On January 6, 2015, FINRA released its annual Regulatory and Examination Priorities Letter (Letter) for 2015. As in prior letters, FINRA discusses specific areas of focus it believes threaten investor interests and market integrity. Significantly, however, FINRA discusses a number of general concerns that contribute to overall compliance and supervisory concerns. Firms should use the Letter to review their compliance and supervisory procedures and to make revisions if necessary. Firms also should be prepared to address the firm’s compliance and supervisory policies in these areas in their upcoming FINRA examinations.
Overall Concerns and Guiding Principles
FINRA has observed challenges in five areas that contribute to compliance and supervisory issues. Those areas are: 1) the alignment of firm and customer interests (putting customer interests first); 2) the standards of ethical behavior (the firm’s culture); 3) supervision, risk management and controls; 4) development, marketing and sales of novel products and services; and, 5) management of conflicts of interests.
FINRA believes that many firms are not putting customer interests first and that this is particularly harmful when it involves vulnerable investors such as seniors. FINRA states that a firm’s interests must be aligned with their customers’ interests (by putting the customers’ interests first) and doing so will reduce regulatory risk.
FINRA believes that many of the regulatory problems they observe have their roots in a firm’s culture. FINRA stresses that firms must create the proper business environment for a good culture to flourish and that firms’ boards and senior executives must articulate and practice high standards of ethical behavior. Those same standards and expectations should be imbedded in a firm’s incentives. Moreover, a firm’s policies should make clear that poor and unethical practices, whatever the magnitude of the harm caused or potential implications, will not be tolerated (the broken window principle). Firms should review their procedures and policies in light of these standards.
FINRA maintains that a firm’s system of supervision, risk management and controls are essential safeguards and protect and reinforce a firm’s culture. And one indicator that a firm is meeting this objective “would be that it has already identified and addressed the concerns FINRA identifies in [the] Letter.” In this light, a firm should not only be able to demonstrate to FINRA that its policies and procedures address the areas of focus discussed in the Letter, it also should be able to demonstrate that it has established and is enforcing the newly implemented supervisory rules (FINRA Rules 3110, 3120, 3150 and 3170) and requirements to investigate the background of new hires (FINRA Rule 3110(e)).
As in prior annual Letters, FINRA is concerned about complex and new product offerings and services. FINRA stresses that firms need to continue to conduct rigorous new product reviews, assess reasonable basis and customer-specific suitability analyses prior to offerings and permit wealth management to make independent decisions about the products and services that are best for their customers.
While FINRA states that it has observed positive changes since it issued its Report on Conflicts of Interest (October 2013), it points out that it has recently imposed enforcement action regarding conflicts of interest related to the issuance of favorable research and is reviewing situations where market access customers self monitor and self report suspicious trading despite inherent conflicts of interest. Additionally, FINRA continues to review fee and compensation structures that give rise to conflict of interest issues. FINRA believes that firms must continue to be diligent in identifying and addressing conflicts.
Concerns Regarding Compliance with Regulatory Requests
Firms should be acutely aware that FINRA has expressed a serious concern with firms’ compliance with regulatory requests. Specifically, FINRA states that it has experienced an increasing number of situations in which firms have repeatedly failed to provide timely responses to information requests made in connection with examinations and investigations.
FINRA states that this failure to provide information is particularly troubling because FINRA discusses large and complex information requests with firms and is flexible with respect to due dates, rolling productions, scope and format—as long as the integrity of the regulatory matter is not compromised. As firms have experienced, FINRA’s requests sometimes call for significant documentation and information that far exceed books and records maintenance requirements. These requests can stretch compliance resources to the point that it endangers ongoing compliance efforts, and requires the development of new programming and automated queries to identify the data requested and then produce it in the specific form the FINRA staff requires.
Further, FINRA examiners and investigators are not always as accommodating and understanding as the Letter states and sometimes refuse to modify the scope or timing of the request. This being said, FINRA requests must be timely and accurately complied with and the response cannot be conditioned. With that in mind, it is best to be in constant communication with the staff regarding production and any difficulties the firm may be having in complying with the completion of the production or its timeliness.
