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FINRA Announces 2015 Regulatory and Examination Priorities for Broker-Dealers

Investment Management Law Update Hoyt R. Stastney, Peter J. Kaiser, Barbara R. Olson

On January 6, 2015, the Financial Industry Regulatory Authority (FINRA) released its 2015 Regulatory and Examination Priorities letter to alert broker-dealers to those areas of significant risk that, if not properly addressed, could adversely affect investors and market integrity. The examination priorities address several broad-based recurring regulatory challenges, as well as numerous areas of examination focus for 2015. All broker-dealers should carefully review the examination priorities and consider necessary enhancements to their operations and policies and procedures, as well as potential revisions to the substance or focus of training programs. The full text of the examination priorities may be reviewed online here.

Recurring Regulatory Challenges

FINRA has observed that challenges in five key areas may, at times, compromise the quality of service that firms and their registered representatives provide to clients. These challenges also contribute to compliance and supervisory breakdowns. Addressing the following challenges will enable firms to get ahead of the many specific areas of examination focus discussed later in this update.

Putting Client Interests First. FINRA has observed that not putting clients' interests first is a central failing of many firms, with the related harm compounded for vulnerable investors (e.g., senior investors) or a major liquidity or wealth event in an investor's life (e.g., an inheritance or Individual Retirement Account rollover). FINRA advises that irrespective of whether a firm must meet a suitability or fiduciary standard, it believes that firms best serve their clients, and will reduce their regulatory risks, by putting clients' interests first.

Firm Culture. FINRA warns that many of the problems in the financial services industry have their roots in firm culture. A poor culture may arise, for example, if firm management places undue emphasis on short-term profits or pursues rapid growth without an associated concern for controls. High standards of ethical behavior should come from the board and executives, and should not be viewed merely as a compliance task.

Supervision, Risk Management, and Controls. A firm's systems of supervision, risk management, and controls are essential safeguards to protect and reinforce a firm's culture. FINRA recommends that firms consider adopting or further enhancing data analytics to help identify problematic behavior.

Product and Service Offerings. FINRA notes that while firms have improved new-product review processes, the sale of novel products, and services remains a regulatory flashpoint. FINRA encourages firms to continue to conduct rigorous new product reviews, assess reasonable-basis, and customer-specific suitability prior to offerings and permit wealth management personnel to make independent decisions about products and services that are best for their clients.

Conflicts of Interest. Conflicts of interest are a contributing factor to many regulatory actions FINRA and other regulators have taken against firms and associated persons over the past year. FINRA has stated that it will continue to focus on this area, particularly with respect to fee and compensation structures that lie at the heart of many conflicts and which can at times compromise the objectivity registered representatives provide to clients.

Areas of Focus in 2015

FINRA's 2015 priorities also focus on the following key sales practices, financial and operational issues, and market integrity matters.

Sales Practices

Products. FINRA's 2015 examination program will focus on due diligence, suitability, disclosure, supervision, and training in relation to the specific product types described below. FINRA further urges firms and registered representatives to be attentive to changing circumstances throughout the year, such as the continued fall in oil prices or the rapid fall in some emerging and frontier market indices, which may affect suitability decisions and risk descriptions.

Interest Rate-Sensitive Fixed Income Securities. FINRA will continue its focus on these products, and in 2015 its examiners will look for concentrated positions in products that are highly sensitive to interest rates (such as long-duration fixed income securities, high yield bonds, mortgage-backed securities, or bond funds composed of interest rate-sensitive securities)and test for suitability and adequate disclosure.

Variable Annuities. FINRA's focus will include assessments of compensation structures that may improperly incent the sale of variable annuities, the suitability of recommendations, statements made by registered representatives about these products, and the adequacy of disclosures made about material features of variable annuities. FINRA examiners will also focus on the design and implementation of procedures and training by compliance and supervisory personnel to test the level of brokers' and supervisors' product knowledge, to prevent and detect problematic sales practices in variable annuities, and to assess compliance with requirements that firms file retail communications concerning variable annuities with FINRA within 10 business days of first use.

Alternative Mutual Funds. FINRA recognizes that sales of alternative mutual funds have increased rapidly over the past several years, as has the related regulatory risk. While there is no standard definition of alternative mutual funds, FINRA recommends that if a fund's strategy involves non-traditional asset classes, non-traditional strategies or illiquid assets, then the fund should be considered an alternative mutual fund. FINRA recommends that firms refer to such funds based on their specific strategies, as opposed to bundling them under one umbrella category. Firms should also ensure that communications regarding such funds accurately and fairly describe how the products work, and confirm the funds are consistent with the representations in the funds' prospectuses.

Non-Traded Real Estate Investment Trusts (REITs). FINRA recommends that firms perform due diligence on an ongoing basis on non-traded REITs they allow their representatives to recommend, including related to risks such as general lack of liquidity, high fees and valuation concerns. FINRA also reminds firms about how these investments are to be valued on customer account statements under the recently adopted amendments to the Customer Account Statement Rule and the Direct Participation Program Rule, which may be found here.

