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Regulation and Compliance > State Regulation

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With changes afoot on everything from e-mail archiving to breakpoints to money laundering and the Patriot Act, independent broker/dealers have to be nimble. Into the mix of corporate scandals, clients still smarting from losses in the recent bear market, and a proliferation of lawsuits and arbitrations, inject the crusading efforts of New York State Attorney General Eliot Spitzer, and the rush by the NASD and the SEC to head off any more blows to the morale of the investing public. The result is a hypersensitive atmosphere in which new rules are issued with a frequency that makes it almost impossible for industry professionals to keep up with them all. But keep up they must; there is no other option if you want to remain in business. The good news is that a well-run, well-funded, and, most important, well-staffed compliance department can not only ease the regulatory pain but also make it more likely you’ll prosper in this new atmosphere.

First, the Bad News

New regulations are being issued with such frequency that Karen Eyster, chief compliance officer at NEXT Financial, a broker/dealer based in Houston, says she could spend “all day, every day, just reading up” on regulatory changes. The additional work and expense generated by the new regulations is causing serious problems for some B/Ds and reps alike, and keeping others on their toes.

Dennis Kaminski, chief compliance officer at Mutual Service Corp., a B/D based in West Palm Beach, Florida, sees the situation as a “Perfect Regulatory Storm.” The first element he cites is an increase in the SEC’s budget that he says has led to a “knee-jerk reaction” to Congressional inquiries and a devotion of those increased resources to “their surveillance of B/Ds and RIAs.” Next, he points out that many people believe that a major rule is needed to police the minority of B/Ds causing problems; this then penalizes the majority of B/Ds “who are relatively good and clean firms.” Another factor, he says, is the fact that state attorneys general who levy large fines on offending firms can fatten their state treasuries, making themselves look good politically at the same time. To complete the picture, he reminds everyone of the ads of “fly-by-night attorneys” encouraging people to sue their brokers to try to recover market losses.

Tom Delaney, chief brokerage officer and chief compliance officer at Brecek & Young, a B/D in Folsom, California, adds that “regulators are not giving a whole lot of guidance.” Their approach, he says, is to “keep their cards close to the vest and see what opportunities [they] have to catch [firms] asleep at the wheel.”

That Was Then

One of the major challenges faced by broker/dealers is that the old ways of compliance are no longer sufficient. Dale Brown, head of the new Financial Services Institute, the B/D organization spun off from the Financial Planning Association, says that members are frustrated by perceived “retroactive arbitrary enforcement of rules that didn’t exist at the time the alleged behavior occurred.” He points to the regulatory focus on mutual fund B share suitability as an example. “Suddenly there’s intense scrutiny, while for several years it seemed to be perfectly suitable for investors investing $100,000 or even $250,000.” He cites this as an example of something that was “acceptable under the rules a few years ago [and is now] suddenly not. It’s a real problem.”

The NASD declined to comment in time for this article on its actions or approach to regulation.

Brown noted that it’s no secret that B/Ds have been an important distribution channel for the mutual fund industry, and the funds have been an important part of the B/Ds’ revenue stream. “The whole breakpoint exercise and the proposals for making mutual fund investment more transparent cost more,” he points out. The concern, Brown says, is the cost of putting in systems to comply with the new rules, though even then, he worries, “Will we even be able to be sure we are compliant?”

Nancy Johnson of Strategic Compliance Concepts in Lanark, Illinois, a compliance coach, agrees. “Regulators need to be careful not to enforce rules that weren’t in force at the time the activity occurred. It makes it impossible to do our jobs as compliance professionals–or as B/D management–correctly.”

Carla Wright, chief compliance officer for Signal Securities, a B/D in Fort Worth, Texas, believes regulators and legislators are being unrealistic, and making it difficult for folks in the financial services industry to make a living. She cites as an example 12(b)-1 trails. “People have spent a lifetime building those as retirement income, and what’s really frightening is that they could take that away from them.”

