On January 31, 2012, the Financial Industry Regulatory Authority (FINRA) issued its annual letter to member firms outlining FINRA’s 2012 Regulatory and Examination Priorities. The annual letter has grown in recent years to a current length of 16 single-spaced pages with 41 separate regulatory priorities. The annual examination priorities letters were developed in 2006 to inform member firms about FINRA’s current areas of focus so as to allow broker-dealers to address those issues before they become deficiency findings in examinations. This year’s list includes a number of familiar examination priorities from prior years — e.g., suitability, private placements, structured products, municipal securities, outside business activities, and social media and electronic communications. Perhaps more surprisingly, more than half of the issues were not on the 2011 priorities list, although almost all have been the subject of recent FINRA or SEC enforcement actions, or regulatory notices, — e.g., mortgage-backed securities, reverse mergers, foreign finders, valuation of illiquid securities and high frequency trading.
In addition to the examination priorities, the letter announces a new initiative to improve FINRA’s surveillance, examination and disciplinary programs through the use of a new risk control assessment survey. The survey will attempt to capture information about member firms to better understand members’ business activities, customers and product offerings. FINRA intends to distribute the survey to all member firms in the first quarter of 2012 and will include pre-populated information that FINRA already has about the member firm and will only ask questions that it believes are relevant to the member’s business.
The examination priorities discussed in the letter are largely the result of deficiencies identified by FINRA during member examinations. These priorities can be classified into four broad categories including business conduct and trading issues, product specific issues, supervisory control functions, and financial and operational controls. In the sections that follow, we discuss some of the more noteworthy examination priorities discussed in FINRA’s letter. A copy of the letter is available here.
Sales Practice and Trading Issues
The letter discusses a number of sales practice and trading issues that FINRA has identified as being examination priorities for 2012. The letter reiterates FINRA’s recent Notice 12-03 regarding heightened supervision of complex products when offered to retail investors. FINRA explains that the challenging economic environment that has been in place since 2008 has raised several concerns it will examine for:
- Yield chasing. Customers may be assuming risks that they don’t fully understand to achieve higher yields.
- Liquidity. The lack of a secondary market may make certain investments unsuitable for some investors.
- Cash Flow. A product’s future cash flows should match investor expectations.
- Transparency. A product’s financial details (and returns) should be made available to customers at the time of an investment to ensure an informed decision.
The annual priorities letter also highlights the following sales practice issues:
- Suitability. FINRA reiterates the importance of suitability and, in particular, the need to perform reasonable diligence regarding the products and services offered by the member to determine whether such products or services are suitable for at least some investors. FINRA reminds members that the new Suitability Rule (FINRA Rule 2111) and Know Your Customer Rule (FINRA Rule 2090) become effective on July 9, 2012.
- High Frequency Trading (HFT). The surveillance of HFT programs is a high priority for FINRA and requires firms using HFT strategies and other trading algorithms to test these strategies, prior to and during their use, to monitor whether the strategies result in abusive trading or other unintended consequences. FINRA is particularly concerned about “momentum ignition” strategies and the trading of sponsored participants through a direct market access platform.
- Market Access Rule. Under the Market Access Rule, firms are responsible for having risk management controls and supervisory procedures that are reasonably designed to manage the financial, regulatory and other risks associated with market access. Inadequate controls of market access may jeopardize the financial condition of a broker-dealer, create regulatory and compliance risks, and disrupt the orderly functioning of markets. FINRA will review and test firms’ written supervisory procedures and risk controls required by the Market Access Rule.
- Fixed Income. FINRA continues to review execution pricing in debt securities transactions and will continue to focus on whether firms are charging fair and reasonable markups.
FINRA also identifies a number of products where FINRA believes that its concerns regarding business conduct and suitability are particularly heightened. Many of FINRA's concerns relate to FINRA's views regarding potential for a product’s lack of liquidity or concerns that inadequate disclosure may result in the product being unsuitable for retail investors. Members should consider these issues when performing their suitability due diligence on such products and when recommending any of these products to a retail investor. FINRA specifically discusses:
- Residential Mortgage-Backed Securities and Commercial Mortgage-Backed Securities. FINRA expresses its view that these securities may carry reinvestment risk because of the embedded prepayment option that may affect the yield investors realize. Also, some tranches of collateralized mortgage obligations, such as interest-only strips or inverse floaters, may carry higher levels of risk than others.
- Non-Traded REITs. Non-traded REITS generally do not have an active secondary market and, as a result, offer limited price transparency and liquidity. As a result, FINRA reminds firms to be aware that the associated risks and value of such products may be difficult for investors to ascertain.
- Municipal Securities. FINRA expresses the view that certain municipal securities issuers do not provide investors with timely disclosures and/or complete financials, which may make it difficult for investors to make informed investment decisions. FINRA also points out that a lack of information may preclude associated persons from having a reasonable basis to recommend such a security.
- Complex Exchange-Traded Products. FINRA states that some exchange-traded products that employ sophisticated strategies or access more exotic markets may expose investors to unexpected results or unforeseen risks.
