This month (January 2017), FINRA released their annual examination priorities letter. For those in the broker-dealer industry, this is really a must read, as it gives insight into what issues and concerns the industry’s primary regulator sees as important. It also gives a heads-up as to what FINRA will be doing in exams this year. When reviewing this letter, it is important to recognize that just because an issue or rule is not contained in this annual letter, that does not mean that FINRA will not inspect for compliance with those rules and will not pursue enforcement actions for items not contained in the letter. FINRA will continue its wide-sweeping exams and enforcement programs, but this letter outlines items that they currently view as priorities. And that means that these areas will likely get extra attention when they are investigating firms and individuals. Because forewarned is forearmed, this letter also is a reminder for firms, and individual representatives, to evaluate their business operations, including their compliance with the issues identified, so as to reduce exposure to violations and enforcement actions. You can find the full letter online here.
One announcement contained in the letter is that FINRA will begin using what they call “electronic, off-site reviews to supplement [their] traditional on-site cycle examinations.” So, firms that are not scheduled for a regular cycle exam this year, may be receiving information requests focused on some of the areas highlighted in the priorities letter, with FINRA staff conducting their review/examination off-site. While this is rather common for cause exams focused on a representative’s conduct, it appears that FINRA will be expanding off-site exams focused on firms.
We won’t attempt to discuss the full letter and all of the priorities identified in it in this article, but will share some highlights, while focusing our discussion on sales practice issues that affect both firms and individual representatives. Here are some things to consider:
High Risk / Recidivist Brokers
According to the letter, FINRA will be focused on the hiring and supervision of “high-risk and recidivist” brokers. What is a high-risk or recidivist broker? That’s a good question and it is not fully defined. But, we think that description is meant to encompass brokers with several disclosures such as arbitrations, customer complaints, terminations for cause, as well as those with regulatory actions against them. It will also likely include those who had been statutorily disqualified from association with any broker-dealer, but have been approved to re-enter the industry.
A takeaway for brokers with disclosures is this: you’re going to be more under the microscope by FINRA, and they will certainly be evaluating compliance with suitability of recommendations, as well as for participation in undisclosed outside business activities or participation in private securities transactions away from the firm. As a result of this heightened focus, it may be more difficult to change firms, or to join a firm if you’ve been out of the industry for some time, as some firms may not want to be the subject of extra scrutiny from the regulators.
A takeaway for firms is this: your supervision of brokers whom FINRA considers as “high-risk” or “recidivist” will be under the microscope as well. And firms that have a concentration of brokers with a disciplinary record or a high number of customer complaints/arbitrations etc., will also be closely reviewed. As such, make sure your supervisory systems and procedures are reasonable for your business and the risks posed by these brokers, that supervisors are trained on what is required of them, and that supervisory steps are followed and documented.
FINRA notes in their letter that they will be also examining a firm’s “due diligence” in hiring these individuals, and checking to ensure that they are complying with the recently strengthened requirements to carefully and reasonably work to evaluate the accuracy and completeness of information on a broker’s Form U4. FINRA also advises that their review will also include determining whether the firm (itself or through a vendor) is conducting a national records search of publicly available information to help verify the accuracy and completeness of a broker’s Form U4.
Note for Independent Contractor Firms: FINRA explains that they will be focusing on the effectiveness of a firm’s branch inspection program, including the: “supervision of account activity; advertising and communication, including the potential use of unapproved email addresses for business; communications with customers, including through the use of social media, seminars, radio shows or podcasts; registered representatives’ websites; outside business activities; the use of consolidated account statements; and operational activities such as distribution of funds and changes of address or investment objectives.”
Sales Practice Issues
Senior Investors. Protecting senior investors remains a high priority for FINRA in 2017. IN this year’s letter, they announce that they have identified numerous instances of brokers recommending that senior investors purchase speculative investments and complex investments in search of earning a higher yield on their investment. FINRA is concerned about the suitability of such recommendations given the needs and investment objectives/risk tolerance of the investor. Expect that FINRA will review a firm’s supervisory procedures and system for ensuring the suitability of such investments for seniors.
