In October 2019, FINRA released its “2019 Report on Examination Findings and Observations.” The report is intended to reflect key findings and observations identified in FINRA’s recent examinations of broker-dealers. The report also describes practices that FINRA deemed to be effective and that could help firms improve their compliance and risk management programs. In this article, we summarize aspects of FINRA’s report that are relevant to the structured products industry. The full report may be found at the following link: https://www.finra.org/rulesguidance/guidance/reports/2019-report-examfindings-and-observations/supervision.
INSUFFICIENT WRITTEN SUPERVISORY PROCEDURES FOR NEW OR AMENDED RULES
FINRA reported that some broker-dealers did not adequately address newly adopted or amended rules by developing controls to address recently enacted regulatory requirements and updating their written supervisory procedures (WSPs). These rules include:
- Fixed income mark-up disclosure requirements under FINRA Rule 2232 (Customer Confirmations);8
- Trusted contact person information requirements under FINRA Rule 4512 (Customer Account Information);9
- Rules relating to temporary holds, supervision and record retention requirements under new FINRA Rule 2165 (Financial Exploitation of Specified Adults).10
The report reminds broker-dealers that FINRA expects them to evaluate which new and amended laws and regulations apply to their businesses and review whether their supervisory systems, WSPs and training programs need to be amended or updated to comply.
LIMITED SUPERVISION AND INTERNAL INSPECTIONS
FINRA noted that some broker-dealers did not have reasonably designed branch supervision and inspection programs. According to the report:
“…some firms did not adequately understand the activities being conducted through their branch offices, including products and services that were offered only at certain branch locations, which could prevent such firms from effectively supervising and addressing the unique risks of each branch location. Many firms also did not conduct periodic inspections of non-branch locations as required by FINRA Rule 3110(c) (Internal Inspections); did not determine relevant areas of review at branch offices or non-branch locations, taking into consideration the nature and complexity of the products and services offered or any indicators of irregularities or misconduct; failed to reduce the inspections and reviews to a written report; or did not follow through on corrective action determined to be necessary through their branch inspections.”
INADEQUATE SUPERVISION OF PRODUCT EXCHANGES
FINRA also noted in the report that some firms did not maintain a supervisory system reasonably designed to assess the suitability of recommendations that customers exchange certain products, such as mutual funds, variable annuities or unit investment trusts (UITs). In particular, some firms did not maintain processes to identify patterns of unsuitable recommendations of exchanges involving long-term products. In addition, FINRA stated that some firms did not reasonably supervise exchanges because they could not verify the information provided by registered representatives in their rationales in order to justify a recommended exchange, such as inaccurate descriptions of product fees, costs and existing product values. In other cases, a firm’s supervision team did not detect that the source of funds for a purchase was misrepresented (i.e., it was represented as “new” money and not properly represented as funds coming from sales of other products).
As previously discussed in this publication,11 this topic has already been addressed by the SEC. For example, the SEC’s opinion is that exchanges of structured notes prior to maturity can be profitable for the relevant broker-dealer, but can subject the relevant investor to additional risk of loss.
LIMITED SUPERVISION TO IDENTIFY “RED FLAGS” FOR SUITABILITY
FINRA explained that some firms’ supervisory systems were not reasonably designed or used to detect red flags of possible unsuitable transactions. According to FINRA:
“For example, some firms did not identify or question patterns of similar recommendations by representatives or branch offices across many customers with different risk profiles, time horizons and investment objectives. In some instances, several customers of a representative or branch office appeared to have made ‘unsolicited’ transactions in identical securities, which could raise questions around whether the transactions were actually ‘unsolicited.’”
INADEQUATE SUPERVISION OF CHANGES TO CUSTOMER ACCOUNT INFORMATION
FINRA noted instances where registered representatives unilaterally changed account information, such as customers’ income, net worth or account objectives. In some cases, these changes preceded or were made at the same time as one or more transactions that, if the account change had not been made, would have been subject to heightened supervisory scrutiny, raised suitability concerns or would not have been approved.
UNSUITABLE OPTIONS STRATEGY RECOMMENDATIONS
FINRA reported about situations in which registered representatives recommended complex options strategies to customers who did not have the sophistication to understand the features of an option or the associated strategy, or without adequately considering the customers’ individual financial situations and needs. In addition, some firms did not properly implement trade limits and controls in order to identify and prevent options trading that exceeded customer pre-approved investment levels.