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Dropping the Ball in AML Compliance Testing

Another instructive AML disciplinary action reveals more of FINRA’s expectations for the independent testing process for AML compliance programs (“AMLCP”).

Recently, FINRA censured and fined a firm and its Chief Compliance Officer, jointly and severally, $15,000 for certain failures in its AML Program and Independent Testing. As this was an identical disciplinary action toward the same firm in 2 years, the firm must provide FINRA copies of the annual independent testing reports for this year and the previous 2 years. The fine this time around was increased by a factor of 3. All totaled, this firm has shelled out $20,000 in fines for essentially identical violations.

In the first disciplinary action, the firm was censured and fined because it failed to conduct and evidence an independent test of its AMLCP for calendar year 2008. In the second instance, FINRA found that the firm did not conduct and evidence an adequate independent test of its AMLCP.

In this second go-around, the firm delegated the “independent testing” to the Public Finance Co-Manager. Given the findings, however, it appeared that the person chosen for the independent testing did not have a working knowledge of the applicable requirements and implementing regulations under the Bank Secrecy Act, which is a pre-requisite of anyone who undertakes to conduct such testing. FINRA chose not to sanction that person in this case and limited the individual action to the firm’s CCO, who was also the AML Compliance Officer responsible for administering the program and ensuring the adequacy of the independent testing.

FINRA’s findings in this disciplinary action are instructive and, frankly, astonishing. The inadequacies in the testing were as follows:

The review was limited to only one branch office instead of sampling transactions at all branch locations.

  1. Transaction sampling at the branch was limited to deposit slips.
  2. The testing did not review or test the firm’s AML procedures or make an assessment of the AMLCP’s adequacy for the firm.
  3. The Customer Identification Program (“CIP”) was likewise not reviewed or assessed, nor did the testing review whether the firm’s registered representatives were complying with its CIP.
  4. The testing did not include any review of the AML training program, its adequacy, and whether the firm’s registered representatives complied with the annual training program.
  5. The firm did not review samples from all of its business lines.
  6. The test failed to review for the movement of funds that were previously deposited in accounts.

Take this case and use it to assess your independent testing process and be sure you’re doing adequate sampling and comprehensive assessment of your AMLCP. FINRA expects firms to have a robust and well-tailored program to fit the firm’s businesses. Gone are the days of reviewing the AML policy against the FINRA template to ensure completeness and writing up a report. FINRA expects robust testing of transactions and procedures by a well-qualified independent party. Please feel free to contact me at ddawe@wnj.com, or any other member of our group, if you have any additional questions or if you think you might need to review your independent testing process at your firm.

Resources for CCO and Compliance Staff

Recent Security and Exchange Commission (“SEC”) examinations of investment advisers have again focused on the knowledge and authority of the Chief Compliance Officer (“CCO”).  Rule 206(4)-7 requires investment adviser firms to designate a supervised person as CCO.  In addition, the SEC states in Release No. 2204, that in order for the supervised person to compel others to adhere to the compliance policies and procedures they must be in “a position of sufficient seniority and authority within the organization.”  For many firms, the CCO has other managerial responsibilities and, therefore, is challenged to stay informed on the ever changing regulatory environment.  The CCO continues to require support to implement effective policies and procedures that adequately monitor the firm’s policies and procedures.

Some resources to help the CCO, compliance staff and firm employees identify and manage risks and determine appropriate compliance controls may be found below.

  • Subscribe and read the Warner Norcross & Judd LLP Compliance Corner Blog http://compliancecorner.wnj.com/
  • Bookmark and periodically visit the SEC’s website http://www.sec.gov/divisions/investment.shtml
    • Review Staff Guidance and Studies
    • Review recent No-Action and Interpretive Letters
  • Join the National Society of Compliance Professionals (“NSCP”) a non-profit organization that provides support to compliance professionals in the securities industry.  Membership benefits include:
    • Access to webinars, regional and national conventions
    • Subscription to NSCP Currents, a bi-monthly compliance journal
    • Additional information may be found at http://www.nscp.org/.
  • Attend the NSCP’s National Conference October 22 – 24, 2012 in WashingtonD.C.  https://www.eiseverywhere.com/ehome/42305
    • Conference will cover over 80 topics for compliance professionals at IA, BD, Hedge Fund/Private Fund and Investment Companies.
    • Workshops applicable to small and large firms
    • CCOs and other compliance professionals will benefit from relevant information.