Specific Areas of Focus
The 2015 priorities focus generally on three different areas: 1) sales practices; 2) financial and operational concerns; and 3) market integrity matters. As in prior Letters, some of the specific areas of focus have been discussed in prior annual Letters.
As in prior years, FINRA is focused on certain products and related distribution and sales practices. Some of these products are complex and may have recently been modified to be marketed to retail customers. FINRA is always concerned that a proper reasonable basis and customer-specific suitability analysis is conducted, that registered representatives are trained and understand the product and that the product risks are described in a balanced manner that investors can understand. FINRA’s 2015 surveillance and examination activities that include product-related risk reviews will routinely focus on due diligence, suitability, disclosure, supervision and training.
As in prior years, the specific products discussed in the Letter include : 1) Interest Rate-Sensitive Fixed Income Securities; 2) Non-Traded Real Estate Investment Trusts; 3) Variable Annuities; 4) Exchange-Traded Products; and 5) Structured Retail Products. The Letter discusses for the first time the following products:
Floating-Rate Bank Loan Funds
Retail investors are exposed to bank loans through mutual funds, closed-end funds and exchange-traded funds (ETFs) in an effort to protect against the threat of rising interest rates. Despite the promise of hedged exposure to interest-rate risk, these loans can carry significant credit and call risk.
Securities-Backed Lines of Credit (SBLOCS)
SBLOCs are revolving, non-purpose loans that allow investors to borrow money from lending institutions using fully paid-for securities held in their brokerage accounts as collateral. FINRA has observed that the number of firms offering SBLOCs is increasing and is concerned about how they are marketed.
IRA Rollovers and Other “Wealth Events”
FINRA has previously expressed concerns about the suitability of recommendations to open IRA rollover accounts. This year, FINRA has broadened its concern to focus on firms’ controls around the handling of all so-called “wealth events” in investors’ lives. Wealth events refer to those situations where an investor faces the decision about what to do with a large amount of money arising from an inheritance, life insurance payout, sale of a business or other major asset, or divorce settlement, in addition to an IRA rollover. In 2015, examiners will focus on the controls firms have in place related to wealth events, with an emphasis on firms’ compliance with their supervisory, suitability and disclosure obligations. Firms’ systems should be reasonably designed so that the financial incentives to the associated person or the firm do not compromise the objectivity of suitability reviews.
Alternative Mutual Funds
Alternative mutual funds are often marketed as a way for retail customers to invest in sophisticated, actively-managed hedge fund or private equity-like strategies that may perform well in a variety of market environments. Alternative mutual funds generally purport to reduce volatility, increase diversification, and produce non-correlated returns and higher yields compared to traditional long-only equity and fixed-income funds, all while offering daily liquidity. FINRA is concerned that registered representatives and customers may not understand how the funds will respond to various market conditions or even the strategy in which the fund’s adviser will engage in various market scenarios. In addition, FINRA believes that some firms are not reviewing alternative mutual funds through their new-product review process, such as when the firm already has an existing agreement with the mutual fund family.
Other Sales Practice Concerns
FINRA examiners will focus on firms’ supervisory processes, systems and controls concerning how firms monitor for excessive trading and product concentration. FINRA examiners will review the criteria for exception reports firms use and the adequacy of firms’ follow-up on such exceptions. FINRA examiners also will review customer communications and account activity to determine whether aggressive trading strategies were recommended and whether broker-recommended transactions, or series of transactions, constitute excessive trading or result in a customer’s portfolio becoming over-concentrated in a particular type of product.
FINRA has observed that in some instances customers do not receive the volume discounts (breakpoints) or sales charge waivers to which they are entitled when purchasing products such as non-traded REITs, Unit Investment Trusts, Business Development Companies and mutual funds. FINRA has addressed this issue through examinations and enforcement actions in the last few years and will make it a priority again in 2015. FINRA also plans to launch examinations of municipal advisors, including whether firms are properly applying exceptions and exemptions from municipal advisor registration.
