FINRA Publishes 2016 Regulatory and Examination Priorities | Practical Law

FINRA Publishes 2016 Regulatory and Examination Priorities | Practical Law

FINRA published its annual Regulatory and Examinations Priorities Letter to highlight the issues it regards as emerging and existing risks that, if not properly addressed, could adversely affect investors and market integrity in 2016.

FINRA Publishes 2016 Regulatory and Examination Priorities

Practical Law Legal Update w-001-1626 (Approx. 7 pages)

FINRA Publishes 2016 Regulatory and Examination Priorities

by Practical Law Corporate & Securities
Published on 07 Jan 2016 • USA (National/Federal)
FINRA published its annual Regulatory and Examinations Priorities Letter to highlight the issues it regards as emerging and existing risks that, if not properly addressed, could adversely affect investors and market integrity in 2016.
On January 5, 2016, FINRA published its annual Regulatory and Examinations Letter for 2016 setting out the key issues that its broker-dealer members should focus on under the current investment and regulatory environment, and that its examiners will use in the course of performing examinations of members during the year. In-house legal and compliance personnel should review the list of issues, discuss the letter with their management and outside counsel, as necessary, and evaluate whether changes in its operations and procedures should be implemented to address these areas to improve regulatory compliance and to prepare for FINRA examinations.
The issues covered in the letter are summarized below.

Broad Issues

Culture, Conflicts of Interest, and Ethics

The letter states that in 2016, FINRA will formalize its assessment of firm culture while continuing its focus on conflicts of interest and ethics. FINRA's assessment will focus on the frameworks that firms use to develop, communicate and evaluate conformance with their culture. The assessment will examine whether:
  • Control functions are valued within the organization.
  • Policy or control breaches are tolerated.
  • The organization proactively seeks to identify risk and compliance events.
  • Supervisors are effective role models of firm culture.
  • Sub-cultures that may not conform to overall corporate culture are identified and addressed.
Firms should take visible actions that help mitigate conflicts of interest and that promote the fair and ethical treatment of customers. For example:
  • Material breaches of firm policies and procedures should not be tolerated.
  • Compliance functions should be equipped with the necessary resources to help firms navigate a complex and changing regulatory and market environment.

Supervision, Risk Management and Controls

FINRA will also focus on four areas where it has observed repeated concerns that affect the business conduct of firms and the integrity of the markets:
  • Management of conflicts of interest.
  • Technology.
  • Outsourcing.
  • Anti-money laundering (AML).

Management of Conflicts of Interest

In 2016, FINRA will focus on:
  • Incentive structures. FINRA will complete the targeted examination it launched in late 2015 on incentive structures and conflicts of interest in connection with firms' retail brokerage business. The review encompasses firms':
    • conflict mitigation processes regarding compensation plans for registered representatives; and
    • approaches to mitigating conflicts of interest that arise through the sale of proprietary or affiliated products, or products for which a firm receives third-party payments (such as revenue sharing).
    On a related topic, FINRA reminds firms that it recently filed proposed Rule 2273 with the SEC, which would require firms to deliver educational communications in connection with firm recruitment practices.
  • Investment banking and research business lines. FINRA reminds firms that they may not use research analysts or the promise of offering favorable research to win investment banking business. FINRA will assess whether research analysts are inappropriately involved in investment banking activities and whether investment banking personnel exercise undue influence on analysts.
  • Information leakage. Firms should identify, minimize and mitigate information leakage within or outside the firm. FINRA will examine for information leakage issues in 2016.
  • Position valuation. FINRA will focus on assessing firms' supervision, control and validation of traders' pricing of illiquid level 3 assets (assets or liabilities whose value is calculated based on unobservable inputs) to ensure that positions are fairly valued.

Technology

Additional areas of focus will include:
  • Cybersecurity. FINRA will review firms' approaches to cybersecurity risk management. FINRA will examine certain topics depending on a firm's business and risk profile. FINRA will also consider examining firms' abilities to protect the confidentiality, integrity and availability of sensitive customer and other information, including compliance with SEC Regulation S-P and Exchange Act Rule 17a-4(f). FINRA will also assess the ability of high-frequency and proprietary trading firms to protect their systems from unauthorized access.
  • Technology Management. FINRA will examine firms' technology governance and change management practices (such as lifecycle development and algorithm testing) and, where applicable, incorporate new system implementation reviews. FINRA also notes that it has been seeing significant operational breakdowns at firms when there is a change from legacy to new compliance systems.
  • Data quality and governance. FINRA will examine firms' data governance, quality controls and reporting practices to ensure the accuracy, completeness, consistency and timeliness of data reported to firm management and to firms' surveillance and supervisory systems.

