CITRIN COOPERMAN2014 EDUCATIONAL SEMINAR

December 3, 20144:30PM– 6:30PMCitrin Cooperman

529 5th Avenue, 4th FloorNew York, NY

WHAT FINOPS NEED TO KNOW

BOB E. LEHMANPartner

LEHMAN & EILEN LLPAttorneys-at-Law

50 Charles Lindbergh BoulevardSuite 505

Uniondale, NY 11553Telephone Number: (516) 222-0888Facsimile Number: (516) 222-0948

Email Address: blehman@lehmaneilen.com Firm Website: http://www.lehmaneilen.com

This outline provides general information on the subject matter discussed herein. It is not designed to, and does not constitute legal advice on any matter and should not be relied upon for that purpose.

Copyright 2014All Rights Reserved

SUGGESTIONS FOR AVOIDING FINANCIAL REGULATORY PROBLEMS

I. INTRODUCTION

A. Three Rules to Live by

1. Follow the money.

2. Do not assume.

3. Use your common sense.

B. Know Your Client

1. What are its lines of business?

2. Is it sufficiently capitalized to conduct all of its business lines?

3. Have you assessed the quality of its management team?

a. Conduct due diligence background checks on the principals.

b. What hands-on experience do they have in running a broker-dealer?

c. Is management committed to devoting sufficient resources to managing its capital and compliance needs.

4. What systems are in place to monitor the capital requirements to conduct each business line?

5. Is the Firm’s accounting system up-to-date to record and monitor its net capital position for its intended businesses?

a. Are there proper checks and balances in place?

b. Are the Firm’s financial procedures and protocols appropriate for monitoring the financial position of the Firm?

c. Are the Firm’s Supervisory Procedures and protocols sufficient to alert the financial team of issues that may impact the Firm’s net capital on a real-time basis?

II. UNDERSTANDING THE FIRM’S BUSINESS

A. What are the lines of business?

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1. Establish and maintain appropriate books and records based on the actual business lines of the Firm.

2. What are the capital needs for each line of business and, in the aggregate?

3. For those member firms that introduce accounts on a fully-disclosed basis to a clearing firm, be sure that you have selected appropriate reports offered by the clearing firm to monitor the Firm’s business and activities.

4. For those firms which may receive customer funds and/or securities, they need to be sure that appropriate records and protocols are set up in advance.

a. In other words, who is designated at the Firm for handling the receipt, logging and further transmission of such funds and certificated securities?

b. When is this done?

c. What exactly should be recorded, logged and transmitted?

d. How will this be evidenced?

5. Ask and verify that the Firm is not engaged in any other businesses, such as commodity trading, FOREX activities, the purchase and sale of precious metals, etc.

a. Firms mistakenly believe that if they are not involved in the purchase and sale of securities, the Customer Protection Rule does not apply.

b. If a Firm receives customer funds for any purpose, the Customer Protection Rule is very much applicable even though the receipt of the customer’s funds does not pertain to the purchase and sale of securities.

c. Review the potential impact of the same on the Firm’s net capital.

d. Consider whether any new line of business may cause the Firm to violate its Membership Agreement with FINRA.

B. What systems are in place?

1. Establish and maintain an appropriate accounting system that is reasonably designed to handle the expected business of the Firm.

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2. Assure that the Firm has accounting software that is capable, at a minimum, of producing a general ledger, auxiliary ledgers, a trial balance, balance sheet, income statement, and a net capital computation, with backup capabilities.

3. It is critical that the Firm and the FINOP have complete and unfettered access to its accounting system.

4. If the Firm has an off-site FINOP, it is recommended that the FINOP have, at a minimum, 24/7 access to the Firm’s accounting system to review and monitor all financial transactions involving the Firm. Such FINOP should have, at a minimum, read-only access to the Firm’s bank accounts and clearing firm reports with unlimited access to see all of the Firm’s activities.

5. Map out the flow of money and the entire trade, settlement and confirmation process. It may sound simplistic, but if you approach your financial books and records requirements with this premise, you can identify all of the steps that are, and should be, taken as required by the member’s business. There is no one-size, fits-all system. Every firm is different.

