Advisors and broker-dealers have just received a “cheat sheet” of sorts from the Financial Industry Regulatory Authority.
Right after the start of the new year, FINRA shares its Annual Regulatory and Examination Priorities Letter, which highlights areas the regulator will focus on in its 2017 exams.
As in previous years, the 2017 letter emphasizes “core ‘blocking and tackling’ issues of compliance, supervision and risk management,” according to FINRA President & CEO Robert Cook.
“Most of the topics addressed in this year’s letter have been highlighted in prior years, but specific areas of emphasis have been updated or modified based on recent observations and experience. Attention to the core regulatory requirements identified in the letter — and how to address them in light of new business challenges and market developments — will serve investors and markets well,” Cook explained.
The letter aims to help firms identify business priorities and enhance compliance, supervisory and other controls, he adds.
In addition, the FINRA executive says that this year it will begin using electronic, off-site reviews to “supplement” its on-site cycle examinations. The group intends to “make targeted and limited information requests to firms and then analyze the responses off site.”
It also says the off-site exams will affect only “a select group of firms that are not currently scheduled for a cycle exam in 2017.”
Read on for more details on the top issues and concerns of FINRA for 2017:
1. High-Risk Brokers
FINRA says it plans to “devote particular attention to firms’ hiring and monitoring of high-risk and recidivist brokers, including whether firms establish appropriate supervisory and compliance controls for such persons.”
To do so, the group recently set up a special examination unit to identify and examine brokers who may pose a high risk to investors. The unit “will rigorously review” these brokers’ interactions with clients — including their compliance with rules concerning suitability, know-your-customer, outside business activities, private securities transactions, commissions and fees.
Second, the organization plans to review firms’ supervisory procedures for the hiring and retaining of “statutorily disqualified and recidivist brokers.”
Specifically, FINRA wants to see if firms are reviewing “reasonably available public records to verify the accuracy and completeness of the information contained in an applicant’s Form U4.” It also will monitor disclosures on Form U4 and U5 for the timely submission of required disclosures.
“FINRA will assess whether firms develop and implement a supervisory plan reasonably tailored to detect and prevent future misconduct by a particular broker based on prior misconduct and regulatory disclosures. We will also focus on firms with a concentration of brokers with significant past disciplinary records or a number of sales practice complaints or arbitrations,” the letter explained.
In 2016, Massachusetts securities regulators conducted a sweep (or review) of more than 240 broker-dealers with a “higher than average” number of advisors that have disciplinary incidents on their records.
Third, the organization plans to keep evaluating branch office inspection programs, including independent contractor branches, any use of unapproved email addresses for business, client communications (such as social media) and more.
2. Bad Sales Practices
FINRA has several areas of concern when it comes to sales to seniors, suitability, frequent trading, outside business activities and related concerns.
In terms of protecting seniors, the group intends to assess how firms protect these investors from fraud, abuse and improper advice.
“We are seeing numerous cases where registered representatives have recommended that senior investors purchase speculative or complex products in search of yield. While the quest for higher yield is not per se problematic, FINRA will assess whether such recommendations were suitable given an investor’s profile and risk tolerance, and whether firms have appropriate supervisory mechanisms in place to detect and prevent problematic sales practices,” the letter stated.
FINRA will zoom in on fraud schemes that emphasize microcap or penny stocks. Over the past two years, FINRA says, there was “an increase in the use of aggressive boiler room tactics by unregistered persons in pump-and-dump schemes targeting elderly investors.”
As for product suitability and concentration, the regulatory group says firms and advisors continue to “recommend products that are unsuitable … including situations where customers and sometimes registered representatives do not understand important product features.”
To address the issue, FINRA may look at firms’ product vetting processes, supervisory systems and controls for reviewing recommendations.
“Firms should be attentive to the adequacy of their supervision and training when new products come to market, new features of existing products are introduced or market conditions change in ways that could affect product performance,” it stated.