Outsourcing

Another area of concentration will be firms' due diligence and risk assessment of providers of outsourced services and their supervision of those services. FINRA reminds firms that although certain tasks can be performed by a third-party provider, the responsibility to supervise covered activities for compliance with applicable federal securities laws and regulations, as well as self-regulatory organization rules, remains with the broker-dealer. In addition, firms must avoid outsourcing functions that are required to be performed by qualified registered persons.

AML Controls

FINRA will also focus on:
  • Suspicious activity monitoring. Firms should routinely test systems and verify the accuracy of data sources to ensure that all types of customer accounts and customer activity, especially higher-risk accounts and activity, are properly identified and reviewed in a manner to detect and report potentially suspicious activity. Firms should consider reviewing customers' activity over a period of time sufficient to identify patterns and to ensure that they assess the full scope of activity.
  • Microcap securities. Firms should assess whether their process for conducting due diligence on deposits of large blocks of microcap securities ensures compliance with the registration provisions of the Securities Act. Firms should continue to review deposits of microcap securities to determine compliance with, or exemptions from, registration requirements. Firms should also have processes in place to identify suspicious trading activity, in particular regarding securities that exhibit signs of "pump-and-dump" schemes. They should also focus on red flags of potentially manipulative trading, like pre-arranged trades and marking the close, particularly when securities are thinly traded.

Liquidity

FINRA will review the adequacy of firms' contingency funding plans in light of their business models. FINRA will also focus on the adequacy of the liquidity planning and controls of high-frequency trading firms.

Other Areas of Focus in 2016

Sales Practice

FINRA will also focus on the following areas related to sales practice:
  • Suitability and concentration.
  • Seniors and vulnerable investors.
  • Sales charge discounts and waivers.
  • 529 college savings plans.
  • Private placements, the JOBS Act and public offerings.
  • Outside business activities.

Suitability and Concentration

FINRA has observed many deficiencies in the area of suitability of concentration. In 2016, FINRA will focus on these deficiencies by assessing firms' policies and processes that govern monitoring for excessive concentrations, as well as suitability determinations for recommended transactions or investment strategies. This means that FINRA will assess whether registered representatives adequately consider, for example, factors such as credit risk, duration and leverage as relevant to specific fixed-income, complex and alternative products.

Seniors and Vulnerable Investors

FINRA requests that firms monitor investor accounts for red flags of possible abuse, such as overly aggressive investments or unusual asset movements, including to recipients outside the US. FINRA will make the treatment of senior and other vulnerable investors a priority in 2016.

Sales Charge Discounts and Waivers

FINRA continues to express concern about the failure of firms to provide appropriate volume discounts or sales charge waivers for products such as mutual funds, unit investment trusts, non-traded real estate investment trusts (REITs), and business development companies (BDCs). In 2015, there were multiple enforcement actions on these issues that resulted in millions of dollars in fines and restitution to customers.

529 College Savings Plans

FINRA expects firms that recommend a specific share class of a 529 college savings plan to analyze whether the fee and expense structures of that class are appropriate for a customer, given their investment time horizon and liquidity needs.

Private Placements, the JOBS Act and Public Offerings

FINRA will also concentrate on the following in 2016:
  • Private placements. In focusing on private placements in 2016, FINRA will address concerns regarding suitability, disclosure, and due diligence. FINRA's focus will reflect recent regulatory developments, including the ability to conduct general solicitations under Rule 506(c) of Regulation D and the SEC's final crowdfunding rules which take effect in 2016. Where a firm's communication addresses a specific investment benefit associated with a private placement offering, the firm must ensure that the key risks associated with the benefit are disclosed. FINRA will continue to evaluate firms' compliance relating to their communications, including general solicitation advertisements and materials posted on the internet.
  • Public offerings. Firms that participate in Regulation "A+" offerings must file with FINRA and receive clearance before they begin selling. In reviewing these filings, FINRA will consider possible red flags that may warrant a deeper inquiry, such as a broker-dealer or insider of the issuer with a problematic regulatory history, conflicts of interest among parties, non-compliance with escrow requirements, and disclosures that indicate inadequate due diligence by the underwriter. FINRA will track the Regulation "A+" filings to gauge how the market is developing.
  • Non-traded REITS and direct participation programs (DPPs). FINRA has observed that in advance of amendments to the Customer Account Statement Rule and the DPP Rule, which take effect in April 2016, sponsors of unlisted REITs and DPPs are restructuring and positioning their product lines. While the changes in product lines should increase the information and choices available to retail investors, to whom they are generally sold, the changes may also add complexity to these illiquid investments. REIT and DPP sponsors are increasingly adding BDCs to the product lines they offer, which may increase their availability to retail investors, exposing those investors to high commissions and fees, illiquidity risks and uncertainty on how long the BDC will hold funds before they are invested. FINRA will conduct rigorous reviews of all these products.
  • Excessive charges to customers in new bond sales. Although municipal bond underwriters are required to offer new bonds to their customers at the initial offering price, FINRA is aware of instances in which firms have taken new issues into inventory and then improperly offered them to customers at higher prices. In 2016, FINRA will:
    • review whether firms have processes in place to ensure that investors are treated fairly, that firms are complying with fair pricing obligations, and that firms conduct bona fide public offerings;
    • monitor the primary market sales reported by syndicate participants relative to issuance size; and
    • assess secondary market trading, particularly by syndicate participants, following completion of the offering to ensure customers are receiving fair and reasonable prices.