- Structured Products. Structured products may be complex and have cash flow characteristics and risk-adjusted rates of return that are uncertain and/or hard to estimate. In addition, such products may lack an active secondary market. FINRA reminds members that this requires investors in these products to be willing to assume liquidity risk in addition to market risk and credit risk associated with the issuer of the product. FINRA further reiterates its view that such features may make the products unsuitable for some retail investors.
- Reverse Mergers. Significant allegations of fraud have surfaced relative to this practice, particularly related to issuers based in China. FINRA reminds members that current and accurate information on such issuers may be difficult to obtain and may not be reliable.
Supervisory Control Functions
FINRA also emphasizes the importance of a number of supervisory control functions.
- Private Securities Transactions and Outside Business Activities. FINRA reiterates the importance of supervising private securities transactions and outside business activities.
- Branch Examinations. FINRA reiterates the guidance in Notice 11-54 about its and the SEC’s expectations for effective member firm inspections of branch offices. FINRA also indicates that both regulators will be reviewing the effectiveness of the broker-dealer’s branch inspection program when they examine that broker-dealer.
- Cyber Security. FINRA continues to be concerned about information technology (IT) and cyber security threats. Such concerns include security and authentication practices for Web-facing systems and the risks to security controls and testing protocols when IT functions are outsourced. FINRA recommends firms reassess their policies and procedures to review whether they are adequate to protect customer assets from unauthorized transactions resulting from compromised customer email accounts.
- Outsourcing. FINRA reminds members that the use of a third-party service provider to perform functions and activities on behalf of the member does not relieve the firm of its responsibility to comply with all applicable securities laws, regulations and rules.
- Foreign Finders. FINRA discusses foreign finders suggesting that they may pose compliance risks and may elevate a firm’s AML risk level. FINRA reminds members that foreign finders likely need to be registered as associated persons if they are involved in the servicing of non-U.S. customer accounts, have trading authority over accounts, enter customer orders directly to the clearing firm’s online platform, or process new account documents and funds transfers. FINRA further reminds members that their AML risk may be affected by use of foreign finders and foreign affiliates depending on the geographical regions involved, types of customers introduced, and products and services offered. Prior to entering into these relationships, FINRA reminds members to have reasonably designed procedures to address the scope of permissible activities and the potential AML risks and to monitor any subsequent activity conducted with foreign finders.
- Rogue Trading. FINRA reminds members that they should have a process for reviewing internal controls to prevent and detect unauthorized trading and regularly assess the effectiveness of those controls.
Financial and Operational Controls
Finally, FINRA also highlights financial and operational controls that member firms should have in place.
- Margin-Lending Practices and Custody of Assets Collateralizing Margin Loans. The letter reminds firms of the importance of determining whether collateral supporting receivables is readily marketable, appropriately valued, unencumbered and readily available to finance the credit extended to clients. Firms should have a governance process to vet extensions of credit against less-liquid or concentrated-asset classes. Further, firms that do not have unrestricted control over and ready access to the securities collateralizing margin loans may be subject to punitive capital charges and computation penalties.
- Legal Contingencies. For pending arbitrations and lawsuits, FINRA reminds firms that they should document the basis for any liability accrual or lack thereof. Further, a broker-dealer subject to a lawsuit that could have a material impact on its net capital must obtain an opinion of outside counsel on the potential effect of the suit on the firm’s financial condition. Absent such an opinion, the item may be considered a contingent liability and be included in the calculation of Aggregate Indebtedness. In addition, a broker-dealer subject to an adverse award in an arbitration proceeding must record the award as a liability, even if the appeal process may not have been exhausted and no final judgment has been entered. Firms are cautioned not to rely upon an insurance policy’s potential coverage of a loss in determining the amount to be accrued because payment on an insurance claim may be conditioned on factors that cannot be determined until after the loss becomes actual and a claim is evaluated by the insurance carrier.
- Expense Sharing. Firms are reminded that expense-sharing arrangements cannot prevent a firm from recording expenses and liabilities unless the party agreeing to pay the expenses or liability on the firm’s behalf has the financial means to do so. Further, the expense charges must reflect the services provided to the broker-dealer. Excess charges may be deemed to be a withdrawal of equity capital pursuant to Rule 15c3-1(e).
- Liquidity and Leverage. FINRA intends to review whether firms are increasing their balance sheets to meet their targeted returns on investment and whether those practices would be sustainable in an adverse economic environment. FINRA is particularly interested in firms’ use of off-balance sheet leverage and whether firms are properly netting assets and liabilities for balance sheet purposes.
The annual priorities letter lays out a helpful blueprint of FINRA’s concerns and where future examinations will be focused. Member firms should review their written supervisory procedures and policies to address these issues and be prepared to address these topics, as well as any deficiencies noted in prior examinations, in their upcoming FINRA examinations. During their examinations, firms should be prepared to demonstrate that they have established, maintained and enforced such procedures or that they are in the process of being implemented or do not apply to the firms' business.
*This alert was co-authored by W. Hardy Callcott, Amy Natterson Kroll, Michael Wolk and Aileen Foley.
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