Broker/Dealer Remote Office Supervision – South Florida FINRA Arbitration and Regulatory Attorney

Remote Office Supervision

This post is designed to provide a summary of various rules and regulations requiring the establishment and enforcement of supervisory responsibilities over remote activities of a firm’s business activities. It is being presented for educational purposes only and thus, is not designed to be complete in all material respects. If you have any questions, you should contact a qualified professional.

Introduction

The Securities and Exchange Commission has provided guidance relative to “Remote Office Supervision.” Sections 15(b)(4)(E)1 and 15(b)(6)(A) 2 of the Securities Exchange Act of 1934 (Exchange Act) authorize the Commission to impose sanctions on a firm or any person that fails to reasonably supervise a person subject to their supervision that commits a violation of the federal securities laws. Section 15(b)(4)(E) also provides an affirmative defense against a charge of failure to supervise where reasonable procedures and systems for applying the procedures have been established and effectively implemented without reason to believe such procedures and systems are not being complied with. The Commission’s policy regarding failure to supervise is well established. The Commission “has long emphasized that the responsibility of broker-dealers to supervise their employees is a critical component of the federal regulatory scheme. A broker-dealer must develop a system for implementing its procedures that could reasonably be expected to prevent and detect securities law violations. In addition, a broker-dealer must have an appropriate system of follow-up and review if red flags are detected. However, establishing policies and procedures alone is not sufficient to discharge supervisory responsibility. It is also necessary to implement measures to monitor compliance with those policies and procedures.

Some broker-dealer firms have geographically dispersed offices staffed by only a few people, and many are not subject to onsite supervision. Their distance from compliance and supervisory personnel can make it easier for registered representatives (representatives) and other employees in these offices to carry out and conceal violations of the securities laws. The supervision of small, remote offices, therefore, can be especially challenging. The Commission staff has examined branch offices and the Commission has brought numerous enforcement cases involving inadequate supervision of these small, remote offices. These cases address situations in remote offices where supervisory mechanisms failed to detect and prevent misconduct.

Policies and Procedures

Clearly articulated and vigorously enforced policies and procedures, with sufficient resources to implement them, are an essential part of a supervisory system for remote offices. Comprehensive policies and procedures address all aspects of a remote office’s operations. The following policies and procedures may form part of an effective supervisory system.

Inspections. Inspections are a vital component of a supervisory system. The Commission has determined that broker-dealers that conduct business through remote offices have not adequately discharged their supervisory obligations where there are no inspections of those offices. Effective inspections can detect misconduct in its infancy, deter future wrongdoing, and prevent or mitigate investor harm. An effective supervisory system employs a combination of onsite and offsite monitoring, including the use of unannounced inspections and mechanisms for verifying that deficiencies are corrected.

Routine or “For Cause” Inspections. Onsite inspections usually take one of two forms: routine or “for cause.” Routine inspections are conducted in the ordinary course of business, while “for cause” inspections are conducted upon learning about a specific event or potential violation. It is suggested that all inspections include at least: (1) a review of a sampling of customer files, including account opening documents and trading records; (2) a review of the signature guarantee log; (3) a review of correspondence, advertisements, and sales literature made available at the remote office; (4) a review of business records, including physical and computer files; (5) in-person questioning of the representative by the supervisor about business activities, including inquiry about any unusual activity; and (6) in-person interview by the supervisor of the representative’s assistant or support staff, if any, about the remote office’s business and any unusual activity. If during the course of the examinations deficiencies are identified, examiners should consider the need to conduct a more in-depth review.

Unannounced Inspections. Routine or “for cause” inspections may be either announced or unannounced. Unannounced inspections are conducted on a random, surprise basis. Firm’s are encouraged to use unannounced, onsite inspections of remote offices to enhance supervision. They can deter and detect misconduct because they diminish the opportunity for concealment, removal, or destruction of the evidence of misconduct.

In addition, a supervisor is more likely to uncover evidence of misconduct in customer files, such as fictitious account statements, during an unannounced inspection than in an announced inspection that gives the representative an opportunity to remove such documents from customer files. An unannounced inspection might also reveal marketing materials that describe unapproved products, local billboards with unapproved advertisements, or customer account statements showing purchases of unapproved securities.

Unannounced inspections could be employed at random, as well as when triggered by “red flags” warning of potential misconduct. When indications of impropriety reach the attention of those in authority, they must act decisively to detect and prevent violations of the federal securities laws. Red flags that could suggest the existence or occurrence of illegal activity and might prompt an unannounced inspection include: (1) customer complaints; (2) a large number of elderly customers; (3) a concentration in highly illiquid or risky investments; (4) an increase or change in the types of investments or trading concentration that a representative in a remote office is recommending or trading; (5) an unexpected improvement in a representative’s production, lifestyle, or wealth; (6) questionable or frequent transfers of cash or securities between customer accounts, or to or from the representative; (7) the disciplinary history of the representative; (8) substantial customer investments in one or a few securities or class of mutual fund shares that is inconsistent with firm policies related to such investments; (9) churning; (10) trading that is inconsistent with customer objectives; or (11) significant switching activity of mutual funds or variable products held for short time periods. It is equally important that representatives do not obtain advance notice about a particular focus of an inspection. Advance notice of the focus affords representatives an opportunity to “doctor” particular records.

