Earlier this month, FINRA published its Annual Regulatory and Examination Priorities Letter (the “Letter”). This is the first Letter under the tenure of new FINRA President and CEO Robert W. Cook. Notably, Mr. Cook introduced FINRA’s annual Letter with his own “cover letter” in which he shared several thoughts with the broker-dealer industry, including a common thread running through FINRA’s Letter—specifically a focus on core issues of compliance, supervision, and risk management. Mr. Cook also discussed his “listening tour” to meet with member firms, regulators, and investor groups since joining FINRA in August. In doing so, he shared two takeaways. First, starting this year, FINRA will publish summary reports that outline key findings from examinations in selected areas to serve as additional tools that firms can use to strengthen their controls. Second, in response to feedback from smaller firms, FINRA will start providing more, and perhaps different, compliance tools to assist smaller firms in complying with regulatory requirements.
Turning to the Letter, FINRA annually publishes such a letter to provide its member firms with helpful insight into the focus areas for the upcoming year’s examinations. Though we encourage all clients, blog readers, and interested parties to review the Letter in its entirety, we have highlighted certain topics and points that we believe are the most important for our clients and followers, as discussed in more detail below. At the offset, however, we should note that in its introduction FINRA advised that starting in 2017 it will conduct electronic, off-site reviews in addition to traditional on-site examinations. These new electronic reviews will involve a select group of firms that are not currently scheduled for a cycle examination in 2017. These reviews will focus on selected areas including those identified in the Letter. In another change for 2017, FINRA will release a “compliance calendar” and a directory of compliance service providers, with the goal of helping small firms better meet their regulatory requirements.
In the body of the Letter, FINRA provides several broad categories for its priorities: (1) High-risk and Recidivist Brokers; (2) Sales practices; (3) Financial Risks; (4) Operational Risks; and (5) Market Integrity. Within these broad categories, FINRA also identified sub-categories. For ease of referencing the Letter, our summary below follows the organization of the Letter.
High-risk and Recidivist Brokers
Not surprisingly, FINRA will continue to devote particular attention to the member firms that hire high-risk and recidivist brokers and apply greater scrutiny to such firms. First, FINRA recently established a dedicated examination unit whose sole mission is to rigorously review and monitor high-risk and recidivist brokers’ interactions with customers. Second, FINRA will also focus on the ways that firms hire, retain, and monitor statutorily disqualified and recidivist brokers, and will also focus on firms that have a high concentration of brokers with significant disciplinary records, complaints, or arbitrations. Third, and more generally, FINRA is committed to ensuring that firms have sufficient inspection programs and supervisory systems for their branch offices and non-branch office locations, including independent contractor branches.
- Senior Investors – FINRA will continue to closely evaluate recommendations that senior investors purchase speculative or complex products, particularly in light of the investor’s profile and risk tolerance. Last year, fraud schemes involving microcap (or “penny”) stocks were on the rise, and often targeted senior investors. FINRA encourages firms to take steps to protect elderly customers from such fraud by contacting these customers to verify those types of transactions.
- Product Suitability and Concentration – FINRA will continue to assess how firms conduct reasonable-basis and customer-specific suitability reviews, and will increase its focus on the controls firms have in place for recommending new products and for recommendations that result in excess concentration in customers’ accounts. FINRA makes specific reference to ETPs, non-traded REITS and BDCs. Furthermore, firms should be prepared to discuss how changes in the interest rate environment impact their recommendations to clients.
- Excessive and Short-term Trading of Long-term Products – FINRA is clearly concerned about excessive and short-term trading of long-term products, as such activity is detrimental to clients but can bolster sales credits for registered representatives. FINRA makes specific reference to UITs. In addition to FINRA’s examination of this activity, FINRA urges firms to determine whether their control systems are sophisticated enough to detect deliberate attempts to avoid automatic surveillance for excessive switching activity.
- Outside Business Activities and Private Securities Transactions – FINRA will continue to focus on firms’ controls, documentation, and evaluation of written notifications of proposed outside business activities by registered representatives and associated persons. In addition, FINRA will focus on associated persons’ notification of private securities transactions and firms’ ongoing supervision of approved private securities transactions.
- Social Media and Electronic Communications Retention and Supervision – FINRA makes clear that both SEC and FINRA record-retention requirements extend to all business-related communications, regardless of the devices or networks used. FINRA will ensure that firms are complying with these retention requirements, as they are essential to a firm’s ability to detect inappropriate business conduct.
- Liquidity Risk – FINRA’s 2016 assessment of liquidity management practices at firms identified a variety of issues. As a result, in 2017 FINRA intends to focus on firms’ funding and liquidity plans to determine whether firms adequately evaluate their liquidity needs, develop contingency plans to handle market stresses, and effectively test those contingency plans.
- Financial Risk Management – Furthering its attempts to understand how larger firms manage risk across their organizations, FINRA will ask a select group of firms to explain how they would react to specific stress scenarios, considering the areas of readiness, communication plans, risk metrics, and contingencies.
- Credit Risk Policies, Procedures and Risk Limit Determinations Under FINRA Rule 4210 – On December 15, 2016, the first phase of the new amendments to FINRA Rule 4210 became effective. In 2017, FINRA will evaluate firms’ compliance with the first phase of the rule amendments and the corresponding supervision, policies, procedures and processes.