Contact any member of the Broker Dealer/Investment Adviser Practice Group at Warner Norcross & Judd to see how we might assist you with your compliance matters.

Mid-Sized Advisers – Don’t Forget the Switch

NASAA is reminding mid-sized  investment advisers eligible to switch from federal to state registration, that have yet to switch, to contact their state securities regulator to begin the process.

Read the full article here.

Retirement Plan Service Provider & Investment Fee Disclosures: More Work To Be Done

U.S. Department of Labor (DOL) regulations require that retirement plan service providers whose fees are paid directly or indirectly from a plan make disclosures of their fees by July 1, 2012. Then, plan sponsors must make disclosure of plan level and individual investment fees and performance to plan participants by August 30, 2012.
Evaluation of Service Provider Disclosures Required
Plan sponsors cannot simply review and file the provider disclosure. The prohibited transaction rules require that the fees be reasonable. In addition, the regulations require that the provider disclose its fiduciary status. To fulfill their duties, plan sponsors must perform at least the following four tasks:
  1. Confirm that all service providers have made the required disclosures. If a service provider that receives at least $1,000 in fees has not made a disclosure, the plan sponsor must demand a disclosure within 90 days and, if it is not provided, notify the DOL of the failure. The plan sponsor should also review the disclosure to confirm that it meets all of the regulatory requirements and provides sufficient information for the sponsor to determine if the fees are reasonable for the services provided. If it does not, the plan sponsor should request the items needed for complete disclosure. If the provider does not provide any requested disclosures, the sponsor may have to terminate the relationship.
  2. Determine the provider’s fiduciary status.  Particularly if the provider is receiving fees related to investment advice, there is no legal or practical reason that the provider should not have acknowledged its status as a fiduciary. If the provider attempts to avoid that status, the plan sponsor should evaluate whether the relationship should continue.
  3. Compare the disclosed fees with contractual or promised fees.  The fees should not be different from those disclosed in the provider’s service agreement or be used to secure the business. If the fees paid exceed the amount agreed upon, the plan sponsor should request a return of the excessive fees.
  4. Determine whether the fees are reasonable. The prohibited transaction rules require that a provider’s fees be reasonable for the services provided. The preferred method to make this determination is to engage an independent benchmarking service to compare the fees charged in light of the services provided against all plans of similar size and characteristics.
Unanticipated DisclosureRequirements for Brokerage Windows
The original investment fee disclosure requirements applied largely to “designated investment alternatives.” Many plans include an opportunity for participants to leave the designated investment menu and select individual investments through brokerage accounts. Most observers believed that the investment specific disclosure requirements did not apply to these brokerage windows.The DOL turned these assumptions on their head in a series of Questions and Answers issued on May 5, 2012. Q&A 13 requires a general disclosure of basic information regarding the brokerage window – how the window works, to whom to give investment  instructions, any account balance requirements, trading restrictions and whom to contact with questions.

At the fee level, the description must disclose: any start-up fee; ongoing fee or expense; and commissions charged for purchases and sales of securities including sales loads. The statement should advise participants to ask the provider about all investment related fees. Moreover, the participant must be provided a quarterly statement of fees actually charged against the account for the preceding quarter. Q&A 30 indicates that any window that offers more than 25 investment alternatives must provide the designated investment alternative fee information for: (1) at least three investment alternatives: equity, fixed income and balanced; and (2) every other investment in which at least the greater of five participants or 1% of all participants are invested.

Because these disclosures are required by August 30, 2012, plan sponsors should act immediately to:

  1. Identify any brokerage windows provided;
  2. Contact the broker that provides the window requesting the information necessary to meet the general disclosure requirements;
  3. Work with the broker to identify the three investment alternatives that will be utilized to meet the detailed fee disclosure requirements; and
  4. Work with the broker to identify those investments in which the greater of five participants or 1% of all participants were invested and to collect the information needed to satisfy the detailed fee disclosure requirements.
A failure to meet or review the disclosures not only risks a violation of the prohibited transaction requirements but also claims of a breach of fiduciary duties by the DOL and plan participants. A plan sponsor’s work must begin and be completed to mitigate these risks.

Pay to Play Provisions Compliance Date Extended

The SEC has extended the compliance date of the “Pay to Play” third-party solicitor provisions of the Investment Advisers Act from June 13, 2012, until nine months after the compliance date of the final rule when the Commission will adopt regarding municipal advisor registration.  The expected date for the municipal advisor registration rule is September 30, 2012.

