BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 91-4 (SA)
February 8, 1991
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Guidelines for the Inspection of Investment Adviser Subsidiaries of Bank Holding Companies
Enclosed is a copy of inspection guidelines for the use of Federal Reserve Bank staff in performing inspection of nonbank subsidiaries that engage in investment advisory activities pursuant to Section 225.25 (b)(4) of Regulation Y. Since investment advisory subsidiaries are required to observe the standards of care and conduct applicable to fiduciaries, it was suggested in SR 88-11 that examiners specifically trained in procedures utilized in trust examinations should be called upon to perform inspections of investment advisory subsidiaries whenever possible. The enclosed inspection guidelines have been prepared in response to requests for additional guidance from Reserve Bank examination personnel.
Should you have any questions or comments, please contact Robert S. Plotkin, Assistant Director (202-452-2782) or the Trust Activities Program (202-452-2717).
Frederick M. Struble
Cross Reference: SR 88-11 (April 28, 1988)
ENCLOSURE ELECTRONICALLY TRANSMITTED BELOW
Guidelines for the Inspection
Investment Adviser Subsidiaries
(Acting Pursuant to Section 225.25(b)(4) of Regulation Y)
Board of Governors
Federal Reserve System
February 8, 1991
Table of Contents
B. Inspection Objectives
C. Inspection Procedures
2. Inspection Checklist
a. Review of Fundamental Policies and Procedures
b. Supervision and Organization
c. Portfolio Management
Investment Standards and Research
d. Conflicts of Interests
Trading Practices & Policies
f. Security Storage and Processing
g. Other Matters
D. Inspection Findings
Inspection of Investment Advisory Subsidiaries of Bank Holding Companies
The term "investment adviser" is defined in Section 202(a)(11) of the Investment Advisers Act of 1940 ("the Act") to include any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities or who, for compensation and as a part of a regular business, issues or promulgates analyses or reports concerning securities. Banks are statutorily excluded from the definition of investment adviser in the Act provided the performance of such services is incidental to banking. Parent bank holding companies, but not bank holding company subsidiaries, are also statutorily excluded. Brokers and dealers are also excluded provided the performance of such services is solely incidental to the conduct of their business and no special compensation is received.
Section 203(a) prohibits any investment adviser, except as provided in Section 203(b), from using the mails or any means or instrumentality of interstate commerce in connection with this investment advisory business, unless registered with the SEC. Section 203(b) provides certain limited exceptions from registration. Of particular relevance is the exception for those investment advisers who during the course of the preceding 12 months have had fewer than 15 clients and who do not hold themselves out generally to the public as an investment adviser. However, even where an adviser is not required to register it is nonetheless subject to the anti-fraud provisions contained in Section 206 of the Act.
The complexity of the activities in which investment adviser subsidiaries engage has continued to increase due to fundamental changes in both the structure of the financial services industry itself and the legal and regulatory environment. For example, services which are primarily of a fiduciary nature and which were historically performed by bank trust departments, such as portfolio management and advice, are increasingly being spun off into separate subsidiaries in order to create and identify an independent profit center. These subsidiaries serve as non-asset based sources of revenue for a bank or bank holding company.
Regulation Y (Section 225.25(b)(4)), permits a bank holding company or a nonbank subsidiary to provide portfolio investment advice to any person (defined in federal statutes to mean any individual, corporation, trust or other entity) and act as an investment adviser, as defined in Section 2(a)(20) of the Investment Company Act of 1940 to an investment company registered under that Act. The Federal Reserve System as the primary regulator for bank holding companies and their directly held nonbank subsidiaries conducts inspections of their operations, financial condition and compliance with banking law and related regulations.
In furnishing portfolio advice, investment adviser subsidiaries are required to observe the standards of care and conduct applicable to fiduciaries (Regulation Y, Section 225.25(b)(4), footnote 1). Therefore, examiners specifically trained in procedures utilized in trust examinations should be called upon to perform the inspections of investment adviser subsidiaries whenever possible. (See SR-88-11, April 28, 1988)
Registered advisers are subject to supervision and examination by the SEC. However, SEC examinations of registered investment advisers are infrequent. Therefore, on-site inspections should be conducted by Federal Reserve Bank examiners as an integral part of bank holding company inspections whenever the investment adviser activities are considered to be significant. Individual circumstances will determine which investment adviser subsidiaries should be examined and how often. Factors to consider include volume and type of activity, date and results of previous Reserve Bank inspection and/or SEC examinations and extent of services provided to affiliate banks or trust companies.
