The Bad, the Good, and Avoiding
the Ugly: How to Help an Exam
Go Wrong – and Right
Part 1: The Bad
By: J. Christopher Jackson and John H. Walsh
C
J. Christopher Jackson is Senior Vice
President & General Counsel at Calamos
Investments.
John H. Walsh is a partner in the Washington, DC Office of Sutherland Asbill &
Brennan LLP. Mr. Walsh was previously on
the staff of the Office of Compliance Inspections and Examinations of the Securities and
Exchange Commission.
ompliance professionals spend much of their time on regulatory compliance examinations. They are either planning
for the next exam, being examined, or following up on the
lessons learned from the last exam. This constant attention gives
them a depth of experience in the field. They need it because their
firms look to them for expertise in how to deal with examiners,
manage the examination process, and achieve a good result. Chief
Compliance Officers know that their leadership will play a critical
role in determining their firm’s experience in its next exam.
In this series of articles, two compliance professionals offer practical
suggestions on how to manage a regulatory compliance exam. One has
been a senior legal official with oversight for the compliance function
for many years, and has managed many exams for regulated firms.
The other was a long-time examiner, and has conducted many exams.
Often, the authors have observed, an exam’s failure or success does
not depend on some technical issue under the securities laws. Instead,
common sense plays a critical role. A common sense mistake can push
the process in the wrong direction, or a common-sense success can
push it in the right. Once pushed, the law of inertia can make it harder
and harder for the exam process to change course.
With this is mind, what are these common sense mistakes and successes? In this Part 1, the authors consider the “Top Ten Ways to Help
an Exam Go Wrong.” In Part 2, to follow in a future issue, they will
consider the “Top Ten Ways to Help an Exam Go Right.”
Top Ten Ways to Help an Exam Go Wrong
The most important rule of managing regulatory compliance exams
is to do no harm. Unfortunately, there are many simple mistakes a
compliance professional can make that will help push an exam off in
©
2012, J. Christopher Jackson and John H. Walsh
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The Bad, the Good, and Avoiding the Ugly: How to Help an Exam Go Wrong – and Right – Part 1: The Bad
the wrong direction. An easy way to identify them
is to ask: what would I do if I wanted the exam
to go wrong? Seen in this light, there are ten easy
ways any compliance professional can make an
exam go wrong. A misstep – or said differently –
accomplishing one of the following top ten mistakes
– can raise the odds that you will do just that: cause
harm to yourself and your firm.
10. When the examiners first contact you,
do your best to act shocked, stunned, and
completely unaware of the regulatory regime
and the SEC’s oversight responsibility.
First impressions count. In our daily lives we know
this instinctively. Within seconds of making a new
acquaintance, we start to develop a sense of how
we feel about him or her as a person. Indeed, recent
research suggests people form their first impressions in fractions of a second. Additional exposure
increases confidence in the snap assessment, but
generally does not cause fundamental adjustments.
One of the first rules of common sense is to
remember what you already know. The first impression a firm makes in an exam is a good example.
When an exam team calls or walks in your front
door, they are certain to be wondering: what kind of
place is this? Small scraps of information can make
a strong impression. Just as we take in fast impressions of a new acquaintance – attitude, appearance
and grooming -- so you can expect the exam team
to quickly take in first impressions of your firm.
Many firms place themselves in an unnecessary
hole by ignoring this simple lesson. While making
their first impression, they go out of their way to
communicate their indifference or hostility to the
regulatory regime. The most common approach is
to state that you have a lot of important work to
do, and communicate – in words or tone – that the
examiners are not a priority. Some go even farther,
and challenge the examiners: “What do you mean
an exam, what the heck is that?” Whichever approach you take, this has two primary effects. It
worries the exam team. Indifference and ignorance
rarely lead to good compliance. Moreover, worried
examiners usually assuage their anxiety by expanding the scope of their review. Even if their findings
end up positive for your firm, by sowing doubt you
have gotten yourself a much more searching review.
