Continuing its efforts from previous years to provide meaningful feedback to member firms, FINRA’s Report provides guidance to assist firms in complying with FINRA rules and federal and state securities laws. As with all FINRA guidance, firms should consider information contained in the Report seriously. A firm that does not adopt such guidance should consider whether it can demonstrate that its procedures are equally effective.
The following summarizes the topics and findings in the Report and includes best practices. While some of the issues discussed in the Report may remind firms about basic responsibilities, other topics, such as the discussion of volatility-linked products, suggest that firms may need to formulate new review processes or procedures based on findings in the Report.
Suitability for Retail Customers
FINRA observed situations where registered representatives did not adequately consider their customers’ financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors when making recommendations. Registered representatives often fail to take into account cumulative fees, sales charges or commissions charged. FINRA found that firms with sound supervisory practices for suitability generally identify risks, develop policies and implement controls tailored to the specific features of products they offered to their customers. These controls include restricting recommendations of products for certain investors, as well as establishing systems-based controls (or “hard blocks”) for recommendations of those products to retail investors to ensure that registered representatives adhere to those restrictions. Further, we note that suitability considerations and controls should equally be used when recommending listed products, as we understand that FINRA may view certain listed products as not suitable for certain, or any, investors.
Findings From Targeted Examination of Volatility-Linked Products
Following the high-volatility market conditions of February 2018, FINRA conducted a sweep to assess firms’ supervisory systems and controls to meet their suitability obligations when recommending volatility-linked products to retail customers. Many firms have comprehensive written supervisory procedures (WSPs) and controls regarding such products, and several firms prohibit or restrict representatives’ recommendations to retail clients for all or some volatility-linked products. The Report urges firms that recommend any complex or risky products, such as leveraged and inverse exchange-traded products, to focus on suitability when communicating or making recommendations to customers. These findings are a reminder that firms should consider exchange-listed products in their new product approval process; simply because a product is listed on an exchange does not mean that a firm’s representatives should be recommending it to retail customers.
Fixed Income Markup Disclosure
To implement the markup disclosure rules, the Report states that firms should consider performing a regular review of confirmations to review whether they include the new disclosures on all confirmations that require them. In particular, firms should review samples of their confirmations for all of the required disclosure elements, including markup/markdown and time of execution. FINRA observed that in implementing the amended FINRA and Municipal Securities Rulemaking Board rules, some firms face challenges relating to their confirmation review processes, systems and vendors. For example, certain firms fail to enter information into order entry systems or make inadequate disclosures for agency trades.
Reasonable Diligence for Private Placements
FINRA observed instances where some firms with suitability obligations failed to conduct reasonable diligence on private placements and failed to meet their supervisory requirements under FINRA Rule 3110. Firms with the strongest compliance programs perform reasonable diligence; conduct meaningful, independent research on material aspects of each offering; identify any red flags with the offering or the issuer; and address concerns that would be relevant to each potential investor. These firms independently verify information that was key to the performance of the offering, and some employ due diligence firms, experts and third-party vendors. These considerations apply with special force to offerings involving affiliated issuers or issuers whose control persons are employed by the firm — offerings that also may require extra due diligence and disclosures concerning conflicts of interest.
Abuse of Authority
FINRA’s Report reminds firms that engage in trustee roles or act on discretionary trading authorization from customers that such activity can expose investors to material risks (e.g., unsuitable or excessive trading) unless firms implement appropriate controls required by National Association of Securities Dealers Rule 2510 (Discretionary Accounts). FINRA observed that some firms prohibit the use of all discretionary customer accounts. Firms that permit such accounts establish and maintain robust supervisory procedures and controls, such as automated systems to detect potential excessive trading in customer accounts, inconsistencies or errors related to the completion of customer new account forms, and indications of customers granting discretionary authority to their registered representatives. Further, certain firms prohibit registered representatives from acting in some positions of trust, such as trustees or co-trustees, executors or beneficiaries. Other firms mitigate the potential conflicts of interest involved in such roles by implementing additional supervision and review procedures.
SUMMARY OF ADDITIONAL OBSERVATIONS
FINRA highlighted the issues above as ones of primary importance. However, the Report discusses various additional issues.
Anti-Money-Laundering — FINRA continued to find problems with some firms’ overall anti-money-laundering (AML) programs; allocation of AML monitoring responsibilities, particularly responsibilities for trade monitoring; data integrity in automated AML surveillance systems, such as suspense accounts for processing foreign currency movements and conversions; adequacy of firm resources for AML programs; and independent testing of AML programs.
Accuracy of Net Capital Computations — Firms have faced challenges in complying with the net capital rule and related guidance from the Securities and Exchange Commission staff, particularly with respect to operational charges, inventory haircuts and documentation of expense-sharing agreements.
Liquidity — FINRA observed that many firms have substantially strengthened their liquidity management practices, but some firms would benefit from expanding the breadth and scope of their stress testing. FINRA recommends that firms assess whether extended stress test periods and a greater focus on incorporating stress tests results into firms’ business models would strengthen firms’ compliance programs.
Segregation of Client Assets — FINRA observed various shortcomings including inconsistent check-forwarding processes, challenges with possession and control and inaccurate reserve formula calculations.
Operations Professional Registration — FINRA observed that some firms permit unregistered staff to engage in activities that require registration as an operations professional, such as approving general-ledger journal entries, acting as supervisors and approving certain business requirements.
Customer Confirmations — FINRA observed that some firms did not maintain adequate supervisory programs relating to confirmations or comply with certain confirmation disclosure under Exchange Act Rule 10b-10 and FINRA Rule 2232 (Customer Confirmations) for transactions with customers in equity securities. Most confirmation deficiencies are caused by programming errors. Frequent and thorough review can discover such issues early and potentially prevent thousands or millions of violations.
DBAs and Communications With the Public — FINRA observed that certain firms did not maintain sufficient WSPs and controls or provide adequate disclosures regarding the use of “doing business as” names. These issues may lead to failures to disclose firm names on correspondence to retail customers or lack of a hyperlink to BrokerCheck on the websites of registered representatives.
Best Execution — FINRA advised that firms should not allow conflicts of interest relating to financial benefits from routing orders to particular venues to affect the objectivity of their regular and rigorous review. Also, firms should engage in regular and rigorous review for execution quality, including comparing a firm’s current order-routing destinations to market centers it is not routing to and conducting such review by order type.
TRACE Reporting — FINRA observed that some firms engaging in institutional sales of fixed-income securities did not comply with certain key Trade Reporting and Compliance Engine reporting rules, specifically FINRA Rules 6730(a)(7), 6730(b)(1) and (2), 6730(c)(8) and 6730(d)(4)(E). Many of these issues were discussed in FINRA’s report issued last year.
Market Access Controls — FINRA generally observed that some firms continue to encounter challenges with intraday adjustment of pretrade financial thresholds and oversight of third-party vendors. Further, we recommend that firms ensure that they are able to demonstrate the basis for market threshold controls and have WSPs for all order controls, including single-order controls tailored to the trading characteristics of a given security, as applicable.
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