The Pay to Play rule places a two year ban on investment advisers from providing “advisory services for compensation” after the adviser, or certain employees, make contributions to elected officials or candidates. The adviser and certain employees are also prohibited from paying a third party to solicit “advisory business from any government entity” unless such third-party is an SEC-registered investment adviser or a registered broker or dealer subject to pay to play restrictions.

Although, the compliance date has been extended, many states and local municipalities have adopted regulations regarding how advisers may solicit advisory business from government entities. Further, the SEC Pay to Play rule does not preempt those regulations and your local rules may already apply – and those laws may be more restrictive as to time banned and to the amount contributed. Further, under certain state laws, investment management activities provided to government entities could be considered lobbying and may require registration as a lobbyist, which could involve additional reporting and disclosure requirements, ethics training, and more fees. Among those states are: California, New York, Ohio, and Texas. Failure to register as a lobbyist could result in a fine, and possible loss of SEC safe harbor exemptions.

If you have questions about your compliance obligations, please contact any member of the Broker Dealer/Investment Adviser Practice Group at Warner Norcross & Judd.

Service Provider Fee Disclosures – Are You Ready?

The compliance date for the final service provider fee disclosure regulations under ERISA Section 408(b)(2) is July 1, 2012. That is when registered investment advisers (RIAs) and broker dealers (BDs) must disclose certain information to the responsible plan fiduciary, including services provided to the covered plan, fiduciary status and direct and indirect compensation.

We suggest RIAs and BDs take these seven steps right now:

1. Identify affected accounts
2. Determine identity of responsible plan fiduciary to ensure delivery to appropriate person
3. Determine the types of services being provided and the applicable disclosure requirements
4. Determine where and how to obtain disclosure data.
5. Develop an approach for meeting compliance deadline
6. Establish procedures for communicating any changes to disclosures – an amended Form ADV may be sufficient
7. Reconcile services provided with errors and omissions coverage

Click here to read an article with additional information about the requirements and the steps that must be taken to remain in compliance. Failure to comply can result in a 15% excise tax.

If you have questions about the disclosure regulations or need help with compliance, please contact Lisa Zimmer (lzimmer@wnj.com or 248.784.5191) or any other member of the Broker Dealer/Investment Adviser Law and Regulation Group at the law firm of Warner Norcross & Judd.

“Heads Up” from Recent Routine FINRA Examination Document Request

Spring is in the air and FINRA’s 2012 B-D inspections are in full swing. The other day, we received word from a client of a particular document request that merits a “heads up” to broker-dealers with regard to certain records and supervisory systems for subaccount transfers within variable annuities.

FINRA asked for an activity log or trade blotter of all subaccount transfers.  In the alternate, if the firm didn’t keep such a document, FINRA asked for a written statement from the firm as to how subaccount transfers are monitored and the associated documentation evidencing review by firm personnel.

Asking around, we noticed more than a few firms who don’t routinely capture or supervise and monitor these variable annuity subaccount transfers.

This recent FINRA examination document request serves as a good reminder to firms that those variable annuity subaccounts are each separate securities, just as is the case with each mutual fund within a mutual fund family. Both FINRA and SEC books and records rules require that each such securities transaction, especially those initiated or recommended by registered representatives, be included in the firm’s trade blotters, including those done on a direct-way basis (i.e., that don’t go through the automated record-keeping processes of a clearing firm). Additionally, it also means that the firm has a duty to supervise the blottered trades and monitor for suitability, just as with any other security recommended by a representative.

Certain variable annuity products have automatic asset allocation and rebalancing programs for subaccounts. Since these are initiated by the insurance company’s own systems and bypass the representative, they don’t need to be recorded since they weren’t initiated or recommended by the representative. Of course, the initial suitability review of using such an automatic system for a given client is still required, but out of the purview of this current topic.

So you’re not blind-sided by any similar future regulatory request, we’d recommend a review of your written supervisory procedures to assess the adequacy of the supervisory systems and related recordkeeping for internal subaccount transfers. And if you’re not also capturing mutual fund exchanges, we’d urge a similar review for those.  Please feel free to contact me at ddawe@wnj.com or any other member of our group if you have any additional questions or comments.