Product Suitability, Including Concentration. FINRA advises that they will “assess how firms conduct reasonable-basis and customer specific suitability reviews.” This means that they will review a firm’s due diligence review of a product, wherein the firm determines that the product is suitable for some type of investor, and then will also focus on how the firm determines that a recommendation for a product is suitable for the individual investor to whom the recommendation is made. In this area, FINRA also states that, “Training should ensure that registered representatives, compliance and supervisory staff understand the objectives, risks and pricing factors of the products sold, including any changes in the features of those products.”
With regard to concentration, FINRA explains that they will increase their focus on how a firm monitors recommendations that “could result in excess concentration in customers’ accounts.” This relates to both a concentration in a specific security, but also to a particular type of product/security or industry. FINRA cautions firms to be aware of changing market conditions, including interest rates, and to discuss these changes with clients.
Short-Term Trading of Long-Term Products. In this annual letter, FINRA says that they will review a firm’s ability to monitor trading activity wherein products intended for longer-term holding are traded on a short-term basis. This may include products such as mutual funds, unit investment trusts, and variable annuities. FINRA is concerned that this type of trading causes investors to experience diminished returns because of increased commissions and fees, and, in the case of UITs, FINRA says that investors may miss dividend payments.
In this area, FINRA is urging firms to review their supervisory systems to ensure that they can detect a broker’s trading activity that may be designed to evade automated review systems for switching activity. Here, FINRA reports that they have identified situations where a broker switches customers through a series of investments to mask the true source of funds for the investment from a firm’s surveillance system.
OBAs and Selling Away. Each year, FINRA brings numerous enforcement cases against brokers for participating in an undisclosed outside business activity, or participating in a private security transaction (selling away). This year, FINRA announces that it “will focus on firms’ obligations with respect to their registered representatives’ outside business activities and private securities transactions.” Here, we can expect FINRA to review how a firm documents receipt, review and approval (or disapproval) of a broker’s OBA notification, including the, “firms’ consideration of whether the proposed outside business activity may compromise a registered person’s responsibility to the firm’s clients or be viewed as part of the firm’s business.” With respect to PSTs, FINRA will evaluate a firm’s procedures for review and approval/disapproval of PST requests, and the firm’s supervision of any approved transactions for compensation. Remember that under the PST rule (FINRA Rule 3280), if a firm approves a broker’s participation in a PST for which the broker will receive compensation of any type, the firm must carry that transaction on its books and records and supervise it as if it is a transaction of the firm.
In addition to sales practice related priorities, FINRA announces several operational risks that they consider a priority for 2017. These include risks relating to cybersecurity, testing of supervisory controls, customer protection/segregation and custody of client assets, AML, municipal advisor registration and more.
Cybersecurity issues are again a priority, and likely will continue to be for many years. FINRA advises that in 2017, they will continue to assess firm’s programs to mitigate risks relating to cybersecurity threats, including the loss of data. Importantly, FINRA is also concerned about how a firm monitors and controls data, including the sharing of data internally and with vendors.
With respect to brokers, FINRA is particularly concerned about cybersecurity controls at independent contractor firms, stating their belief that these controls at independent branch offices, “tend to be weaker than those at firms’ home offices.” Along these lines, FINRA states that, “We have observed poor controls related to the use of passwords, encryption of data, use of portable storage devices, implementation of patches and virus protection, and the physical security of assets and data.” You can expect that independent model firms will be examined heavily on the steps and controls they use to protect client and other data, and how those steps and controls are rolled out to the brokers, and then how the firm monitors for compliance with the firm’s policies in this area. Like it or not, I expect that we may see some significant enforcement actions by FINRA in this area over the next few years.
FINRA closed their priorities letter announcing annual priorities in the market integrity area including manipulation, best execution complaint with audit trail reporting, the market access rule, and more.
Forewarned is forearmed. FINRA has announced their priorities, and it is fair to expect a significant amount of their exam resources to be devoted to the areas in their January 2017 letter. Should these examinations find violations of industry rules, we can also expect to see an increased emphasis on enforcement activity in these areas as well. Wise firms and brokers will review this letter, consider their own business practices and operations, and make any needed adjustments to help ensure that they reasonably comply with the applicable rules and regulations, and therefore avoid further regulatory issues and enforcement actions.