The Federal Reserve System does not intend to assume responsibility for the enforcement of securities laws and regulations for which the SEC is primarily responsible. However, where Federal Reserve Bank examiners discover potential violations of securities laws or regulations in the course of an inspection, Board staff should be advised so that a determination can be made whether to provide the SEC with information to investigate the matter or take other appropriate action.
The SEC has prepared an Investment Adviser Examination Manual which may be useful as background information for evaluating compliance with the Investment Advisers Act of 1940 and various SEC rules. The manual contains reference materials and examinations checklists. A copy of the SEC manual may be obtained from the Trust Activities Program.
The adviser's financial condition should be reviewed to insure that the adviser's financial condition is sound. It may be a violation of the anti-fraud provision of Section 206 of the Act for an adviser to continue doing business and solicit new clients while its financial condition is impaired unless it makes appropriate disclosure of its financial condition to its clients and prospective clients. It should be noted that there are no formal capital standards for investment advisers and there are no bonding requirements under the Act for the protection of clients or other creditors.
B. Inspection Objectives
The objectives of an investment adviser inspection are to:
- review the adviser's organizational structure and qualifications of management to conduct business and determine whether they are satisfactory;
- determine whether the adviser's financial condition and internal accounting controls are satisfactory;
- review investment practices considering the adviser's investment responsibilities for the selection and allocation of investments for various types of accounts to determine whether they are appropriate;
- determine whether the institution has adequate policies and procedures to prevent self-dealing and similar improper conflicts;
- to evaluate compliance with applicable bank holding company laws, regulations and interpretations including compliance with the standards of care and conduct applicable to fiduciaries as required by Regulation Y.
C. Inspection Procedures
1. Scope of Inspection
It is expected that investment adviser subsidiary inspections will generally be conducted as part of regularly scheduled bank holding company inspections. If, however, the investment adviser subsidiary provides portfolio management services for a significant portion of trust assets held by a State member bank, the Reserve Bank should inspect the investment adviser subsidiary at the same time it examines the trust operations of the bank subsidiary.
The scope of the inspection should be based upon a review of the nature and complexity of the financial services provided to customers. An adviser which merely provides investment advice and does not provide any additional financial services such as portfolio management, safekeeping, recordkeeping or trading services, may not require an inspection. However, an adviser which provides portfolio management, safekeeping or other services will require an inspection. In order to determine the scope of the inspection it is essential to identify what types of services are being offered to customers and to assess the risks associated with those services. The examiner needs to understand the adviser's operations, including how it represents itself to clients and whether the adviser has any vested interests in the financial services which it offers.
As indicated in SR 88-11 (April 28, 1988), examiners should use their discretion to schedule inspections based upon the size and complexity of the adviser's operations.
Appropriate checklist questions should be completed for registered investment advisers which provide investment advice to affiliated banks or trust companies and for investment advisers which engage in activities which could have a significant impact on the bank holding company's financial safety and soundness. The checklist should also be completed for all advisers that manage investment portfolios for their customers. The checklist is only a guideline and some of the sections in the checklist may not be applicable. Conversely, the scope of such examinations is not limited to the items included in this checklist.
2. Inspection Checklist
The questions in this checklist will assist the examiner in evaluating various areas of supervisory concerns.
a. Review of Fundamental Policies and Procedures
The investment advisory's policies and procedures should be reviewed using the following checklist to ensure that fundamental policies and procedures have been established and implemented.
- Are adequate minutes of the board and board committee meetings prepared?
- Is the adviser properly chartered and registered?
- Does the adviser have sufficient blanket bond or other fidelity or liability coverage in place?
- Is the corporate and regulatory reporting performed on a timely basis?
- Does the reporting fairly present the accounting and supplemental data reflected by the corporate records?
- Are internal accounting controls, provided by a segregation of duties or a need for administrative approvals, adequate?
- Are duties properly segregated in the receiving, disbursing and recording of cash and cash transactions?
- Are fee calculations and billing procedures adequate to insure accuracy and propriety?
- Are all security transactions authorized or approved by the appropriate management level, with evidence of the authorization or approval documented?
b. Supervision and Organization
Supervision refers to the conduct of the institution's board of directors and senior management in establishing, communicating and enforcing a system of policies, procedures and practices suitable to its business objectives and legal requirements. Organization may be characterized as the framework of committees and assigned responsibilities through which supervision functions. The examiner should review the structure of the organization for adequacy of management information systems and the organization framework as they relate to meeting the institution's stated responsibilities as well as generally accepted standards of conduct.
