On January 6, 2015, the Financial Industry Regulatory Authority (FINRA) released its 2015 Regulatory and Examinations Priorities Letter. This is the tenth yearly edition of the letter, and while much is familiar, FINRA has organized its priorities under a "customers first" umbrella. This new approach should give firms a better idea of the lens through which FINRA will be looking at compliance issues in the year ahead. FINRA has observed that firms and registered representatives face challenges that compromise the quality of the service they provide to customers and contribute to failures in compliance and supervision. The 2015 letter focuses firms' attention on the following areas: (1) putting customer interests first; (2) firm culture, with a particular focus on ethical standards and incentives; (3) supervision, risk management, and controls; (4) development, marketing, and sales of novel products and services; and (5) management of conflicts of interest.
This year's letter organizes FINRA's priorities into three categories, Sales Practices, Financial and Operational Priorities, and Market Integrity. Many of the issues addressed are a continuing focus for FINRA, but there are also new priorities, many of which stem from regulations that went into effect in 2014. The following provides an overview of some of the most significant issues contained in FINRA's letter. For a complete listing of priorities, see the full letter here.
FINRA is maintaining its focus on sales practices related to various products, including interest rate-sensitive fixed income products, variable annuities, REITS, structured products, and exchange traded products. In keeping with the "customer first" theme, firms should advise customers of the risks and the effect of interest rates and market conditions when marketing products.
In a new area of emphasis, FINRA expects firms to institute additional procedures to protect customers with securities-backed lines of credit (SBLOCs), which are revolving, non-purpose loans secured by the assets in the lending institution's brokerage accounts. As the number of SBLOCs in the market increases, FINRA expects broker-dealers to inform customers of program features and the effect of market conditions on their ability to draw on the SBLOC.
Continuing from last year, FINRA will review firms for anti-money laundering (AML) issues, including lax monitoring and due diligence for suspicious activity, and the adequacy of firms' surveillance of customer trading for AML risks. In addition, FINRA will focus on the AML implications of certain types of accounts, including Cash Management Accounts and certain Delivery versus Payment/Receipt versus Payment (DVP/RVP) accounts.
On December 1, 2014, FINRA's new supervision rules (FINRA Rules 3110, 3120, 3150, and 3170) went into effect. The new rules modify requirements relating to (1) designating offices of supervisory jurisdiction and inspecting non-branch offices; (2) managing conflicts of interest in a firm's supervisory systems; (3) performing risk-based reviews of correspondence and internal communications; (4) carrying out risk-based reviews of investment banking and securities transactions; (5) monitoring for insider trading through, among other things, internal investigations; and (6) testing and verifying supervisory control procedures.
FINRA has found that broker-dealers participating in private placements often conduct inadequate due diligence and suitability analyses. Firms must file most private placement materials with FINRA pursuant to Rules 5122 and 5123. In addition, firms need to review private placement transactions to ensure that the firm is in compliance with regulations governing contingency offerings and escrow procedures.
Municipal Advisors and Securities
The Securities and Exchange Commission's (SEC) new municipal advisor registration rules became effective July 1, 2014. FINRA has observed that firms do not realize that their activities subject them to municipal advisor registration requirements. Any firm that provides advice to customers that are municipal entities or obligated persons may be required to register as a municipal advisor. In addition, firms must not sell municipal bonds in less than the minimum denomination. The SEC provides guidance in this regard and the Municipal Securities Rulemaking Board (MSRB) has developed a regulatory framework for municipal advisors.
Financial and Operational Priorities
Tax-Exempt and FDIC-Insured Products
For tax-exempt and FDIC-insured products, some firm actions may cause customers to lose their tax-exempt status on interest payments or the FDIC protection they think they have. For example, tax-exempt status can be jeopardized if a firm is in a short position with respect to such securities. In 2015, FINRA will be examining firms for such short positions and corresponding supervisory procedures, including compliance issues with Rule 15c3-3(d) of the Securities Exchange Act of 1934, which imposes possession and control requirements.
FINRA will make outsourcing a priority area of review during 2015 examinations. Firms should be aware that outsourcing covered activities does not diminish a broker-dealer's responsibility for compliance with all federal securities laws and regulations – and FINRA and MSRB rules – and for supervising the service provider. In evaluating an outsourcing service provider, firms should perform appropriate due diligence and risk assessment.
In January 2014, FINRA initiated a sweep to better understand the threats firms faced from cyber-attacks and what firms were doing to address those threats. The results of that report should be published in early 2015 and will include principles and effective practices firms should consider in developing and implementing their cybersecurity programs. A firm's cybersecurity efforts need to take into consideration the level of risk, the identification of critical assets, and the implementation of controls commensurate with the scale and business model of the firm.
One of FINRA's main objectives is to preserve investor confidence in U.S. capital markets by maintaining fair and orderly markets. To respond to advances in technology and changes in market structure, FINRA is adapting its surveillance program to identify misconduct. Some of the biggest concerns center on market manipulation and the use of abusive algorithms to accomplish such manipulation.
Examiners will be reviewing firms' supervisory processes and related controls with a particular focus on changes in trading technology and the accompanying testing of those systems. High-frequency trading brings with it even greater risks, because the speed with which orders enter the market can be out of sync with the firm's net capital. In addition, firms' use of algorithms must not function to manipulate the market through layering, spoofing, wash sales, marking the close, or by any other means.
Following the conflicts of interest theme, FINRA has planned a sweep of firms that route a significant percentage of their unmarketable customer limit orders to trading venues that provide the highest trading rebates for providing liquidity. This process may lead to the customer receiving inferior executions of their unmarketable limit orders while the firm still collects a trading rebate. Firms should ensure that their best execution committees and other supervisory structures are regularly evaluating customer executions.
Finally, FINRA has launched two programs for 2015 focusing on market integrity. The first is a program to conduct fixed income-based examinations focusing on trading issues and related controls. The second is a new team focused on identifying potential equity audit trail issues that may not be detected through routine compliance sweeps and review. This group will work to resolve reporting errors promptly so surveillance patterns can scan the most accurate data possible.
Looking ahead to the rest of 2015, firms should keep in mind FINRA's added emphasis on overall firm culture and how that affects the customer interests. If firms heed the advice in this letter, stay current on new and existing priorities as they develop, and enact robust supervisory procedures, they will be well-positioned to avoid problems and achieve positive results in future regulatory examinations. Finally, FINRA's letter reminds firms of their obligation to respond to FINRA inquiries in a full and timely fashion. Failing to produce timely responses to information requests made in connection with examinations and investigations could expose firms to disciplinary action.