Regulators Issue Annual Priorities Letters for Broker-Dealers

January 17, 2014

On January 2, 2014, FINRA issued its annual letter to member firms outlining its 2014 Regulatory and Examination Priorities (the “FINRA Letter”).1 A week later, on January 9, the SEC issued its own letter (the “SEC Letter”).2 While both regulators are quick to note that the letters are not all inclusive, they do give some insight into areas that firms should expect examiners to ask about in the coming year.

FINRA Priorities Letter

As in the past, FINRA has divided its letter into several categories (this year, Business Conduct, Fraud, Financial and Operations, and Market Regulation).

Business Conduct

Not surprisingly, the longest of the four categories is Business Conduct, and the single area of greatest focus within Business Conduct is on suitability.3 FINRA notes concerns about sales of many of the same products it has highlighted in years past and in its Regulatory Notices, including complex investments, non-traded REITs, and “Frontier Funds” (also known as emerging market funds). FINRA then devotes a subsection to “Interest Rate Sensitive Securities.” FINRA warns in the letter that, if interest rates rise in 2014 (as many are predicting), firms will need to consider the impact of rising rates on investments like mortgage backed securities, long duration bonds, bond funds and ETFs holding those bonds, emerging market debt, municipal securities, and “Baby Bonds” (issued by business development companies).

The possibility of a material change in interest rates has two potential consequences under FINRA Rule 2111. First, firms and representatives have a duty to perform a reasonable basis suitability analysis — they must understand the product they are recommending and how it works. If interest rates start to rise, an analysis of a particular product that was first made in a low interest rate environment may need to be revisited before further recommendations are made. Second, express hold recommendations must also be suitable. In reviewing customer portfolios, representatives and firms will need to carefully consider how actual or potential changes in interest rates impact a recommendation to continue holding particular investments.

In addition to suitability, the letter touches on several Business Conduct topics that were absent from the 2013 letter:

Conflicts of Interest: In October 2013, FINRA published its Report on Conflicts of Interest.4 FINRA states in the letter that examiners will be asked to review firms’ conflict management practices to evaluate, among other things, new product reviews, post-launch product reviews, incentives that favor proprietary products, and firms’ supervision of compensation thresholds.5

Qualified Plan Rollovers: FINRA encourages firms to review its recent notice on retirement plan rollovers (Notice 13-45) and says it plans to look at the materials provided to customers regarding rollovers, the supervision of rollover activity, and the suitability of associated securities recommendations.6

Recidivist Brokers: FINRA notes in the letter that it plans to expand its High Risk Broker program focusing on recidivist brokers, that it has “[c]reate[d] a dedicated Enforcement team to prosecute such cases,” and that it is now using
“[s]ophisticated analytics — known as the Broker Mitigation Model” to generate a risk scoring from which it will “[p]rioritize surveillance and . . . conduct focused or accelerated examinations and enforcement efforts.”7

Senior Investors: Building on a joint FINRA/SEC initiative from 2013 to review firms’ policies, procedures, disclosures and supervision in this area, FINRA states that it plans to
“[c]ontinue to focus on how firms engage with senior investors.”8

Initial Public Offerings: With the revival of the IPO market, FINRA reminds firms to be alert to “past abuses” and to the
“[r]isk that bad actors will be drawn to the IPO market as has happened in the past.”9

FINRA also addresses a number of the same topics as in its 2013 letter, but often with a slightly different focus.

Private Placements: In its 2014 letter, FINRA focuses on three different aspects of private placements.10 First, FINRA notes that “new challenges” may accompany the general solicitation of private placements now permitted under the JOBS Act Amendments, and that firms must ensure advertisements and marketing materials are “[f]air and balanced, and provide a sound basis to evaluate the facts about securities.”11 Second, FINRA says it plans to focus on firm due diligence, both into the securities offered, and into investors’ accredited status. Finally, FINRA notes that its review of private placement documents — now required to be filed under Rules 5122 and 5123 — has uncovered various deficiencies, which it, presumably, plans to pursue this year.

