CURRENT SECURITIES REGULATORY COMPLIANCE ISSUES FOR INSURANCE COMPANY BROKER- DEALERS

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1 URRENT SEURITIES REGULATORY OMPLIANE ISSUES FOR INSURANE OMPANY BROKER- DEALERS INTRODUTION October Brussels Frankfurt Harrisburg London Los Angeles Miami New York Philadelphia Northern Virginia Pittsburgh Princeton Tokyo Washington

2 urrent Securities Regulatory ompliance Issues for Insurance ompany Broker- Dealers October 2000 Introduction Many insurance companies rely upon geographically dispersed representatives to offer their products. These representatives often are independent contractors and/or operate from small, local offices. ompanies that use this model believe that such an extensive and widely arrayed sales force provides a competitive advantage. They are seeking to leverage this advantage as they expand into markets for other financial services, such as the sale of mutual funds, variable annuities, and other securities products. Their insurance businesses allow them to maintain a presence in towns and neighborhoods that would not support a business based exclusively on the sale of securities. These companies also believe that the personal relationships they have forged through providing customers with traditional insurance products provide a foundation for the expansion of their businesses into these new areas. The SE, the NASD, and other securities regulators have scrutinized the sales practices and supervisory structures of these dispersed organizations. They also have expressed concerns that some of the products insurance companies offer through these organizations, especially variable annuities and variable universal life policies, have been the subject of potentially abusive sales practices. Insurance companies offering variable products through dispersed sales organizations sometimes have had difficulty adjusting to a securities regulatory environment. Some companies have had to revise their compliance programs, if not overhaul them completely in order to fit within the securities regulatory framework. This article reviews regulatory enforcement actions and other pronouncements that have particular significance for these companies. In particular, this article discusses a series of recent SE enforcement actions and the NASD s recent Notice to Members (July 2000). 1 We then suggest certain enhancements to compliance and supervisory programs that firms that use dispersed sales organizations to offer variable products may wish to evaluate. Firms should determine whether such enhancements are appropriate for their particular organization and adopt them as appropriate. 1/ NASD Notice to Members 00-44, NASD Reminds Members of Their Responsibilities Regarding the Sale of Variable Life Insurance (July 2000). This White Paper is published to inform clients and friends of Morgan Lewis and should not be construed as providing legal advice on any particular matter Morgan, Lewis & Bockius LLP

3 The Regulatory Perspective on Dispersed Sales Organizations: Prior Actions The SE and other regulators have taken the position that all securities firms should be judged against similar standards of investor protection. This presents a challenge to firms using dispersed sales organizations because it assumes a level of organizational control which they cannot (and do not wish to) duplicate. Although regulators have disavowed any bias against firms that use dispersed sales organizations, they appear to particularly scrutinize the activities of such firms. For example, the SE s Director of Enforcement, Richard H. Walker, recently said, As remote brokerage offices have proliferated in recent years, there have been too many failures in supervision. Investors are well served by effective supervision of these offices, including regular unannounced inspections. ustomers of these offices must be assured the full range of investor protections. 2 Until the SE s recent series of enforcement actions (discussed below), In the Matter of Royal Alliance Associates, Inc. (1997) 3 and In the Matter of NYLIFE Securities, Inc. (1998) 4 were the agency s leading statements on the compliance responsibilities of securities firms that use dispersed sales organizations. The Royal Alliance matter involved a broker-dealer that had approximately 2,700 registered representatives located in approximately 1,500 offices. Two of these representatives, acting independently of each other, allegedly defrauded their customers through a variety of schemes, including misappropriation of client funds, forgery, improper transfers among accounts and churning. The SE alleged that Royal Alliance had failed to supervise these representatives. In particular, the ommission asserted that Royal Alliance had failed to assign specific supervisory responsibility to individuals in the supervisory hierarchy and had failed to establish an adequate program of branch office supervision. The ommission s action focused on specific alleged deficiencies in Royal Alliance s compliance program, such as the firm s practice of conducting pre-announced inspections of its offices. Although the SE s order disavowed the suggestion that firms that employ diffused sales organizations cannot devise an adequate system of supervision, the ommission warned that such arrangements necessarily entail greater supervisory challenges. The ommission stated that it would require firms 2/ SE Takes Action Against Four Broker-Dealer Firms, Seven Associated Persons (Sept. 27, 2000), available at 3/ Exchange Act Release No , 1997 SE LEXIS 113 (Jan. 15, 1997). 4/ Exchange Act Release No , 1998 SE LEXIS 2000 (Sept. 23, 1998). This White Paper is published to inform clients and friends of Morgan Lewis and should not be construed as providing legal advice on any specific matter Morgan, Lewis & Bockius LLP