The examiner should review the institution's supervisory function by first identifying the duties and responsibilities of the board of directors. The directors owe the institution the duty of reasonable supervision, including appropriate attention to areas where the institution is assuming sensitive and complex fiduciary responsibilities. The next level of review is the committee and officer positions to which certain authority has been delegated. In reviewing this level of supervision, the examiner should keep in mind that certain functions cannot be delegated: for example, approval of significant new services or lines of business, approval of formal policies designed to ensure that the institution operates in basic compliance with laws and regulations, and the selection and supervision of senior management cannot ordinarily be delegated. Informal delegations and operating practices, represent the last level of review. In reviewing both formal and informal delegations, consideration should be given to the institution's size and complexity. A final determination of the adequacy of supervision and organization must be based upon findings of the entire inspection.
While topics directly or indirectly impacting the adequacy of director supervision and management competence are of particular sensitivity, examiners nevertheless have a responsibility to carefully address and comment upon such issues.
During the course of the inspection the examiner should review the supervisory and organizational structure of the institution, with particular reference to investment related activities. The examiner should determine whether the board of directors has developed adequate objectives and policies.
The following procedures may be used to review the supervision and organization of an adviser:
- Obtain or update copies of policy and procedure manuals. Assure that examiners performing other portions of the inspection receive relevant sections.
- Review minutes of board of directors, and of board audit committees, as well as any officer level committees. Assure that examiners performing other portions of the inspection review relevant minutes or summaries thereof.
- Obtain, evaluate and summarize matters in litigation (or threatened) and compromise actions.
- Ascertain current liability insurance relating to the adviser function; and evaluate the adequacy of such coverage, particularly the extent to which possible significant surcharges would be covered by such insurance.
- Obtain or update biographical/experience information for key management personnel, together with overall staffing and salary levels as appropriate for full evaluation.
- Ascertain if senior management is aware, or has adopted the procedures necessary to become aware, of its current and potential responsibilities in connection with any regulatory reporting and/or regulatory compliance requirements.
- Determine whether operating practices provide for adequate legal documents and agreements such that the account activities, in general, are consistent with contractual responsibilities
SUPERVISION AND ORGANIZATION CHECKLIST
c. Portfolio Management
1. If the institution's board of directors does not directly supervise investment adviser activities:
a. Has a responsible board committee(s) been named to exercise this function?
b. Are any delegations consistent with by-law provisions and other appropriate principles?
c. Do the board's minutes nevertheless reflect periodic, but timely, review of the conduct and operating results of the function?
2. Do minutes of the board, or its committee(s), reflect that members:
a. Attend meetings with reasonable frequency?
b. Require and approve, where necessary, appropriate, written policies, strategic plans and management reports relating thereto?
c. Review audit and regulatory reports (and management proposals and corrective measures in response thereto), litigation developments, earnings and expense reports, and changes to fee schedules?
3. Through adoption of formal policies and provision for auditing, does the board adequately seek to assure the integrity of the institution's records and operational systems?
4. Are policies and procedures adequately communicated to officers and staff?
5. Does the institution's board or a board committee consider, periodically review, and provide for insurance protection?
6. Does the institution maintain access to competent legal counsel, and where appropriate obtain written opinions on significant legal questions such as:
a. Pending or threatened litigation?
b. Account agreements whose terms are unclear, ambiguous or raise complicated points of law?
c. Proposed actions or policies involving matters such as conflicts of interest, restricted securities, ERISA, and other matters involving possible legal exposure?
7. If securities of accounts are registered in nominee name(s):
a. Is the nominee agreement current?
b. Is the nominee registered with: The American Society of Corporate Secretaries (to guard against duplication of the nominee name), and state authorities (where required by local law)?
8. Is staffing adequate in numbers and qualifications to handle current volume of business?
9. Is there adequate provision for management succession, or for continuing operations in case of loss of key personnel?
10. Is senior management aware of its responsibilities in connection with, and has it established written policies and procedures to ensure compliance with, any applicable regulatory reporting requirements?
11. Are significant functions of the investment adviser subject to either internal or external audit? If not, ascertain whether an audit program should either be developed or expanded.
12. Where appropriate in light of the size and complexity of the adviser's operations, has management caused an audit of financial statements to be performed by certified public accountants.
13. Have all significant exceptions and recommendations contained in audit or examinations reports been corrected, implemented, or otherwise satisfactorily resolved?
Investment selection comprises the process whereby the adviser evaluates, selects and re-evaluates those securities it will buy or sell, or as to which it will make recommendations. It includes the process of researching and selecting recommended individual stocks and bonds, and setting objectives or strategies for diversifications by types and classes of securities into general or specialized portfolios. It includes the process of communicating and executing overall strategies for particular accounts.
