On January 6, 2015, FINRA set forth its regulatory and examination priorities (the  “Priorities  Letter”)  for 2015, providing  insight into FINRA’s concerns about  the operation of the securities industry and markets.1 The Priorities Letter presents an agenda of  important regu- latory matters that FINRA believes need to be addressed by the secu- rities  industry. Of utmost importance is the industry’s relationship with the customer.

The Priorities Letter introduction is most telling in that it is vastly dif- ferent from years  past. In 2015, it identifies five recurring challenges facing FINRA and the industry. The  challenges are:

  • Placing the “best interests” of clients first, although there is no industry rule;
  • Creating a culture within firms that values ethics and compli- ance;
  • Developing and maintaining robust supervision and risk man- agement systems and internal controls  that act as critical safe- guards to protect clients and encourage ethical conduct;
  • Improving product development, sales training, and supervision. FINRA expects firms to establish reasonable basis and customer -specific suitability standards prior to offering a new product. Wealth Management divisions must  act independently in order to safeguard their determination about the suitability of the prod- uct;  and
  • Developing and implementing programs to address enterprise conflicts of interest, which is a  combination of ethics, cultural and organizational structure, policies, processes and incentives  that in totality shape the firm’s management of conflicts.2

Along with a focus on the customer relationship, sales practices, financial and operational  activities, and market integrity remain FINRA’s focal points for 2015.3 In the sales practice area,  FINRA highlighted eight new product types of concern, while restating two previous products.  FINRA’s concern with all products deals with the complexity of product features and sales  practices. Appropriate prod- uct risk reviews need to concentrate on due diligence, suitability,  disclosure, and supervision and training of sales personnel. Further- more, changing circumstances,  such as economic events, require firms to reevaluate products.

Sales Practices. Variable annuities have attracted FINRA’s attention in regard to IRC Section 1035  exchanges and new purchases. FINRA intends to examine firms’ compensation structures to deter- mine  if they may incentivize variable annuity sales and suitability recommendations, product feature  disclosures, and training and testing of broker’s and supervisor’s product knowledge. It is  suggest- ed that a firm’s product committee analysis, training programs and testing of brokers’  knowledge will be paramount for satisfying a FINRA inquiry.4

The explosion in the marketplace of exchange traded products (“ETPs”) has attracted FINRA’s  attention as well. Products that track indices such as equally weighted, fundamentally weighted and vola- tility weighted indices are viewed as complex products for the indi- vidual investor. Risks  associated with ETPs remain questionable to FINRA, even when the ETP has been back tested.

Structured Retail Products (“SRPs”) are complex products that may fall within a derivative  classification. FINRA will focus its examina- tions on broker understanding of SRPs and investor  knowledge. Re- tail communications related to the sale of SRP must be filed with FINRA within 10  days of first use.

Floating Rate Bank Loan Funds (“Funds”) are typically marketed to institutional investors. FINRA,  however, has observed that retail investors have increased their exposure to these Funds. Although  the Funds are said to be a hedge to interest rate fluctuations, these Funds carry significant  credit and call risk. FINRA viewed these Funds as difficult to value, have longer terms than other  investments, and to be relatively illiquid. The suitability of Funds will be a key focus of FINRA,  along with determining the potential for a conflict of interest between the firm and the retail  investor.

Securities-backed lines of credits (“SBLOC”) are another product that concerns FINRA. SBLOCs are  revolving loans that allow a customer to borrow from a lending institution using securities in  their brokerage account as collateral. FINRA stressed that firms need to have proper controls in  place regarding SBLOCs. Customers need to understand SBLOC program features and how market  conditions may affect their brokerage account.

