Client Alert: FINRA Publishes its Annual Exam Priorities 1 January 2019 2019 Risk Monitoring and Examination Priorities of the Financial Industry Regulatory Authority On January 22, 2019, the Financial Industry Regulatory Authority (“FINRA”) published the latest in its annual letters to member broker-dealers identifying regulatory topics on which FINRA will focus in the coming year.1 As described below, several of the topics identified by FINRA were also noted by the Office of Compliance Inspections and Examinations (“OCIE”) of the U.S. Securities and Exchange Commission (“SEC”) in its own 2019 Examinations Priorities Letter, which was issued in December 2018. 2 Moreover, some of the priorities highlighted by FINRA for 2019 were previously identified in prior years. Risk Monitoring and Newly Highlighted Priorities FINRA has updated the title of its 2019 Letter, from previous years’ “Regulatory and Examination Priorities Letter” to this year’s “Annual Risk Monitoring and Examination Priorities Letter,” to reflect a broadened scope promoting the concept of “risk monitoring.” The cover note to the FINRA 2019 Letter defines risk monitoring in this context as the ongoing process by which FINRA monitors member firms and the broader security industry to “identify risks and assess their prevalence and impact.” This change portends a commitment to a holistic approach to regulation outside of the examination process, thereby seeking to identify and manage issues before they occur. In addition, FINRA took a different approach in 2019 from prior years by focusing on materially new priorities, each of which is highlighted below, and leaving aside 1 FINRA is a self-regulatory organization authorized under the Securities Exchange Act of 1934 (“Exchange Act”) to write rules governing all U.S.-registered broker-dealers and to examine its member firms for compliance with those rules. To alert member broker-dealers to current topics of interest to FINRA, FINRA publishes lists of such topics on an annual basis, the latest of which is available at http://www.finra.org/sites/default/files/2019_Risk_Monitoring_and_Examination_Priorities_Letter.pd f (“FINRA 2019 Letter”). 2 The SEC’s 2019 Examinations Priorities report is available at https://www.sec.gov/files/OCIE%202019%20Priorities.pdf (“OCIE 2019 Report”). In contrast to the FINRA Priorities Letter, the OCIE Report is applicable to U.S.-registered broker-dealers and other SEC-regulated entities, such as SEC-registered investment advisers and self-regulatory organizations. Indeed, the OCIE Report notes that OCIE has, among its priorities, examinations of FINRA focusing on FINRA’s operations, regulatory programs, and the quality of FINRA’s examinations of FINRA members. Contents Risk Monitoring and Newly Highlighted Priorities......... 1 Online Distribution Platforms ....................... 2 Fixed Income Mark-Up Disclosure ..................... 2 Regulatory Technology . 2 Other Identified Risks ....... 2 Sales Practice Risks ..... 2 Operational Risks.......... 3 Market Risks ................. 3 Financial Risks.............. 4 Shared FINRA and SEC 2019 Examination Priorities .......................................... 4 Concluding Thoughts........ 5 Client Alert: FINRA Publishes its Annual Exam Priorities 2 mainstay topics of FINRA interest unless they involve aspects not articulated in prior letters.3 Online Distribution Platforms FINRA is increasingly concerned with member firms’ use of online platforms – typically in reliance on Rule 506(c) of Regulation D and Regulation A – to distribute securities that are not registered with the SEC under the Securities Act of 1933. FINRA will evaluate how firms conduct business on such platforms, including reasonable-basis and customer-specific suitability analyses, supervision of communications with the public, and compliance with AML requirements. FINRA will also be evaluating whether and how member firms review offering documents or communications for these unregistered offerings and, for offerings made pursuant to Regulation D, how member firms address the risk of sales to non-accredited investors and non-compliant escrow arrangements. Fixed Income Mark-Up Disclosure In May 2018, FINRA Rule 2232 and Rule G-15 of the Municipal Securities Rulemaking Board were adopted to impose new requirements to disclose mark-ups/downs charged by member firms in connection with corporate fixed income and municipal securities transactions. 