Holding itself out as a professional will result in the adviser being held to a high standard of prudence and expertise in the investment selection and review process. Therefore, advisers must carefully consider policies and procedures in this area in accordance with the size and character of the investment selection responsibilities undertaken. In furnishing portfolio investment advice, an investment adviser should observe the standards of care and conduct applicable to fiduciaries.
Investment Standards and Research
1. Are the institution's general investment standards, review and selection responsibilities defined and approved by the board of directors?
2. Does management or senior investment personnel review overall investment policy and potential investment problems at least annually?
3. Is portfolio management policy adequately communicated to appropriate personnel (e.g., by including in committee minutes, directives, or memoranda circulated to such personnel)?
4. Does the institution, where appropriate, diversify investments according to:
a. Types of assets, such as common stocks, fixed-income securities and real estate?
b. Types of securities according to characteristics, such as income, growth, and size of company?
c. Types of securities according to industry and specific companies within industries?
d. Maturities of debt securities?
e. Geographic location of companies of issue, such as utilities?
f. Tax exemption of income?
5. If the institution has a list of securities approved for purchase, retention and/or sale:
a. Are recommendations for additions to or deletions from such list(s) approved by a committee or group with appropriate authority and expertise?
b. Are periodic reviews made of the lists(s) of securities approved for purchase, retention or sale to assess the current appropriateness of the investments listed?
6. If the institution utilizes any research or analysis in its general investment review and selection process:
a. Are appropriate factors taken into account?
b. Is appropriate documentation obtained and filed to reflect consideration of such factors?
7. If the size and character of the institution's discretionary investment responsibilities are such that the type of detailed research considerations and files envisioned in the previous question are not relied upon, does it utilize ratings by acceptable financial rating services, such as Moody's or Standard and Poor's, together with evaluation of basic relevant factors pertaining to the type of security under consideration?
8. Where appropriate, does the institution differentiate in its investment selection process as to the type of account in question; such as for those where need for growth or income is paramount, or for taxable versus tax-free trusts?
9. Do personnel possess sufficient expertise and experience to properly implement the institution's investment selection systems and responsibilities?
Special consideration has to be given to accounts subject to the Employee Retirement Income Security Act of 1974 (ERISA) which imposes fiduciary responsibilities upon any person who has any power of control, management or disposition over the funds or other property of any employee benefit fund. Where an adviser exercises investment discretion over such plans the extensive fiduciary responsibility and prohibited transaction rules of ERISA will apply. In addition to the following general checklist questions, refer to Section 10 of the Trust Examination Manual for more specific checklists and references to the laws and regulations which apply to employee benefit accounts.
1. Does the adviser have portfolio management procedures which provide for: a. Consideration of the needs and objectives of particular types of accounts, such as need for income versus growth, or taxable versus tax-free income? b. Conformity with investment provisions of governing instruments? c. Consideration of the liquidity needs of the account for anticipated distributions? d. Appropriate diversification, including avoidance or elimination of concentrations in individual securities and by type and sub-class of securities? 2. When assets in discretionary accounts are considered unsuitable, does the institution have a program of prudent and timely sale of such assets unless retention is required? 3. In order to determine the advisability of retaining or changing assets, does the adviser have procedures for periodic reviews? 4. Do minute books or other records: a. Identify reviewed accounts? b. Report written conclusions on the advisability of retaining or disposing of assets in the accounts? 5. As appropriate to its size and character of business, does the institution utilize account synopses and historical data in the review of account assets? 6. Does the institution's investment review information include: a. Amount and description of investment? b. Categories of investment, such as bonds and stocks? c. Types of investments within each category, such as industry groups for stocks? d. Cost? e. Market or appraised value at review date? f. Annual income? g. Yield at market? h. Rating of recognized financial service? 7. In accounts where the advisor makes investments at the direction of the client, does the advisor: a. Review the account to detect illegal, nonconforming, substandard or otherwise unsuitable investments? b. Advise the power holder of any improper investments? c. Inform parties at interest in the account if any improper investment is not disposed of, and seek legal relief, if necessary? d. Resign from the account if corrective action is not taken concerning improper investments? 8. Has the institution established proxy voting policies and procedures for ERISA accounts suitable to assumed responsibilities? a. Voting of routine proxies? b. Identification and handling of proxy or tender determinations when involving sensitive social issues, conflicts of interest, significant increases in management power or perquisites, or merger or buy-out proposals? Note: For requirements relating to proxy processing and the Shareholder Communications Act of 1985, see Operations and Internal Controls, Trust Examination Manual page 2.016. For questions relating to the voting of affiliate stock, see Conflicts of Interest, Trust Examination Manual page 15.011. Where an adviser invests accounts in options and/or futures the following checklist questions number 9 through 13 should be completed. For additional information as to appropriate uses of options and futures contracts, see SR 83-2(SA) and SR 83-39(SA). 9. Where an adviser utilizes options and/or futures, has the Board of Directors or a Directors' level committee approved a policy and strategy for their use? a. Does the policy address: The investment objectives to be accomplished by the use of these contracts? The specific types of contracts to be used? The types of accounts authorized to use these contracts?
