Lessons from a recent Finra audit

A firm's response to an examiner's findings is more important than findings themselves

May 20, 2012 @ 12:01 am

Notification of a pending Finra examination can strike fear in a firm no matter how thorough its compliance.

The intent behind an examination is to determine points of weakness in procedures and to provide corrective action. Having recently undergone an examination, I can say that it isn't the findings but what a firm chooses to do with them that is most important.

Here are a few key things you should keep in mind.

Outside IA supervision. Many firms have accepted the hybrid-adviser concept by allowing producers to act as representatives of the firm but also maintain an outside investment adviser. In allowing this activity, many firms provide limited oversight. The idea of “limited oversight” won't be acceptable during your next examination; it is likely to be considered a private securities transaction. Firms must demonstrate clear oversight of this activity. One area of ambiguity relates to the use of third-party money managers. My position has been that situations in which the adviser doesn't directly control or transact trades eliminate the PST status. To date, I haven't received any response agreeing or disagreeing with this position.

OSJ supervision. One of the many challenges that broker-dealers face is office of supervisory jurisdiction management. Many OSJs perform well, while some are ineffective in implementing a firm's policies and procedures. The Financial Industry Regulatory Authority Inc. is likely to visit at least a pair of broker-dealer branch offices during a review, and one of the things most closely scrutinized is the amount of override received by the OSJ. Finra may ask, “Does the representative know how much his or her OSJ received in overrides?” Although I find this line of questioning somewhat overreaching, it does suggest ways of improving documentation.

Firms should establish separate written agreements for OSJs that highlight their responsibilities. The document should include a list of the individuals they are responsible for supervising and the compensation agreement that they have with each representative (the override amount). OSJ managers need to wear their home office hat during examination.

Fund analyzer. During the review process, we discovered a misunderstanding about the definition of “investment time horizon.” Broker-dealers need to ensure that their firm's policy regarding time horizon is clear and consistent, and maintain clear procedures for investment switches and delivery of asset class disclosures. Firms tend to enforce asset class disclosures and switch letters on nonbrokerage transactions but don't actively collect them for brokerage transactions. Explaining why a firm doesn't supervise these transactions consistently is difficult at best.

Written supervisory procedures. A failure to supervise indicates inadequate implementation of a firm's written supervisory procedures. For the 12-month period ended in November, more than a fifth of Finra fines were based on a failure to supervise. When completing the firm's 3012 and 3130 requirements, ensure that you document any potential risk and the procedure to mitigate such risk. If weaknesses are identified, document the corrective action taken. I would highly recommend developing an annual master calendar that involves various levels of testing each month.

Findings. At the end, you will receive a long list of findings, which are an important part of determining fines or the need for a compliance interview. The approach that a firm takes in responding to the findings is as important — if not more so — than the findings themselves.

Firms should respond quickly and thoroughly. If a weakness exists, respond with a resolution, timeline for implementation and include all supporting documentation possible. In cases where you don't agree with a finding, take a stance and demonstrate the rationale. With the exception of one item, areas where we disagreed weren't listed in the final report.

Firms should work closely with the examination manager and work aggressively to address all findings.

When navigating the land mines, it is important to consider the impact of collateral damage. Often, not only is the person who triggers the explosive hurt but those nearby, as well.

The same applies in our business. When another broker-dealer or representative fails, the impact of that failure can be felt throughout the industry.

Although we are all competing, we have an obligation to work collaboratively to make our industry better. The next regulatory land mine might affect you more than you think.

Todd J. Pack (todd.pack @btadvisers.com) is president and chief operating officer of Financial Advisers of America.

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