Noted in the 2014 Priority Letter, interest rate sensitive fixed income securities make a repeat  appearance in 2015. The risks identified for this product last year remain applicable in 2015. Some  of the risks include lack of liquidity, high fees and valuation difficulty. Valuation of these  products remains a notable concern to FINRA.5 As with other products identified in the Priority  Letter, firms need to be vigi- lant and conduct on-going due diligence of these products. FINRA  reminded firms that suggesting to a retiree that his/her only choice is to roll over retirement  plan assets to a firm-sponsored IRA is false and misleading.

FINRA will examine a firm’s procedures and controls for preventing excessive trading and product  concentration issues.

Due diligence and suitability analysis concerning private placements is another supervisory area  discussed by FINRA in the Priority Letter. Some issues associated with contingent offerings and  escrow provi- sions relating to private offerings noted by FINRA include6 amending offering terms  without a proper rescission offer being made to inves- tors, and failure by a firm to establish  escrow procedures.

Supervision. FINRA’s new supervision rules (3110, 3120, 3150 and 3170) became effective on December  1, 2014. The new rules modified requirements pertaining to the supervision of offices of supervisory jurisdiction, inspections of non-branch offices, conflicts of interests, performing risk-based reviews of correspondence and investment banking activ- ities, monitoring of inside  trading, conducting internal investigations, reporting of selected information to FINRA, and  testing and verifying supervisory control procedures.

Instances of customers not receiving volume discounts (breakpoints) and sales charge waivers to  which they were entitled when purchas- ing products like REITS, Unit Investment Trusts, and mutual  funds were observed by FINRA. Thus, it is imperative that firms focus on their internal controls  regarding the handling of wealth events, such as IRA rollovers, to assure their customers receive  sales charge dis- counts and waivers when appropriate.

In 2014, increases in microcap activity and foreign currency conver- sions in delivery versus  payment/receipt versus payment (DVP/RVP) accounts occurred. Some firms were not monitoring activity  in these accounts due to improper procedures and controls,  and  may have failed to report  suspicious activity pursuant to the Anti-Money Laundering rule. For purposes of compliance with the  Anti-Money Laundering rules, FINRA will examine cash management accounts and DVP/RVP accounts.

Financial and Operational Priorities. Valuation of securities remains a priority for FINRA. A  firm’s program for monitoring its funding and liquidity risks will be examined by FINRA.  Mark-to-market processes and supervisory controls, especially with non-high grade, illiquid assets,  are key areas of concern to FINRA.

A firm’s cybersecurity system is of critical importance to risk man- agement as a cybersecurity  issue could ultimately impact the accu- racy of a firm’s books and records. Accordingly, FINRA will  review a firm’s approach to compliance with SEC Rule 17a-4(f) in the event of cyber attack. This  rule, in part, permits a firm to store its records electronically, in a non-rewriteable,  non-erasable format.

Market Integrity. One of FINRA’s goals is to maintain fair and orderly markets. In this regard, a  broker-dealer must have supervisory con- trols and proper governance. A firm’s trading technology  is critical in the satisfaction of its obligation to supervise trading activities. Algorithms used in trading continue to raise FINRA’s interest. Trading activities implicate the  firm’s risk management and financial operational control, and may adversely affect a firm’s net  capital. Moreover, abusive algorithms pose a significant risk to market integ- rity. Cross-market  and cross-product manipulation continue to be an issue for FINRA. It intends to enhance both its  equities and options cross-market surveillance activities.

Firms should also examine their best execution procedures in routing customer  option  orders.  An   active  best  execution  committee  is a necessity in order for a firm to meet its regulatory  obligation.

Summary. FINRA’s Priority Letter lays out FINRA’s view of issues challenging the securities  industry. One issue, however, impacts all of their concerns - firm ethics. Putting the interest of  the client over that of the broker is a key priority for FINRA, which appears to be moving ahead of  the SEC in addressing a fiduciary standard for bro- kers. Brokers need to examine, and continue to  reexamine, their conflict of interest policies and procedures. In part, the firm’s culture for  ethical practices and compliance must originate from its highest levels in order to filter down  within the organization. Sales practices, supervision and market integrity will all benefit positively.