On January 9, 2014, the U.S. Securities and Exchange Commission (SEC) published its 2014 examination priorities (SEC Letter),1 just one week after the Financial Industry Regulatory Authority (FINRA) published its 2014 regulatory and examination priorities for FINRA members (FINRA Letter).2 With the publication of these letters, broker-dealers can better anticipate where the SEC and FINRA will focus their examination priorities and enforcement programs in 2014.
I. FINRA Letter
The FINRA Letter outlines examination priorities for business conduct, fraud, financial and operational, and market regulation areas, as summarized below.
Business Conduct Exam Priorities. The FINRA Letter identifies 13 different “business conduct” exam priorities, focusing on the following areas of concern:
Suitability. Not surprisingly, the first priority discussed is the suitability of recommendations to retail investors for complex products. The FINRA Letter lists 10 different types of products for focus during examinations, including structured products, private real estate investment trusts, frontier funds, and several types of interest rate sensitive securities, and identifies disclosure, interest rate risks, concentration, and broker training as key concerns. Suitability concerns are also mentioned in three other priorities:
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Senior Investors. The FINRA Letter mentions suitability concerns in connection with senior investors, returning to an exam focus identified in previous years. According to the letter, FINRA, among other things, will focus on whether firms have adequate controls to identify potential financial abuse of senior investors with diminished mental capacity.
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Qualified Plan Rollovers. The FINRA Letter expresses concern that the financial industry generally encourages employees to “roll over” their retirement savings into IRAs without fully explaining alternative options and associated costs, referencing both a U.S. Government Accountability Office report issued last year3 and two Regulatory Notices – RN 13-23 and RN 13-45.4 The letter indicates that FINRA will review firm rollover practices and related marketing materials and supervision, and whether the securities recommendations associated with rollovers comply with the suitability standards of FINRA Rule 2111.
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Rule 506 Private Placements. The FINRA Letter notes concerns that broker-dealers may not be performing adequate due diligence to ensure that recommendations to purchase private placement securities under Rule 506 of Regulation D are suitable for investors.
IPOs and Private Offerings. The FINRA Letter observes that the market for initial public offerings (IPOs) has increased recently and indicates that exams will focus on compliance with FINRA Rule 5131 (covering “spinning” and “flipping” practices) adopted in 2011. In the case of private offerings, and with a nod to the recent amendments to Rule 506 of Regulation D, the FINRA Letter notes that FINRA will be increasing its scrutiny of the sale and marketing of private placements where general advertising and solicitation are used, as well as reviewing the steps taken by member firms to validate that investors meet the standards for an “accredited investor.”
New Regulatory Regimes. The FINRA Letter also notes the recent adoption of laws and rules authorizing two new types of registrants – crowdfunding portals and municipal advisors – and FINRA’s examination and enforcement authority for these registrants. FINRA warns that it will focus on municipal advisory activity in its sales practice examinations, and will implement an examination program for crowdfunding portals, once proposed rules for them have taken effect.
Other Sales Practice Concerns. Referring to the “High Risk Broker” program and “Broker Migration Model” analytics (which were recently described in a November 2013 letter from FINRA Chairman and CEO Richard Ketchum), the letter said that FINRA will review hiring process due diligence and supervision at firms that hire higher risk brokers.5 The letter also notes that FINRA will evaluate broker-dealers’ conflicts management practices in light of the recently published “Report on Conflicts of Interest” issued by FINRA,6 as well as cybersecurity and anti-money laundering programs.
Fraud Priorities. Microcap fraud and insider trading are mentioned as two areas that continue to be top concerns in exams.
Financial and Operational Priorities. The FINRA Letter identifies four financial and operational priorities for 2014, the first three of which are primarily applicable to large firms, such as how they manage their funding and liquidity risks; how they document their credit, market, and liquidity risk management controls in light of recent amendments to Rule 17a-3; and the manner in which they maintain their books and records, so that they can prepare accurate financial statements and properly calculate net capital under SEC and FINRA rules. The fourth priority concerns auditor independence and reflects FINRA’s stated concern that there can be a “lack of independence” by auditors of small broker-dealers.