Exchange-Traded Products Tracking Alternatively Weighted Indices. FINRA recognizes that indexing has continued to expand beyond traditional market capitalization-weighted methods to alternatively weighted strategies, which allow exposure to specific investment risk factors or strategies. FINRA's examinations will focus on these products, given its view that these indices may seem unduly complex or be unfamiliar to clients and may carry generally higher expenses.

Structured Retail Products (SRPs). FINRA continues to see firms creating or distributing SRPs, including structured notes, with complex payout structures and using proprietary indices as reference assets. FINRA intends to focus on complex features, long maturities and linkages to less traditional or less well understood reference assets in some structured retail products, which may present investors with unique or unfamiliar risks.

Floating-Rate Bank Loan Funds. FINRA recognizes that retail investors have increased their exposure to these products through mutual funds, closed-end funds and exchange-traded funds in an effort to protect against the threat of rising interest rates. FINRA warns that despite the promise of hedged exposure to interest-rate risk, these products can carry significant credit and call risk.

Securities-Backed Lines of Credit (SBLOCs). FINRA has observed that the number of firms offering SBLOCs is increasing and is concerned about how these products are marketed. Broker-dealers offering SBLOCs should have proper controls in place to supervise these programs. Clients should be fully apprised of program features, including loan restrictions and how changing market conditions may affect their brokerage account and their ability to draw on the SBLOC. Moreover, firms should have operational procedures that enable them to interact with the related lending institution to monitor the client's account, keep adequate records and ensure that clients are promptly notified when collateral shortfalls occur.

Supervision Rules. FINRA regulatory coordinators and examiners intend to contact and inspect their assigned firms to address regulatory questions and become familiar with how the firms are implementing the supervision rules that became effective on December 1, 2014, which rules modify requirements relating to, among other items: (1) supervising offices of supervisory jurisdiction and inspecting non-branch offices; (2) managing conflicts of interests in a firm's supervisory system; (3) performing risk-based reviews of correspondence and internal communications; (4) carrying out risk-based reviews of investment banking and securities transactions; (5) monitoring for insider trading, conducting internal investigations, and reporting related information to FINRA; and (6) testing and verifying supervisory control procedures.

Individual Retirement Account (IRA) Rollovers and Other Wealth Events. FINRA examiners intend to focus on the controls firms have in place related to wealth events, with an emphasis on firms' compliance with their supervisory, suitability and disclosure obligations. Firms' systems should be reasonably designed to help ensure that financial incentives to the associated person or the firm do not compromise the objectivity of suitability reviews. With respect to IRA rollovers, FINRA has stated that, whether in retail communications or an oral marketing campaign, it would be false and misleading to imply that a retiree's only choice, or only sound choice, is to roll over plan assets to an IRA sponsored by the broker-dealer.

Excessive Trading and Concentration Controls. FINRA examiners will focus on firms' supervisory processes, systems and controls concerning how firms monitor for excessive trading and product concentration. FINRA examiners will review the firms' criteria for exception reporting and the adequacy of firms' follow-up on such exceptions. FINRA examiners will also review client communications and account activity to determine whether aggressive trading strategies were recommended, and whether broker-recommended transactions, or series of transactions, constitute excessive trading or result in a client's portfolio becoming over-concentrated.

Private Placements. FINRA will review firms' private placements to determine whether broker-dealers performed sufficient due diligence on the issuer and the offering prior to recommendations to clients, focusing in particular on whether the level of due diligence complies with the firm's procedures and was adequate to support a suitability determination. FINRA will also focus on whether the offering documents comply with FINRA's communications rules, are properly filed with FINRA, and whether the offering complies with applicable rules regarding contingency offerings and escrow procedures.

High-Risk and Recidivist Brokers. FINRA intends to expand its use of data mining, analytics, specially targeted examinations, and expedited investigations and enforcement actions to remove from the securities industry unscrupulous registered representatives who prey on investors. Furthermore, FINRA warns that firms that hire or seek to hire high-risk brokers, including statutorily disqualified and recidivist brokers, can expect rigorous regulatory attention.

Sales Charge Discounts and Waivers. FINRA has observed that in some instances clients do not receive the volume discounts (breakpoints) or sales charge waivers to which they are entitled when purchasing products like non-traded REITs, unit investment trusts, business development corporations and mutual funds. FINRA intends to determine if firms have adequate systems to ensure breakpoints and sales charge waivers are provided to their clients for products they sell that possess these features.

Senior Investors. FINRA recently completed an examination initiative on issues related to senior investors. Preliminary findings show that many firms are increasingly proactive in dealing with senior investors by developing specific internal guidelines to strengthen suitability decisions and providing training on the unique needs of these investors. FINRA's examinations will focus on firms' treatment of these investors.

Anti-Money Laundering (AML). FINRA examiners will focus on the adequacy of firms' surveillance of customer trading, with the expectation that firms tailor client trading surveillance around the AML risks inherent in their business lines, products and client bases. In addition, FINRA will focus on certain types of accounts, including Cash Management Accounts and certain Delivery versus Payment/Receipt versus Payment accounts.

