Self-Supervision

How can you believe that self-supervision can effectively detect and prevent malpractices?

NASD recently fined Raymond James Financial Services, Inc. (RJFS) US$2.75m for failing to maintain an adequate supervisory system to oversee the sales activities of its branch managers. In a related action, NASD permanently barred one of those branch managers for making unsuitable sales recommendations and misleading statements.

From early 2000 to Sep 2004, RJFS employed over 1,100 branch managers, most of whom worked in small, geographically dispersed offices. These branch managers were allowed to act as the primary supervisors of their own business activities. They approved their own transactions, opened and accepted new accounts, and reviewed their own correspondence.

RJFS relied on an electronic transaction surveillance system maintained by its Compliance Department, and a series of exception reports, to flag transactions that required further review. It also assigned supervisory responsibility for these 1,100 branch managers to three sales managers. The activities commonly associated with daily supervision, however, were conducted by the branch managers, who in many cases, in effect, supervised themselves. By permitting these principals to engage in self-supervision, RJFS's supervisory system was not reasonably designed to achieve compliance with securities rules and regulations.

Donna Vogt was one of those branch managers and the only registered person working in her office in Wisconsin. She maintained hundreds of customer accounts and sold mainly mutual funds and variable annuities. Many of her customers were of retirement age or older. In determining which products to recommend, Vogt treated her customers as a homogeneous group, regardless of age, financial status, investment experience and objectives. Of her approximately 700 accounts, more than 90% listed their primary investment objective as "growth" and risk tolerance as "medium". RJFS never questioned the fact that Vogt listed these objectives and strategies for almost all of her customers. In fact, the person who reviewed and accepted the customer account documents was Vogt herself.

Vogt recommended unsuitable purchases and concentrations of aggressive mutual funds and variable annuities to at least five customers who were elderly, retired or nearing retirement. These transactions were unsuitable due to the over-concentration in aggressive growth funds, and because access to their funds was limited by the variable annuity surrender charges.

RJFS failed to detect or prevent these unsuitable transactions by Vogt for approximately four years. The firm also failed to prevent Vogt from sending misleading communications to some of her customers, in part because the firm allowed all of its branch managers, including Vogt, to review their own incoming and outgoing correspondence.

RJFS's Compliance Department screened variable annuity purchases using only three exception reports which did not screen transactions for suitability based on customer net worth, annual income, investment experience or concentration of variable annuity holdings as a percentage of net worth. In addition, there was no system in place at the firm for reviewing the suitability of variable annuity sub-account transactions recommended by branch managers, nor was there any system for ensuring that a record of sub-account recommendations and transactions was maintained.

In HK, many financial planners are working like self-employed persons. Remote control of their sales activities is more difficult, especially if the supervisory system is too lax.