On January 4, 2017, the Financial Industry Regulatory Authority (“FINRA”) released its 2017 Regulatory and Examination Priorities Letter (the “Letter”). Within the Letter, FINRA identified new and recurring challenges for broker-dealers in the following categories:
- High-Risk and Recidivist Brokers
- Sales Practices
- Financial Risks
- Operational Risks
- Market Integrity
FINRA also announced that, for the first time, it will be conducting electronic off-site reviews to supplement its examination program. FINRA will conduct these reviews on a limited number of firms that are not scheduled for a cycle exam in 2017. These exams will focus on the priorities listed in the Letter.
High-Risk and Recidivist Brokers
FINRA first included this item in its 2015 Exam Priorities Letter. Since then, the agency has conducted surveillance and exams of “high-risk” registered representatives. For 2017, FINRA will take a comprehensive approach to high-risk brokers in three areas:
A dedicated examination team will identify and examine high-risk brokers, focusing on the following areas:
- Interactions between brokers and customers
- Know your customer
- Outside business activities
- Private securities transactions
- Commissions and fees
- examine supervisory policies and procedures to ensure a firm adequately reviews the background of prospective brokers, including conducting a national search of public records;
- review policies and procedures in place to supervise brokers with regulatory histories;
- focus on firms with a history of associating with brokers with regulatory histories; and
- scrutinize applications of firms which associate with brokers with regulatory histories.
FINRA will review firms’ supervision and inspections of branch and nonbranch offices, emphasizing the following:
- Supervision of account activity
- Advertising and communications
- Communications with customers
FINRA generally includes some element of sales practice in its annual priorities letter. For 2017, FINRA has identified the following areas of focus:
- Senior Investors – FINRA will place special emphasis on the types of products offered to senior investors. FINRA has noted that firms frequently steer senior investors looking for higher yields toward higher-risk, complex products. In addition, FINRA will focus on the sale of microcap and penny stocks, particularly to senior investors
Product Suitability and Concentration – FINRA continues to have concerns about the sale of complex products. The agency will look to see whether firms offering complex products maintain a strong supervisory system, including firms’ due diligence processes with regard to bringing on new products. FINRA also reminds firms of their responsibility to ensure they train representatives on new products, emphasizing training for new representatives who may not have experience selling these products. FINRA reminds firms that reps must understand the products their representatives sell.
Firms must also monitor concentration of products in customer accounts. Specifically, FINRA notes that firms and representatives must monitor the possible effects of a rising interest rate environment on customer portfolios. In addition, FINRA has received increasing calls regarding senior and unsophisticated investors purchasing the following products:
- Speculative energy-based products
- Complex exchange-traded products
- Structured products
- Leveraged and inverse exchange-traded funds
- Non-traded real estate investment trusts
- Non-listed business development companies
FINRA reminds firms of their customer-specific suitability requirements regarding the above products.
- Excessive and Short-Term Trading in Long-Term Products – FINRA has noted increased occurrences of customers trading in and out of long-term products, such as unit investment trusts and mutual funds. Therefore, FINRA will review firms’ monitoring of such activity, including monitoring for representatives attempting to avoid surveillance of such trading.
- Outside Business Activities and Private Securities Transactions – These topics have appeared in FINRA examination priorities letters several times, including in 2016. In 2017, FINRA will focus on notification about, and supervision of, these areas.
- Social Media and Electronic Communications Supervision and Retention – FINRA reminds firms they must supervise and retain customer-related communications regardless of platform, pursuant to U.S. Securities and Exchange Commission (“SEC”) and FINRA rules.
- Liquidity Risks – In 2016, FINRA prioritized firms’ controls with regard to assessing and monitoring risks to their liquidity. FINRA again identified liquidity risk controls as an examination priority in 2017. Specifically, FINRA will look at systems firms have developed to assess their liquidity needs regarding market-related stress, as well as contingency plans to address any related issues. FINRA points to Regulatory Notice 15-33 for further guidance in this area.