4 organized in such fashion to meet the same high standards of supervision as at more traditionally organized firms. Following Royal Alliance, regulators accelerated their scrutiny of firms which use dispersed sales organizations. In the NYLIFE Securities case, settled in September 1998, the ommission asserted that the company had failed to supervise two registered representatives, including one who worked in a one-person, off-site office, who had misappropriated funds from their customers. Specifically, NYLIFE Securities allegedly had failed to conduct surprise inspections of the off-site office, to review customer files and to ensure that the manager of the relevant branch office was diligently exercising his supervisory authority. The firm s supervisory procedures mandated that branch office managers interview annually each registered representative for whom they were responsible. The procedures also required that regional compliance officers conduct an annual inspection of each branch office. According to the SE, however, the procedures did not require the managers or the regional compliance officers to conduct further, more detailed reviews to confirm the representations made during the interviews or the information generated during the annual inspections. In particular, the ommission alleged that the firm s supervisory procedures did not require a review of customer files or other documents that, the ommission believed, would have detected the illegal conduct. According to the SE, because the firm scheduled inspections of off-site offices, the registered representative who worked off-site had the opportunity to purge his files of incriminating materials and advised his assistant to be out of the office on the days that the inspections were scheduled. The SE has issued several other opinions which further develop the themes articulated in Royal Alliance or NYLIFE. These include In the Matter of GKN Securities orp. (1997); 5 In the Matter of H. Beck, Inc. (1998); 6 In the Matter of PFS Investments, Inc. (1998); 7 In the Matter of FS Securities orp. (1998); 8 and In the Matter of James Harvey Thornton and Payne & Thornton (1999) 9. NASD Regulation also has been highly visible in this area, initiating several enforcement actions involving organizations with widely scattered operations. The most 5/ Exchange Act Release No , 1997 SE LEXIS 111 (Jan. 15, 1997). 6/ Exchange Act Release No , 1998 SE LEXIS 832 (May 1, 1998). 7/ Exchange Act Release No , 1998 SE LEXIS 1547 (July 28, 1998). 8/ Exchange Act Release No , 1998 SE LEXIS 2651 (Dec. 9, 1998). 9/ Exchange Act Release No , 1999 SE LEXIS 220 (Feb 2, 1999). Morgan, Lewis & Bockius LLP 3

5 significant of these matters was the NASDR s action, Pruco Securities orporation (1999) 10. The NASDR alleged that Pruco representatives had committed fraud and misrepresentations in the sale of variable insurance products. These alleged violations included: Allegedly inducing existing customers to purchase new policies by representing that the customers could acquire the new policies using the cash value of old policies when, in fact, the cash value of the old policies was insufficient. This resulted in the new policies eventually lapsing for non-payment of premiums; Allegedly misrepresenting that cash value generated by the policies eventually would be sufficient to pay the premiums, and that the customers requirement to pay premiums eventually would vanish; Allegedly misrepresenting the risks and investment purposes of variable insurance products (including misrepresenting such products as primarily investment vehicles rather than as insurance); Allegedly selling variable insurance products to clients for whom such products were not suitable. The NASDR also alleged that Pruco managers had encouraged at least some of these sales practices, and that the practices had become ingrained in the culture of Pruco s sales force. Indeed, the NASDR alleged that Pruco s sales force had simply disregarded memoranda and other materials advising that such sales practices were inappropriate. Finally, the NASDR alleged that Pruco had failed to respond to red flags indicating that its representatives may have acted improperly. According to the NASDR, these red flags included internal audit reports that noted instances of sales financed through the cash value of existing policies, the use of unauthorized sales materials, and customer complaints. The NASDR alleged that Pruco had failed to train its representatives adequately as to the need to carefully determine whether a given variable product was suitable for a given customer and to obtain basic client information to enable supervisors and principals to review that determination. The NASDR, importantly, attributed these alleged failures to structural issues involving the relationship between Pruco and its parent, the Prudential Insurance ompany of America. These issues concerned, among other things, the supposed lack of attention, within the Prudential organization, to the particular compliance and 10/ No. AF (July 7, 1999). Morgan, Lewis & Bockius LLP 4

