The Financial Industry Regulatory Authority released its annual exam findings on Friday, zooming in on improper activity that it wants to stop.
The report lists the areas in which industry players need to do better, based on what FINRA staff has been seeing out in the advisory field: advisors working on accounts and transactions for which they do not have authorization or the authorization had expired, as well as cases of mismarked order tickets, false statements, blank forms and the abuse of trustee status.
The summary also discusses investor suitability, fixed income markup disclosure and due diligence for private placements, as well as findings from a targeted exam (or sweep) tied to with volatility-linked products.
“One of our core priorities is to provide firms with information that will help them more easily comply with rules and regulations, and this report aims to do just that,” according to FINRA CEO Robert Cook. “We hope the observations within the Exam Findings Report enable firms to strengthen their own control environments and address potential deficiencies before their next exam.”
Separately, the group shares report cards for specific firms, so they can look at how their compliance controls are doing in comparison with the rest of the industry’s. In addition, FINRA publishes an yearly Regulatory and Examination Priorities Letter each January.
1. Suitability for Retail Clients
FINRA says it continues to see unsuitable recommendations and deficiencies in supervisory systems for registered representatives’ activities. “Firms should also consider the guidance in FINRA Regulatory Notice 18-15 to determine whether certain representatives engaging in repeated misconduct should be subject to special supervisory procedures, such as a heightened supervision plan,” it states.
For example, some reps are not adequately considering a client’s financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives or liquidity needs when when making recommendations.
In other cases, the advisors are not taking into account the cumulative fees, sales charges or commissions. Plus, some are making unsuitable recommendations that include complex products (such as leveraged and inverse exchange-traded products) or an overconcentration in illiquid securities, variable annuities, switches between share classes, and sophisticated or risky investment strategies.
FINRA also is concerned about the unsuitability of some mutual fund share classes and unit investment trusts (UITs), which were also discussed in last year’s exam report.
In addition, inadequate product due diligence, such as failing to understand specific features and terms of products, was “a common contributor to the challenges FINRA observed.”
Proper controls entail measures such as restricting or prohibiting the recommendations of products for certain investors, as well as establishing systems-based controls (or “hard blocks”).
Some firms have allowed clients to keep concentrated positions in complex structured notes or sector-specific investments, as well as illiquid securities, such as nontraded real estate investment trust (REITs), “which were unsuitable for customers and resulted in significant customer losses,” FINRA explains.
In these cases, advisors recommended structured notes or sector-specific investment strategies to clients who lacked “the sophistication to understand their features,” for instance. Certain recommendations involved illiquid securities with limited price transparency, “which made
it difficult for investors to know the true value of their investment and led them to believe that their investments would not fluctuate in value.”
3. Excessive Trading
FINRA observed a failure to set up and enforce adequate supervisory systems for identifying and preventing potentially excessive trading. It points out that some firms have not reviewed account alerts from their clearing firm or used other available compliance tools that can detect excessive trading, commissions or trading losses.
There also are problems with indicators that did not adequately identify potential quantitative suitability concerns, like “identifying active accounts based solely on the quantity of trades executed while failing to consider other pertinent criteria, such as turnover ratio, cost-to-equity ratios, margin balances, total commissions, total fees paid, and profit and loss.”