Yesterday, FINRA released its tenth annual Regulatory and Examination Priorities Letter in which it identifies its areas of examination focus for 2015, recurring challenges faced by firms, and possible risks impacting the financial sector. A copy of the letter is available here. FINRA’s 2015 exam priorities are largely in lockstep with those announced in 2014; FINRA will continue its focus on interest sensitive securities, “high risk” brokers, senior investors and management of cyber-security risks. We described those for you in our 2014 summary and analysis of FINRA’s Regulatory and Examination Priorities Letter from last year.
For 2015, FINRA describes new areas examiners will focus upon during routine examinations, including sales practices surrounding complex investment products, financial controls, and order routing practices.
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The 2015 Recurring Challenges Impacting Firms
As an overarching matter, FINRA highlights five “recurring challenges” it believes potentially may impact the quality of customer service and can contribute to compliance and supervisory breakdowns. These are essentially FINRA’s “lessons learned” from decades of regulatory and enforcement efforts. FINRA discusses each in non-objective and somewhat amorphous terms. They are, as described by FINRA:
- “Putting customers’ interests first,” which FINRA appears to champion as an investment advisor-like fiduciary obligation for broker-dealers.
- Poor “firm culture,” which can be an underlying cause for compliance failures. The 2015 letter encourages firms to implement policies that “should come from the board and executives and not be viewed as a compliance task.”
- Adopting robust “supervision, risk management and controls,” including enhanced data analytics.
- Ensuring proper disclosures and rigorous review of new investment “products and services.”
- “Conflicts of interest” as a contributing factor to many regulatory actions commenced by FINRA against firms and brokers. In 2013, FINRA commissioned a report that set forth effective practices for identifying and managing conflicts of interest. Since then, FINRA has observed positive changes, but will continue to focus on perceived conflicts issues, including fee and compensation structures that can create conflicts of interest and undercut broker objectivity.
FINRA has referenced many of these “challenges” in other contexts before, including in Notices to Members and regulatory actions. They will indeed provide a basis for doing so in the future.
For 2015, FINRA will focus on eight specific investment products: (1) interest rate sensitive fixed income securities; (2) variable annuities; (3) alternative mutual funds; (4) non-traded real estate investment trusts; (5) exchange traded products tracking alternatively weighted indices; (6) structured retail products; (7) floating rate bank loan funds; and (8) securities backed lines of credit.
The sale of these products will undergo heightened scrutiny because they are believed to be either complex, previously available only to more sophisticated investors but now offered to retail investors, or subject to substantial market, credit, liquidity, or operational risk. FINRA examinations involving these investment products will focus on due diligence, suitability, disclosure, supervision and training.
Many of these products (variable annuities, alternative mutual funds, structured retailed products floating rate bank loan funds, and securities backed lines of credit) were not included in FINRA’s 2014 letter.
Interest Rate Sensitive Securities
FINRA’s 2015 letter echoed concerns about interest rate sensitive securities highlighted by FINRA in its 2014 letter, presumably because the marketplace anticipates – as it has for over a year – an increase in interest rates as the government stimulus winds down. As FINRA said last year when a rise in interest rates was perceived as being on the horizon, FINRA remains focused on the disclosures made by firms and brokers when recommending interest sensitive securities. In examinations, FINRA also intends to continue to evaluate instances of perceived concentrations of interest rate sensitive products, such as long-duration fixed income securities, high yield bonds, mortgage backed securities, or bond funds composed of interest rate sensitive securities.
Individual Retirement Account (IRA) Rollovers (and Other Wealth Events)
The 2015 letter renews FINRA’s focus from 2014 on IRA rollovers, particularly through an enhanced review of communications and marketing materials. This year, the focus also expands to include investment activities that FINRA refers to as “wealth events.” According to the 2015 letter, “wealth events” refer to the receipt and investment of an inheritance, a life insurance payout, proceeds from a sale of a business or other major asset, divorce settlement or an IRA rollover, among other events. Routine examinations will review the control systems firms have in place regarding wealth events, with a particular emphasis on firms’ compliance with supervisory, suitability and disclosure obligations.
Broker “Risk Scoring”
FINRA’s “High Risk Broker” program was implemented in 2013 and expanded in 2014. The program utilizes two computer algorithms, the “Broker Migration Model” and the “Problem Broker Model,” to monitor brokers’ disclosure events and movement between firms. Despite much press and fanfare, FINRA only examined 42 “high risk brokers” in 2013, and of those 42 examined brokers, only 16 were expelled. Statistics regarding FINRA’s examination and expulsion of “high risk brokers” for 2014 are not yet available. FINRA now intends to further expand the program in 2015 by increasing its use of data mining, analytics, specially targeted examinations and expedited investigations and enforcement actions. Furthermore, firms that hire so called “high risk brokers” will undergo enhanced exam scrutiny, including heightened review hiring and supervisory practices. Unfortunately, FINRA’s computer algorithms remain shrouded in secrecy and it is still unknown what exactly will result in a “High Risk” designation.
Sales Charge Discounts and Waivers
Following concerns raised from routine examinations regarding sales charge waivers and volume discounts (break points), FINRA’s review of volume discounts and sales charge waivers will continue in 2015, with a particular focus on whether brokers properly disclose the availability of a volume discount and make appropriate investment recommendations to customers in that regard. There appears to be special emphasis on charges associated with the sales of non-traded REITs, Unit Investment Trusts, Business Development Corporations and mutual funds.