Anti-Money Laundering: While the 2013 letter focused on currency exchanges, FINRA highlights a different AML issue in 2014.12 FINRA notes a trend in using executing brokers by DVP/RVP customers to liquidate large positions in low-priced securities. This arrangement, FINRA says, makes the source of the securities hard to determine and may cause the executing broker to unwittingly engage in an unregistered offering. FINRA reminds firms that CIP requirements apply to these DVP/RVP accounts, and that if the prime broker has not agreed to screen the customers, the executing broker must do so.

Cybersecurity: Of perennial concern, FINRA notes that it
[c]ontinues to be concerned about the integrity of firms’ infrastructure and the safety and security of customer data.13

Market Regulation

A trend that FINRA hopes to expand is its use of automated systems to conduct surveillance of the markets. In its letter, FINRA notes that it has implemented new surveillance programs to monitor best execution in equity and fixed income securities, and will more closely review the quality of customer executions in the options markets.14 In a separate letter accompanying the FINRA letter, Richard Ketchum, FINRA’s Chairman and CEO, highlights FINRA’s expanded automated surveillance abilities, including expanded cross-market surveillance patterns and new threat scenarios added to those patterns, designed to identify potentially manipulative trading activity.15 According to Mr. Ketchum, the markets FINRA regulates (NASDAQ and NYSE markets) account for 80 percent of the volume of listed equity securities, and are expected to grow to 90 percent once Direct Edge is integrated early this year.16 As FINRA increases its ability to conduct surveillance, firms will need to review their own internal efforts if they are to keep pace with the regulators.

In other respects, the Market Regulation concerns in 2014 are identical to those from 2013. FINRA’s discussion regarding algorithmic and high frequency trading (HFT) is a continuation from last year — right down to using nearly identical language to describe the issues. FINRA again reminds firms they need adequate testing and controls for algorithms and HFT strategies, with particular attention given to ensuring that these systems do not result in manipulative trading.17

FINRA — in similar terms to 2013 — again warns the industry about ongoing weaknesses in Large Options Positions Reporting and in firms properly marking their capacity on options orders.18


FINRA’s discussion of fraud priorities highlights two areas. Insider trading remains a priority for FINRA and other regulators.19 Firms are reminded of the obligation to maintain reasonable procedures and controls to protect material, non-public information. Specific examples given include: routine review of electronic communications; maintenance of appropriate information barrier policies and procedures; monitoring of employee trading activity both inside and outside the firm; conducting regular reviews of proprietary and customer trading in securities on a watch or restricted list; and conducting employee training with respect to the use and handling of material, non-public information.20

FINRA’s second area of focus — microcap stocks — is a reiteration of the warning given in 2013. Firms are reminded of the need to impose heightened supervision of employees and traders engaged in trading microcaps, and diligently to supervise and review the customer accounts in which they are traded to ensure that disclosures are fair and balanced, that trading is not manipulative, and that the trading does not constitute an unregistered distribution.21

Financial and Operational Controls

FINRA remains focused on the protection of customer assets and net capital issues. In particular, FINRA intends to concentrate on:

Funding and Liquidity Risk: FINRA plans to conduct a more structured review of liquidity risk to identify effective practices across firms, and the regulator will implement a liquidity stress test for larger firms.22

Risk Control Documentation: Pursuant to a recent amendment to Rule 17a-3 of the Securities Exchange Act of 1934, certain firms are required to document their risk controls. FINRA will review the documentation to determine if it is functioning as designed.23

Net Capital Requirements: Firms should ensure that they properly compute net capital and that they are aware of interpretations to the Net Capital Rule that are applicable to their business model.24 Firms should be particularly vigilant in this area as recent amendments to Rule 17a-5 require certain broker-dealers to file a compliance report along with their annual financial reports in which they will be required to detail any violations of the Net Capital Rule.

SEC Priorities Letter

Unlike FINRA’s more expansive discussion, the SEC Letter, as usual, is filled with terse descriptions of areas of focus applicable across the entities that it regulates, as well as particularized guidance to advisors and funds, broker-dealers, exchanges and SROs, and clearing agencies and transfer agents.