6 supervisory requirements of a broker-dealer. The NASDR believed that Prudential and its employees had failed to differentiate between variable and more traditional insurance products and to appreciate the different regulatory issues associated with each. In addition to the NASDR s enforcement matters, the NASD s Notices to Members are instructive regarding the compliance and supervisory issues presented by dispersed sales organizations. In Notice to Members 98-38, 11 for example, the NASD reiterated that member firms must supervise each of their associated persons, regardless of their location, compensation arrangement, or registration status. The Notice continued: [A] large number of geographically diverse offices presents the potential that sales practice problems will not be as quickly identified as would be the case for larger, centralized branch offices. Such potential needs to be taken into account in drafting supervisory procedures. NTM interpreted NASD conduct Rule 3010, which requires securities firms to establish supervisory programs and to develop written procedures describing what individuals must do to effect those programs. The discussion in NTM of the need for a securities firm to tailor its supervisory system to the specific attributes of the firms business is pertinent to our discussion of dispersed sales organizations. Among the factors the NASD suggested a firm consider in tailoring its program are: number and geographic location of offices and personnel and existing reporting systems, operating units and organizational structures. The NASD advised that, in considering these factors, firms should evaluate, among other things, the availability, location and qualifications of registered principals and, where appropriate, representatives to be assigned supervisory duties. In particular NTM noted that some firms allow representatives to work from locations other than a registered branch, and observed -- in language virtually identical to that contained in NTM that a large number of geographically diverse offices present the potential that sales practice problems will not be as quickly identified as in larger, centralized branch offices. This increased potential must be taken into account when drafting supervisory procedures. The NASD suggested that firms maintain regular and frequent professional contact with individuals working from unregistered offices. Dispersed Sales Organizations: Recent SE Enforcement Actions On September 27, 2000, the ommission announced its most recent actions involving alleged failures to supervise dispersed sales organizations. The agency brought actions against four brokerage firms (as well as seven individuals associated with those firms) for purportedly failing to adequately supervise individual brokers 11/ NASD Notice to Members 98-38, NASD Reminds Members of Supervisory and Inspection Obligations (May 1998). 12/ NASD Notice to Members 99-45, NASD Provides Guidance on Supervisory Responsibilities (June 1999). Morgan, Lewis & Bockius LLP 5

7 working in small, remote offices. The actions against the firms shared many common themes: While the firms allegedly were on notice that each representative at issue had some form of disciplinary history, none of the representatives were subject to meaningful heightened supervision. The SE alleged that no one at the firms had ever conducted on-site inspections of the representatives offices. The firms allegedly failed to have effective branch office inspection programs. Deficiencies in their programs supposedly included failures to review customer files, verify annual attestations with respect to outside business activities, and conduct unannounced inspections. The ommission maintained that the brokerages written supervisory procedures did not adequately assign supervisory responsibilities to specific personnel. ompliance and other supervisory personnel allegedly failed to adequately follow up on potential violations and red flags that they did detect and often left it up to the representative who was the subject of the red flag to resolve the problem. The ommission alleged that two of the firms had failed to devote adequate resources to their supervisory systems in order for them to be effective. In fashioning the administrative opinions, the SE was unusually instructive about the steps that the firms supposedly could have taken to prevent the problems that occurred. For example, In re Prospera Financial Services, Inc. 13 involved two representatives -- one representative located in a one-person off-site office and another representative located at the firm s home office. Both were found to have engaged in various violative conduct, including misappropriation of customer funds and recommendation of unsuitable transactions. The SE found that Prospera s procedures: Failed adequately to provide for: delineation of supervisory responsibilities; heightened supervision of registered representatives who had a history of sales practice related complaints; monitoring of the off-site offices of registered 13/ Securities Exchange Act Release No (Sept. 26, 2000). Morgan, Lewis & Bockius LLP 6