6. Arrange for the delivery of those records which will enable the FINOP to track what is going on in the Firm, including bank statements and brokerage statements, as well as the securities activities of the Firm and its customers.

a. Tailor the Firm’s books and records to what is relevant for the Firm.

b. Some records should be reviewed daily, such as trade break reports, money lines, firm trading records, error account records, margin balances, missing document records for customers, etc.

c. Other records may be reviewed weekly.

d. Consider which books and records can be reviewed less frequently, e.g., monthly, quarterly, semi-annually or annually.

e. Keep a calendar and checklist of the records that should be reviewed at these various intervals.

7. If the Firm uses a clearing firm, select those exception reports which are applicable to its business. Some examples include:

a. Unsecured and partly secured debit balances;

b. Money lines;

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c. Margin accounts;

d. Commission reports;

e. Error reports;

f. Proprietary account reports;

g. Trade details (confirmations and comparison reports);

h. Incomplete document reports (e.g., missing customer agreements, particularly those covering options, municipal securities, margin and tax forms);

i. Large open position reports; and

j. Reports, if available, which identify customer accounts or patterns of specified activity in a customer’s account, such as those with more than five trades effected during the preceding month, and those which identify a high level of cancel and rebills by a particular broker (a potential flag to investigate whether there are authorized transactions which, in turn, may lead to a capital charge to the member).

8. Compensation arrangements with all associated persons (which need to be in writing). This has been a hot topic during the last couple of years. If there is no employment, independent contractor or other form of agreement between those working for the Firm and the Firm itself, there needs to be some records to memorialize the arrangements. Absent the same, the underlying issue is not just the failure to maintain the necessary books and records, but the potential failure of the Firm to record all of its liabilities on its books and records. Note: Under New York’s Labor Law, absent a written agreement with a commission salesperson, the salesperson’s understanding of the arrangement is presumed correct.

9. Impress upon Management the need to build, implement and maintain effective Supervisory, Compliance and Financial Systems.

10.Impress upon the Firm’s ownership the need for the broker-dealer to have sufficient capital to carry out its intended mandate. Maintaining sufficient net capital in the Firm often softens all other financial problems.

III. IS THE FOX GUARDING THE HENHOUSE

A. Are there proper checks and balances in place?

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1. Establish, maintain and enforce financial controls reasonably designed to keep track of all of the Firm’s assets, liabilities, ownership equity and cash flow.

a. Who has access to reports that show deficiencies?

b. Is there any potential conflict with such individual having access to such reports? For example, a trader should not be responsible for reviewing and addressing trade breaks.

2. There should be tight controls as to the persons who have authority to access the system and for what specific purpose.

a. From a Firm perspective, it is best to have the Firm’s books and records maintained at the Firm’s headquarters.

b. The Firm should not be in a position where its access to its books and records can be denied or limited.

c. Separation of the accounts payable and accounts receivable functions is an important means to ensure there are appropriate controls in place.

B. Tailored Supervisory Procedures and Protocols.

1. Adopt specific written supervisory procedures to ensure that all those involved with, or who could impact, the financial condition of the Firm notify, in advance, the FINOP of those matters which may impact the financial well being of the Firm. Require management to notify the FINOP of those matters which MAY have an impact on the financial condition of the Firm, including, without limitation:

a. Known or contingent liabilities;

b. Knowledge about the material assets of the Firm, particularly if the Firm is a trading firm and maintains significant positions in a small concentration of securities - test on at least a monthly basis;

2. Notification of claims made against the Firm or any of its executive officers, managers or key personnel for whom indemnification may be provided by the Firm, whether such claim is in the form of a customer complaint, arbitration or litigation;

3. Notification of intention to settle any claims - agreements in principle do not have to be reduced to a writing but if probable and quantifiable, will trigger a liability;

4. Notification of resolution of claims;

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5. Existing or anticipated subordinated loan arrangements;

6. Existing or contemplated compensation arrangements, particularly if there are guaranteed payments, bonuses - whether discretionary or not – which need to be carefully reviewed to verify what they specifically provide;

