FINRA’s Exam Priorities Letter for the coming year reflects a continuing move toward a risk-based regulatory scheme, as opposed to the “what’s hot” list from prior years. In its 2015 Exam Priorities Letter (the “Letter”),1 FINRA identifies several reoccurring areas of concern that transcend many of the specific areas of focus detailed in the Letter. These five areas include:
- Prioritizing customer interests ahead of the Firm’s;
- Promotion of ethical considerations through the Firm’s culture;
- Strong Supervisory and Risk-Management system and controls;
- New or novel product due diligence and suitability review; and
- Management of Conflicts of Interest.
Aside from these general areas of concern, we expect FINRA to specifically focus on certain specified sales practice issues, financial and operational issues and market integrity issues. This bulletin focuses primarily on the sales practice concerns.
FINRA continues to note concerns regarding the sale of products intended to generate higher yields in the face of the current sustained period of low interest rates. This includes concern for the sale of complex products originally intended for more sophisticated and/or institutional investors but repackaged for sale to retail investors. Often, these products are not subjected to sufficient due diligence and thus, the suitability analysis is lacking. Against this backdrop, in connection with product- related risk reviews, FINRA Examiners will be looking at due diligence, suitability, disclosures, supervision and training.
The Letter also notes FINRA’s focus on firms’ controls related to wealth events (such as an inheritance, life insurance payout, sale of a business or other major asset, divorce settlement or an IRA rollover), with an emphasis on firms’ compliance with their supervisory, suitability and disclosure obligations.
In terms of specific products, the Letter delineates the following products for special attention:
- Interest Rate-Sensitive Fixed Income Securities
- Variable Annuities
- Alternative Mutual Funds
- Non-traded REITs
- Exchange Traded Products
- Structured Retail Products
- Floating-Rate Bank Loan Funds
- Securities-Backed Lines of Credit
Some of the concerns associated with these products include consideration of account concentration, compensation to the sales person, sufficiency and clarity of product disclosures, product expenses, sufficiency of supervision and surveillance mechanisms, and volatility in light of potential interest rate fluctuations.
Aside from the articulated product issues, FINRA notes the December 1, 2014 effective date of several new supervision rules (3110, 3120, 3150, and 3170), all of which will be reviewed by Examiners with the firms they visit. These new rules pertain to, among other things: (1) supervising offices of supervisory jurisdiction and inspecting non-branch offices; (2) managing conflicts of interest in a firm’s supervisory system; (3) performing risk-based reviews of correspondence and internal communications;(4) conducting risk-based reviews of investment banking and securities transactions; (5) monitoring for insider trading, conducting internal investigations and reporting related information to FINRA; and (6) testing and verifying supervisory control procedures.
FINRA’s Letter also references several areas of concern from prior years, including:
- IRA Rollovers
- Excessive Trading and Concentration Controls
- Senior Investors
- Recidivist Brokers
- Sales Charge Discounts and Waiver
Financial and Operational Priorities
In the operational area for 2015, FINRA Examiners anticipate focusing on firms’ respective abilities to manage liquidity, and as part of that scrutiny, Examiners will look at how firms mark securities. Additionally, FINRA notes various issues surrounding the sale of certain tax-exempt or FDIC-insured instruments whereby those investments could lose tax-exempt status with respect to interest payments and/or lose the FDIC insurance. Firms need to be aware of these potential eventualities and counsel clients accordingly.
In addition, concerns surrounding outsourcing and cybersecurity will be areas of examination by FINRA in 2015. In particular, what are firms doing in terms of due diligence on vendors and what governance structures and processes exist to assess technology related risks – both internal and with respect to outside vendors.
As in previous years, in 2015, FINRA will focus on abusive algorithmic trading and layering, spoofing, wash sales and other manipulative trading practices. FINRA examiners will utilize a variety of surveillance programs intended to identify potentially violative conduct and to deter cross-market and cross-product manipulation.
FINRA will also look for firms to be more aggressive in detecting and preventing misconduct. Maintenance of a strong technology backbone for review and surveillance of electronic trading is one indicia to FINRA of an adequate supervisory process. The organization of the technology staff performing the necessary surveillance or reviews will also be considered by Examiners. For 2015, FINRA is also calling out algorithmic trading (including abusive algorithms and supervision) and attempts to disguise market manipulation by trading across markets or products. Additionally, FINRA will increase its emphasis on reviewing firms’ fixed income pricing practices, including whether firms have the supervision and controls in place to ensure they are using reasonable diligence and employing their market expertise to achieve best execution for their customers and avoiding excessive mark-ups and mark-downs.
FINRA will also launch a pilot program to conduct fixed income-based examinations focusing on trading issues, including related controls. Among other things, the fixed income examinations will focus on the operation of alternative trading systems for fixed income trading.