Transparency continued – The SEC clarifies its examination selection process for broker-dealers

The SEC’s Division of Examinations released a Risk Alert defining the elements it weighs when selecting broker-dealers as examination candidates, illuminating how firms can prepare and refine their compliance efforts.

17 June 2024 8 mins read
Profile picture of Kathryn Fallah By Kathryn Fallah

In brief:

  • To select firms for examination and outline areas to review, the Division of Examinations uses a “risk-based approach” as part of its assessment process
  • This Risk Alert described the factors that go into choosing a broker-dealer candidate for examination, and what’s included in the scope of an examination once a firm is selected
  • As well as this, the Division defined the types of documents and information it may request from a broker-dealer during an examination

It is said that honesty is a virtue, which translates across multiple situations – such as market integrity in the field of finance. Per newly released regulatory guidance, it seems transparency is becoming a substantial virtue within the industry as well.

Transparency is increasingly emerging as a vital factor contributing to complete compliance. As regulators across regions share insight into how regulatory processes are carried out to enable firms to prepare accordingly, they expect that firms reciprocate this candidness by cooperating during examinations and informing them when compliance concerns arise.

In a Risk Alert issued by the Securities and Exchange Commission’s (SEC) Division of Examination on June 5, the Division detailed the aspects it deliberates when choosing broker-dealer candidates for examinations. Within this alert, the regulator also outlined how it decides the scope of an examination depending on the firm it’s examining and the range of documents that may be requested.

Magic mirror on the wall, how does the SEC make its examination call?

When selecting a broker-dealer to pursue during an examination, the Division listed ten factors it evaluates, including:

  1. Examination history, such as by a self-regulatory organization like FINRA
  2. Supervisory concerns, such as disciplinary action against personnel engaging in misconduct
  3. Tips or complaints against a firm
  4. Length of time since previous examinations
  5. A firm’s customer base
  6. The products and services a firm offers
  7. Alerts that imply any financial stress a firm is undergoing
  8. Media coverage that involves or impacts a firm
  9. Information filed by a firm with the SEC or a self-regulatory organization
  10. If a firm deals with customer cash and securities

Also mentioned in the Risk Alert was the scope of an examination’s focus area, which is decided on a case-by-case basis:

“The scope…will vary from examination to examination depending on the examined firm’s business model, associated risks, and the Division reason for conducting the examination.”

As part of the process, the Division will also maintain examination oversight by checking that an examination in the same area has not already been conducted by another self-regulatory organization. While this is meant to prevent duplicate efforts, it does not mean it is impossible that another examination in the same area could occur if the Division decides it is necessary.

Once a broker-dealer is chosen, the Division will send a letter about the upcoming examination containing an “initial request list identifying certain information, including documents that the staff will review as part of the examination,” such as:

  1. General information that helps the Division understand a broker-dealer’s business and securities activities better
  2. Policies and procedures a firm has implemented and managed to address securities activities
  3. Information from the Division that outlines how a firm’s staff can conduct internal compliance testing in specific focus areas

The Risk Alert listed and categorized some samples of the documents it may request. Under financial information, for example, it included “annual audited reports” or “income statements.” Under books and records/compliance processes, it included “customer complaints and correspondence and the process for monitoring such communications, including electronic communication.”

Transparen-SEC with the SEC

Concurrent to the SEC’s fundamental mission to protect investors and maintain market integrity, the Division’s goal is to ensure that broker-dealers are conforming with regulatory expectations. Within the Risk Alert, it referenced the “four pillars” that describe its purpose for conducting examinations, which are as follows:

  1. Improve compliance
  2. Prevent fraud
  3. Monitor risk
  4. Inform policy

This is not the first instance where regulators have encouraged transparency. Just recently, we’ve seen the SEC’s Division of Enforcement Director Gurbir Grewal lay out five principles firms should follow to cooperate with SEC investigations. By abiding by these policies, Grewal stated that there are real benefits, including reduced or even absolved charges on both the charging and remedies side. 

In April, SEC Director Sanjay Wadhwa demonstrated the regulator’s transparency efforts at the SEC Speaks 2024 event by providing insight into the trigger factors that could lead to recordkeeping investigations.

Wadhwa said the regulator will conduct an individual assessment of a firm to understand its revenue and personnel headcount. Doing so helps ensure that a proposed penalty amount is proportionate. On top of this, it will consider other mitigation defenses, such as the steps a firm has in place to achieve compliance. For example, if a firm has adopted meaningful capture solutions to match pace with modern channels, this could contribute to how the SEC approaches an investigation.

Relatedly, we’ve seen other regulators practice and encourage transparency within the industry, such as the U.K.’s Financial Conduct Authority (FCA) in its effort to “name and shame” firms under investigation. Yet, despite the intent to encourage compliance and deter risk, this tactic received criticism from both the industry and related governing agencies, suggesting it counterproductive to the FCA’s desire to increase competitiveness and growth.

What’s the Big Deal for BD’s?

The Risk Alert also referenced the SEC’s Examination Priorities, which are meant to “provide broker-dealers with insight regarding those areas that the Division has identified as the key risks, trends, and examination areas that the Division plans to focus on in the upcoming year.”

The SEC released its 2024 Examination Priorities in late 2023, which came as a surprise due to its favoring of enduring themes like fiduciary duty and liquidity risk as opposed to modern topics the industry has been grappling with as technological advances become embedded into business practices, such as AI, cybersecurity, and social media risk.

Despite this, there was mention of certain emerging risk areas – particularly operational resilience, information security, third party oversight, crypto, and financial technology. Broker-dealers were also specifically highlighted within the 2024 Examination Priorities in relation to topics like Regulation Best Interest, regulatory compliance, and branch office supervision. Could these subjects suggest what may be studied within the scope of an examination?

Despite the failure to address persisting challenges in the SEC’s 2024 Priorities, we’ve still seen action from financial regulators around subjects like record retention, the Marketing Rule, and data capture procedures over the course of this year. Enforcements and regulation involving these topics serve as a forewarning to firms to continue observing these areas as innovative communications methods become indisputable assets to business growth.

The SEC has been steadfast in issuing fines to combat all instances of noncompliance. Over the past few years, the number of enforcements filed has rapidly increased from 434 in FY 2021 to 784 in FY 2023. With a jump this vast occurring over the course of just two years, it’s unlikely that regulatory attention will be letting up.

All this considered, it is wise to take note of the SEC’s recommendation to uphold strong policies and procedures surrounding business activities to ensure misconduct is at bay. With the Division laying out the factors it investigates when determining which broker-dealers it will examine, firms can reevaluate their surveillance approaches and adherence to regulations to verify they’re set to comply with any inquiries that may occur. 

We recently released our second Industry Insights report, which uncovers the way that compliance executives within the financial services industry are reacting to a wave of new regulations and surveillance trends, the emergence of AI, and the risks that new avenues of communication like social media present. The report highlights the geographical split in actions taken towards these trends and offers insights into the change in business behavior compared to our 2023 report.

As firms reassess to ensure they are fit to face regulatory scrutiny, the need for surveillance and monitoring solutions has become a major priority. Global Relay offers supervision and surveillance tools to ensure compliance with regulation as it evolves and adapts, helping to improve and empower your business operations.