7. Anticipated withdrawals of capital, advances and loans to shareholders, partners, limited liability company members, etc. - Rule 15c3-1(e) issues - including tax distributions;

8. Anticipated underwriting and selling group commitments –

a. The Firm’s corporate finance department may trigger open contractual commitment haircuts based on underwriting or selling group commitments.

b. Note that a selling group member may be subject to an open contractual commitment haircut if it does not have a written agreement in place with the underwriter to return any unsold portion of the securities being offered.

c. Members may need to secure Temporary Subordinated Loans or draw down under existing Revolving Subordinated Loans.

d. Multiple deals cause headaches for the FINOP. The Firm needs to be in moment-to-moment compliance with the Net Capital Rule.

9. Position limits on trading the Firm’s capital, both on a security-by-security basis, and in the aggregate;

10.Consider establishing an Executive Capital Commitment Committee to pre-approve use of the Firm's capital.

11.Engagement of sufficient qualified personnel to support the accounting functions which need to be performed.

12.Proper training and education of personnel who are involved in the Firm’s financial management and reporting process.

13.Coordination of personnel and establishment of an appropriate timetable to assemble all necessary information to prepare and timely file all FOCUS Reports, Supplemental Statements of Income and other submissions to be made to the regulatory authorities.

14.Necessity for senior management of the Firm to include the FINOP in those decisions which may have an impact on the financial condition of the Firm.

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a. It is recommended that the FINOP establish and maintain a system that ensures that the FINOP is advised of any events or circumstances which may have an impact on the financial condition of the Firm. Preferably, this should be set up on an automated basis, in which the FINOP has a standing monthly request, and as circumstances warrant, at any time of an extraordinary event, which requires all members of senior management and the key principals of the Firm, including the Chief Executive Officer, Chief Compliance Officer, Chief Administrative Officer, Chief Legal Officer, the heads of each business unit, and the Controller, to notify the FINOP of any matter which may have a material impact on the Firm’s financial position.

b. Depending upon the circumstances, it may be advisable for the FINOP to confer with the Firm’s regular outside counsel to determine if there is any matter which may require an accrual by the Firm. The FINOP should document every inquiry and response.

c. It may be as simple as sending and recording emails to and from the FINOP on a monthly basis and as such circumstances arise.

d. It is imperative that the FINOP ensure that he or she is made aware of these events.

15.Need to investigate and follow-up on matters which are or were identified as issues and verify that all necessary corrective actions have been taken. It is not enough to simply raise the issue and accept, without verification, that the issue has been resolved. Again, document everything.

C. Financial Procedures – the Details. Among other matters, they should include, without limitation:

1. Identification of the specific books and records to be reviewed.

2. What should be reviewed and examined?

a. The general ledger and auxiliary ledgers – have all entries been made?

b. Bank statements and brokerage statements.

c. Verification of all assets and liabilities.

i. Evidence of current valuations, particularly of thinly-traded securities.

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ii. Does the Firm own its assets free and clear of any encumbrances, liens, etc.

iii. Expense reports, credit cards, etc.

iv. What is the status of payroll and bonuses, if any?

v. What is the status of current lawsuits, arbitrations, payables, etc.?

vi. Examine each line item to ensure there is current support for the same.

3. Preparation of bank reconciliations.

4. Accounts payable and accounts receivable.

5. Preparation of balance sheet and trial balance.

6. Preparation of Statement of Income (or Cash Flows).

7. Preparation of net capital computations.

8. Assembly and verification of the Firm’s FOCUS Reports and Supplemental Statements of Income.

9. Proof of filing of the same.

10.Who is responsible for each of the foregoing steps?

11.What is the timeline to complete each step?

12.How are the steps evidenced?

13.Broker-dealers should have their internal audit departments and/or outside experts, such as consultants, experienced FINOPS and lawyers familiar with the brokerage business, review the Firm's systems and records.

14.Consider engaging external experts to conduct a mock audit of the Firm. They are a wonderful tool for identifying and fixing problems before they become significant issues.

