Exception Report

Ahead of a scheduled regulatory exam, a principal directs staff to compile exception report logs showing every alert as "reviewed and cleared," while the actual working file used day-to-day — which shows several alerts left open for months — is kept separately and not provided to examiners. What is this?

1. A.It is acceptable as long as the exception reports provided to examiners are internally consistent with each other, regardless of whether they match the working file.Wrong. Internal consistency between fabricated documents does not make them accurate; the problem is that they misrepresent the firm's true operational record.
2. B.It is the creation of a second, misleading set of records for regulators while the true operational record is withheld — a serious falsification of the firm's actual books and records, not merely an incomplete recordkeeping practice.Correct. Maintaining a sanitized version for examiners while the true record exists elsewhere is falsification of the firm's books and records, a materially more serious violation than incomplete review alone.
3. C.It is a deficiency only because the working file was not also provided; providing either set alone would have been sufficient.Wrong. The two sets are not interchangeable alternatives — one is accurate and one is misleading, and providing the misleading one to regulators is itself the violation.
4. D.It is a supervision failure because the alerts were left open for months, but the separate recordkeeping practice itself is not independently a violation.Wrong. This understates the conduct: creating a sanitized second set of records for regulators is a distinct and separate violation from the underlying exception-handling delay.

Why: This is the creation of a second, misleading set of records for regulators while the true operational record is withheld — a serious falsification of the firm's actual books and records, not merely an incomplete recordkeeping practice.

A principal's exception reports for penny stock activity are configured to flag only individual transactions above a certain dollar size. A representative who generates high commissions through a rapid, high-frequency pattern of small penny stock trades in a customer's account never appears on any exception report because no single trade is large enough to trigger it. What is the flaw in this surveillance design?

1. A.There is no flaw, since reviewing only larger transactions focuses supervisory attention where the dollar risk is greatest.Wrong. A high-frequency pattern of small trades can present equal or greater concern and would be missed entirely.
2. B.The design misses patterns of frequent, high-cost trading because it only screens for individually large transactions rather than reviewing frequency and pattern.Correct. Surveillance must consider frequency and pattern, not just the size of individual trades.
3. C.The flaw is that the dollar threshold used for the exception report was set too low rather than too high.Wrong. Adjusting the threshold wouldn't fix the structural gap of ignoring frequency and pattern altogether.
4. D.The flaw only matters if the customer's account is a discretionary account.Wrong. The surveillance gap exists regardless of whether the account is discretionary or non-discretionary.

Why: Reviewing penny stock activity only for individually large transactions misses patterns of frequent, high-cost trading that can be just as concerning — including potential excessive trading — in an account; supervisory review must also consider the frequency and pattern of activity, not only the size of any single trade.