Restrictions and/or conditions upon use of contracts, such as selection of brokerage houses, position limits, time frames, leveraging, etc.? 10. Was adequate disclosure made and adequate authorization obtained to execute contract transactions for various types of participating accounts? 11. Are adequate systems and controls in effect to ensure: a. Proper tax treatment? b. Proper segregation of securities and/or monies? c. Conformance with account objectives? d. Adherence to adopted strategy, position limits and related program parameters? e. Periodic management evaluation and reporting systems with respect to: - Results of contract activities upon overall investment performance? - Market developments, including current liquidity of relevant futures and options contracts in which positions are taken? - Financial condition, fee competitiveness and performance of involved broker/dealers? 12. Does the accounting system accurately reflect contract activities with respect to: a. Transaction details? b. Current gains or losses on open contract positions? c. Necessary tax information? 13. Do operating personnel appear sufficiently knowledgeable relative to the level of contract transactions activity?
d. Conflicts of Interests
The inspection of an investment adviser subsidiary which provides services to an affiliated trust company or bank with a trust department requires expanded inspection procedures. Often the investment adviser subsidiary was organized for the purpose of providing investment advice and services for the trust accounts held at one or more of its affiliates. These subsidiaries often employ the same individuals who worked in the banks or trust company which they advise.
Conflict of interest problems may arise when the adviser exercises any "discretion" where mutually opposing interests are involved. The most serious conflict of interest is self-dealing, which could include transactions such as an investment in affiliated banks or purchase of securities from or through an affiliate. Such transactions and fees associated therewith must be fully disclosed and authorized by appropriate parties in interest to resolve conflict of interest issues.
Potential conflict of interest situations are not limited to transactions between affiliates but can also be between the adviser and any of its directors, officers or employees individually.
Due to the complexity, sensitivity and exposure involved in conflicts of interest, it is particularly important that an adviser develop the awareness and policies and procedures to identify and deal with conflicts situations. Therefore, it is considered highly desirable, even where not specifically required by regulation, that written policies be adopted and periodically revised as necessary.
1. Has the adviser: a. Acquired any assets from itself or its affiliates? b. Acquired any assets from Directors, officers or employees of the institution or its affiliates or any other individuals with whom there exists such connection as might affect the exercise of best judgment? 2. Has the adviser sold or transferred any account assets by loan or otherwise to: a. Any affiliates? b. Directors, officers or employees of any affiliates? c. Other individuals or corporations with whom there exists such a connection, or other organizations in which there exists such an interest, as might affect the exercise of its best judgment? 3. Has the institution purchased any securities for a customer account from any member of an undivided syndicate for which the adviser or any of its affiliates are participating or from a private placement which the adviser assisted? 4. Does the institution have satisfactory policies and procedures, in terms of its size and character of business, to address the preceding situations? 5. If the institution directs extra fee-producing business to itself or an affiliate (e.g., brokerage services, or options trading services), or charges separate fees to accounts for securities transactions or other services commonly provided as part of general account administration (e.g., fees for cash management, or investments in mutual funds where management or administration fees are received by the institution or an affiliate): a. Has it identified those accounts which may properly participate in such services in accordance with adopted policy, legal opinion, DOL ruling and/or other necessary determinations? b. Has it made appropriate prior disclosures and obtained adequate specific authorizations for those accounts identified as entitled to the services? 6. Have any assets held by the institution in one account been sold to another account? NOTE: The transaction may be permissible if appropriate disclosure is made and authorization is received and the law or the governing instrument do not prohibit it. However, an inter-account transaction for ERISA accounts may be a prohibited transaction. In addition, difficult problems can arise in establishing or documenting a "fair" price for the transaction, particularly if the asset is a thinly-traded security or is a unique asset. 7. Does the institution have appropriate policies and procedures to assure: a. Its discretionary accounts are not left in uninvested cash positions beyond a minimum period of time? b. Its accounts are invested in affiliate interest-bearing deposits only for appropriate temporary or other purposes? Note: To the extent the institution has long-term affiliate deposits, or significant aggregate holdings, a special review should be made of the institution's documentation of the suitability of such investments in view of available alternate vehicles. 8. Are securities of affiliates only purchased upon proper direction or specific authorization in account instruments? 9. Where the adviser purchases securities which are underwritten by an affiliate, does the adviser do so only upon proper direction and specific authorization of the customer? 10. Does the institution act as investment adviser to an open-end or closed-end investment company that is registered under the Investment Company Act of 1940? If so, does its activities conform with the Board's interpretation at 12 C.F.R. 225.125 which defines the scope of permissible activities? For a list of restrictions and checklist questions, see Section 3130.1 of the Bank Holding Company Supervision Manual.