Municipal Advisors and Securities. FINRA examiners will focus on current SEC and MSRB municipal advisor requirements, reviewing for proper application of exclusions and exemptions, and potential unregistered activities. Examiners will adjust their reviews throughout the year as new rules become effective.

Financial and Operational Priorities

Funding and Liquidity: Valuing Non-High-Quality Liquid Assets. FINRA examinations will focus on broker-dealer efforts to develop and monitor funding and liquidity risk programs. FINRA has observed that at times firms' funding and liquidity plans rely on being able to sell or enter into repurchase transactions at or very near to the prices at which the firms have marked their inventory to market. The issue of mark-to-market pricing is particularly acute with respect to infrequently traded positions in corporate, asset-backed and municipal debt securities. FINRA intends to examine for the integrity of mark-to-market for such securities and for supervisory controls surrounding the overall valuation process.

Sales to Clients Involving Tax-Exempt or FDIC-Insured Products. With respect to firms that sell tax-exempt securities or FDIC-insured instruments, or products with similar characteristics, FINRA intends to focus its examinations to ensure that firm actions do not cause clients to lose the tax-exempt status on interest payments or the FDIC protection they believe they have.

Cybersecurity. FINRA examiners will review firms' approaches to cybersecurity risk management, including their governance structures and processes for conducting risk assessments and addressing the output of those assessments. Further, FINRA expects to publish the results of the cybersecurity sweep that it conducted in early 2014, which report will include principles and effective practices firms should consider in developing and implementing their cybersecurity programs. FINRA will also focus on firms' approaches to ensuring compliance with SEC rules regarding electronic storage of records in the event of a cyber attack.

Outsourcing. FINRA examinations will include an analysis of the due diligence and risk assessment firms perform on potential providers of outsourced services, as well as the ongoing supervision firms implement for the outsourced activities and functions.

Timely Reporting of Disclosable Information. FINRA is making changes to its registration review process, rules and examination program to address noncompliance by firms with their reporting requirements, including Form U4 and U5 registration filings. This review process will include a public records review of all active registered persons, which review will continue on a periodic basis for all registered persons.

Market Integrity

Supervision and Governance Surrounding Trading Technology. FINRA expects broker-dealers to maintain a robust technology governance framework for electronic trading. FINRA has identified a number of concerns in this area and, in 2015, FINRA examination teams will review firms' technology and related controls with an emphasis on the development and ongoing supervision of algorithms. FINRA examiners will review the adequacy of firms' formal supervisory processes for the development and testing of technology changes and will review the segregation of duties for technology staff performing various functions, namely, developing, testing, deploying, and modifying new and existing technologies.

Abusive Algorithms. FINRA views abusive algorithms and deficient supervision for potential manipulation as among the most significant risks to the integrity of markets. For that reason, FINRA will continue to pursue firms whose traders or clients use algorithms to manipulate the markets. In addition, FINRA intends to further enhance its surveillance program to detect new types of potentially manipulative trading activity brought about through the use of abusive trading algorithms.

Cross-Market and Cross-Product Manipulation. Fragmented markets provide opportunities for market participants to disguise misconduct by trading in multiple markets. In 2015, FINRA will continue to enhance both its equities and options cross-market surveillance patterns.

Order Routing Practices, Best Execution and Disclosure. FINRA's examinations will focus on determining whether firms base order routing decisions on benefits to the firm without thoroughly evaluating the potential conflicts presented and the quality of execution they receive for client orders. FINRA also intends to increase its emphasis on reviewing firms' fixed income pricing practices, including whether firms have the supervision and controls in place to ensure they are using reasonable diligence and employing their market expertise to achieve best execution for their clients and avoiding excessive mark-ups and mark-downs.

Market Access. FINRA recognizes the control challenges firms face when clients conduct potentially manipulative activity through multiple broker-dealers. Consequently, FINRA plans to commence a pilot program during 2015 to leverage the trading alert activity detected in its cross-market surveillance program to provide firms with information intended to supplement firms' supervision efforts with respect to detecting and preventing manipulative trading activity.

Audit Trail Integrity. FINRA intends to continue to focus on late reporting in TRACE-eligible and municipal securities that appears to result from inadequate processes and procedures on trading desks. To this end, FINRA has created a new team to focus on identifying potential equity audit trail issues not typically detected through routine compliance sweeps and reviews.

Conclusion

Given the multiple and oftentimes complex areas of supervisory focus for 2015, it is imperative that broker-dealers carefully review their practices, policies and procedures, and corresponding training programs to ensure that all facets of their operations are fully compliant with the examination priorities discussed above.

For more information or help determining how the examination procedures might apply to your operations, or to discuss the benefits of conducting a mock audit or examination, please contact Hoyt R. Stastney at (414) 277-5143 / hoyt.stastney@quarles.com, Peter J. Kaiser at (414) 277-3051 / peter.kaiser@quarles.com, Barbara R. Olson at (608) 283-2648 / barbara.olson@quarles.com, or your Quarles & Brady attorney.