In most respects, the SEC’s broker-dealer priorities coincide with FINRA’s. The SEC Letter highlights six areas of general focus: Fraud Detection and Prevention; Corporate Governance, Conflicts of Interest, and Enterprise Risk Management (the control environment, “tone at the top,” and policies for dealing with conflicts); Technology (operational capability, market access, information security, and preparedness to respond to malfunctions and system outages); Dual Registrants (how customers are steered to a particular platform and the differences in supervision); New Laws and Regulations (general solicitations under Rule 506(c), municipal advisors, and trading of securities based swaps (when rules are implemented)); and Retirement Vehicle and Rollovers (sales practices surrounding rolling assets from a retirement plan to an IRA).25

The broker-dealer specific guidance also largely coincides with FINRA’s priorities. The SEC highlights three “new” areas of focus:26

Market Access: The SEC plans to examine whether firms are appropriately applying Rule 15c3-5 and documenting access provided in master/subaccount arrangements.

Suitability of Variable Annuity Buybacks: The SEC plans to focus on representatives’ recommendations to customers to accept insurance company offers to buy back variable annuity contracts where the policies have valuable income and death benefits.

Fixed Income Market: The SEC’s focus is on market structure, particularly the use of ATSs on which only certain quotes are displayed and the resulting quality of execution on these platforms.

In addition, the SEC lists six “core” risk areas of ongoing concern and focus: Sales Practice/Fraud (affinity fraud and fraud against seniors; micro-cap manipulation; sales of high yield and complex products; and brokerage activity conducted by unregistered persons and entities); Supervision (independent contractors, remote branches and large branches; brokers with disciplinary history; and private securities transactions); Trading (algorithmic and high frequency systems; cyber security; and market manipulation); Internal Controls (risk management practices regarding liquidity, credit and market risks; valuation; and compliance); Financial Responsibility (compliance with net capital and customer protection rules) and Anti-Money Laundering.27


These letters provide firms with a roadmap of the regulators’ concerns and areas where firms can expect they will focus their examinations and reviews. Firms should review their current business practices, as well as their written policies and procedures to proactively address the areas outlined in the letters.


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:


1 FINRA’s 2014 Regulatory and Examination Priorities Letter (“FINRA Letter”), available at

2 SEC’s Examination Priorities for 2014 (“SEC Letter”), available at

3 FINRA Letter at 1-3.

4 FINRA’s Report on Conflicts of Interest, available at See also FINRA Publishes Report on Conflicts of Interest and Provides Guidance to Broker-Dealers About Managing and Mitigating Conflicts, dated Oct. 26, 2013, available at

5 FINRA Letter at 3-4.

6 Id. at 4.

7 Id. at 3.

8 Id. at 7.

9 Id. at 4.

10 Id. at 5.

11 FINRA Letter at 5.

12 Id.

13 Id. at 4.

14 Id. at 10-11.

15 Richard Ketchum’s January 2014 Letter to Firms about FINRA's Regulatory Program (the “Ketchum Letter”), available at The Ketchum Letter also discussed the Comprehensive Automated Risk Data System, FINRA’s recent proposal to collect certain retail account information, account activity and securities holdings. See also FINRA Proposes a New Method to Obtain Transaction Information: Comprehensive Automated Risk Data System, dated Jan. 6, 2014, available at

16 See Ketchum Letter.

17 FINRA Letter at 9.

18 Id. at 10.

19 Id. at 7.

20 Id. at 8.

21 Id. at 7.

22 Id. at 8 (The liquidity stress test will cover four main areas: (1) stressed funding of proprietary positions; (2) stressing of repo book; (3) stressing settlement payments and clearing deposits; and (4) funding loss of customer balances or increases in obligations to lend to customers).

23 FINRA Letter at 8.

24 Id. at 9.

25 SEC Letter at 2-3.

26 Id. at 8.

27 Id. at 7-8.

This article was originally published by Bingham McCutchen LLP.