1. Where volume of activity warrants, is allocation of brokerage business controlled through an approved list which is periodically reviewed and approved by the institution's board or a senior officer level committee? 2. Does the institution attempt to obtain the best service for customers, including periodic evaluations of broker qualifications such as: a. Financial condition? b. Past record of good and timely delivery and payment on trades? c. Quality of execution and ability to handle specialized transactions? d. Quality of research received, if applicable? 3. Does the institution have procedures to monitor or periodically survey available negotiated commission prices in order to ascertain reasonable costs for the execution requirements of its accounts? 4. If the institution is paying higher than the "lowest" available negotiated commissions for executions in order to receive goods and/or services: a. Have such goods and/or services been determined to reasonably qualify as "brokerage and research services" as defined in Section 28(e)(3) of the Securities Exchange Act of l934? b. Does an appropriate committee periodically (at least annually) review and determine that the value of the goods and services justifies the payment of the higher brokerage commissions? 5. Does the institution periodically review and maintain records of all goods and/or services received from brokers or third parties in return for brokerage and/or dealer business allocated to particular firms? 6. Do policies and procedures preclude: a. Selection of broker/dealers on the basis of deposit balances? b. Agreements or understandings for allocation of specific amounts of business to a broker/dealer such that the institution would not be able to cease allocating business to the firm if it were no longer providing acceptable execution? 7. Does the institution have auditing and other monitoring controls and reporting procedures in effect to verify compliance of traders with its policies regarding broker selection and payment of commissions? NOTE: Under Section 28(e), the institution may also legitimately pay more than the lowest available commission for reasons of execution, financial soundness, and efficiency of delivery and payment. 8. In addition to advisory services, does the institution also provide brokerage services for customers pursuant to Section 225.25(b)(15) of Regulation Y? If so, the examiner should refer to SR 85-29 (FIS) which contains guidelines and checklist questions for the inspection of brokerage activities.
Trading Policies and Practices
1. Where trading specialists are employed, does the institution have adequate written or unwritten standards of competence, education and training for such individuals? 2. Where the institution does not employ specialists, are individuals responsible for trading reasonably trained and informed in relation to the volume and character of trading activity they are required to perform? 3. Where transactions are permitted to be crossed between accounts: a. Are procedures adequate to insure fair pricing of the transactions? b. If not clear, has the institution determined through counsel that crossing is permissible under applicable law? 4. Where specialists are employed and volume of activity permits, does the institution, in order to obtain more favorable trade prices and execution price for its accounts, consider block trades? 5. If applicable, do procedures require special authorization and attention for large or "block" trades which are to be executed in a number of transactions, including establishment of time frames in advance of such trading? 6. If procedures permit the combining of purchase or sale orders of the same security: a. Are resulting benefits in price and/or execution costs applied on a pro-rata or average basis to the participating accounts? b. Does the institution similarly pro-rate allocable shares to participating accounts when a combined trade is not executed at once, but in a number of transactions over a period of time? 7. Does adviser maintain policies "reasonably designed to prevent the misuse of material non-public information?"
CROSS REFERENCES to TRUST EXAMINATION MANUAL:
See Trust Examination Manual section on Cash Management, for conflicts of interest involving uninvested cash and extra fee-producing business arising from utilization of cash management vehicles.
See Trust Examination Manual section on Employee Benefit Trust Administration for special treatment of self-dealing where ERISA accounts are involved.
Registered investment advisers are subject to extensive recordkeeping requirements. SEC Rule 204-2 imposes recordkeeping standards and requires that registered investment advisers keep accurate records. In addition to this recordkeeping, the adviser is subject to the "brochure rule" (Rule 204-3). This rule requires an investment adviser to deliver a specified disclosure statement with respect to its background and business practices to every client or prospective client. In addition to an initial disclosure, the adviser must offer annually to deliver a current disclosure statement upon request. Those advisers which have custody or possession of securities of any client must maintain certain additional records including separate ledger accounts for each client, copies of confirmations, and a position record showing the interest of each client and the location of the securities.
