) the Office of Large Firm Monitoring, which will seek to identify the business units, products, and activities of large firms that will better focus exams of such firms.
Beyond tools and resources, Mr. di Florio said that OCIE has started to issue Risk Alerts as a way to share what SEC examiners learn with the industry – both concerns and effective practices. He said seven had been issued and that more were in the pipeline.
Exam Findings and Priorities
Mr. di Florio next identified seven findings from the 2011 exam program. All of them represent areas in which the staff found some deficient practices. The most frequently found problem areas included:
- Deficiencies in reserve formula and net capital;
- Safe keeping of customer funds;
- Risk controls, compliance functions, and internal audit;
- Supervision, particularly with the independent contractor model;
- Sales practices, suitability, misrepresentations, churning, and unauthorized trading;
- Order handling and execution; and
- Underwriting and distribution issues.
Top areas for enforcement referrals in 2011 included fraudulent transactions, misrepresentations and omissions, employment of manipulative and deceptive devices, unsuitable recommendations, registered distributions of securities, inadequate supervisory practices, and inadequate information barriers.
One of the exam priorities for 2012 is new issue due diligence, especially with regard to municipal securities and private placements. Mr. di Florio noted the issuance of a risk alert in connection with due diligence in municipal securities offerings. Another key area of focus involves supervision of broker-dealer employees, particularly those involved with structured and other complex products, high commission products often involving private placements, and employees working in remote locations. Trading activities continue to command attention, including unauthorized trading and supervision of branch offices. Mr. di Florio noted the issuance of risk alerts on those issues as well. Fraud continues to be a high priority, particularly abusive sales and retail distribution practices, ponzi schemes, exploitation of seniors, affinity frauds, insider trading, manipulation, excessive mark-ups, money laundering and unregistered entity activities. These are comprised of either attempts to avoid the registration requirements of the federal securities laws or the misuse of limited exceptions to the rules. Mr. di Florio cited the master–sub account risk alert as instructive. The particular areas of focus there involved excessive margin debt, money laundering, insider trading and market manipulation. Mr. di Florio noted that where fraud appears to be involved, the OCIE staff is making immediate referrals to the Division of Enforcement.
Another area of concern is activities that represent trading risks – the traditional ones including short sales and best execution, but also developing areas like high frequency and algorithmic trading. The staff has also examined 7 of the 10 largest equity volume ATSs and has plans to look at the top three that handle 90% of the volume on the credit side.
New regulatory risk areas of focus include the new market access rule (Rule 15c3-5), temporary municipal adviser registration, and incentive compensation as it is implemented. Large firm risk areas continue to get special focus, especially the financial operations / net capital issues, but also scales practices. The staff is also preparing to examine for the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) rules when they are finalized down the road.
Questions and Answers
Mr. di Florio then took several questions:
Mr. di Florio was asked about the drivers of increased international cooperation among regulators. First, he cited increased international coordination as driven by Dodd-Frank, for example, with respect to clearing agency regulation, but also by the Financial Stability Board, especially its ongoing risk governance exams, and International Organization of Securities Commissions. Mr. di Florio also emphasized the utility of bi-lateral engagements with individual foreign regulators. In response to a question about the staff’s expectations for the market access rule, Mr. di Florio said the staff understood every new rule had a compliance life cycle. They expect to see firms developing polices and procedures to conduct training, fostering communication, and testing, and escalation where warranted. On the master–sub issues, Mr. di Florio said the staff expected firms to consider the guidance and suggested practices and implement the recommendations based on what made sense for the firm. He said that assessments on internal controls would look for a firm to have developed good core processes and policies and procedures to address substantive requirements, and then a commitment by management to train, monitor and test controls.
A questioner asked how OCIE evaluates its examiners. Mr. di Florio said that OCIE managers had gone to trade associations and some firms about two years ago seeking feedback. Among the concerns raised by firms were that some examiners were inexperienced and often seemed to lack knowledge about the firm’s business. Moreover, the examiners sometimes were not forthcoming with information during the exams so that there was not a dialogue about the firm’s practices. Thus, a deficiency letter would appear without a preceding discussion. In response to such concerns, Mr. di Florio referred to the specialists that OCIE has hired as providing additional expertise. He also said that training had been increased and that there was much more analysis of a firm’s business before the exam started. Mr. di Florio also said that examiners were encouraged to engage the firm in discussion that would both inform the examiners about the firm’s business and the firm about the examiners’ concerns. He urged firms to engage the staff at the outset of an exam about the state of the staff’s knowledge and its focus during the exam.
Another questioner urged that the staff should recognize that Chief Compliance Officers had only one seat at the table and could not control everything. Mr. di Florio said he understood and that the staff appreciated the challenges of the compliance function.
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