More On Legal & Compliancefrom The Advisor's Professional Library
- Trading Practices and Errors When SEC-registered investment advisors conduct annual audits of firm policies and procedures, they should pay close attention to trading practices. Though usually not required to, state-registered advisors should look at their trading practices and revise policies that do not fully protect clients.
- Privacy Policies and Rules Whether an RIA is SEC or state-registered, the firm must have policies and procedures in effect to protect clients privacy. Policies and procedures should explicitly require an RIA to send out its privacy notice each year.
On May 30, the U.S. Government Accountability Office (GAO) released a report regarding the Securities and Exchange Commission’s (SEC) oversight of the Financial Industry Regulatory Authority (FINRA). Among other things, the GAO noted that FINRA does not have in place a mechanism to retroactively review its rules. According to the report, absent such a system, “FINRA may be missing an opportunity to systematically assess whether its rules are achieving their intended purpose and take appropriate action, such as maintaining rules that are effective and modifying or repealing rules that are ineffective or burdensome.”
Historically, FINRA has reacted to market events by providing guidance and rules to the industry. By revisiting existing rules and their real-life implications, particularly those rules that no longer work as intended, or have effectively been replaced by other rules or guidance, FINRA will be able to proactively help the U.S. capital markets retain their pre-eminent position.
In response to the GAO recommendation, we propose that FINRA consider revisiting the following rules and making the following changes:
1. FINRA should update and streamline the registration forms and guidance for firms and associated persons relating to arbitrations.
Over time, some of the questions on Forms U4 and U5, and certain corresponding questions on Form BD have required increasing analysis and judgment to answer. For example, under FINRA guidance, a broker-dealer must determine whether an arbitration claim raises sales practice violations not only against the representative(s) named in the caption of the action but also against other representatives. Prior guidance, which required Form U4 and U5 filings only for representatives named in the caption of a statement of claim or complaint, was easy to follow. Requiring legal or compliance personnel to read and analyze each claim or complaint to ascertain whether the action should be reported on filings for additional personnel imposes an unnecessary burden.
2. FINRA should coordinate Form U4 amendments with Rule 4530 filings to reduce duplicative paperwork.
FINRA Rule 4530 requires member firms to report, within 30 calendar days, a number of events, disciplinary actions or conclusions regarding the firm or associated persons. Firms do not have to report certain information about an associated person if that information has already been reported on the associated person’s Form U5, which is the form for reporting information on terminated or former associated personnel. However, because there is no similar exception for information reported on Form U4, firms must report virtually the same information under Rule 4530 as is reported on Form U4. The duplicative reporting does not appear to add to FINRA’s enforcement or other programs, and the disparity in Rule 4530 in reporting requirements between current and former associated persons is confusing.
Rule 4530, which became effective in July 2011, requires firms to report to FINRA conduct that:
- has widespread or potential widespread impact to the member, its customers or the markets, or
- arises from a material failure of the member’s systems, policies or practices involving numerous customers, multiple errors or significant dollar amounts.
The terms contained in the rule are vague and relatively new to the regulatory vocabulary. For example, in the first bullet, FINRA should explain what “widespread” means. With regard to “customers” in the first bullet, does “widespread” mean a certain percentage of customers (say, over 10%) or does it mean a certain number of customers, regardless of the percentage (say, over 1,000)? With regard to the second bullet, is “numerous” customers different from or the same as “customers” affected by a “widespread impact”? Similarly, is “significant dollars” measured as a percentage (of what, we don’t know) or as an absolute number? If FINRA expects meaningful and consistent reporting, it should clarify the terms in the rule so that firms will know when to report certain conduct to FINRA.
4. FINRA should issue updated cooperation guidelines in light of the new self-reporting requirements.
It is unclear what effect, if any, FINRA intends Rule 4530 to have on the issue of awarding credit for extraordinary cooperation. For example, will FINRA give credit to firms for reporting matters of limited impact? Or has Rule 4530 effectively removed self-reporting as one of the criteria for cooperation credit? Updated guidance with respect to receiving credit for cooperation would be useful for the industry.
5. If FINRA wants to receive non-securities information and documents from broker-dealers, it should undertake to amend FINRA Rule 8210.
FINRA Rule 8210 authorizes FINRA to: (1) require a member or an associated person to provide requested information; and (2) “inspect and copy the books, records, and accounts” of members and persons.