4 FINRA intends to closely monitor member firms’ compliance with these newly effective disclosure requirements. Regulatory Technology In the coming year, FINRA will review member firms’ use of regulatory technology, or “RegTech,” to streamline their compliance programs. FINRA is looking to gather information on the challenges associated with adoption and implementation of RegTech, especially in the areas of supervision and governance systems, third-party vendor management, safeguarding customer personally identifiable information, and cybersecurity. Other Identified Risks Sales Practice Risks First, while suitability requirements are a mainstay of FINRA’s past priorities lists, the 2019 version highlighted specific concerns around deficient quantitative suitability determinations and related supervisory controls,5 overconcentration of 3 Member firms should still expect FINRA to review for compliance areas not listed, such as mainstays like suitability determinations, reviews for insider trading and market manipulation, and regulatory compliance with a variety of rules, including anti-money laundering (“AML”) requirements. 4 See FINRA Rule 2232, Customer Confirmations (2011, as amended May 14, 2018), available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=17462&element_id=9788& highlight=2232#r17462; see also MSRB Rule G-15, Confirmation, Clearance, Settlement and Other Uniform Practice Requirements with Respect to Transactions with Customers (2017, as amended May. 14 2018), available at http://www.msrb.org/Rules-and-Interpretations/MSRBRules/General/Rule-G-15.aspx?tab=2. 5 Quantitative suitability refers to requirement that brokers with actual or de facto control over a customer’s account must account for the suitability of a series of recommended actions taken as a whole and not merely the suitability of each underlying transaction. See FINRA, Suitability, available at http://www.finra.org/industry/suitability. Client Alert: FINRA Publishes its Annual Exam Priorities 3 illiquid securities, and recommendations to purchase share classes outside of a customer’s time horizon or hold for a period outside of the security’s performance characteristics. Second, FINRA, as in prior years, highlighted its concerns regarding services to senior investors, both retired and approaching-retirement persons. Third, FINRA expressed heightened interest in how member firms review and supervise the outside activities of associated persons, especially the fundraising activities or other “private securities transactions” of such persons for entities the associated persons control, manage, or in which they otherwise have an interest. Operational Risks First, FINRA is looking into how member firms analyze whether a digital asset, such as a cryptocurrency or utility token, is a security, and whether the firms have implemented adequate controls and supervisions depending on the outcome of such analyses. Second, FINRA will be reviewing member firms’ compliance with the recently effective Customer Due Diligence (“CDD”) rule, promulgated by the Financial Crimes Enforcement Network of the U.S. Department of the Treasury.6 In brief, the CDD requires covered entities, including U.S.-regulated broker-dealers, to identify and verify the identity of the natural persons who maintain beneficial ownership of legal entity customers seeking to open accounts. On a related note, FINRA also will monitor the integrity of suspicious activity monitoring and reporting systems of member firms. Market Risks The FINRA 2019 Letter highlighted a range of activities broadly lumped under the category of market risks. For example, FINRA is concerned that member firms are failing to conduct due diligence to assure customer order flows are directed to the best market, particularly when all, or substantially all, of such order flow is directed to a small number of wholesale market makers in which a member firm has an interest. FINRA also announced that it is enhancing its surveillance capabilities to detect market manipulation and will be paying additional attention to the exchange-traded product market. Other initiatives include continued review of firms’ compliance with Exchange Act Rule 15c3-5 (under which member firms sponsor and permit non-members to have direct access to various exchanges and trading platforms), how member firms structure their aggregation units for purposes of calculating net short positions under Rule 200(f) of Regulation SHO and how firms account for their option positions when tendering shares in a short tender (i.e., using borrowed stock to respond to a tender offer). 