Then there’s the business continuity plan, a requirement that broker/dealers have a written plan that addresses how they will continue to function in the event of a disaster that disrupts their normal business operations. Nancy Lininger of The Consortium, a compliance consulting firm in Camarillo, California, points out that while “the NASD had this pending rule since 1999, and hadn’t passed it until recently, the expectation was that most firms should have it. They would look for it in an audit and ding you on it if it wasn’t there.” It wasn’t just B/Ds; advisors as well, she says, were being dinged by the SEC if it wasn’t in place (when the audit exam letter, or deficiency letter, was prepared, the absence of a plan would be cited as a deficiency, and B/Ds and advisors were required to respond and affirm that corrective action had been taken). This particular incarnation of the business continuity plan, however, was passed as part of compliance program rule 3510 of 2004, “to be effective for clearing firms 120 days after publication and 150 days after for other firms.” The rule was published in the Congressional Register on April 13, 2004, and will begin to take effect in August.

While most B/D firms have a head start on a business continuity plan, says Lininger, this rule requires that clients be given a document that specifies, among other things, where alternate sites are; how data is backed up; and how the B/D intends to respond to varying disruptions to business, whether the disruption is only to their own business, their own building, or citywide, regional, or greater–and not only whether it intends to do business again after the scenario takes place, but also how long it will take to get up and running. The summary, she adds, must also include a discussion on how clients will have access to their funds if the business is not running. “It’s one thing,” she says, “to give a custodian’s name and number; a summary of all the other stuff will be a whole booklet”–and this, of course, adds a great deal of expense.

More Than They Ever Wanted To Know

Dennis Kaminski says that the current rash of regulations is contributing to what he calls “information overload–of written materials, prospectuses, new account forms, privacy notices, and disclosure forms that now look like War and Peace.” He also argues that this has pushed the regulatory atmosphere to the point of diminishing returns. Information given to investors was once meaningful, he says, but is now “akin to reading a mortgage contract and signing or initialing forms a thousand times.”

In addition, he says, this has driven a wedge between advisors and their clients, damaging the trust built up over the years. “We hear from our financial advisors that customers are suspicious,” he says, “as to why they have to read and sign so many forms. Is it really to help educate them, or to better legally insulate the rep and B/D?” he asks.

Wright of Signal Securities agrees. “In several areas, there are new documents produced to tell the client what we’re doing,” she says, and inform them of potential problems regarding variable annuities, tax-qualified plans, and so forth. “We’ve had to create so many forms,” Wright says, “that the clients are starting to complain. We’re inundating the clients with information, and most of them don’t really care. We send them documentation and warning letters–whenever they open an account or make a transaction, we send more paperwork warning them of all the pitfalls–and we get complaints about it, but there’s not anything we can do. These are disclosures that are required. Clients hate them.”

Lininger agrees that the level of detail in such disclosures is in some cases inappropriate to the client. The business continuity plan, she says, takes information that was intended as an internal guide to get business up and running again and gives it to a client who has little or no understanding of the internal processes required for a B/D to do business.

Another example of a regulation that has added to the burden of advisors and investors alike, says Lininger, is the point-of-sale disclosure. POS disclosures spell out just what information a B/D must provide to a potential client, and when, concerning sales of mutual fund shares and the costs and expenses involved. While operating on the principle that investors need more information on costs and conflicts of interest on mutual funds, she says that the POS rule means that “confirmations are no longer going to be easy to read, and a prospectus is no longer a good disclosure document.” Not only that, but disclosures on investment objectives will now have to specify how the firm issuing the disclosure defines them, as in: “Here’s what I mean by ‘income.’” Anti-money- laundering disclosures will have to include information about customer identification procedures; mutual funds will have to include breakpoint disclosures. Regulators believe that it’s necessary to give consumers all this information so that they can decide which firm to invest with. While Lininger as a compliance consultant can usually appreciate the rules, she says, now it’s hard for her to keep up. “Some of these I don’t appreciate,” she says.