Although the rule refers to books, records and accounts (which sound to us like broker-dealer required books and records) and FINRA’s mission is to “protect America’s investors by making sure the securities industry operates fairly and honestly,” FINRA has taken the position that it has the right to obtain non-broker-dealer documents if the member or person can obtain them for FINRA. Thus, FINRA has been known to request bank, insurance and investment adviser documents (and obtain them because few parties want to litigate against FINRA on a failure to produce charge). If FINRA truly believes it is entitled to such documents to regulate the securities industry, it should request that authority from the SEC.
Currently, FINRA provides no confidentiality or privacy protections for documents and information produced pursuant to Rule 8210. Similarly, it has no Freedom of Information Act (FOIA) process or protections. Rather, FINRA’s existing policy, as set forth in production request letters, is that it will not:
- entertain requests for confidential treatment of any information or documents you produce in response to this request;
- give you notice of any subpoena or access request we receive that encompasses any such information or documents; or
- undertake to return documents when this investigation is completed.
Firms and individuals often produce documents and information that should receive procedural or substantive protection from third parties because FINRA often requests nonpublic, confidential information such as customer personal information and firm trade secrets or commercial or financial information. To protect investors, member firms and registered representatives, FINRA should revisit this issue.
7. FINRA should articulate a coherent standard of supervisory requirements for registered personnel.
While many FINRA pronouncements concern supervision of registered personnel, the guidance often fails to distinguish whether all associated persons (that is, those who are required to be registered and those with “permissive registrations”) are subject to the same supervisory regimen. FINRA should review, against the backdrop of NASD Rule 3010, the issue of whether associated persons with permissive registrations under NASD Rule 1031(a) need to be supervised with respect to their activities, and if so, by whom and how, and for what activities.
8. FINRA should eliminate the annual compliance meeting requirement.
NASD Rule 3010(a)(7) requires that registered persons participate at least annually in an interview or meeting on “compliance matters relevant to the activities” of those registered persons. FINRA Rule 1250 requires that member firms maintain “a continuing and current education program” for their registered persons that, among other things, address sales practice considerations and applicable regulatory requirements concerning the securities products, services and strategies offered. As a practical matter, continuing education programs cover the same content and considerations as are required for annual compliance meetings. Yet, firms are required to document separately their compliance with two very similar rules (including making sure that a particular program is labeled as the annual compliance meeting and attendance at the meeting is separately tracked). Firms would welcome a consolidation of these requirements into a single program.
NASD Rule 2210 is titled “Communications with the Public.” Despite this clear title, for the past several years, FINRA has brought enforcement actions applying the content standards of NASD Rule 2210 against firms relating to internal communications, such as firms’ intranet and sales material marked as “internal use only.” FINRA appears to have changed its mind—somewhat—on this issue. FINRA amended NASD Rule 2210 and related rules, with the changes to take place next year. In Regulatory Notice 12-29, FINRA stated that Rule 2210 “will not apply to a firm’s internal communications.”
Nonetheless, under NASD Rule 3010, firms must now supervise these internal communications, including communications that “train or educate registered representatives,” to ensure that they are “fair, balanced and accurate”—a reference to standards for communications with the public.
Because of the way FINRA’s interpretations have developed in this area, member firms are now without adequate guidance as to what FINRA requires with respect to internal communications. For example, if a principal describes a product in an email to a representative, “educating” the representative, must that email contain multiple disclosures about risks? FINRA needs to clarify its expectations. If FINRA wants to treat all internal communications as, in effect, advertisements subject to the advertising rules’ “fair and balanced” requirements, it should make explicit how supervisors are expected to review such communications. The industry (and particularly supervisors) could then better implement the steps FINRA thinks should be employed.
10. FINRA should consider repealing rules that duplicate SEC rules.
There are numerous FINRA rules that substantially overlap with SEC rules without adding any meaningful regulatory requirements. Examples include FINRA Rules 2262 (Disclosure of Control Relationship with Issuer), 2230 (Customer Account Statements and Confirmations), 2261 (Disclosure of Financial Condition) and 2269 (Disclosure of Participation or Interest in Primary or Secondary Distribution), all of which overlap with SEC rules. Eliminating overlap between regulatory schemes enhances clarity and reduces waste of regulatory resources.
Sutherland Asbill & Brennan is a national law firm with approximately 425 attorneys. Its seven major practice areas are financial services, corporate, energy and environmental, intellectual property, litigation, real estate and tax. Heilizer, Krawczyk and Rubin regularly represent broker-dealers and investment advisors.