8 representatives; monitoring of outside business activities of registered representatives; and a system of follow-up and review to ensure that supervision was being diligently exercised. The SE found particularly egregious the firm s supposed failure to conduct an examination of the office of the off-site registered representative. The ommission suggested that such an examination might have enabled supervisors to detect the existence of fictitious account statements, confirmations, correspondence, and checks to and from customers. An examination also might have enabled supervisors to observe and review records and activities related to other business activities conducted by the representatives. The SE stated that Prospera did not go far enough in supervising these activities because it was on notice of certain red flags indicating the possibility of illegitimate business activities (e.g., the off-site representative was suffering trading losses in his personal trading account that exceeded the income he received from the firm). In light of this red flag and the history of the representative s customer complaints, the SE stated that the firm should have required independent verification of such matters as the nature and extent of outside business activities and the representative s sources of income. In re Signal Securities, Inc. 14 involved much of the same alleged fact pattern as Prospera. Signal s sales force was comprised of a number of independent contractor registered representatives located in Texas and other states. After finding that a representative located in one of Signal s off-site offices misappropriated over $2 million in customer funds, the SE found that Signal lacked adequate supervisory and compliance procedures and failed adequately to implement procedures that were in place. According to the SE, although the firm divided supervisory responsibilities among the compliance department, line supervisors, and other principals, these procedures were supposedly ineffective because they failed to adequately assign specific supervisory duties among the parties. Similar to Prospera, the basis of the failure to supervise claim was Signal s alleged failure to supervise a registered representative, who supposedly had a history of compliance oriented concerns, whose off-site office had never been inspected by anyone associated with the firm, and who was engaged in outside business activities through which the representative largely concealed the misappropriation of customer funds. The SE noted that the representative s office was not a registered branch office of the NASD. Nonetheless, the SE emphasized that all business locations, registered or not, should be included in the firm s branch office review program and be visited on a regular basis. The SE also reiterated that an essential element of any business office review includes review of customer files and verification of any annual compliance questionnaire or attestation completed by registered representatives. 14/ Securities Exchange Act Release No (Sept. 26, 1000). Morgan, Lewis & Bockius LLP

9 With respect to outside business activities, the SE found that Signal did not go far enough to review the outside business activities of its registered representative. The SE stated that the firm had no procedures for reviewing, analyzing, or following up on information representatives had provided concerning their outside activities. Because this particular representative had been cautioned previously by the NASD about the very activity in which he supposedly had engaged (the misappropriation of customer funds), the SE found that Signal should have required independent verification of such matters as the nature and extent of outside business activities and [the] representative s outside sources of income. The other two cases announced by the SE on September 27, 2000, In re First olonial Securities Group, Inc. 15 and In re D.E. Frey and ompany, Inc. 16 involved alleged supervisory breakdowns similar to Signal and Prospera. First olonial, involved a registered representative with a disciplinary history who apparently converted over $1.33 million in customer funds for his own use. D.E. Frey involved three registered representatives who engaged in unauthorized trading, churning, wash trades, switching, and other abusive activities involving customer funds and securities. The SE found, among other things, that the firms failed to institute effective heightened supervisory procedures for representatives who had disciplinary histories and failed to conduct onsite reviews of registered representatives business offices. In the SE s view, First olonial and D.E. Frey also failed to devote adequate resources to make their supervisory systems work. The SE particularly stressed this point in First olonial: [The firm] failed to devote adequate resources to First olonial s supervision and compliance framework to keep pace with the considerable growth of the firm. Despite having grown from one office with three registered in 1989 to 24 offices with 150 registered representatives in 1998, First olonial employed only one person to devote only part of his time to compliance matters. That same individual was also responsible for supervision of all First olonial registered representatives who sold mutual fund shares and variable annuities, and also had his own customers. Thus, Prospera, First olonial, Signal, and D.E. Frey offer an unusual degree of guidance on effective supervisory measures for dispersed sales organizations, especially when read in the context of prior SE and NASDR enforcement actions and other pronouncements. 15/ Securities Exchange Act Release No (Sept. 26, 2000). 16/ Securities Exchange Act Release No (Sept. 26, 2000). Morgan, Lewis & Bockius LLP 8

10 The Regulatory Perspective on Variable Products To this point, this article has discussed some of the organizational issues applicable to broker-dealers that use dispersed sales forces. We now turn to issues applicable to the variable annuities, variable universal life and similar securities-based insurance products frequently offered through such organizations. The SE conducted a targeted review of sales practices related to variable annuities in late 1996 and early The SE found instances of churning, questionable contract exchanges, and transactions that resulted in excessive commissions but that provided no economic benefit to the clients. Lori Richards, Director of the Office of ompliance Inspections and Examinations, cautioned firms about what to expect from future SE examinations of sales practices relating to these products: You can expect that we will visit branch offices with a high rate of 1035 exchanges, a large number of customer complaints, a high level of internal switching between underlying funds or where home office supervision appears lax....firms must focus attention and resources on the critical area of internal controls.... [for] two good reasons: 1) To protect yourself against the unscrupulous conduct of employees in order to prevent, detect, and correct problems before they can hurt the firm; and 2) Because that s where securities regulators are going to focus their attention / Tracey Longo, Annuities Under Fire: Regulators Think It s Time to Take a loser Look at Who s Selling What and Why. Fin. Plannning, June 1, Morgan, Lewis & Bockius LLP 9