Talk Fast

Another problem with the flood of rules is the speed with which they are put into effect, says Dale Brown of FSI. He says that, as part of the organization’s ongoing efforts to look out for the interests of its B/D members, FSI has asked regulators to provide more time for comment on proposed rules. FSI is also encouraging members to become more active in the process, writing “thoughtful, meaningful comment letters on rule proposals” and meeting with regulators to educate them on the business. To do just that, FSI is alerting members about proposals that need their attention, so that they can focus on the most important issues and not have to wade through regulations that don’t apply to B/Ds. This is particularly important “in this environment of 21- to 90-day comment periods.”

Lininger agrees. “When the SEC or NASD publishes anything in the Federal Register, they give you 30 days to respond. That’s minus 10 days by the pub date. Since most people don’t read it on a daily basis, the comment period is usually over” by the time they find out about a given issue. “I would recommend that they still write past the comment period,” she says, arguing that if the regulators get enough comments before the deadline that people are working on responses, they will extend the comment period.

Commenting and thereby having some input on new regulations could save B/Ds a lot of money, too.

The Cost of Doing Business

Just keeping up with the proposed rules can be expensive. Art Grant, president of Cadaret, Grant, a B/D based in Syracuse, New York, says that his firm spends more on compliance each month than it did the month before. Mike Pagano, chief compliance officer at 1st Global in Dallas, Texas, which provides B/D services to tax and accounting professionals, says that in three years his staff has tripled, and his department’s budget this year is 2.3 times what it was three years ago. Tom Delaney at Brecek & Young says that when he came to the firm in February 2002, he was one of two compliance officers for a firm that had 456 producing reps. Now, he says, just a little over two years later, there are seven people in the compliance department: three officers and four support staff serve a rep population that numbers between 375 and 380.

Karen Eyster at NEXT argues that one of the most expensive compliance efforts had to do with a required breakpoint mailing. “NASD said we had to send a claim form to all our clients who bought A shares of mutual funds from January 1999 to early November of 2003,” Eyster says. “That had a big impact on our compliance budget.” NEXT has already budgeted for additional staff, she says, but the breakpoint assessment and the time spent on it were expensive. First NEXT had to scrub the data “so that the same clients weren’t getting multiple letters because they had multiple trades with us,” and then NEXT had to send out 80,000 letters. Even then, some were still duplicates, says Eyster: “We had some clients calling and saying, ‘I got three copies of this letter.’” For the past three months, she says, three of her staff were doing nothing but researching breakpoint claim forms. “They couldn’t do the other things they were supposed to be doing,” she points out. “We’re finally seeing the light at the end of the tunnel on that, but everyone’s six weeks behind on regular work.”

Then there’s fact checking to meet the requirements of the Patriot Act, which calls for verifying the identity of any person seeking to open an account, maintaining records to verify client identity, and determining whether any client’s or potential client’s name appears on any list of known or suspected terrorists or terrorist organizations. “It certainly can be very high cost if you buy one of the outside source vendors,” Eyster says, although it’s not cheap to do it in-house either because of man-hour expense. Vendors who do that sort of work, she explains, are similar to firms who do background checks and credit checks. “They charge anywhere from 17 cents to 47 cents a hit. If you’ve got 100,000, 200,000, or 300,000 clients, that’s expensive,” she points out.

Johnson adds that “additional compliance costs mean less revenue for the firm’s other services–and that may mean a decrease in personnel or services they offer to reps. It also means the B/D often has to put the focus of its compliance department on one topic to meet the demands of a ‘sweep,’ for example, the breakpoint issue, and pull resources from other important compliance topics, such as surveillance or training. Those areas get neglected and then the regulators catch ‘em on that–it’s definitely a very sharp, double-edged sword.”

So What’s the Answer?