6 Department of the Treasury, FinCEN, Customer Due Diligence Requirements for Financial Institutions; Final Rule (2018), available at https://www.govinfo.gov/content/pkg/FR-2016-05- 11/pdf/2016-10567.pdf; see also FinCEN, Information on Complying with the Customer Due Diligence (CDD) Final Rule, available at https://www.fincen.gov/resources/statutes-andregulations/cdd-final-rule. Client Alert: FINRA Publishes its Annual Exam Priorities 4 Financial Risks Finally, FINRA will be monitoring overall financial stability of member firms. For example, FINRA will be reviewing member firms’ credit policies, especially in relation to identifying, measuring, and managing credit risks. As a specific instance of this risk, the margin collected by a member firm may be insufficient as a regulatory requirement or prudential matter where a customer’s margin account contains illiquid, volatile, or concentrated security positions. As such, FINRA will focus on member firms’ assessment of such risks as well as general compliance with the margin requirements of FINRA Rule 4210. This compliments FINRA’s assessment of firms’ own funding and liquidity, which will be a focus in the coming year. Shared FINRA and SEC 2019 Examination Priorities Cybersecurity remains a major area of examination focus for both FINRA and OCIE. FINRA recently published a report on cybersecurity practices,7 and the OCIE Report stated that the SEC views cybersecurity as “critical to the operation of the financial markets.”8 OCIE examiners will focus on, among other things, adequacy of network security devices, information security governance, and policies and procedures protecting retail trading information. Additionally, both FINRA and OCIE will be focused on senior investors and those saving for retirement. As the OCIE Report emphasizes, “[e]very dollar a [senior investor] pays in fees and expenses is a dollar not invested.” This concern reflects broader and ongoing U.S. regulatory and legislative focus on protections afforded senior investors. 7 FINRA, Report on Selected Cybersecurity Practices – 2018 (Dec. 2018), available at http://www.finra.org/sites/default/files/Cybersecurity_Report_2018.pdf. 8 OCIE Report, supra n.2, at 11. Client Alert: FINRA Publishes its Annual Exam Priorities 5 / / Authors: Jerome Roche, Doug Davison, Jonathan Ching, Jacques Schillaci, Jimi Du, Benjamin Kurland This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. © Linklaters LLP. All Rights reserved 2019 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC326345. It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on www.linklaters.com. Please refer to www.linklaters.com/regulation for important information on Linklaters LLP’s regulatory position. We process your data in line with our Global Privacy Notice. You can view this at www.linklaters.com/en/legal-notices/privacy-notice. To opt-out of receiving any marketing emails from us, or to manage your email preferences and the personal details we hold for you, please contact: email@example.com. Contacts For further information please contact: Jerome Roche Partner (+1) 202 654 9275 firstname.lastname@example.org Doug Davison Partner (+1) 202 654 9244 email@example.com Jonathan Ching Counsel (+1) 212 903 9170 firstname.lastname@example.org Jacques Schillaci Counsel (+1) 212 903 9341 email@example.com Jimi Du Senior U.S. Associate (+1) 212 903 9256 firstname.lastname@example.org Benjamin Kurland Law Clerk (+1) 202 654 9270 email@example.com Linklaters LLP 1345 Avenue of the Americas New York, NY 10105 Telephone (+1) 212 903 9000 601 Thirteenth Street NW Suite 400 South Washington, 20005 Telephone (+1) 202 654 9200 Concluding Thoughts FINRA’s examination priorities remain, as they have always been, wide and varied. Despite the listing or priorities noted above, FINRA member broker-dealers must always be prepared for the possibility that any 2019 FINRA examinations will include many familiar topics from previous examinations – i.e., the examiners will play their classic hits. That said, if resources are strained, a sound strategy would be first to attend to the items highlighted in the FINRA 2019 Letter. While all of these items deserve attention, the repeat items from prior FINRA guidance, the newly included concept of “risk monitoring,” and those priorities common to both the FINRA 2019 Letter and the OCIE 2019 Report warrant particular attention.
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2019 Risk Monitoring and Examination Priorities of the Financial Industry Regulatory Authority
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