What two words — after “Bear Market” — can send reps reaching for their Mylanta fastest? Try “surprise audit.” The thought of a pair of compliance officers showing up unannounced, poring through your files, can make even the most conscientious rep feel a little like Al Capone when Eliot Ness paid a visit.
Surprise audits were once favored only by regulators, with most firms reluctant to go through the expense and stress of such a procedure, except in cases when the broker was suspected of cooking the books. But they have become increasingly common in recent years, to the extent that some wirehouses rely on them almost exclusively.
The bad news is that the trend will likely continue. The good news is that an unexpected visit from the compliance department no longer needs to feel like a raid.
The shift to surprise audits can be traced back to Royal Alliance's well-publicized failure-to-supervise violations in 1997; the SEC faulted the firm for allowing reps to avoid proper supervision because they had been warned in advance when audits were coming. Since then, regulators have made it clear they expect more audits to be unannounced, a message that has struck home in several more cases, mostly involving independent contractors.
The Feds alone are not the only force pushing for more compliance oversight. The bear market has produced more unhappy customers and more lawyers seeking restitution. “There's a heightened sensitivity to compliance issues throughout the industry right now,” says Michael Caccese, partner at Kirkpatrick and Lockhart's Boston practice. “Arbitration in the brokerage business is going through the roof, which has focused attention on suitability issues.” (see page 22).
Another Poster Child?
The headlines about lawsuits against Credit Suisse First Boston and Merrill Lynch have made firms more anxious to safeguard their reputations, especially during lean times. Who wants to replace Royal Alliance as the poster child for sloppy compliance?
Then, too, there are the still unknown effects that the U.S. Patriot Act and other money laundering legislation will have on the industry (see article on page 67).
As often happens when regulatory winds shift, firms are unsure of how far to go in meeting new demands. “I'm getting more questions from broker-dealers about what their obligations are,” says Caccese. “They want to comply with their legal responsibility, but are getting resistance from their reps.”
Surprise audits are more practical, and thus more prevalent, at wirehouses. Even if the producer is out, auditors who show up unannounced can get the information they need from the branch manager or local compliance officer.
Of the 7,500 internal audits conducted in 2000 by Edward Jones, 75 percent were unannounced, according to compliance director Pamela Cavness, compared to roughly 50 percent in 1999 and under 20 percent six years ago. Compliance experts say that number is probably higher than the average for wirehouses, but by no means unusual.
By way of contrast, National Securities, which has 350 independent contractors, isn't conducting any surprise audits. “It's not worth the expense for us,” says compliance director Janice Greene. With the power to examine essentially any part of the rep's life they need to, National's compliance officers “can keep a pretty tight rein on our reps without showing up unannounced,” she says. But Greene is heeding the message from regulators. She says that the Seattle-based National will conduct 10 percent of its audits unannounced within the next few years.
‘A Waste of Resources’
Whether surprise audits are any more effective than routine ones is a matter of debate. “Our incidence of findings are no higher than on announced audits,” says Edward Jones' Cavness. Indeed, says Nancy Lininger, a compliance consultant in Camarillo, Calif., “Surprise audits can be a big waste of resources.”
One reason may be that the computer systems in place at the major wirehouses are so effective at monitoring broker behavior that the audit is unlikely to produce anything new. “The information that's really significant in helping us protect customers comes through the computer in real time,” Cavness says. “So when we go to the rep's office, it's unlikely that we'll find something on paper that's a real problem.”
Besides, now that surprise audits are no longer much of surprise, it's less likely that a rep with something to hide will leave incriminating evidence lying around.
That, however, is perhaps the point, says Cavness: “Knowing that someone could show up at your door on any day is a good preventive measure, which is the best way to enforce compliance.”
Chicago consultant Nancy Johnson argues that the purpose of surprise audits is less to nail reps than to help them. “Auditors used to come in and say ‘Look what you did wrong! How could you do it this way?' Today, they are there to give reps suggestions, not only on how to meet compliance standards, but also to make their work easier and offices more organized.”
If that's true, many reps have not gotten the message that the folks from the compliance department are here to help them. “Firms are not doing a good job getting across the idea that they're not dreaming up ways to make reps' lives miserable,” says Katherine Vessenes, president of Vestment Consulting in Shorewood, Minn. In speeches to the sales force, Vessenes says she's “an outside voice telling reps that the compliance guys are there to protect you.”
As they gain experience, compliance departments will probably learn to make audits less painful. Edward Jones' Cavness says the firm is developing ways to customize the branch inspection to the rep. Visits to newer brokers focus on helping them get their book straight. For veterans with complicated accounts, auditors assist in estate planning and diversification issues.