Market Regulation Priorities. The FINRA Letter identifies algorithmic trading and high frequency trading as two areas for focus, as well as the integrity of audit trails and the best execution of certain securities, including equities, options, and fixed income securities.
II. SEC Letter
The SEC Letter covers the SEC’s National Examination Program (NEP), which spans all markets and entities examined by the SEC, and is not limited to broker-dealers. As such, the SEC Letter identifies “NEP-Wide Initiatives,” generally applicable to all industry participants, as well as “core risk” and “new and emerging issue” initiatives for different types of registrants. The following discussion focuses on those initiatives applicable to broker-dealers.
NEP-Wide Initiatives. The SEC Letter identifies six NEP-Wide Initiatives applicable to all parties, including broker-dealers:
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Fraud detection and prevention, particularly with respect to scams, theft, and unfair advantage.
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Corporate governance, conflicts, and risk management, with a focus on a registrant’s “tone at the top” and approach to conflict and risk management.
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Technology, particularly governance and supervision of information technology systems, and preparedness to respond to sudden market malfunctions and system outages.
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In the case of dual registrants (firms registered as both broker-dealers and investment advisers), influences affecting whether a customer establishes a brokerage or investment advisory account. The SEC Letter indicates concern that firms are putting customers in account types that may produce more revenue for the firm, but not provide benefits to customers.
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Compliance with recently adopted laws and regulations, such as the changes to Rule 506 and the adoption of municipal advisor rules.
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The SEC Letter indicates many of the same concerns with retirement vehicles and rollovers as the FINRA Letter, and also indicates a particular concern with the use of “potentially misleading” designations by registered persons recommending rollovers.
Core Risks for Broker-Dealers. The SEC Letter identifies six core risk areas for focus in broker-dealer examinations during 2014:
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Sales practices and fraudulent conduct aimed at senior investors, unsuitable recommendations of higher yield and complex products such as exchange-traded funds and structured products, and unregistered entities selling unregistered offerings.
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Supervision of the work of, among others, independent contractors, financial advisers, and representatives with significant disciplinary histories.
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Focus on algorithmic and high frequency trading, as well as certain trading practices (e.g., parking, fraudulent stimulation of demand, market manipulation, and excessive markups and markdowns).
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Effectiveness of firm internal controls, such as risk management practices, valuation, and audit functions.
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Compliance with the SEC’s customer protection and net capital rules.7
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Anti-money laundering programs of clearing and introducing broker-dealers, as well as proprietary trading firms that give customers direct market access.
New and Emerging Issues for Broker-Dealers. Finally, the SEC Letter lists three “new and emerging issues for broker-dealers in 2014” that will receive focus in broker-dealer exams:
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Application of the Market Access Rule to the proprietary trading of broker-dealers, as well as the adequacy of books and records maintained by broker-dealers that provide customers with market access.
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Suitability of recommendations made to customers to accept insurance companies’ offers, and disclosures provided to customers, to “buy back” variable insurance products.
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Quality of executions in the fixed income market, including market structure and the use of alternative trading systems.9
Broker-dealers may want to consider these priorities when designing and conducting their internal compliance and risk management review programs.
1 The SEC Letter is available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf.
2 The FINRA Letter is available at http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p419710.pdf.
3 The U.S. Government Accountability Office report is posted at http://www.gao.gov/products/GAO-13-30.
4 FINRA Regulatory Notice 13-23 is posted at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p304670.pdf and FINRA Regulatory Notice 13-45 is posted at https://www.finra.org/Industry/Regulation/Notices/2013/P418694.
5 Richard Ketchum’s letter is available at http://www.markey.senate.gov/documents/2013-11-13_FINRA_Ketchum.pdf.
6 The “Report on Conflicts of Interest” issued by FINRA is available at http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p359971.pdf.
7 Rules 15c3-3 and 15c3-1 of the Securities Exchange Act of 1934 (Exchange Act).
8 The Market Access Rule (Rule 15c3-5 of the Exchange Act), which went into effect on July 14, 2011, mandates certain risk management controls for broker-dealers with access to trading in securities on an exchange or alternative trading system.
9 The SEC recently released guidance concerning risk management in the fixed income market, which is susceptible to volatile swings due to growing interest rate uncertainty. The guidance is available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2014-1.pdf.