1. Does the investment adviser make and keep current appropriate books and records including: (a) Journals or summary journals? (b) A memorandum of each order given by the firm or instructions received, showing terms and conditions of the orders? (c) All check books, bank statements, canceled checks and cash reconciliations? (d) All bills or statements, paid or unpaid? (e) Trial balances, financial statements and internal audit papers? (f) Written communications received or sent by the firm? (g) List of discretionary accounts? (h) Powers of attorney and discretionary powers? (i) Written agreements? (j) Copies of each notice, circular, advertisement, newspaper article, investment letter, bulletin, or other communication recommending the purchase or sale of a security? 2. Does the adviser maintain a record of every transaction in which the adviser or any "advisory representative" has a direct or indirect beneficial interest? 3. Are partnership articles, articles of incorporation, charter, minute books and stock certificate books maintained at adviser's principal office? 4. If required books and records are photocopied or microfilmed or are produced or reproduced on computer storage media: (a) Are such media indexed and arranged to permit immediate location of any particular record? (b) Were any copies or printouts of such records promptly provided on request? (c) Is at least one copy of original records on such media stored in a separate location from the original for the time required? (d) Does the adviser maintain procedures for the maintenance and preservation of, and access to, records so as to reasonably safeguard them from loss, alteration, or destruction? (e) Does the adviser have facilities for the immediate, easily readable projection of microfilmed records and for producing easily readable facsimile enlargements? 5. Do the entries in the general ledger and the journals properly reflect payments or receipts of monies or other goods or services? 6. Do the financial statements, canceled checks, deposit slips, and check register properly reflect payments or receipts of monies or other goods or services? 7. Where the adviser's financial records indicate that it is capitalized with client funds (through either loans or equity), have adequate disclosures been made to clients about the risks and conflicts of interest involved?
f. Security Storage and Processing
Investment advisers generally do not take possession and control of client funds and securities. However, in those cases where such responsibilities are assumed, the inspection must evaluate those internal controls which are in place for the safeguarding of client funds and securities. Controls and related processing procedures must be appropriately designed and implemented by the adviser to efficiently and safely facilitate such operations.
1. Does the adviser have custody of client funds or securities? 2. Does the adviser gain effective access to client assets through practices, arrangements, or relationships with clients such as trustee, executor, account signator? 3. Where the adviser has custody of client funds or securities, does the adviser maintain the following records: (a) A record reflecting all purchases, sales, receipts and deliveries of securities and all debits and credits to such accounts? (b) A separate ledger account for each client showing purchases, sales receipts and deliveries of securities? (c) Copies of confirmations of all transactions for such clients? (d) A record for each security in which any client has a position reflecting: name of client, amount of interest and location of security? 4. Where the adviser renders investment management services, are the following records maintained: (a) A record for each client of securities purchased and sold, containing the date, amount and price of each transaction? (b) A record for each security in which any client has a current position showing the name of each client and current interest or number of shares owned by each client? 5. Are client assets physically segregated from the adviser's own assets? 6. For the vault and other related security processing areas, are adequate controls/safeguards in effect which include the following: a. Are assets maintained under a system of joint custody or dual control? b. Is access to these areas restricted to designated/authorized personnel? c. Are other controls/safeguards considered as appropriate to systems in place? (e.g., rotation of assignments, key/lock combinations, vault or area entrance log(s), etc.) d. Is a security ticket system utilized as a vault and asset movement control system? 7. If a security ticket system is utilized, are adequate controls/safeguards in effect which include the following: a. Are security tickets prenumbered? b. Does each copy of the security ticket clearly indicate its destination to assure prompt and accurate delivery? c. Does the security ticket provide the necessary information to assure proper processing and recording of the transaction? d. Does the security ticket contain sufficient copies to assure that sound internal control is maintained over the physical security movement process by providing the following with a copy(s): (1) Portfolio managers who initiated the transactions? (2) Appropriate vault/operations personnel? (3) Audit/asset control function? e. Are unissued security tickets properly safeguarded and subject to adequate numeric controls? 8. Does the control of security ticket/transaction cancellation and replacement include: a. Restricting the ability to initiate such action to supervisory personnel? b. Reporting such activity to the audit/asset control function and other function(s) affected by such action? c. Procedures to assure that securities are returned to the vault or that funds charged from an account are redeposited; or that the securities or funds are immediately placed under the control of a new security ticket/transaction? d. Identifying a replacement security ticket by recording such information on the replacement ticket? e. Requiring all copies of the replaced security ticket to be forwarded to the audit/asset control function? 