Domain 10: Risk Management

Body of Knowledge

Compliance programs are designed to prevent compliance problems from happening and to catch them if they do occur.  To accomplish this, broker-dealers, investment advisers and investment companies (“Firms”) should establish appropriate policies and procedures to guide and control work in all areas that present compliance risks. 

Every Firm is exposed to operational risks that can result in harm to clients and/or cause the Firm to violate Federal securities laws or regulations.  Some risks, such as conflicts of interest, are common to all Firms, whereas others are Firm specific.  In particular, Firms typically have an array of risks that are unique as a result of their organizational structure, affiliate relationships, business partners, diversity of client base, products and services offered to clients, geographical location and staff.

An important step in creating and maintaining appropriate and relevant policies and procedures is to identify risks areas and potential problems at the outset and on an ongoing basis.  In order to accomplish this goal, every Firm should create a repeatable process that operates firm wide through which it can conduct periodic risk assessments.  The end result of this effort should be an inventory of potential risks and problems that reflects the current risk environment of the Firm and a corresponding set of policies and procedures tailored to address these risks.  Further, it is also important for Firms to recognize that their inventory of risks is not static.  Every Firm should treat its inventory of risks as a living document that should be constantly updated to reflect the changing kaleidoscope of compliance risks confronting the Firm as the environment in which it operates changes.  As new risks are identified, they must be properly addressed in the Firm’s compliance policies and procedures.

Through a series of readings and course materials, compliance professionals will learn how to develop a risk management program that ensures adherence to company policies, procedures and internal processes consistent with applicable laws, regulations and industry best practices.  As part of this process, the compliance professional will discover how compliance and operations can work together to help the Firm identify risks and potential conflicts of interest.  In particular, the risk management curriculum focuses on four specific areas:

Readings

1.	Compliance Programs of Investment Companies and Investment Advisers, 68 FR 74714 (Dec. 24, 2003)
2.	Stephen M. Cutler speech “Remarks Before the National Regulatory Services Investment Adviser and Broker-Dealer Compliance/Risk Management Conference” September 9, 2003
3.	“Conducting a Risk Assessment” and “Risk Identification Questionnaire” Investment Adviser Association (2006)
4.	“Questions Advisers Should Ask While Establishing or Reviewing their Compliance Programs” May 2006
5.	NSCP 2006 National Conference Materials – IA Fundamentals of Compliance (Small Firms) – Pre-Conference Course; Aaron D. De Angelis, Brandywine Global Investment Management, LLC; Michelle L. Jacko, Core Compliance & Legal Services
6.	NASD Notice to Members 99-92 – Risk Management Practices
7.	NSCP 2006 National Conference Materials – BD Internal Audits and Inspections  Workshop V(a); Jerry C. Danielson, Lincoln Financial Group and Bruce Hiler, Cadwalder, Wickersham & Taft LLP
8.	“Operational Risk Management for the Buy Side,” International Association of Financial Engineers, (Nov. 1, 2002)

Every test question on NSCP's certification examination must be referenced to a valid, credible, and current resource. In addition to the aforementioned resources noted by the CDC, the Test Development Committee, during the item writing process, also referenced the following:

• NASD Rule 3010
• "The Ultimate Multiple Choice Test for Brokers: the ABC's of Mutual Fund Share Classes" July/August 2006; NSCP Currents; Patirica C. Foster
• NASD Fines Merrill Lynch, Wells Fargo and Linsco $19.4 Million For Improper Sales of Class B and C Mutual Fund Shares; News Release Monday, December 19, 2005

Learning Objective

The professional should be able to demonstrate a thorough knowledge of the role and purpose of risk management program, how to identify risks and potential conflicts of interest, how to mitigate those risks and conflicts with firm policies and procedures and how to conduct audits and reviews of risk areas.

Learning Outcomes

Compliance Programs of Investment Companies and Investment Advisers, 68 FR 74714 (Dec. 24, 2003)

After reading this SEC release, candidates should be able to:

• summarize the conflicts and other compliance factors creating risk exposure for an investment adviser and its clients.  (Knowledge and Comprehension)
• summarize the six risk areas that investment companies need to address in addition to the risk areas applicable to investment advisers.  (Knowledge and Comprehension)
• describe what the annual compliance review entails for an investment adviser/investment company.  (Knowledge and Comprehension)

Stephen M. Cutler speech “Remarks Before the National Regulatory Services Investment Adviser and Broker-Dealer Compliance/Risk Management Conference” September 9, 2003

After reading this document, candidates should be able to:

• identify the conflicts of interest contained within the five case studies cited (Paul E. Johnson; Prudential Securities; Jamison, Eaton & Wood; Nevis Capital Management; and Deutsche Asset Management). (Knowledge and Comprehension)
• analyze each of these cases and explain how each problem might have been avoided with appropriate compliance policies and procedures.  (Application and Analysis)

“Conducting a Risk Assessment” and “Risk Identification Questionnaire” Investment Adviser Association (2006)

After reading these documents, candidates should be able to:

• discuss the types of risks that may potentially harm the interests of an investment adviser and its clients.  (Knowledge and Comprehension)
• explain what should be done after a potential risk has been identified.  (Knowledge and Comprehension)
• discuss the types of questions that a risk assessment should take into consideration in order to identify potential risks to the adviser and its client’s interests.  (Knowledge and Comprehension)

“Questions Advisers Should Ask While Establishing or Reviewing their Compliance Programs”

This document identifies ten risk areas for investment advisers.  By answering questions directed at each of these areas, the adviser “can begin to develop a solid foundation for drafting policies and procedures designed to mitigate, manage and control each risk area in ways that reflect the adviser’s resources and need for assurance that violations can be prevented or, if violations occur, such violations will be detected promptly and corrected.” 

After reading this document, candidates should be able to:

• identify the seven areas a sound compliance management program should address.  (Knowledge and Comprehension)
• identify the six areas advisers providing investment advice should address.  (Knowledge and Comprehension)
• identify the six areas advisers providing brokerage services should address.  (Knowledge and Comprehension)
• identify the four areas advisers should address when establishing procedures for allocation of investment opportunities among clients.  (Knowledge and Comprehension)
• identify the six areas advisers should address when reviewing their code of ethics.  (Knowledge and Comprehension)
• identify the four areas advisers should address regarding valuation of client assets.  (Knowledge and Comprehension)
• identify the six areas advisers should address regarding safeguarding client assets.  (Knowledge and Comprehension)
• identify the four areas advisers should address when reviewing their marketing and performance advertising. (Knowledge and Comprehension)
• identify the three areas advisers should address regarding creating, recording and retaining books and records. (Knowledge and Comprehension)

IA Fundamentals of Compliance (Small Firm) by Aaron D. DeAngelis, Brandywine Globals Investment Management LLC and Michelle L. Jacko, Core Compliance & Legal Services  NSCP National Membership Meeting Pre-Conference Course October 17, 2006.

After reading this document, candidates should be able to:

• describe the ten “Critical Focus Areas” associated with an investment advisory firm. (pages 26-35).  (Knowledge and Comprehension) 

NASD Notice to Members 99-92 – Risk Management Practices

After reading this document, candidates should be able to:

• discuss the three cited examples of risk management policies and practices considered to contain material weaknesses.  (Knowledge and Comprehension)
• discuss the six cited examples of risk management policies and practices considered to be sound.  (Knowledge and Comprehension)
• summarize the role a firm’s senior management is expected have with respect to risk management. (Knowledge and Comprehension)

NSCP 2006 National Conference Materials – BD Internal Audits and Inspections  Workshop V(a), Jerry C. Danielson, Lincoln Financial Group and Bruce Hiler, Cadwalder, Wickersham & Taft LLP (pages 1-28)

This reading addresses broker-dealer office inspections and, specifically, non-registered offices.

After reading this document, candidates should be able to:

• summarize the requirements for inspections of broker-dealer offices. (pages 3-4) (Knowledge and Comprehension)
• describe the different office inspection cycles and the regulatory agencies that use them. (pages 4-7) (Knowledge and Comprehension)
• define a branch office and the nine typical exclusions. (pages 13-17)  (Knowledge and Comprehension)
• describe the typical reports and follow-up tracking corrective action plans (pages 19-22) (Knowledge and Comprehension)
• describe how to conduct risk-based focused in-house audits of a broker-dealer including identifying personnel to interview and documents to review. (pages 22 – 28)  (Knowledge and Comprehension)

“Operational Risk Management for the Buy Side,” International Association of Financial Engineers (Nov. 1, 2002)

After reading this document, candidates should be able to:

• summarize the seven key findings of the Operational Risk and Investor Risk Committees of the International Association of Financial Engineers pertaining to managing operational risk. (Knowledge and Comprehension)
• explain why operational risk management is driven more by business issues than regulatory issues. (Application and Analysis)
• discuss how one can use the problems of other Firms to help enhance and maintain a Firm’s compliance program.  (Application and Analysis)