IV. ISSUES TO BE ADDRESSED

A. Customer Protection Rule - Rule 15c3-3 and NASD Conduct Rule 2110 and General Handling of Customer Funds and Securities.

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1. Establish, maintain and monitor the Special Reserve Account for the Exclusive Benefit of the Firm’s customers.

2. Establish, maintain and monitor complete and accurate books and records to reflect the receipt, delivery and transmittal of:

a. customer funds, including a proper receipt and disbursement blotter; and

b. certificated securities, including establishment and maintenance of appropriate receipt and delivery blotter.

3. For introducing broker-dealers which do not have authority to take possession or control of customer funds or securities, proper notification has to be given to customers to send checks directly to the clearing firm, mutual fund or issuer.

4. Sales personnel need to be instructed to tell customers to send checks directly to their clearing firm, mutual fund or issuer (cover this in the Firm’s Supervisory or Registered Representative Procedures).

5. Ensure that there is proper notification included on confirmations sent to the customer as to whom such checks should be made payable and where they should be sent.

6. If the Firm were to receive a check from a customer, send a follow-up letter to the customer informing him or her of the requirement to forward checks directly to the party indicated on the confirmation. Maintain a record of this instruction both in the customer’s file and in a separate file where you also maintain the Firm’s checks received and forwarding blotter.

B. How is the Firm ensuring that it is fulfilling its Anti-Money Laundering requirements, including addressing the USA PATRIOT Act, the Bank Secrecy Act and OFAC?

1. You should take the time to ensure that you have procedures in place which cover the movement of funds, even if the funds are handled by the clearing firm.

2. Appoint a gate-keeper and at least one backup to monitor the flow of funds into and out of the accounts of customers.

C. Regulation S-P. Is the Firm ensuring that customer information is protected when shared with its FINOP?

1. You need to be mindful of the requirements of Regulation S-P, particularly when sharing information with others, especially when the

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Firm’s vendors and service providers, including any off-site FINOP, its Information Technology provider and other consultants, have access to such information through the Firm’s computer network or otherwise.

2. The Firm needs to take reasonable steps to protect the confidential information provided by its customers to these vendors.

3. Consider requiring all electronic communications concerning customer information be limited to distribution only on the broker-dealer’s e-mail domain. How can the Firm otherwise ensure that the information is protected? Consider the situation where customer information is shared by the Firm with its FINOP to review a financial issue concerning the customer’s account. Delivering the customer’s information to its FINOP or vendor by means that are outside of the Firm’s control, and could be in violation of Regulation S-P.

4. Verify the privacy policy of each vendor and ensure that the information you provide to them is adequately protected.

5. Consider updating your Privacy Policies and notices to reflect the sharing of such information with the Firm’s vendors and professionals.

V. MONITORING OF THE OUTSIDE FINOP

A. A Firm has a continuing duty to monitor the activities of the Outside FINOP, including his or her outside business interests.

B. The Firm needs to ensure that it can monitor and retain all emails, instant messages and other communications sent to or on behalf of the FINOP, whether to or from personnel at the Firm, or to or from the regulatory authorities, which involve the Firm.

C. As with other associated persons, the Firm needs to ensure that the Form U4 and Associated Person Questionnaire of the FINOP is maintained on a current basis.

D. The Firm should ensure that the FINOP has sufficient time to deal with the Firm’s financial issues. It would be best to make a record of the same on some periodic basis, perhaps quarterly, semi-annually, but in no event less than annually, to ensure that the needs of the Firm are being served.

E. The Firm should ensure that its Written Supervisory Procedures sufficiently describe the responsibilities of the FINOP, including, without limitation, when and what books and records should be reviewed. This also includes the process of performing bank reconciliations, preparation of net capital computations and filing of the Firm’s FOCUS Reports and Supplemental Statements of Income on a timely basis.

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F. As noted above, it is essential that the Firm has in place appropriate confidentiality provisions to protect the information concerning the Firm’s customers, as required by Regulation S-P. This is particularly an issue with part-time FINOPs.

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