9. For assets received, are adequate controls/safeguards in effect which include the following: a. Are all assets received promptly placed under joint custody or dual control? b. Is appropriate documentation required and on file for all assets received and is it compared to actual assets received and posted to control ledgers? c. As applicable, are procedures in place for controlling and properly handling assets received by other means including delivery by mail or messenger? d. If assets are not to be physically held or issued (e.g. mutual fund shares), is a receipt, statement or acknowledgement obtained from the issuer or holder and processed by receipt ticket or other means in order to assure proper accountability? e. If securities received are not properly registered in the institution's nominee name, are procedures in place to assure prompt re-registration and control and follow-up until re-registration? 10. For the delivery of assets, are adequate control/safeguards in place which include the following: a. Are appropriate receipts obtained and on file for securities delivered? b. Are procedures in place to assure that bearer securities are not mailed in amounts in excess of the institution's insurance limits? 11. Do vault custodians: a. Compare securities received/withdrawn to the security ticket? b. For withdrawals, verify that the security ticket is signed (initialed) by authorized personnel? c. For securities temporarily withdrawn from the vault (e.g. transfer, re-registration, account/portfolio manager review), is a copy of the security ticket retained by vault personnel pending the return of the security to the vault? 12. For pending security transactions, are adequate controls in effect which include the following: a. Are pending items periodically reviewed by operations personnel? b. Do procedures provide for the prompt follow-up on items which have not been completed within established time periods? c. Are exceptions promptly reported and resolved by appropriate personnel (e.g. management, supervisors and/or the audit/asset control function)? d. Are current pending security items in compliance with established procedures for reporting exceptions; and are those transactions which have not been completed within established time periods followed-up in a satisfactory manner? Note: Examiner judgement should be used in determining the scope of this review. However, the review at a minimum should include procedures for handling security transactions pending 30 days or more. 13. Does the security processing system: a. Contain a sufficient number of controls/safeguards to properly reflect the current status of, and limit an individual's control over, a security transaction? b. Contain sufficient information to identify, locate and trace the movement of each asset? c. Provide for adequate segregation of duties and responsibilities? 14. Has individual accountability or responsibility been properly assigned for the physical protection of the securities and related cash flow, if applicable, throughout the security processing system? 15. Do procedures require that orders for trades originate with account or portfolio managers, with the signature or initials of the authorizing party shown on the order form or purchase/sale ticket? 16. Are transactions made on a first-in, first-out basis? (i.e., executed in order of receipt) except when combined in blocks for execution pursuant to appropriate written procedures? 17. For purchases/sales, do operations personnel independent of account or portfolio managers and traders: a. Reconcile trade tickets to brokers' confirmations? b. Monitor and promptly follow-up on any outstanding transactions, such as confirmations not received within specified time periods or purchases/sales which have not settled on settlement date? d. Promptly post payments for purchases/sales to the recordkeeping system and promptly record/remove assets?
g. Other Matters
1. Is the adviser or any of its principals involved in litigation or arbitration which will have an impact on its ability to fulfill its contract with clients? 2. Were any matters of a material nature found in the adviser's correspondence such as significant client complaints? 3. Did a review of customer complaint files reveal any possible areas for special inspection focus? 4. Did a review of the adviser's current financial condition raise concerns as to the adviser's solvency or its ability to otherwise continue to provide advisory services? 5. Are there any other aspects of the adviser's operations, or the operations of an affiliate, which raises concerns?
D. Inspection Findings
A written summary of the subsidiary's activities should be presented to the examiner in charge of the bank holding company inspection and may be included in the inspection report. Material exceptions should be noted with management's responses under an appropriate caption in the open section of the report. Any comments in the report regarding the scope of the investment advisory inspections should note that such inspections are primarily focused on safety and soundness considerations and not on compliance with securities laws.
In those cases where a separate Report of Bank Holding Company Inspection on Investment Advisory Activities is prepared examiners may utilize the Uniform Interagency Trust Rating System (SR 82-28 FRB, revised 5/82) which provides a basis for the evaluation of critical areas of supervisory concern. The rating system is generally used by federal supervisory agencies to assess the condition of trust institutions. However the system can be adopted to report on advisory operations as well.
Where the inspection uncovers significant deficiencies which require corrective action, and the inspection was not done in conjunction with a concurrent bank holding company inspection, a separate report should be prepared and delivered to the examined institution. Send a copy of the summary and any report comments to the Trust Activities Program, Washington D.C., 20551.
SR letters | 1991