11 In another targeted examination program begun this year, the SE examined sales practices relating to bonus variable products (i.e., variable products that offer rebates to customers of 1-5% of the investment but that may have higher surrender charges, longer surrender charge periods, and higher asset based charges). 18 SE officials stated that they were specifically concerned about customers receiving full and fair disclosure with respect to these products and that the products were suitable. Paul F. Roye, the Director of the SE s Division of Investment Management, stated that the agency was particularly concerned in cases when a bonus is paid to an investor transferring funds from one variable annuity to another in a 1035 exchange where an investor at or near the end of a surrender-charge period takes on a new surrendercharge period as a result of the exchange. He also urged the industry not to wait for our inspections staff or NASDR to come knocking on your door with questions about bonus products. 19 In an action that emphasized its concern about the adequacy of disclosure to investors in this area, the SE recently issued an Investor Alert advising investors that they should consider carefully whether variable annuities should be part of their overall financial plans. The Alert cautions investors as to some common potential misrepresentations concerning such products, including the placement of such products in tax-deferred accounts, the effect of surrender and other charges on investor returns, replacements and "1035" exchanges and the offer of bonus credits as an inducement to purchase a variable annuity. 20 SE officials have stirred some industry controversy over who is responsible for detecting and preventing the types of misrepresentations and other sales practice abuses that are addressed in this Investor Alert. It is clear that a brokerage firm has the responsibility to supervise the sale of variable products by its representatives, whether or not the brokerage firm is owned by or affiliated with the issuer of the variable product. However, SE officials have signaled that they also intend to hold the issuers (e.g., insurance companies) of variable life and variable annuity products responsible for supervising the sale of these products. 21 For example, in June of 1999, the Director of the SE s Division of Investment Management summarized the agency s position on the matter: 18/ Joseph B. Treaster, Mutual Funds Report: In Some Annuities, Free Money (With Strings), N.Y. Times, April 9, 2000, Sec. 3, at 17. See also Ron Panko, an Annuities Pass Muster? Attorneys Take Insurance ompanies to ourt, Best s Review, No. 3, Vol. 101, at / Paul Roye, Remarks Before the National Association for Variable Annuities Regulatory Affairs onference (June 5, 2000), available at 20/ 21/ See i.e., Jeffrey S. Puretz and Michael Zuckerman, SE Position Will Burden Insurers, The National Underwriter, Life & Health/Financial Services Edition, Aug. 16, 1999, at 8. Morgan, Lewis & Bockius LLP 10

12 Whether a life insurance company has a captive or independent sales force, or distributes its products through other intermediaries, controls must be in place to prevent sales practice abuses to the greatest extent possible. Effective internal controls to prevent, detect, and correct misleading or abusive sales practices are essential, and will prevent irreparable harm to the company s reputation.... You can expect that the ommission s examination program will continue to focus on the sales and marketing activities of agents and the supervision they receive in the sale of variable products. 22 Following suit with the SE, the NASD has also addressed the supervision of the sale of variable products. For example, in NTM 99-35, 23 the NASD sets out certain supervisory guidelines for broker-dealers offering variable annuities. These include suggestions that a firm obtain customer information relevant to a determination that the investment is suitable for the customer, ensure that representatives understand the product (including fees and surrender charges), and apply particular scrutiny to replacement transactions. NTM 00-44, 24 issued in July 2000, provided similar advice regarding the sale of variable life insurance policies. The Notice recognized that variable life insurance may be appropriate for a customer with a need for life insurance and an ability to pay for permanent life insurance protection but cautioned that purchasers of variable life insurance should also be able to assume investment risk and understand the implications of adverse investment performance. With this admonition, the NASD suggested, among other things, that firms and representatives selling variable life policies should: Obtain comprehensive suitability information and document that such information has been obtained; 22/ Paul F. Roye, Variable Products: Industry Success, Industry Responsibilities, Speech at the National Association of Variable Annuities Regulatory Affairs onference (June 28, 1999). 23/ NASD Notice to Members 99-35, The NASD Reminds Members of Their Responsibilities Regarding the Sales of Variable Annuities, (March 1999). 24/ NASD Notice to Members 0044, The NASD Reminds Members of Their Responsibilities Regarding the Sale of Variable Live Insurance, (May 2000). Morgan, Lewis & Bockius LLP 11