New SEC Exam-Related Guidance Available

New SEC Investment Adviser Guidance

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) has made publicly available on OCIE’s webpage two new resources providing guidance about changes in its objectives, operations, as well as trends in examination deficiencies:

National Exam Program Overview.  This 45 page internally-generated SEC report describes OCIE’s “self-assessment” and related changes in its strategy, structure, people, process, training and technology improvements in its examination program to address, among other things, the Dodd-Frank Act’s redesign of investment adviser regulation.

The report includes a description of OCIE’s inspection process (Part II) and a summary of recent enforcement actions against investment advisers (Part I).  Current IA, BD, and investment company compliance issues and 2012 examination priorities are highlighted in Part III of the report.

OCIE has established an Office of Risk Assessment and Surveillance to evaluate risks, both in markets and in registrants.  New risk-assessment tools have been developed and more training is being provided to IA examiners.  Other exam program improvements are described, including a new alignment of OCIE’s national exam program leadership.  OCIE expects to issue more Investor Risk Alerts and sweep examination reports in 2012.

National IA Compliance Outreach Program.  This day-long webcast can now be watched for free at your convenience on the SEC’s website.  The program aired on January 31, 2012, and its agenda included these topics:

Compliance and Enterprise Risk Management

  • How risk management and compliance intersect
  • How CCOs can engage operational units
  • Documenting, reporting, and attesting to control activities

Trading Practices

  • Risk management – insider trading issues
  • Protecting confidential investment information from misuse
  • Using expert networks, affiliations, relationships, and consultants
  • Using Alpha capture systems
  • Aligning risks to identify:

–   Potential insider trading (Section 204a) issues

–   Misuse of material non-public information

–   Insider trading

  • Control Activities – detection tools

Dodd-Frank Wall Street Reform and Consumer Protection Act

  • Rules implementing the Dodd-Frank IA amendments
  • Transition of mid-sized advisers to state registration
  • Private fund advisers – registration and/or reporting
  • Collaboration with other regulators

Enforcement-related matters

  • SEC Enforcement Division’s Asset Management Unit
  • Enforcement trends and lessons
  • Enforcement against CCOs
  • National exam program changes

Safety and Soundness of Client Assets/Custody

  • Lessons learned under the SEC’s Custody Rule
  • Asset verification within the national exam program
  • Terminated funds and funds-of-funds custody issues

In 2011, the OCIE hosted the CCOutreach Broker-Dealer Program addressing a wide range of broker-dealer compliance topics.  A recording of that webcast is available on the SEC’s website.  These materials could be useful in planning your firm’s next continuing education program.

Should you have any questions about these new SEC resources, please do not hesitate to contact any member of the WN&J Broker-Dealer and Investment Adviser Practice Group.

SEC Announces Members of New Investor Advisory Committee

As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC has formed a 21-member committee to advise the Commission and among other things “help promote investor confidence and integrity of the securities marketplace.”  Read the full press release http://www.sec.gov/news/press/2012/2012-58.htm

FINRA Proposes Rule Changes Expanding the Scope of Simplified Arbitration

FINRA recently filed proposed rule changes with the SEC regarding the simplified arbitration procedures contained in the Customer and Industry Codes of Arbitration Procedure.  The proposed rule changes raise the limit for simplified arbitration from $25,000 to $50,000 and provide a more streamlined arbitration process for a larger scope of arbitration claims.

Currently, Rules 12401 and 12800 of the Customer Code and Rules 13401 and 13800 of the Industry Code provide for simplified arbitration procedures for any claims where $25,000 or less, exclusive of interest and expenses, is at issue.  Among other differences, the simplified arbitration procedures set out that one, rather than three, arbitrators will be appointed to decide the claim, the claim will be decided without a hearing based on the written materials submitted by the parties, unless the customer in a customer case or the claimant in an industry case requests a hearing, and the discovery procedures are more streamlined.  If FINRA’s proposed rule changes are approved, the $25,000 threshold will be increased to $50,000 and an increased number of claims will be subject to the simplified arbitration procedures.

According to the FINRA materials regarding this rule proposal, FINRA’s purpose in proposing these rules changes is to reduce the costs and fees associated with pursuing a FINRA claim and make the arbitration process more inexpensive and less burdensome for claimants raising small dollar claims.  The proposed rule changes are currently before the SEC but have not yet been approved.

If you have questions regarding FINRA’s proposed rule changes or the arbitration procedures, feel free to contact me.

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