Regulators turn up the heat on branch office oversight

SEC and Finra want to see more surprise inspections, especially at remote locations

Apr 22, 2012 @ 12:01 am

By Dan Jamieson

Broker-dealers and their independent representatives are feeling the pinch of tougher oversight.

Regulators have issued several warnings in recent months about the need to pay close attention to independent representatives who work in remote offices.

In November, the Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc. issued a joint reminder about branch office inspections. In addition, several recent enforcement cases have highlighted the risk to broker-dealers if they are found to have weak branch office oversight.

Additionally, in a related development, independent representatives and their broker-dealers must take more care in disclosing and approving outside businesses under tougher reporting rules. The new, more restrictive rules went into effect in December 2010, and some industry participants are just getting up to speed.

On the enforcement front, the most worrisome case could be one the SEC settled in January with 1st Discount Brokerage Inc., according to Alan M. Wolper, a partner at Ulmer & Berne LLP.

The SEC went after the firm and one of its executives over a $9 million Ponzi scheme run by a broker at the firm. Notably, SEC enforcers said the independent- contractor-broker model that 1st Discount used “requires greater supervision than that of a traditional wirehouse brokerage firm.”


Mr. Wolper fears that the case signals a shift from the SEC's long-held position stated in a 1997 case against Royal Alliance Associates Inc., where the commission said independent offices simply present “greater supervisory challenges.”

The 1st Discount case could “represent a major change in how supervision is viewed by the SEC,” Mr. Wolper said. “Instead of requiring you to meet the same supervisory standards as traditional firms, now, by virtue of your [independent] business model, the SEC will be holding you to a higher standard.”

In another case from January, John Derek Lane, who ran Lane Capital Markets LLC, settled with Finra over the failed supervision of a remote independent office. Finra alleged that Mr. Lane knew that the office was not being adequately overseen by a part-time financial operations principal.

“More than ever, as an independent-contractor [broker-dealer], you may be called upon to defend ... your supervisory system, particularly your branch audit program,” Mr. Wolper said.

Indeed, broker-dealers should be conducting a series of unannounced exams on remote offices, observers said.


“Regular branch office inspections over reasonably short intervals, including unannounced inspections, are the cornerstone of a well-designed branch office inspection program,” the SEC and Finra said in their joint November regulatory notice.

By contrast, pre-announced examinations can “create opportunities for branch office personnel to alter or destroy documents, or commit other securities law violations,” the notice said.

“Most [brokers] engaged in fraud don't disclose it” in outside-activity reports, said Joel Beck, founder of The Beck Law Firm LLC, so surprise audits are key to a rigorous inspection program.

“We're getting requests for more unannounced exams” from broker-dealer clients, said Victor Shier, owner of Broker Dealer Services LLC, a compliance firm.

In fact, of all the exams he performs, most are unannounced.

Regulators are also concerned about the quality of audits.

In the joint notice, the SEC and Finra said firms have gotten into trouble by using generic examination procedures and a “check the box” approach devoid of critical questioning.

“You can't use a cookie-cutter approach,” Mr. Shier warned.


The regulators said firms also should use examiners “with sufficient experience to understand the business being conducted at the [branch] and the gravitas to challenge assumptions.”

Meanwhile, Finra has tightened up on its outside-business-activity rules, and some in the broker-dealer community may not be aware of the changes, Mr. Beck said.

Many independent representatives run other businesses, such as tax practices and investment advisory firms, so the rules have wide impact.

Under a requirement in effect since December 2010, registered representatives must provide prior written notice to a firm before engaging in an outside activity. Under the old rule, only “prompt written notice” was needed.

The updated rule, Finra Rule 3270, also requires representatives to report any outside activity for which they have a “reasonable expectation” of being paid, Mr. Beck said.

“The new rule is much more broad” in what brokers should report, Mr. Beck said.

Individual representatives also have to understand their own company's policies in getting approval for outside business activity, which may be more restrictive than Finra rules, Mr. Beck added.

“Overall, firms are becoming more cautious in this area,” he said.

And more intrusive as well, Mr. Shier said.

“Finra is holding [broker-dealers] responsible” for looking into investment advisory businesses, which are often run separately from the broker-dealer, he said.

That scrutiny isn't new, but under the tightened outside-business-activity rules, firms themselves now have new obligations, Mr. Beck said.

Broker-dealers must review a broker's reported outside activity and consider whether it will interfere with the broker's responsibilities. They must also judge whether customers might view it as an activity of the firm. Firms must then decide whether the activity should be allowed or restricted, and document their entire process.

Mr. Beck hasn't seen any broker-dealers get into trouble under the new standards, but he thinks regulators might get tougher on firms that don't comply with the outside business activity rules.


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