Furthermore, FINRA says it will increase its focus on the controls used by firms to monitor recommendations that could result in excess concentration in client accounts, such as in a particular type of product. It gave the example of long-duration fixed income instruments and the potential impact rising rates could have on these investments.
Other areas of regulatory focus that encompass sales practices to be examined in 2017 include excessive and short-term trading of long-term products, outside business activities and private securities transactions for compensation, social media and electronic communications — including the retention and supervision of these media.
In September 2016, FINRA launched a targeted exam that focused on unit investment trust rollovers at select firms, for instance, and FINRA will review other firms’ UIT sales and surveillance practices as well in the future.
“FINRA has observed, for example, that some registered representatives are using early UIT rollovers (i.e., rollovers prior to the last 30-60 days of the UIT’s term) to increase their sales credits to the detriment of clients,” it explained.
3. Practices That Lead to Financial Risk
Last year, the regulatory group identified firms lacking liquidity risk-management plans, failing to conduct stress tests, applying insufficiently rigorous assumptions in their stress tests and maintaining insufficient sources of funding.
FINRA found that many industry firms’ funding contingency plans relied on committed secured and unsecured loan facilities. “Contracts for these facilities may contain provisions (e.g., restrictive covenants, acceleration and material adverse change clauses) that could either compromise or delay the availability of that funding during a stress event,” it said.
Thus, it will review the funding and liquidity plans of firms offering such products and services.
“We will also review how correspondent clearing firms incorporate funding needs for large introducing firms and market participants in their contingency plans, where such entities rely on their clearing brokers for funding during a stress event, including coverage for intraday risk,” it explained.
FINRA also plans to look at how firms are implementing new margin requirements for covered agency transactions.
4. Conduct That Enhances Operational Risks
A key area of concern for FINRA in 2017 is cybersecurity. The group says it will continue to assess firms’ programs to mitigate risks in this area — such as firms’ methods for preventing data loss.
“We may also examine firms’ controls to protect sensitive information from insider threats. The nature of the insider threat itself is rapidly changing as the workforce evolves to include more employees who are mobile, trusted external partnerships and vendors, internal and external contractors, as well as offshore resources,” it said.
The regulator says it has seen “repeated shortcomings in controls.” For instance, controls at branch offices, especially at independent contractor branch offices, “tend to be weaker than those at firms’ home offices.”
Specifically, FINRA believes controls must be beefed up in terms of the use of passwords, encryption of data, use of portable storage devices, implementation of patches and virus protection, and the physical security of assets and data.
In addition, firms are failing to fulfill one or more of their obligations under Securities Exchange Act (SEA) Rule 17a-4(f) that requires them to preserve records in the write once read many (WORM) format. FINRA took action against 12 firms for such deficiencies.
5. Market Manipulation
FINRA is placing a priority on detecting and deterring market manipulation.
It says it will look for “even larger groups of market participants potentially engaging in manipulation.” Also, the group amended the Order Audit Trail System (OATS) rules to require alternative trading systems (ATSs) to submit broader order book activity to OATS and for FINRA members to identify non-FINRA member broker-dealers participating in the over-the-counter market.
“In addition, we are closely monitoring whether market participants are trading in a potentially manipulative manner surrounding the open or close through the use of, among other tactics, aggressive and dominant trading on one side of the market to benefit a position on the other side of the market,” it said.
The group has developed a cross-product surveillance pattern to “detect layering in an underlying equity to influence options prices.” In the year ahead, it plans to expand surveillance for cross-product manipulation to include trading of exchange-traded products, such as ETFs, and related securities, and “improper trading strategies” that may attempt to take advantage of the “unique attributes” of ETPs.
Last year, FINRA introduced the Cross Market Equity Supervision Report Cards to help it and its members detect and deter manipulative conduct, such as when they or their clients are engaging in potentially manipulative conduct.
“We expect firms that receive report cards to review them as a supplement to, and not a replacement for, their own reviews into potentially manipulative activity, and take appropriate steps in response to their findings,” the regulatory group explained.