It also hurts when you have a real disagreement
with the examiners. If you foolishly undermine
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your credibility when the exam team first arrives,
don’t be surprised if they are less than impressed
when you later try to make substantive points. If
you accomplish this wrong step, you will increase
your chances that your actions will “permeate”
the entire exam. Any exam involves repeated and
constant interaction with the exam team and there
are often “on-the-spot” decisions that need to be
made. By sowing doubt at the beginning, you
can expect more skepticism when you ask for the
“benefit of the doubt”; or a little extra time; or
an opportunity to shift from a strict production
deadline to a rolling production; or flexibility in
scheduling interviews.
Take-away: When the exam team contacts you, or
even arrives at your door, act calm and professional
and do your best to convey an aura of familiarity
with the regulatory process. The impressions you
want forming in their subconscious are: “professional,” and “well informed.”
9. Produce records as slowly as possible
with no explanation.
Time is always of the essence. The one resource
the government can use to implement its financial
examination program is people, and it does not have
a lot of them. Every examiner visiting your firm is
incurring a significant opportunity cost, because
he or she is looking at you, instead of all the other
firms the examiner could be examining.
A good way to help an exam go wrong is to make
your firm as expensive as possible for the examiners.
That is, run up as much opportunity cost as
possible. How do you do this? Slow down, take your
time, make them wait. Take any sense of urgency
you may possess and pay it no mind in your firm’s
exam. You’ll know you’ve succeeded when their
supervisor contacts you to see what is going on. By
that point the supervisor and the exam team leader
have probably had a conversation along the lines
of: “Why are you still there – are you making good
findings?” “No. We’re just waiting.” “Waiting! What
do you mean just waiting? I need you at ABC firm,
your next stop.” “We’re still waiting for records.”
Your call with the supervisor is an opportunity to
dial up the tension by frustrating the person who
will review and approve the examination team’s
findings. If you want to make it a bad exam, don’t
miss the opportunity.
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To really wreak havoc, be sure to offer no
explanation for the delay. If you explain yourself, the
examiners may decide the delay is reasonable, and
find some way to work with or around it. By keeping
them in the dark you can maximize the negative
impression of every delay, no matter how short.
Take-away: The best course of action is to move
quickly and expeditiously to produce the records
they request (or even to have them ready beforehand). The second best is to communicate on the
production status frequently and to make sure they
fully understand the reasons for any delay. The bad
course of action is to delay. The worst is to delay
with no explanation.
8. Make employees mysteriously unavailable.
By profession, examiners tend to be a suspicious lot.
They also tend to be very observant. If they notice
that your employees are disappearing as the exam
proceeds, they are likely to draw negative inferences.
This is a good approach if you want to make them
suspicious, but in a fairly subtle, indirect way.
Perhaps the most effective means of triggering
their suspicion is to have the clerical employees disappear. Clerical employees are reputed to know the
facts, and the records, but often lack the necessary
indoctrination in whatever scheme is under way.
They are dangerous to wrongdoers because they are
prone to making statements that seem innocent, yet
are really incriminating: “That account? Oh, that’s
the slush fund. We save it for our political clients.
Would you like to see the journal of payments?”
By removing clerical employees, you will get the
exam team wondering what is going on. A compliance officer who believes an exam staff is less than
fully observant does so at his or her own peril. Rarely,
if ever, is the case when you will not have at least
some senior and experienced examiners assigned to
your firm’s exam team. Often times that’s all you
need to push the exam off in a negative direction.
When examiners start to wonder whether there
might be some back-story behind what they can
see, they will get worried. Again, examiners assuage
anxiety by expanding the scope of their review.
Take-away: If you have to make staffing changes
during an exam, explain it to the exam team. You
may be thinking: we don’t have to tell them about
the wedding, funeral, engagement party, long-
planned vacation, or whatever, that’s personal. You
would be right. You do not. There is no obligation
to make such a disclosure. Nonetheless, a simple
explanation is much better than the alternative:
worried examiners wondering what happened to
the missing employees.
The most important rule of managing
regulatory compliance exams is to
do no harm.
7. Use sloppiness and chaos to convince the
exam team that your firm is out of control.
Examiners see very little of your firm. They know
that. They depend on drawing inferences about you
from the small samples they can collect and analyze.