In the anti-money laundering area (AML), FINRA will focus on certain types of accounts, including Cash Management Accounts (CMAs) and certain Delivery versus Payment/Receipt versus Payment (DVP/RVP) accounts. FINRA examiners also will focus on the adequacy of firms’ surveillance of customer trading. Firms should tailor customer trading surveillance around the AML risks inherent in their business lines, products and customer bases. Customer trading activity can involve different types of suspicious activity reportable on Suspicious Activity Reports, including market manipulation, insider trading and microcap fraud. FINRA examiners will evaluate whether firms have systems to monitor for red flags indicative of suspicious customer trading activity.
Financial and Operational Priorities
For 2015, FINRA concerns in this area include complete, accurate and timely filing of Form U4s and Form U5s, appropriate due diligence, risk assessment and supervision of outsourced functions. FINRA also intends to review for cyber security risk management and firms’ compliance with the electronic data storage requirements of SEC Rule 17a-4(f).
FINRA will also focus on the mark-to-market pricing of infrequently traded positions in corporate, asset-backed and municipal debt securities and will examine for the integrity of marks-to-market for such securities and for supervisory controls surrounding the overall valuation process. FINRA also expressed concern about firms that engage in practices that could endanger the tax-exempt status of some interest payments, or that could result in customers losing FDIC insurance coverage for bank certificates of deposit.
As in previous years, FINRA will focus on abusive algorithmic trading and layering, spoofing, wash sales and other manipulative trading practices. FINRA also will continue to use its developing technology to detect and to deter cross-market and cross-product manipulation. Its capabilities in this area have been enhanced as it performs regulatory services for an increasing numbers of exchanges.
FINRA has identified a number of concerns regarding the supervision and governance of technology that it will be examining in 2015, including: 1) controls for the development and ongoing supervision of algorithms; 2) controls for the development and testing of technology changes; 3) the segregation of technology personnel that perform developing, testing, deploying and modifying new and existing technologies, and, 4) the firm’s risk management and financial and operational controls with a focus on net capital with respect to high frequency trading.
FINRA also is focused on order routing practices, best execution and disclosure. Specifically, FINRA is determining whether firms base routing decisions on the benefits to the firms without thoroughly evaluating the potential conflicts presented and the quality of execution they receive for customer orders. FINRA also will continue to review whether options floor brokers meet their best execution obligations and conduct appropriate reviews of the execution quality the options floor brokers receive on their customers’ behalf. Now that FINRA is the designated examining authority for almost two-thirds of options trading, FINRA will expand its efforts to detect cross-market and cross-product manipulation affecting options prices.
Additionally, FINRA maintains that electronic trading of fixed income securities has given firms access to improved data and tools to evaluate best execution and mark-ups. In 2015, FINRA will increase its emphasis on reviewing firms’ fixed income pricing practices, including whether firms have the supervision and controls in place to ensure they are using reasonable diligence and employing their market expertise to achieve best execution for their customers and avoiding excessive mark-ups (and mark-downs).
FINRA will also launch a pilot program to conduct fixed income-based examinations focusing on trading issues, including related controls. Among other things, the fixed income examinations will focus on the operation of alternative trading systems for fixed income trading.
Regarding compliance with the Market Access Rule, FINRA states that it continues to find examples of firms’ inadequate market access controls in both the equities and options markets related to potential rule violations (e.g., manipulation) and erroneous activity (e.g., erroneous quotes). Additionally, FINRA has observed that some firms mistakenly believed that the Market Access Rule did not apply to the fixed income markets.
FINRA also plans to commence a pilot program to leverage the relationship trading alert activity detected in its cross-market surveillance program to provide firms with information intended to supplement firms’ supervision efforts with respect to detecting and preventing manipulative trading activity. This means that firms will be required to review their customers’ conduct for potentially manipulative activity through multiple broker-dealers or markets.
If you have any questions regarding this update, please contact one of the following Sidley lawyers:
Timothy B. Nagy
Michael D. Wolk
W. Hardy Callcott
Neal E. Sullivan
Barry W. Rashkover
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