Offsite Monitoring of Trading, Handling of Funds, and Use of Personal Computers. Centralized technology to monitor the trading and handling of funds in remote office accounts, as well as the use of personal computers, helps detect misappropriation of customer funds, selling away, and unauthorized trading, among other things. Thus, if firms permit communications with customers from employees’ home computers or personal computers not connected to the firm’s network, SRO rules require firms to employ systems to monitor those communications.

Designate supervisory responsibility. Explicit delineation of the supervisory hierarchy, including the designation of a direct supervisor for each representative and the assignment of specific supervisory responsibilities to the supervisor, is a necessary part of a firm’s supervisory structure. Consideration should be given to the independence of supervision when supervisory responsibility is designated. For example, one factor firms should consider is whether the supervisor stands to benefit from the representative’s sales activities. No individual can supervise themselves. As with all supervisory procedures, the Commission has stated that firms should provide a system of review and follow-up to ensure that supervision (by a branch manager or a producing manager) is diligently exercised. The Commission also encourage firms to review the number of representatives for whom a supervisor is responsible as well as the number, nature, and extent of remote offices that an office of supervisory jurisdiction oversees. The degree of supervisory effectiveness is likely to decrease if a supervisor does not have adequate resources to oversee all of the representatives for whom he or she is responsible.

Carefully review FINRA Forms U-4 and U-5 when hiring representatives. Firms should be especially cautious about employing personnel with disciplinary histories. Where a representative with a disciplinary history is employed in a remote office, the Commission has repeatedly emphasized the need for heightened supervision of the representative. Where a representative has left a firm for cause or changed firms several times, the hiring firm should try to ascertain the reason for the changes and contact prior firms as necessary.

Closely monitor outside business activities and selling away. A firm should have adequate procedures for reviewing, analyzing, or following up on the information representatives provide concerning outside activities.46 In addition, a firm should be alert to and investigate “red flags” indicating possible undisclosed outside business activities and assess all outside business activities by a representative, whether or not related to the securities business. The Commission has recognized that there is a risk that representatives will use outside business activities to carry out or conceal securities law violations. A representative appearing to live more lavishly than his business income would allow might be a “red flag” indicating pursuit of improper or outside business activities. Additionally, it is suggested that firms be wary of a representative who owns a company with a name similar to the name of the firm. A customer may make a check payable to the firm that could be altered by a representative and deposited into a bank account in the name of the company he owns.

Implement procedures to detect financial misconduct. It is suggested that firms consider implementing procedures to prevent and detect the following improper activities: (1) the receipt of checks made payable to a representative or any outside business of a representative; (2) the opening of a bank account in the firm’s name or any name similar to the firm’s name by a representative; (3) the receipt of cash and securities by a representative; (4) frequent or questionable transfers of funds or securities between customer accounts; (5) use of a post office box or an address associated with the representative for customer accounts; and (6) the transfer of customer funds or securities to employee accounts without supervisory approval. Inspections and thorough investigations of customer complaints can help detect financial misconduct.

Education for representatives. It is incumbent on firms to provide representatives with training so that the representatives understand the responsibilities under the firm’s procedures, as well as under the securities laws and rules applicable to their business. As with all compliance and sales practice matters, firms are more likely to prevent misconduct if they provide training for representatives and periodically reinforce that training.

Monitor and verify customer address changes. SEC rules require firms to send notification of a change of address to a customer’s old address for each account with a natural person as a customer or owner. This verification enhances customer protection, and we encourage firms to send such verifications for all customer address changes. Moreover, a customer address change to a post office box or an address affiliated with a representative warrants additional steps to verify that the change is genuine.

Record use of the signature guarantee stamp. A firm should have procedures to deter misuse of the signature guarantee stamp to prevent forgeries. These procedures might include maintaining a log of all uses of the stamp and using a stamp with a counter that records each use of the stamp.

Maintain copies of and review incoming and outgoing correspondence. The Exchange Act and rules thereunder require firms to maintain copies of incoming and outgoing correspondence, while SRO rules require firms to review and retain such correspondence, including all documents, reports, profit and loss statements, e-mails, or other materials sent to customers by a representative or received from customers. Firms can enhance the effectiveness of their inspections by reviewing e-mails between representatives. One method of monitoring use of facsimile machines in remote offices is to program these machines to automatically send duplicate incoming and outgoing facsimiles to an office of supervisory jurisdiction.

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