This is true in everything they review: portfolio
management, personal trading reports, trade tickets,
transactions supporting the cash journal, and so
on. It is a rare exam team that gets to review all of
anything. This is equally true of your compliance
controls. The examiners usually have the opportunity to review only a sample of your compliance
controls, and then draw inferences from what they
can see. Of course, there is one compliance control
they can see more than any other: you.
It may seem daunting that the examiners are
watching you, and judging your firm by what
they see, but it’s true. You personify your firm.
Other members of the firm may share a few hours
with the examiners, in an interview or two, but
generally a compliance professional has the most
consistent face-time with the team. The words
your executives use about the ‘tone at the top,’ or
the firm’s ‘culture,’ or its ‘attention to compliance,’
will be tested and assessed most quickly, and most
often, in reference to you and your conduct during
the examination.
If you want your examination to go wrong, this is
a real opportunity. Just use sloppiness and chaos to
communicate a hidden mess behind the fine words.
Give the examiners the wrong records; mix up files;
leave them sitting alone when you had agreed to
an interview; it’s easy. At some point you will have
them thinking: “In this kind of an atmosphere,
anything could be going on, and no one would
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notice.” That’s the moment your exam can start to
tip downward.
not perfect, that is certainly better than a narrative
about incompetence or dishonesty.
Take-away: It is impossible to be too organized.
Think of it as symbolic speech. The care with which
you track the requests, organize the production,
tie each item produced to a specifically requested
document or request, reconcile lists, and schedule
interviews visually demonstrates the seriousness
with which you – and through you, your firm –
approach compliance.
5. Have employees argue with each other,
challenge each other’s authority, or
mutually slough off responsibility in
the examiners’ presence.
6. Get your facts wrong.
Everyone makes mistakes. Unfortunately, however,
mistakes with examiners are expensive. Mistakes
undermine your credibility (see item number 5),
and if you send the exam team off on a wild-goose
chase, they will blame you for the wasted time (see
item number 2). There is nothing good to say about
mistakes, except one point. There are worse things.
That honor goes to uncorrected mistakes.
At this point in our Top Ten List we have
reached an important moment. Having dealt
with innocent and thoughtless mistakes that can
send the exam off in an unintended direction,
we have now entered the realm where conscious
decisions are made. When a mistake is made, then
discovered, there will always be a temptation to
“Let it slide,” because, “Maybe they won’t notice.”
That is a high stakes gamble. If the examiners
find the mistake, it will make the exam all about
you (see item number 7) but not in a way you
would like. They will carefully consider how the
mistake could have benefited you or your firm
with a premium on creative thinking. Then the
question of the day will become: Did you make
a mistake, or are you lying to them? If you ask
the exam team to choose between incompetence
and dishonesty, either way, either choice, you and
your firm lose.
Take-away: As painful as it may be, the best strategy
is generally to identify the mistake, explain how
it happened, and make the correction. This will
show that you are not perfect. Congratulations,
no one is. In fact, with a narrative of how you
were double-checking and validating the information already provided, you could actually use it to
show the exam team the extent of your care and
attention to accuracy (see item number 7). While
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Every organization in the world has some level of
conflict over turf: who “owns” a given product,
process, or function? Oddly though, in a reversal of
the normal direction of these conversations, when
government examiners ask the question, potential
owners can suddenly be in short supply. If the
government is asking, the rule seems to be: it must
be somebody else’s responsibility.
If you want your exam to go wrong, make sure
the examiners hear something of these disputes.
The usual way to present this to the exam team
is for an interviewee to hedge and qualify his
responsibility. You know the examiners have
heard the issue when they start making statements like: “Sir, we apologize for continuing to
ask these questions, but it was our understanding that you were responsible for this area.” Of
course, if you want your exam to go wrong in a
really spectacular way, have your managers dispute responsibility in front of the examination
team. Examiners visit numerous different firms,
with different cultures and styles. They are used
to variations. However, without question, firms
where the managers carry their bickering and
backstabbing directly to the exam team really
stand out. Raised voices, fi nger-pointing, or
mutual claims of incompetence and bad faith,
are sure to get their attention. Don’t be surprised
if you see the examiners taking a lot of notes.