In 2014, FINRA commissioned a study on senior investor related issues. The preliminary findings show that many firms have proactively implemented internal policies to strengthen suitability determinations and provide training related to the specific needs of senior investors. In 2015, FINRA intends to continue its heightened review of communications with seniors, the suitability of investment recommendations made to seniors, training related to senior-specific issues and the supervisory procedures. By all indications, senior investors will remain a focal point for the foreseeable future.
Private Placements, Cyber Security and Anti-Money Laundering
Private Placements, cyber security and anti-money laundering were discussed in both the 2013 and 2014 letters. With respect to Private Placements, the 2015 letter reminds firms that most private placement documents must be filed with FINRA in accordance with Rules 5122 or 5123. The 2015 also letter reminds firms that FINRA reviews private placements to determine whether sufficient due diligence was performed prior to the issuance of customer recommendations. FINRA’s review of such transactions revealed that, in some cases, the level of due diligence did not comply with the firm’s policies and procedures or was insufficient to support a suitability determination.
FINRA also notes concerns with cyber security for the third consecutive year. As a result, FINRA will continue to review firms’ approaches to cyber security risk management. Given the increased risk and exposure to cyber-attacks, in January 2014 FINRA commenced a study to better understand the types of cyber threats to which firms are exposed and firms’ responses to such threats. In early 2015, FINRA intends to publish its findings.
Regarding anti-money laundering, FINRA will continue to focus on the increased use of DVP/RVP (Delivery Versus Payment/Receipt Versus Payment) customers of executing broker-dealers to liquidate large volumes of low priced securities as a concern, particularly those based in countries with weak regulatory regimes.
Municipal Advisors and Securities
In 2014, the SEC rules regarding municipal advisors, including definitions of what constitutes municipal advisory activity requiring registration with the SEC, became effective. Since that time, FINRA has been tasked as the examination and enforcement authority with municipal advisor oversight.
Not surprisingly, municipal advisors and securities remain an examination focus in 2015. FINRA’s examination review will specifically focus on proper application of exclusions and exemptions as well as potential unregistered activity. FINRA will also focus on firms that sell municipal bonds in less than the minimum denomination, in violation of MSRB Rule G-15.
Funding and Liquidity: Valuing Non-High-Quality Liquid Assets
In 2015, FINRA expects firms to develop and monitor funding and liquidity risk management programs that ensure accurate valuation and pricing of securities. Past examinations have revealed that, at times, firms’ funding and liquidity plans utilize potentially volatile mark-to-market pricing. Routine examinations will focus on the integrity of mark-to-market pricing and whether firms have sufficient supervisory controls in place to ensure accurate pricing and valuation.
Sales to Customers Involving Tax-Exempt or Federal Deposit Insurance Corporation (FDIC) Insured Products
The 2015 letter announces FINRA’s focus on the sale of tax-exempt securities, FDIC-insured instruments, or products with similar characteristics. This focus is a result of the potential for customers to lose their perceived tax-exempt status on interest payments or FDIC protection when a firm is in a short-position with respect to the security (i.e., where the firm has sold more of the securities than it has purchased or holds in inventory). Examiners will review the creation and resolution of firms’ short positions, the supervisory processes in place for the prompt resolution of such short positions, and firms’ compliance with the SEA Rule 15c3-3d.
The 2015 letter reminds firms that outsourcing covered activities in no way diminishes a broker-dealers’ responsibility to: (1) ensure full compliance with all securities laws, rules and regulations; and (2) sufficiently supervise each third-party service provider’s performance. In 2015, FINRA will focus on outsourcing, including the due diligence and risk assessment utilized to select and hire potential providers and the supervisory controls used to monitor outsourced activities and functions.
Supervision and Governance Surrounding Technology
As a result of concerns raised regarding firm technology, examinations will now focus on firms’ technology systems and related controls, with a particular emphasis on development and ongoing supervision of trading algorithms. FINRA will also review the adequacy of firms’ formal supervision regarding the development and testing of technology changes. In the 2015 letter, FINRA notes that it will specifically review each firm’s net-capital position due to the potential risk caused by the speed with which orders are placed and executed, often in numerous symbols and across multiple markets.
Abusive Algorithms and Cross-Market and Cross Product Manipulation
The 2015 letter emphasizes that through enhanced surveillance FINRA will aggressively pursue firms whose brokers or customers utilize abusive algorithms in an effort manipulate markets.
Similarly, FINRA is implementing enhanced equity and option cross-market surveillance patterns during 2015. Additionally, in 2015 FINRA plans to launch a pilot program intended to provide firms with newly available information designed to enhance the firms’ supervision to detect and prevent manipulative trading activity through customers’ use of multiple broker-dealer.
Order Routing Practices, Best Execution and Disclosure
In July 2014, FINRA commenced an investigation to determine whether trading-fee rebates create conflicts of interest that may compromise the execution quality of customer orders. This issue has been an area of concern, particularly given the rebates that different trading venues offer brokers that send orders their way and the conflict of interest this can cause with meeting best-execution requirements.
As of late, fixed-income trading has undergone stricter scrutiny by FINRA as well as the SEC. Notably, in 2015 FINRA plans to launch a pilot program for examinations focused solely on fixed-income issues, including compliance with books and records requirements and supervision and order execution practices.
Additionally, FINRA’s examiners will review best-execution practices related to fixed-income transactions and focus on firms’ pricing practices, including whether firms are obtaining the best price for their customers of debt securities and not charging excessive markups or markdowns.