FINRA’s 2014 Broker-Dealer Exam Focus

As it does every year since 2006, the FINRA has just released its 2014 Regulatory and Examination Priorities letter  highlighting significant risks and regulatory issues for member firms and how FINRA plans to address such matters in its examination of broker-dealers.  The hope is that broker-dealers will use the letter to identify risk exposures to enhance their supervisory, compliance and risk management programs to protect investors, the integrity of the markets and themselves.  Unfortunately, for some the letter goes unheeded until later the firm is ”shocked” to learn during a FINRA cycle exam that the examination staff is spending so much time reviewing the firm’s records on an issue raised in the letter.

The FINRA letter identifies four topics for this year – business conduct, fraud, financial and operational concerns, and market regulation.  Within each of these topics, FINRA has provided both a framework  and roadmap of how these exam priorities will be addressed.

Business Conduct Priorities

  1. Suitability – focus on concentrations in longer duration instruments, including bond funds with longer average durations, and high yield securities recommended to retail investors, concentrations in speculative equities positions in retail accounts for complex structured products, private REITS, frontier funds, interest rate sensitive securities [(i.e. mortgage-backed securities, long duration bond funds, long duration bond ETFs, long duration corporates (i.e.  zero coupon or bullet bonds)],  emerging market debt, municipal securities (risk related to financial distress of municipalities), baby bonds (risk exposure to business development companies (BDCs).
  2. Recidivist Brokers – focus on firms who hire reps with pattern of complaints, disclosures for sales practice abuses and due diligence in  hiring process, adequacy of supervision of higher risk brokers—including heightened supervision for reps with disciplinary history and reps moving from firms with disciplinary history.
  3. Conflicts of Interest – focus on broker-dealers’ approach to conducting new product reviews to identify and mitigate potential conflicts products raise (i.e. favoring proprietary products or products that firm has revenue-sharing agreements, examining compensation structures and mechanisms used to mitigate conflicts).
  4. Cybersecurity – exam focus on integrity of firms’ infrastructure, safety and security of customer data from disruptions through cyber  attacks.
  5. Qualified Plan Rollovers – focus on recommendations made in rollover scenarios and compliance with suitability standards (i.e. concerns about investors being misled about the benefits of rolling over assets from a 401(k) plan to an IRA (i.e.  FINRA Regulatory Notices 13-23 and 13-45).
  6. Initial Public Offering Market – focus on abuses in new issue distributions in  public underwriting business, reviewing due diligence and compliance with rules concerning the sales and allocations of IPO securities (i.e. FINRA Rule 5131 quid pro quo allocations, spinning).
  7. General Solicitation and Advertising of Private Placements – focus on abuses in the sale and marketing of private placement securities in the wake of amendments to Rule 506 of Regulation D, and use of advertisements and other marketing materials in these offerings.
  8. Due Diligence and Suitability of Private Placements – focus on suitability and whether firms are validating whether investors meet accredited investor standards.
  9. Offerings of Securities through Private Placements – focus on problematic private placement filings under Rule 5122 (self-offerings by firms) and Rule 5123 (i.e. whether firms are conducting reasonable inquiries as described in Regulatory Notice 10-22).
  10. Anti-Money Laundering (AML) – focus on AML issues associated with DVP/RVP liquidating large volumes of low-priced securities where executing broker is responsible for implementing customer identification program (CIP).
  11. Municipal Advisors – SEC final rule requiring municipal advisor registration, municipal advisory activity will be an area of focus in FINRA sales practice examinations in 2014.
  12. Crowdfunding Portals – as funding portals become FINRA members, focus on implementing a regulatory program designed to protect investors recognizing distinctions between funding portals and broker-dealers, ensuring that funding portals comply with FINRA rules.
  13. Senior Investors – FINRA examiners will continue to focus on how firms engage with senior investors, suitability, as well as disclosures and communications.  Firms’ policies and procedures will be examined for situations involving issues of diminished capacity.

Fraud Priorities

  1. Microcap Fraud – significant concern with speculative microcap and low-priced over-the-counter (OTC) securities, including FINRA review of customer accounts liquidating microcap and low-priced OTC securities to ensure firms are not facilitating,  participating in unregistered distributions.
  2. Insider Trading –  firms should conduct employee training covering the use and handling of material, non-public information.

Financial and Operational Priorities

  1. Funding and Liquidity Risk – exam focus on FINRA’s concern about varying practices in how firms monitor and control liquidity risk, including evaluating liquidity stress test (i.e. stressed funding of proprietary positions, stressing of repo book, stressing settlement payments and clearing deposits, funding loss of customer balances or increases in obligations to lend to customers).  Also, FINRA exam focus on adequate liquid capital cushions to weather counterparty credit risk exposures in the event that a material counterparty experiences financial distress or a liquidity squeeze.
  2. Risk Control Documentation and Assessment – focus on whether firms’ tests are documenting  credit, market and liquidity risk management controls, and whether these and other risk control measures are in place and functioning as designed.
  3. Accuracy of Firm’s Financial Statements and Net Capital –  exam focus on whether broker-dealers are preparing accurate financial statements throughout the year, maintaining accurate books and records in accordance with GAAP,  and correctly computing net capital.
  4. Auditor Independence – focus on lack of independence by auditors of small broker-dealers as raised by Public Company Accounting Oversight Board (PCAOB) report.

Market Regulation Priorities

  1. Algorithmic Trading and Trading Systems – FINRA testing and examination focus to assess firms’ testing and controls related to adequacy of high-frequency trading (HFT) and other algorithmic trading strategies and trading systems in light of the Market Access Rule and firms’ other supervisory obligations.
  2. High Frequency and Other Algorithmic Trading Abuses – FINRA surveillance of abusive algorithms remains a high priority and will watch to see if firms using HFT strategies and other trading algorithms are adequately testing these strategies pre- and post-launch to ensure no abusive trading (non-bona fide orders, momentum ignition and spoofing strategies); focus on HFT and algorithmic activity through sponsored participants who initiate activity outside of United States; and focus on cross-market, cross-product manipulation of the price of underlying equities, through abusive trading algorithms.
  3. Audit Trail Integrity – focus on firms filing accurate and complete Large Options Positions Reporting (LOPR) reports; in-concert reporting deficiencies, improper position deletions, non-reporting of positions, and process firms use to internally determine whether an over-the-counter position qualifies as a reportable options position.
  4. Best Execution of Equities, Options and Fixed Income Securities – focus on firm practices to ensure compliance with best execution obligations with respect to limit orders in equity securities; FINRA use of new fixed income surveillance pattern to more closely assess the execution price a customer receives from a firm relative to other recently executed customer transactions on the same side.

Author: Dexter Johnson

The author is a an attorney who for the past 14 years has concentrated his practice in representing, successfully, investment advisers, broker-dealers, corporations and individuals who are subject to SEC, FINRA, State or other regulations and who may be the subject of regulatory examination, review or investigation. He formerly worked at the SEC. His regulatory and litigation experience has encompassed virtually every type of securities issue in the industry. He has also negotiated favorable outcomes in many of these matters for his clients.