13 Establish quantitative guidelines 25 as to whether a client can afford the premium associated with variable life policies; Establish special supervision requirements for sales to older customers; Adopt procedures that provide heightened scrutiny of replacement transactions, including procedures that flag representatives whose clients engage in a significant number of replacement transactions; Be prepared to justify a client s purchase of a variable policy where that purchase is financed through the cash value of another policy. 26 Both NTM and NTM describe supervisory and compliance procedures that, for the most part, are not particular to the sale of variable products and that most firms in the securities industry apply routinely. The fact that the NASD deemed it necessary to reiterate these principles in the context of variable products may indicate that the NASD believes that variable products, because of their complexity and the type of investor to which they are offered, present heightened supervisory and compliance challenges. How to Respond? Insurance company-affiliated broker-dealers that use dispersed sales organizations to sell variable products should strive to establish sound compliance and supervisory programs. Several hallmarks of high quality programs can be derived from regulatory enforcement actions and other pronouncements. Although these themes are common to most broker-dealers, firms that offer variable products through dispersed sales organizations, especially, should consider whether to implement them, because of the heightened scrutiny being exhibited by regulators. These themes include: A compliance-oriented culture A firm should strive to ensure that compliance is an important part of its corporate culture. The company should communicate enforcement directives effectively 25/ The Notice suggested that such quantitative guidelines could include: the ratio of scheduled or target premium to income or household income, or [the] percentage [of] scheduled or target premium to liquid net worth. 26/ The Notice stated: The NASD believes that the burden of demonstrating that such financed transactions are in the customer s best interests would generally be more difficult than for a routine sale of variable life insurance. Morgan, Lewis & Bockius LLP 12

14 throughout the organization. It should demonstrate to its employees that it takes such directives seriously and that they will be enforced. Senior management should be willing to provide leadership on compliance issues and take ownership of such issues until they are resolved. A firm can manifest the cultural aspect of an effective compliance program in several ways. First, it can establish a rigorous training program and develop a mechanism to track participation in the program. The program could include a testing mechanism to ensure that attendees understand the information being disseminated. Second, the firm can include compliance factors, such as incidents of customer complaints and participation in training programs, in performance and compensation evaluations. Third, the firm can attempt meaningful discipline of personnel who violate firm policies or regulatory requirements, regardless of their position within the firm or the volume of business they generate. The firm should send a clear and consistent message to its employees (and its regulators) that it will not give undue deference to large producers when it comes to compliance matters. In those situations where a regulator has ordered remedial action, such as the adoption of procedures recommended by an independent consultant, the firm should do so promptly. In In the Matter of Prudential Securities Inc. (1993) 27 for example, the firm, in the context of a previous proceeding, had agreed to implement a consultant s recommendation that its branch-office managers contact customers to determine the reasons for increased account activity. The firm failed to maintain this procedure, and senior management did not correct the failure when it came to their attention. The failure to contact customers contributed to some of the violations on which the subsequent proceeding was based, and resulted in an increased sanction. learly defined responsibilities A firm should strive to ensure that compliance responsibilities within the organization are clearly defined. Procedures should be well thought out and disseminated throughout the firm. The procedures should designate people at appropriate levels throughout the organization to effect those procedures. If senior management delegates responsibility, such delegation should be clear and effective. A brokerage firm can take steps to ensure that its written procedures are thorough and detailed. Employees, especially those in remote locations who may not have frequent contact with home-office compliance personnel, should not have to guess at what is expected of them in the compliance context. Similarly, these written procedures can designate persons who have enough clout within the organization to 27/ Exchange Act Release No , 1993 SE LEXIS 2866 (Oct. 21, 1993). Morgan, Lewis & Bockius LLP 13