It has been said that in most things preparation
is the key. That is no different in an exam. A sure
way to succeed in having your exam go wrong
is to fail to prepare your firm and its employees
for the exam. Unprepared, employees can easily
avoid owning up to their responsibility, challenge
each other, and argue with one another in front
of the examiners.
Take-away: If a happy atmosphere is impossible
at your firm, at least try for professional while
the examiners are around. Ideally, any turf issues should be resolved now, for their own sake,
and not in preparation for regulatory oversight.
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Be prepared and make sure that each of your
employees who will speak to the examiners is
prepared. Nonetheless, things do come up. Establishing clarity on who is responsible for what
will go a long way toward demonstrating that
you have given careful attention to your control
and supervisory structure.
4. Respond to problems with indifference.
The purpose of an examination is to solve problems.
After much effort the final work product produced
by an exam team is usually a letter to the firm
asking it to please fix whatever problems were
found. The firm’s response is voluntary. In almost
every case, however, firms rush to fix the problems
to avoid the alternative: referral to the Division of
Enforcement for a possible enforcement action. In
an enforcement action the remedies are mandatory,
public, and often accompanied by penalties and
other sanctions.
If you want your examination to go wrong,
and you don’t have time for the other suggestions
in this list, cut right to the core and attack its
problem-solving purpose. Let the examiners
know you have no intention of fixing the
problems they have found. The most common
approach is to belittle the importance of their
findings. “Only a bureaucrat,” you could say,
“would worry about something as arcane as the
Custody Rule.” Better yet, have a member of
the senior management team participate in the
final interview before the exam team leaves and
make similar statements. Another approach is
to assure them that you are far too important to
spend your time on such things. The actual words
you use are less important than the message: you
will only fix the problems if someone makes you.
Of course, the Commission can make you, in a
public enforcement action.
Take-away: If you convince the exam team that
you will respond only to compulsion, you may get
your wish. Indifference is never a good response in
an exam. Even in those situations where you have
a good faith disagreement with the examiners,
an energetic and attentive response is optimal.
Document why you believe your answer is better,
engage with them on it, and carefully consider
their side of the story. In every case, whatever the
situation, show the examiners your continuing
commitment to solving problems.
3. Break the promises you make to the
examination team, or made to past teams.
No one likes it when old problems suddenly reappear. Often they seem even worse the second
time around: the original problem is enhanced by
frustration and disappointment that past remedies
have failed. Karl Marx supposedly said: “History
repeats itself, the first time as tragedy, the second
as farce.” Actually, he got it wrong. The first time
it’s tragedy, the second it’s disaster. Examination
findings are no different.
If you want your exam to go wrong, casually
make promises, and then casually break them.
You can do this during your exam. Tell the
exam team whatever they want to hear, and then
don’t deliver. Pretty soon it will sink in that you
cannot be trusted. You’ve just made yourself
higher risk (see all of the items on this list). But
if you want to have a really bad exam, and are
willing to wait, when an exam team gives you a
letter describing the problems they found, agree
to everything, and then do nothing. This will
guarantee you a bad exam next time around. In
fact, when the next examiners arrive, and find
you didn’t keep your promises, you may have an
opportunity to work with staff from the Division
of Enforcement.
Take-away: View your word as your bond, in
small matters as well as large. Do not make promises unless you are ready to keep them, and then
do so, faithfully. The most important message you
can communicate is that you can be trusted to fix
the problems the examiners have found, without
the need for a formal enforcement action. Like
everything else, trust must be earned. If you want
the exam to be a success, find ways to show the
examiners that you – and through you, your firm
-- are as good as your word.
2. Withhold responsive records without
telling the exam team you are doing so.
Examiners live for books and records. Sculptors
live for marble, carpenters for wood, tailors for
wool … You get it. A professional examiner has
devoted his or her career to collecting, reviewing,
and analyzing books and records. Indeed, a really
good examiner goes beyond analysis and develops
an intuitive feel for records: what’s good, what’s
bad, and what’s missing.