As B/Ds work to find ways to comply with regulations while keeping reps and clients happy, they’ve come up with some solutions. One big one is the FSI; the new B/D organization is hard at work, says Dale Brown, helping members prioritize issues and get access to legislators. Although they are still “in startup mode,” says Brown, they’re busy adding members, getting sponsors, and working on helping members target important issues with letters and talking points.

Then there are compliance consultants and coaches, like Lininger and Johnson. They offer help such as forms, software, and other methods to help make sure businesses keep up with the regulators.

Jerry Singleton, president of Signal Securities, says that Signal has “completely reworked from cover to cover” its policies and procedures manual. Signal has also added compliance staff, adjusted operating procedures, and is archiving e-mails. Branch inspections have been made more in-depth and outside business activities are much more restricted than they used to be. Not only that, says Singleton, but reps looking to join the firm are screened more thoroughly; anyone with past compliance problems will have a tougher time of it.

Finding ways to pay for things without jeopardizing reps’ payouts or client costs is another challenge. Mike Pagano at 1st Global points out that it’s better for everyone concerned if a B/D can manage to spend on compliance without taking away from either other departments or from rep payouts, although he acknowledges that might be difficult. “It’s a fatal business decision not to fund compliance properly,” he says. “Often, unfortunately, resources that compliance needs have to be redirected from other areas. A mature company that has its revenue stream [already in place] has to slice the pie a little differently.” 1st Global, as a high-growth company, is able to allot more money to compliance without disrupting other areas, he claims. “Nobody’s getting resources taken away from them.”

Firms have added technology bells and whistles to help the process as well. Brecek & Young has standardized A share worksheets, software that prepopulates forms with client data, and an automatic e-mail system that notifies reps automatically whether filed paperwork is complete; Cadaret, Grant has improved its exception reports; 1st Global offers new point-of-sale disclosure forms; and NEXT Financial is using Investigo, an aggregation system that, according to Karen Eyster, allows better compliance reports and easier monitoring of an advisor’s methods.

B/Ds have also added educational conference calls, CE-creditable sessions, interactive Web training, and compliance conferences to help their reps learn how to be more compliant. There are more inspections of reps’ offices and there’s less tolerance for “selling away,” as B/Ds try to limit liability for actions not completely under their control. There are preapproved sales materials and brochures, so that reps have access to tools they can use right away and don’t have to wait for compliance approval on original materials.

There’s one thing observers and industry participants agree is most important in compliance: Getting the right people.

Roland Brecek emphasizes, “We have to commit the necessary brainpower to the full compliance mission as a firm. Other firms are relying on automated solutions,” he says, “and their solutions become their single point of failure, because they haven’t committed the brainpower behind it. We’re making sure we have staff on the compliance side to supplement [the automation].”

Nancy Johnson concurs. “Technology that sets up good compliance and surveillance reporting works if the person reading the reports knows and understands what they’re looking at. Training and education of all employees in a rep office and in a B/D work wonders. Often the person that can spot the red flag initially, such as the receptionist or secretary, doesn’t have any training to know what to do with it if she sees it.”

Art Grant argues that “a hostile compliance department will serve to suppress rather than reveal weaknesses.” Many times, he says, Cadaret, Grant will get calls from reps asking if a certain action is okay before they take the action. “I don’t think they feel defensive. We’re on their side,” Grant says, but stresses that “the best defense is being proactive, not reactive.”

One other aspect of the people element is an advantage enjoyed by B/Ds that know their reps well. “When people’s income drops, you have to be concerned about how they’re making payments and making a living,” says Grant. At Cadaret, Grant, he says, more time is spent with reps whose income is suffering. “One of the things you do in a bad market is keep an eye out for people who may be borderline desperate about earning a living,” says Grant, who notes that such sensitivity pays business dividends, too.

Dale Brown tells firms that they should recognize that the current regulatory scrutiny “is not going to go away for a while. It will make everybody’s life difficult.” Recognizing that, and being proactive, he says, will go a long way toward helping B/Ds get through the squeeze.

Marlene Y. Satter is a freelance journalist who can be reached at [email protected].


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