15 ensure that the compliance program is carried out. One technique for such firms to consider is the establishment of a compliance committee, which could concentrate ultimate compliance authority in a small number of senior managers. Firms should also consider establishing a network of regional compliance offices to serve as a conduit between the home office and the branches. For certain organizations, such offices can be highly effective in responding to issues quickly and in disseminating home-office directives to the field. (In the Prudential Securities matter, the SE ordered the firm to adopt both the compliance committee and regional compliance office structures.) Flexibility and redundancy A firm should strive to develop a compliance program that is flexible and redundant. The firm should try to adapt its program as it evolves, responding to rapid growth, new personnel, and increasing decentralization. The firm s program also should have sufficient checks and balances to enable detection of problems if one aspect of the compliance program fails. Ensuring that their compliance programs are both flexible and redundant is especially import for firms that have experienced significant growth or that allow their remote offices substantial autonomy. In GKN Securities orp., 28 for example, the SE criticized the firm for not hiring a full-time compliance officer and other compliance personnel in a manner that kept pace with the firm s expansion. A rigorous inspection program The firm should seek to establish a rigorous inspection program. The staff conducting these inspections should be qualified and experienced, and the firm should act on the results. The firm can determine the details of its inspection schedule through a risk analysis. In other words, the firm can evaluate a variety of factors, including the size of the office, the number of customer complaints, the experience level of the supervisor in charge and other factors particular to the firm s business. Offices that present greater regulatory risk can be inspected more frequently. The inspections can include reviews of customer files, and those files can be cross- checked against trading data and other information to detect inconsistencies. A firm should consider whether its inspection program should include surprise inspections. The SE and other regulators have made it clear that they will consider the substance of the inspection program, not just its form. They also consistently have rejected the argument that inspections would not have uncovered the underlying fraud where the inspections themselves were inadequate. Miscellaneous attributes of an effective compliance system Firms should consider including in their compliance 28/ See supra note 6. Morgan, Lewis & Bockius LLP 14

16 procedures, where appropriate, customer contact and review of customer files, special supervision of registered representatives where there are indications that such supervision is warranted, review of incoming and outgoing correspondence, and the generation and review of exception reports. Firms should consider contacting customers as part of their surveillance programs. Such contact could take a variety of forms, from so-called happiness letters sent at random to a cross-section of customers, to phone calls and meetings with customers who meet specific criteria. Firms can base these criteria on the characteristics of the customer. Such characteristics can include the customer s age, financial condition, or trading patterns. Firms also can base these criteria on the characteristics of the customer s representative. Such characteristics can include the representative s level of experience, customer account activity and/or a history of complaints concerning his or her conduct. More generally, firms can use customer complaints to focus their compliance efforts. They can develop mechanisms to track customer complaints and review them to detect patterns and to identify offices and individual representatives who may present compliance problems. The compliance program can require special supervision if a particular representative or office has a history of noncompliance, or if there are red flags that have (or should have) alerted supervisors to potential problems. In onsolidated Investment Services Inc., 29 the SE found the firm liable for failing to supervise a registered representative because, among other things, it had failed to initiate special supervisory steps despite being aware, when it hired the individual, that there was a pending NASD complaint against him. In such circumstances, the SE believes, a firm should go beyond its normal procedures and respond to the specific circumstance with which it is presented. A firm should consider escalating its response if indications of inappropriate conduct continue. Branch-office managers and other persons in positions of authority can review incoming and outgoing correspondence to try to detect inappropriate behavior, become aware of customer problems, and confirm that letterhead is being used appropriately. This is especially critical for firms concerned with selling-away issues. Finally, the firm can develop a series of exception reports, which identify accounts with higher than normal account activity or concentrations, commission trends, early redemptions, or other indications of potential improper conduct. onclusion 29/ Exchange Act Release No , 1996 SE LEXIS 83 (Jan. 5, 1996). Morgan, Lewis & Bockius LLP 15

17 The programs described above may not be effective for all firms. Many are not required by regulations and represent only techniques that some firms have considered appropriate. Again, we recommend that firms evaluate whether their current programs are effective in addressing the particular issues presented by the use of dispersed sales organizations to offer variable products. If they determine that they should enhance their programs, they can consider adopting some of these techniques. Insurance company-affiliated broker-dealer firms that use dispersed sales organizations to sell variable products should not underestimate the challenges they face as they develop their businesses. With appropriate insight, those challenges are not insurmountable. Paul Huey-Burns Denise Speas Morgan, Lewis & Bockius LLP 16