- Cybersecurity – According to FINRA, cybersecurity threats are one of the most significant risks for many firms. FINRA will focus on reviewing firms’ data systems, the controls designed to protect those data systems (including from insider threats), the strength of controls and practices at branch offices and independent contractor branch offices (which tend to be weaker), and firms’ compliance with Securities Exchange Act of 1934 (SEA) Rule 17a-4(f), which requires the use of write once read many (aka “WORM”) format.
- Supervisory Controls Testing – FINRA reminds all firms of their obligations with respect to supervisory controls testing and chief executive officer certifications with specific reference to FINRA Rules 3120 and 3130.
- Customer Protection/Segregation of Client Assets – Compliance with SEA Rule 15c3-3 is also a priority. FINRA will assess the sufficiency of firms’ documentation of the absence of liens and encumbrances on securities. In addition, FINRA will be examining whether firms are engaging in transactions that are designed, in whole or in part, to reduce a firm’s reserve or segregation requirements.
- Regulation SHO – Close Out and Easy to Borrow – Due to recent SEC enforcement actions regarding SEC Regulation SHO, FINRA will focus on the locate processes employed by firms in connection with short sales, and emphasized that firms should closely monitor their close-out process to ensure they are complying with Rule 204 of Regulation SHO.
- Anti-Money Laundering and Suspicious Activity Monitoring – Anti-money laundering programs will continue to be a FINRA focus in the upcoming year. Firms must incorporate anti-money laundering red flags into their trading surveillance systems, and should evaluate their controls around accounts held by nominee companies.
- Municipal Advisor Registration – Firms that advise state and local governments on municipal securities should ensure that they are registering correctly with the SEC and the Municipal Securities Rulemaking Board and that individuals engaging in municipal advisory activities pass the Series 50 Examination made available on September 12, 2016. Firms that do not register but still provide services to municipal customers should ensure that they meet the appropriate statutory exclusions and regulatory exceptions.
- Manipulation – Manipulation is a perennial top priority for FINRA and FINRA is taking several steps to detect and deter such manipulation, including: (1) enhancing its layering pattern detection capabilities to look for larger groups of market participants engaging in this manipulative activity; (2) enforcing the recent amendments to the Order Audit Trail System (OATS) rules; (3) monitoring potentially manipulative trades surrounding market open and close; and (4) expanding cross-product manipulation surveillance to include exchange-traded products. Lastly, in 2016, FINRA introduced the Cross Market Equity Supervision Report Cards for layering and spoofing activity as a compliance tool to complement firms’ supervisory systems and procedures to detect and deter manipulative conduct by a firm or its customers.
- Best Execution – FINRA emphasizes the importance of Regulatory Notice 15-46 and the importance of providing accurate payment for order flow disclosures. FINRA further advises that firms need to consider how the continuing automation of the markets for equity securities, standardized options and advances in fixed income markets affect order handling decisions, and factor these changes into their review of execution quality.
- Audit Trail Reporting Early Remediation Initiative and Expansion – FINRA expects firms to address potential equity audit trail issues identified through the Audit Trail Reporting Early Remediation Initiative. If firms take quick corrective measures in response to these alerts and the problem is limited in scope, it is possible that a formal investigation can be avoided.
- Tick Size Pilot – The Tick Size Pilot will continue in 2017, and FINRA notes that it is “critical” that firms submit accurate OATS and market maker data. FINRA intends to monitor compliance with these data requirements, and restrictions on quoting and trading.
- Market Access Rule – Firms should focus on improving their compliance with the Market Access Rule. In this subsection, FINRA provides a list of best practices, including: implementing, memorializing, and monitoring pre-trade and post-trade controls; implementing procedures for the supervision, development, testing and employment of algorithmic trading, including code development or changes; and maintaining reasonable processes to monitor whether trading algorithms operate as intended, and processes to disable algorithms or systems that malfunction. FINRA directs firms to Regulatory Notice 15-09 for further discussion of effective electronic trading practices.
- Trading Examinations – Conflicts of interest, the adequacy of alternative trading systems’ disclosures, and the handling of manual option orders by floor brokers and upstairs firms under their best execution obligations will be examination priorities this year. Also, FINRA intends to begin a pilot trading examination program to determine whether targeted examinations of smaller firms are worthwhile.
- Fixed Income Securities Surveillance Program – FINRA will continue to focus on surveilling wash sales and interposing activity, and will review written supervisory procedures and systems designed to detect non-bona fide Also, in light of the TRACE reporting requirements, which are scheduled to become effective in July 2017, FINRA will develop ways to monitor compliance with rules applicable to U.S. Treasury securities.
Drinker Biddle Conclusion
Mr. Cook’s cover letter is revealing in terms of his initial views as FINRA’s new leader. Mr. Cook appears to aspire for increased and better communication with FINRA’s members. He also stated that one of his areas of focus will be the role that member firms “…play in facilitating capital formation by small and emerging growth companies, which are vital engines of our economy and job creation.” Turning to FINRA’s Letter, consistent with its mandate as the main self-regulatory organization for broker-dealers, the Letter and priorities ambitiously seek to cover all corners of the broker-dealer industry. That said, many of the plans discussed are continuations of long-standing efforts, though others are new priorities that demonstrate the ways in which FINRA’s oversight is evolving, expanding, and improving, such as the increased discussion of electronic and algorithmic trading.