- Credit Risk Policies, Procedures and Risk Limit Determinations under FINRA Rule 4210 – On December 15, 2016, the first phase of FINRA Rule 4210, which established margin requirements for covered agency transactions, went into effect. FINRA will review firms’ implementation and supervision of these requirements.
Cybersecurity – As in previous annual priorities letters, FINRA has included cybersecurity as an area of concern. While FINRA stated that there is no one way to conduct cybersecurity assessments, the agency has identified several areas of focus for examinations:
- Methods of preventing data loss
- How firms monitor and protect data
- Management of vendor relationships
- Protection of sensitive information from insider threats
FINRA has also highlighted two areas of weakness for many firms:
- Cybersecurity controls at branch offices, specifically of independent contractor offices, including poor supervisory controls over password security, data encryption, and use of portable devices
- Failure to maintain records in “write once, read many” format
- Supervisory Controls Testing – FINRA reminds firms that they must test their supervisory systems pursuant to FINRA rule 3120, as well as their CEO certification pursuant to FINRA Rule 3130. FINRA will review how firms conduct testing of their supervisory systems.
- Customer Protection/Segregation of Client Assets – FINRA will review how firms comply with the requirement of Securities Exchange Act of 1934 Rule 15c3-3 regarding protection of customer assets. FINRA will focus on firms’ documentation of their reserve formula calculation.
- Regulation SHO and Easy to Borrow – FINRA will focus on how firms process the location of securities pursuant to Regulation SHO.
- Anti-Money Laundering and Suspicious Account Activity – As in 2016, FINRA will continue to review how firms monitor for suspicious activity, especially in relation to anti-money laundering policies.
- Municipal Advisor Registration – Firms conducting activity as municipal advisors may not be properly registered pursuant to SEC and Municipal Securities Rulemaking Board rules. FINRA reminds firms that any representative conducting activity as a municipal advisor has one year from September 12, 2016, to pass the Series 50 Municipal Advisor Representative Qualification Examination.
- Manipulation – FINRA continues to prioritize surveillance and detection of market manipulation. In addition, FINRA also reminds firms about the Cross Market Equity Supervision Report Cards introduced in 2016. FINRA expects firms that receive these report cards to use the information as part of their program to prevent layering and spoofing.
- Best Execution – FINRA reminds firms of their responsibility for best execution of securities, and also the disclosure requirements around payment for order flow.
- Audit Trail Reporting Early Remediation Initiative and Expansion – This initiative notifies firms of equity audit trail issues not found through regular surveillance. FINRA expects firms to use this information to correct such issues. In 2017, FINRA will expand this initiative to include, among other areas, Regulation NMS trade-throughs and locked and crossed markets.
Market Access Rule – Firms need to improve their controls for compliance with the Market Access Rule. FINRA has identified several areas of best practices for compliance, including the following:
- Developing pre-trade and post-trade controls
Systems for supervising algorithmic trading
- Monitoring algorithmic trading is working as programmed
- Disabling algorithmic programs not working as intended
- FINRA also points to Regulatory Notice 15-09 as a reference.
Trading Examinations – FINRA’s priorities include examinations of alternative trading systems, with a focus on the following:
- Adequacy of disclosures to customers
- Potential conflicts of interest
- Whether firms’ handling of manual options orders complies with best execution requirements
- FINRA also will conduct a pilot trading examination program focused on smaller firms.
- Fixed-Income Securities Surveillance Program – FINRA has increased its surveillance program in fixed income. The agency has brought enforcement cases against individuals who have conducted activity that resulted in artificial price levels in bonds in order to charge a higher markup. FINRA will also develop surveillance tools to monitor new requirements around TRACE reporting for U.S. Treasury securities, which becomes effective in July 2017.
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 several issues which have been noted in previous years, as well as new priorities. We encourage all FINRA member firms to review the 2017 letter in its entirety to determine how the topics might affect their compliance measures.
Please contact Dee Stafford for more information or guidance regarding the implications of FINRA’s 2017 Regulatory and Examination Priorities Letter.