On January 22, the Financial Industry Regulatory Authority, Inc. (FINRA) released its annual, but renamed, Risk Monitoring and Examination Priorities Letter (Priorities Letter) for 2019. As discussed in the prefatory cover letter from FINRA President and CEO, Robert Cook, this year’s Priorities Letter departs from previous letters in two main respects.
First, by referencing “Risk Monitoring” in the Priorities Letter’s title, FINRA makes it clear that the covered priorities are relevant not only to FINRA’s examinations program but also to its risk monitoring program as well. As explained in Mr. Cook’s cover letter, risk monitoring is the process FINRA uses “to identify risks and assess their prevalence and impact.” FINRA uses this analysis to determine “whether a regulatory response is appropriate, determine what that response should be and then allocate the required resources to implement the response.” While a number of different “regulatory responses” are available to FINRA—including investor alerts, hosting of conferences, and member education—from a member’s perspective, the most impactful regulatory response is likely to be a targeted examination, particularly a special-purpose examination that occurs outside the member’s routine examination cycle. In other words, firms that engage in activities addressed in the Priorities Letter that FINRA is likely to view as presenting a significant risk should factor in the increased likelihood of being paid a visit by FINRA’s examination program.
Second, as stated in Mr. Cook’s cover letter, this year’s Priorities Letter focuses primarily “on those topics that will be materially new areas of emphasis” for FINRA’s risk monitoring and examination programs in the coming year. This is not to suggest, however, that FINRA intends to decrease its review of members’ compliance with perennial areas of focus such as suitability, complex products, margin, outside business activities and private securities transactions, private placements, communications with the public, anti-money laundering (AML), best execution, fraud (including microcap fraud), insider trading and market manipulation, net capital and customer protection, trade and order reporting, data quality and governance, recordkeeping, risk management, and “supervision related to [the foregoing] and other areas.” (Emphasis added). Other continuing areas of focus by FINRA mentioned in the Priorities Letter include associated persons with a problematic regulatory history and cybersecurity.
All FINRA members would benefit from a careful review of the Priorities Letter. As to each priority that is applicable to their business activities, firms that have not previously done so should consider how well their practices, policies, and procedures address the identified concerns. Firms should also consider the extent to which they document their relevant supervision and monitoring efforts. Firms may also want to consider whether additional training, educational notices, and other efforts might be helpful, both as a way of improving their compliance and as a means, should they be examined, of demonstrating the seriousness with which they have tried to address the applicable issue.
The Priorities Letter highlights three emerging activities of special concern.
Online Securities Distribution Platforms. The first of these relates to involvement by members with online securities distribution platforms. The Priorities Letter states that members are “increasingly” involved in the distribution of securities through online platforms in reliance on Rule 506(c) of Regulation D and Regulation A under the Securities Act of 1933. FINRA is concerned that some members involved with online distribution platforms nevertheless assert that they are not selling or recommending securities to customers. FINRA views the handling of customer accounts and funds, or receiving transaction-based compensation, as indicative of sales activities that can trigger suitability, AML, and other regulatory requirements. The Priorities Letter also states that FINRA will consider how firms are evaluating offering documents and communications with the public, including whether such documents and communications omit material information, contain false or misleading statements, or promise unreasonable returns. In the case of offerings subject to Regulation D, FINRA also intends to review the risk of sales to non-accredited investors and non-compliant escrow arrangements. With respect to Regulation A offerings, FINRA will also assess compensation-arrangement disclosure and whether such arrangements are excessive.
Fixed-Income Mark-Up Disclosure. The second area of special concern relates to compliance with recent amendments to FINRA Rule 2232 (Customer Confirmations) and MSRB Rule G-15 (Confirmation, Clearance, Settlement and Other Uniform Practice Requirements with Respect to Transactions with Customers) that require disclosure of mark-ups and mark-downs on certain fixed-income transactions with customers. FINRA also intends to review for changes that firms might have undertaken to avoid their disclosure obligations.
Regulatory Technology. The third area of focus is innovative regulatory technology (RegTech). Possible regulatory issues related to RegTech listed in the Priorities Letter include supervision and governance systems, third-party vendor management, safeguarding customer data, and cybersecurity.