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If you want your exam to go wrong, be sure to
withhold responsive records from the production
without telling the exam team. As a legal matter,
this could be obstruction, a criminal violation. In
the realm of making exams go bad, committing
a potential ly criminal violation is a pretty
spectacular approach. Of course, this can happen
by accident as well. Examiners know that. It is
A misstep – or said differently –
accomplishing one of the … top ten
mistakes [discussed here] -- can raise
the odds that you will … cause harm to
yourself and your firm.
a rare document production that does not have
at least a few laggard records straggling in, late
in the process. The question is, how were they
missed in the regular production? Paper copies
are misfiled. Legacy archives are overlooked. It
happens. Treated as a simple mistake, compliance
professionals can bounce this issue from item
number 2, all the way back down to item number
6. On the other hand, if you really want your
exam to go wrong, you can make a conscious
decision to keep responsive records out of the
production. At that point, if the exam team can
develop supporting evidence, you’ve bounced the
issue up to item number 1.
When confronting this issue, a compliance
professional may wonder: how will the examiners
ever find out? Over the years, various scenarios
have played out: emails that were produced
make reference to responsive communications
that were not; an employee has a change of heart
and tips-off the staff; or an interviewee mentions
something that was withheld. The specific path of
discovery matters less than the fact that it is always
possible. Moreover, the faithful preservation and
production of records is an important function
of compliance. In its enforcement actions the
Commission has shown a high level of concern
when compliance professionals become part of
the problem. With the hiring of more senior
examiners, the use of specialized experts, the
advent of the Whistleblower Rule under the
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Dodd Frank Wall Street Reform and Consumer
Protection Act of 2010 and other such reforms,
the chances are heightened that any such
misconduct will not go undetected.
Take-away: Every examiner and most compliance
professionals have had to deal with the question:
How were records missed in the regular production?
As a good faith mistake, these problems can generally be resolved. Moreover, if records are withheld
on a claim of privilege, or for some other reason,
full disclosure to the examiners allows an open and
good faith resolution of the issue. Disclosure and
dialogue can cure many ills.
1. Falsify or backdate records.
Regulatory compliance examiners’ full contempt
and fury are reserved for one of their own gone
bad – a compliance professional engaging in
affirmative misconduct. In the cases brought by
the Commission against compliance professionals,
the integrity of books and records has played an
important role. Compliance professionals have
falsified them, backdated them, created them
out of whole cloth, or knowingly withheld them
from a responsive production. If compliance
professionals want to make an exam go wrong,
and importantly, go wrong for them selves
personally, there is no better way than to falsify
or backdate records.
There is a difference between item number 2 and
this, the single best way to make an exam go wrong.
Sometimes there can be a murky line between good
faith and bad faith when a record is withheld. Was
a record withheld under a theory of the scope of
a request that later proved mistaken? Were the
examiners less than clear about what they wanted?
Was the record simply missed? Certainly, when a
record is withheld examiners are likely to consider
whether it was done in knowing bad faith (although
a late production explained as a mistake goes a long
way to addressing that concern, see item number
6). Here, however, it is difficult to imagine the good
faith falsification of records. Here the examiners are
likely to fear that one of their own has gone bad.
Compliance professionals in this situation should
expect the worst. The true compliance professional
can ill afford to take this risk. He or she should
take notice of the enhanced enforcement being
undertaken by SEC’s Division of Enforcement,
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their use of specialized enforcement units as well as
the specter of Wells Notices. When the worst occurs
to the compliance officer, it is further compounded
by the fact that he or she may never be rehired in
such a capacity in the future.
Take-away: Records say what they say. Sometimes
that can be an uncomfortable reality. But the alternative is so much worse.
Conclusion
No compliance professional – at least none who
is sane – would set out to have a bad exam.
Sometimes, though, it can seem that way.
Hopefully, by keeping in mind the first and
most important rule of managing regulatory
compliance exams – Do No Harm -- compliance
professionals will find themselves well on the way
to a successful result.
This article is reprinted with permission from Practical Compliance and Risk Management for
the Securities Industry, a professional journal published by Wolters Kluwer Financial Services, Inc.
This article may not be further re-published without permission from Wolters Kluwer
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