FINRA 2016 Examination Priorities Letter Highlights

January 14, 2016

On January 5, 2016, the Financial Industry Regulatory Authority (“FINRA”) released its 2016 Regulatory and Examination Priorities Letter (the “Letter”). Within the Letter, FINRA identifies challenges for broker-dealers that can be categorized by broad issues and other areas of focus in 2016. A number of the areas were also cited in last year’s letter. Below is a summary of the areas that FINRA has prioritized for this year.

Broad Issues

Firm Culture: This was also a focus in 2015; however, FINRA notes that it will formalize its assessment of firm culture based on the following areas:

  • Whether control functions are valued within the organization
  • Whether policy or control breaches are tolerated
  • Whether the organization proactively seeks to identify risk and compliance events
  • Whether supervisors are effective role models of firm culture
  • Whether sub-cultures (e.g., at a branch office, a trading desk, or an investment banking department) that may not conform to overall corporate culture are identified and addressed

The above areas will help FINRA assess a firm’s overall “Culture of Compliance.”

Supervision, Risk Management, and Controls: FINRA reminds broker-dealers of their obligation to “maintain a system to supervise the activities of their associated persons to achieve compliance with securities laws and regulations and FINRA’s rules.” In addition, FINRA identifies concerns with the following:

  • Management of Conflicts of Interest: Areas creating conflicts include incentive structures for registered representative compensation, research and its relationship with investment banking, information leakage, and proprietary traders’ pricing of illiquid investments.
  • Technology: Key areas of focus include firms’ supervision and risk management related to cybersecurity, technology management, and data quality and governance.
  • Outsourcing: Concerns include firms’ due diligence and risk assessment of vendors, and supervision of covered activities.
  • Anti-Money Laundering: Two areas of concern involve the adequacy of firms’ monitoring of suspicious activity, as well as firms’ review of customer account activity in microcap securities, including, but not limited to, monitoring of large deposits and sales.

Liquidity: FINRA notes that firms’ failures to manage liquidity have been the cause for “systemic crises.” In addition, FINRA will focus on the adequacy of liquidity planning and controls for firms that engage in high-frequency trading. The Letter highlights the practices outlined in Regulatory Notice 15-33 for broker-dealers’ consideration of liquidity needs, particularly stress-testing.


Other Key Areas of Focus

Sales Practices, Operations, and Internal Controls: Instead of focusing solely on specific products, FINRA includes several areas of focus surrounding sales practices in the Letter, including the following:

  • Suitability and Concentration: FINRA notes again the challenges of complex products. Broker-dealers need to continue to develop more robust systems with regard to suitability, which includes reviewing for excess concentration in higher-risk products. In addition, FINRA emphasizes the obligation firms have to conduct due diligence for new product offerings and to train registered representatives in these offerings.
  • Seniors and Vulnerable Investors: FINRA continues to have concerns regarding the protection of senior investors from fraud, sales practice abuse, and financial exploitation. Particular concerns revolve around registered representatives borrowing from elderly investors, powers of attorney, and the recommendation of high-commission products that may not be suitable.
  • Sales Charge Discounts and Waivers: FINRA indicates continued concern regarding firms’ failures to provide appropriate volume discounts in mutual funds, unit investment trusts, real estate investment trusts, and business development companies. 2015 saw firms cited in enforcement actions and assessed millions of dollars in fines in this area.
  • Financial and Operational Controls: FINRA addresses several areas here, focusing on specific circumstances which include the following:
    • Market Maker Net Capital Exemptions: Options market-makers are exempt from net capital requirements under Securities Exchange Act of 1934 (“Exchange Act”) Rule 15c3-1(b)(1). FINRA will focus on whether firms have properly claimed this exemption.
    • Exchange-Traded Funds (“ETFs”): Specifically, FINRA will review Authorized Participants regarding the creation and redemption process of ETFs, focusing on the financial integrity of broker-dealers and their processes for monitoring counterparty credit risk.
    • Fixed Income Prime Brokerage: FINRA notes that broker-dealers entering this business should implement controls for managing the associated credit and operational risks.
    • Internal Audit: Specifically, FINRA intends to review how a strong internal audit program helps a firm maintain effective internal controls and a robust corporate governance structure.
    • Client Onboarding: This area is related to the capital and liquidity risks in the onboarding of new professional clients (hedge funds, institutional traders, broker-dealers, etc.).
    • Transmittal of Customer Funds: FINRA will examine a firm’s controls related to transmittals of customer funds and securities to third-party accounts.
  • Market Integrity: FINRA will focus on firms’ controls and processes with regard to the following:
    • Vendor Display Rule: FINRA expects firms to review their compliance with the requirement that broker-dealers provide a consolidated display of market data when they provide quotation information to customers pursuant to Rule 603(c) of Regulation NMS.
    • Market Access: FINRA will provide Compliance Report Cards to firms based on market surveillance. The first report cards will focus on layering and spoofing, and FINRA will evaluate how broker-dealers utilize this information to identify and address potential misconduct.
    • Fixed Income: FINRA will continue to review fixed income order handling, markups, and related controls.
    • Regulation SHO: FINRA will assess whether firms are implementing supervisory processes to ensure compliance with the net-flat or net-long position requirement of Rule 204, and whether they are correcting deficiencies.
    • Cross-Market and Cross-Product Manipulation: FINRA will focus on coordinated equity and options market activity designed to create momentary, artificial prices intended to affect the settlement prices of related products.
    • Audit Trail Integrity: FINRA will have a continuing focus on late reporting of TRACE-eligible and municipal securities, as well as errors in the equity audit trail.
  • Outside Business Activities (“OBAs”): FINRA will review firms’ controls for the receipt and assessment of registered representatives’ OBA notifications. As part of the assessment, FINRA will expect firms to surveil for possible conflicts of interest between firms and their customers.

Sales Practices – Products: As in other years, FINRA has outlined several products that may inherently pose risks to investors based on their complexity. For 2016, FINRA has noted the following products:

  • 529 College Savings Plans: Among other areas, FINRA will look into share classes of 529 plans. Firms are to evaluate share class, specifically class C shares, regarding their suitability in relation to the long-term time horizon for these investments.
  • Private Placements, the JOBS Act and Public Offerings: For private placements, FINRA will look at aspects of suitability, disclosure, and due diligence. Due to new rules for general solicitation under Rule 506(c) of Regulation D (which became effective last year) and crowdfunding (which will become effective in 2016), FINRA will also focus on communications with potential customers to ensure proper disclosure of the risks and lack of liquidity of private placements.
  • Public Offerings: In 2015, as a result of the JOBS Act, the SEC enacted amendments to Regulation A+ for public offerings. Firms are supposed to file with FINRA and receive clearance prior to engaging in sales. As with other public and private offerings, FINRA will look for red flags in the offerings, such as associated persons and issuers with problematic regulatory histories, lack of due diligence, conflicts of interest, and non-compliance with escrow requirements.
  • Non-Traded REITs and Direct Participation Programs (“DPPs”): In anticipation of amendments to the Customer Statement Rule and DPP Rule, FINRA expects new share classes may provide greater transparency of these products and better share valuation; however, there may be added complexity to these products. FINRA includes Business Development Companies among entities requiring greater scrutiny.
  • New Issue Municipal Bond Sales: Municipal bond underwriters are required to sell bonds at their initial offering price. FINRA has found instances where underwriters have taken new issues into inventory and sold them to customers at higher prices.

Conclusion

Examination priority letters have been an essential source to guide broker-dealers on significant areas of regulatory risk since FINRA began publishing these notices. This year, FINRA has addressed a wide variety of concerns in broad areas as well as very specific topics. We encourage all FINRA member firms to review the Letter in its entirety to determine how the examination priorities impact their compliance and supervisory programs.

Please contact your ACA consultant or Dee Stafford in the Los Angeles office at (310) 322-8840 for more information or guidance regarding the implications of FINRA’s 2016 Regulatory and Examination Priorities Letter.