FINRA’s Regulatory and Examination Priorities for 2015
The Financial Industry Regulatory Authority (“FINRA”) has released its 10th annual Regulatory and Examination Priorities Letter. In this annual open letter, FINRA puts its member firms on notice of the particular issues of importance to FINRA’s regulatory staff. Some highlights of FINRA’s letter are discussed below.
FINRA begins by identifying challenges that it says consistently contribute to firms’ compliance and supervisory breakdowns. FINRA suggests that firms proactively address these recurring challenges before they blossom into one of the regulatory concerns raised by FINRA later in its letter.
RECURRING CHALLENGES FACED BY FIRMS
Not Putting Customers First FINRA has observed firms not putting their customers’ interests first. As FINRA points out, the harm to investors caused by firms putting their own interests first may be compounded if it involves vulnerable investors or a major liquidity or wealth event in the investor’s life. According to FINRA, firms will reduce their regulatory risk if they put their customers’ interests first.
Poor Firm Culture An example of poor firm culture cited by FINRA is where firm management emphasizes short-term profits or seeks rapid growth without equal concerns for compliance controls. FINRA states that firms’ boards and senior executives must implement and observe high standards of ethical behavior. Firms should be clear in their policies that poor practices will not be tolerated.
Inadequate Supervisory and Risk Management Systems Inadvertent harm to investors and intentional acts of malfeasance may be prevented if firms have strong supervisory and risk management systems in place. One proactive approach identified by FINRA is a firm’s use of data analytics to identify problematic behavior.
Sales of Non-Traditional Investments Additional steps need to be taken by firms with respect to the review of new non-traditional products. FINRA acknowledges that many firms have made improvements in this area, but this issue remains an area of concern for regulators. Firms land in regulatory hot water because of increasingly complex products, a lack of transparency in the market for the product, inadequate product disclosures, and insufficient understanding of the new products by salespeople.
Conflicts of Interest Compensation structures can compromise the objectivity of stock brokers in recommending specific investments. Conflicts of interest continue to be a contributing factor in many regulatory actions by FINRA and other regulators. Firms need to identify and mitigate conflicts of interest within the firm.
According to FINRA, if firms proactively address the challenges identified above, they will be more likely to avoid supervisory and compliance breakdowns.
SALES PRACTICE PRIORITIES
Products FINRA identified the potentially problematic products that will be the focus of its surveillance and examination activities for the year.
- Interest rate sensitive fixed income securities (FINRA will look for concentrated positions in products that are highly sensitive to fluctuations in interest rates and test for suitability and adequate disclosures to investors);
- Variable annuities (The primary focus will be on “L Share” annuities which have a shorter surrender period, but higher cost);
- Alternative mutual funds (FINRA will investigate whether communications concerning the funds accurately and fairly describe how the funds work and how they will respond to various market conditions);
- Non-trade real estate investment trusts (REITs) (FINRA will check compliance with the new requirement that firms provide a per share estimated value on account statements– FINRA Regulatory Notice 15-02);
- Exchange-traded products (ETPs) tracking alternatively weighted indices (Products may be marketed as providing superior risk-adjusted performance, but may be thinly traded, have a wide bid-ask spread, generally have higher expenses and it is unknown how they will behave in different market conditions. FINRA will check for adequate disclosures);
- Structured retail products (Complex payout structures and ties to less-traditional reference assets may present investors with unfamiliar risks. FINRA reviewing for sufficiency of disclosures);
- Floating rate bank loan funds (FINRA will be checking for suitability and disclosures because these loans carry significant credit and call risk); and
- Securities backed lines of credit (FINRA is concerned about how these are marketed).
Supervision Rules FINRA’s new supervision rules became effective on December 1, 2014. FINRA will examine how firms are implementing the new rules.
Investors’ Wealth Events Wealth events are situations where an investor receives a lump sum of money, such as from an inheritance, IRA rollover, sale of a major asset, or divorce settlement etc., and must decide what to do with the funds. FINRA will focus on firms’ compliance with their supervisory, suitability and disclosure obligations to ensure that financial incentives to the firms do not influence suitability reviews and recommendations made to investors.
Excessive Trading and Concentration Controls Specifically, FINRA will focus on how firms monitor its clients’ accounts for excessive trading and product concentration and how it follows-up on items identified in firm-generated exception reports.
Private Placements FINRA is concerned with inadequate due diligence and suitability analysis by firms.
High-Risk Brokers FINRA will provide rigorous regulatory attention on firms who hire or seek to hire high-risk brokers.
Sales Charge Discounts and Waivers FINRA will make it a priority to determine if firms have an adequate system in place to ensure that customers receive breakpoints and sales charge waivers for products that possess these features.
Senior Investors FINRA will review communications with seniors, the suitability of investments recommended to seniors, the training given to stock brokers concerning senior-specific issues, and the supervisory programs in place to protect seniors.
Anti-Money Laundering (AML) FINRA will examine the adequacy of firm surveillance systems to detect potentially suspicious activity to identify wrongful conduct such as insider trading and market manipulation.
FINANCIAL AND OPERATIONAL PRIORITIES FINRA will pay particular attention to the following “back-office” functions of firms.
Cybersecurity FINRA is concerned with firms’ efforts to implement cybersecurity risk management. FINRA initiated a review of the type of cyber threats that could be targeted at member firms and their responses. FINRA expects to publish its findings in early 2015.
Outsourcing Firms that outsource operational functions remain responsible for supervision of the provider and compliance with all securities laws and regulations. Examination of due diligence and risk assessment of potential providers and supervision of providers will be a key area of focus for FINRA.
Timely Reporting of Publically Disclosable Information FINRA will determine whether required disclosures to BrokerCheck and the Central Registration Depository are complete, accurate, and timely made.
Supervision and Governance Surrounding Trading Technology Firms’ technology and related controls will be scrutinized with special focus on the development of trading algorithms.
Abusive Algorithms In an effort to safeguard the integrity of the markets, FINRA will continue to focus its efforts on identify those who use algorithms to manipulate the markets through such things as layering, spoofing, wash sales and marking the close. In addition, FINRA will examine whether the firm failed to appropriately detect abusive activity by the firm’s traders or its customers.
Cross-Market and Cross Production Manipulation FINRA will continue its cross-market surveillance program to identify potentially manipulative activity on either a single or multiple markets and work to identify cross-product manipulation.
FINRA’s complete 2015 letter can be read here.