Outside Business Activities (OBAs)

FINRA will also focus on evaluating firms' procedures for reviewing OBAs, which are required under FINRA Rule 3270. In reviewing notifications of proposed OBAs, firms must, among other things, determine whether the proposed activities might interfere with, or otherwise compromise, the registered person's responsibilities to the firm or its customers, or be viewed by customers or the public as part of the firm's business. Firms must also determine whether the OBA should be treated as a private securities transactions under FINRA Rule 3280. FINRA will focus on these areas and determine whether customers have been harmed.

Financial and Operational Controls

Market-Maker New Capital Exemptions

Another focus will be on whether firms have properly claimed an exemption under, and operated consistently with, Rule 15c3-1(b)(1) under the Exchange Act, which is the net capital rule for broker-dealers. FINRA will also assess whether firms are engaged in bona fide market-making and permissible hedging transactions under subsection (a)(6) of the net capital rule.

Exchange-Traded Funds

FINRA will review the role of broker-dealers as authorized participants (APs) in the creation of exchange-traded funds (ETFs) and the redemption process. FINRA will review the processes that firms use to measure and monitor the impact of overnight counterparty credit risk, and to reflect this accurately in their net capital computations under Rule 15c3-1 of the Exchange Act.

Fixed Income Prime Brokerage

FINRA will also:
  • Focus on settlement practices for fixed income trades to understand how the operational and credit risks are managed when large trades are executed away from the prime broker.
  • Explore industry practices regarding disaffirming trades and the legal documentation that supports the settlement process.
  • Consider financing practices for fixed income where extensive leverage is offered.

Internal Audit Function

FINRA will review firms' internal audit function, focusing on the:
  • Process for identifying and prioritizing risks.
  • Interaction between the audit committee and the board of directors.
  • Involvement of internal audit in committees and major projects.
  • Execution of the audit plan specific to coverage of select business and control functions.
FINRA will also review how issues are tracked through resolution and evaluate how internal audit deficiencies are incorporated into business risks.

Client Onboarding

FINRA will assess firms' policies and controls related to onboarding clients and correspondents. It will also review how firms aggregate their information to develop an overall risk assessment.

Transmittal of Customer Funds

FINRA reminds firms of their responsibilities related to the transmittal of customer funds under FINRA Rule 3110. In 2016, FINRA will assess whether firms implement adequate supervisory controls to test and verify systems to prevent the improper transmittal of customer funds.

Market Integrity

Vendor Display Rule

FINRA expects firms to review their compliance with the requirement under Rule 603(c) of Regulation NMS (Vendor Display Rule) that broker-dealers provide a consolidated display of market data when they are providing quotation information to customers. SEC staff recently stated that the reliance of registered representatives on non-consolidated market information as the source of quotations used to assess the current market or the quality of trade execution is inconsistent with the Vendor Display Rule.

Market Access

FINRA plans to deliver compliance report cards in early 2016 to firms derived from FINRA's cross-market equity manipulation surveillance program. It will begin with the publication of monthly report cards focused on layering and spoofing. FINRA will also examine how firms use the new information from the report cards to take steps to identify and address the potential misconduct.

Fixed Income

FINRA will continue to review fixed income order handling, markups and related controls in light of how the fixed income market has evolved in recent years. FINRA will augment its best execution surveillance by implementing spread-based surveillance patterns in 2016. It will also focus on wash sales, marking the close, and trading ahead. In addition, FINRA will continue to review fixed income alternative trading systems.

Regulation SHO

Another area of concentration will be firms' compliance with SEC Regulation SHO. Firms should ensure that they appropriately close out fails to deliver by the designated close out date under Rule 204 of Regulation SHO. FINRA will also assess whether firms are implementing supervisory processes to ensure compliance with the net-flat or net-long position requirement of Rule 204, and whether they are correcting deficiencies. In addition, FINRA will evaluate the adequacy of AP's controls on exchange-traded product redemption orders.

Cross-Market and Cross-Product Manipulation

FINRA will focus its surveillance on coordinated equity and options market activity designed to create momentary, artificial prices intended to affect the settlement prices of related products. It will also add a new surveillance approach to address equity layering to influence options trading, either through newly established or existing positions.

Audit Trail Integrity

FINRA will concentrate on identifying potential audit trail issues not typically detected through routine compliance sweeps. This will include a continuing focus on late reporting of TRACE-eligible and municipal securities, as well as errors in the equity audit trail.