Suitability. Areas of specific focus listed by the Priorities Letter include (1) quantitative suitability determinations and related supervisory controls; (2) overconcentration in illiquid securities such as variable annuities, non-traded alternative investments, and private placements; and (3) recommended share classes that are not in line with customer time-horizon or that are held for a period that is inconsistent with the security’s performance characteristics.
Firms are also cautioned with respect to suitability concerns arising out of novel and increasingly complex exchange-traded products (ETPs), including leveraged and inverse exchange-traded funds (ETFs), floating-rate loan ETFs, and mutual funds that invest in loans extended to highly indebted companies of lower credit quality.
The Priorities Letter also identifies the sale of collateralized loan obligations and other packaged leverage loan products to retail investors as an area of concern.
Senior Investors. General areas of focus include protecting senior investors from fraud, sales practice abuses, and financial exploitation. FINRA will also assess the supervisory controls that firms have put in place to provide heightened scrutiny over accounts of seniors where a representative acts in a fiduciary capacity.
FINRA also intends to review controls regarding the obligation placed on members under amendments to FINRA Rule 4512 (Customer Account Information) to obtain information about trusted contacts as well as firms’ policies and procedures where firms anticipate placing temporary holds on distributions pursuant to new FINRA Rule 2165 (Financial Exploitation of Specified Adults).
Outside Business Activities and Private Securities Transactions. Particular concerns in this regard include fundraising activities for an entity that the associated person controls or has an interest in, specifically entities with potentially misleading names that are similar to established issuers.
Supervision of Digital Assets. The Priorities Letter reminds members that they are encourage to notify FINRA if they plan to engage in activities related to digital assets, even if such activities do not require a membership application. While digital assets are an area of general interest to FINRA, specific concerns include how firms determine whether a digital asset is a security and whether firms have adequate controls and supervision over compliance with rules related to marketing, sales, execution, control, clearance, recordkeeping, and valuation of digital assets, as well as AML/Bank Secrecy Act rules and regulations.
Customer Due Diligence and Suspicious Activity Reviews. FINRA intends to assess compliance with FinCEN[PB3] ’s Customer Due Diligence [PB4] rule. FINRA also intends to focus on the data integrity of suspicious-activity monitoring systems as well as decisions associated with changes to those systems.
Best Execution. Particular areas of focus include best execution decision-making where all or substantially all customer orders are routed to one or a small number of wholesale market makers that pay for order flow or to an affiliated broker-dealer or alternate trading system. FINRA will also assess how firms check for potential price improvement at competing venues, how firms quantify the benefits to customers from their receipt of order-routing inducements, and how firms manage the conflict between such inducements and their duty of best execution.
Market Manipulation. An expected area of FINRA’s focus this year is on manipulative trading in correlated ETPs, including those that track common, broad market indices, and correlated options, e.g., options on broad market indices and options on ETFs overlying the same indices.
Market Access. Compliance by members with the Market Access Rule (Exchange Act Rule 15c3-5) will continue to be an area of focus for FINRA.
Short Sales. FINRA intends to review whether aggregation units that calculate their net long or short position in a security separately from the overall firm position are compliant with the requirements of Exchange Act Rule 200(f) and whether firms can demonstrate the independence of such units.
Short Tenders. FINRA will review for compliance with Exchange Act Rule 14e-4 , which requires firms, for purposes of calculating their net long position in a security, to reduce their long position by the shares underlying any call option sold at a strike price less than an announced tender-offer price.
Credit Risk. FINRA is interested in firms’ policies and procedures for identifying, measuring, and managing credit risk, including risks that are not “readily apparent,” such as transactions executed by customers and correspondents away from the firm, as may occur under clearing, prime brokerage, and “give up” arrangements, and sponsored access or principal letters. FINRA will also assess whether firms are identifying and addressing all relevant risks when they extend credit to customers and counterparties and whether firms are complying with FINRA Rule 4210(f)(1) (Margin Requirements), which requires “substantial additional margin” on positions that are subject to “unusually rapid or violent changes in value, do not have an active market on a national securities exchange, or where the amount carried is such that the position(s) cannot be liquidated promptly.”
Funding and Liquidity. FINRA intends to review whether firms have updated their stress-test assumptions in light of changes in the marketplace, including increased volatility, adequacy of firms’ liquidity pools, and whether firms review the reasonableness of their stress-test assumptions on a regular basis. FINRA will also consider whether firms that rely to a significant extent on government securities repo funding have a contingency plan for disruptions of or reductions in funding from that market.