The Financial Industry Regulatory Authority (“FINRA”) released its annual regulatory and exam priorities letter for 2015 (the “Letter”). As it has done for the past ten years, FINRA outlined the areas in which its examiners will pay particular attention with respect to its inspections this year.
The Letter notes challenges that FINRA has observed in five key areas that firms should address in 2015. These include:
- Alignment of firms’ interests with those of their customers;
- Standards of ethical behavior;
- Development of robust supervisory and risk management systems;
- Development, marketing and sale of new products and services; and
- Management of conflicts of interest.
The Letter also divides FINRA’s 2015 exam priorities into three areas: (1) sales practices; (2) financial and operational issues; and (3) market integrity matters. Below we have outlined a few of the issues identified by FINRA in each area.
Sales practice issues
In the Letter, FINRA highlighted its concerns with respect to several unique products that are increasingly being utilized and made available to a more diverse group of investors. FINRA expressed concerns about the substantial market, credit, liquidity and operational risks that these products can carry.
- Interest Rate-Sensitive Fixed Income Securities- FINRA noted that it was concerned about interest rate-sensitive fixed income securities, and noted the responsibility of firms to communicate to investors the impact of interest rate changes on price when marketing products that are interest rate sensitive.
- Variable Annuities- FINRA will look at sales practices for variable annuities, particularly with respect to compensation practices that may improperly incentivize employees to make sales in such products when they are not suitable for customers.
- Alternative Mutual Funds- The Letter stated that FINRA would focus on the way firms market alternative mutual funds, whose sales have increased dramatically over the past few years. FINRA cautioned firms that their communications regarding alternative mutual funds must accurately describe how the products work and ensure that any descriptions of the funds are consistent with the descriptions contained in the prospectuses.
- Non-Traded Real Estate Investment Trusts- FINRA continued to identify risks associated with non-traded real estate investment trusts (“REITS”), as it did in its 2014 letter. FINRA wants to ensure that firms are fulfilling their customer-specific suitability obligations and that firms are performing due diligence on an ongoing basis on REITS that they recommend.
- Exchange Traded Products Tracking Alternatively Weighted Indices- The Letter highlighted exchange-traded products (“ETPs”) that track alternatively weighted indices. ETPs tracking these indices can be thinly traded and have wide bid-ask spreads, making these funds more costly to trade. Some alternatively weighted indices can have higher turnover than traditional indices, which can lead to higher transaction costs for ETPs that track them.
- Structured Retail Products- Another area of concern for FINRA is structured retail products, including structured notes with complex payout structures. FINRA noted that some firms and retail investors may not be familiar with the complexities of structured retail products and the risks that they carry. In addition, FINRA reminded firms that retail communications regarding certain structured products must be filed with FINRA.
- Floating-Rate Bank Loan Funds- The Letter noted that floating-rate bank loan funds, which are typically geared toward institutional investors, are increasingly being utilized by retail investors through investments in mutual funds, closed-end funds and exchange-traded funds. These loans have significant credit and call risk, are difficult to value and are relatively illiquid. Firms should inform investors that these loans may face liquidity issues if a significant number of investors make redemption requests at the same time.
- Securities-Backed Lines of Credit- FINRA discussed risks associated with securities-backed lines of credit (“SBLOCs”), which are now being offered by an increasing number of firms and to retail investors. Proceeds of these loans are often being used to purchase second homes and luxury items or pay other expenses. FINRA warned that firms offering SBLOCs must have proper controls in place to supervise these programs and investors should be fully informed of the program features, including loan restrictions and how changes in market conditions may affect brokerage accounts and the ability to draw on the SBLOC. Firms should also have procedures that enable them to interact with the lending institution so that customer accounts can be monitored.
In addition to FINRA’s concerns about specified products, FINRA also highlighted that its new supervision rules (FINRA Rules 3110, 3120, 3150 and 3170) recently became effective. The new rules modify requirements relating to, among other things, supervision and inspection of offices, managing conflicts of interest in a firm’s supervisory system, performing risk-based reviews of correspondence and internal communication and testing and verifying supervisory control procedures. FINRA’s examiners will be looking to see how firms are implementing the new rule requirements.
In addition, FINRA continues to be concerned with firms’ practices with regard to private placements. FINRA reviews firms’ private placement materials to determine whether broker-dealers have performed sufficient due diligence with respect to the offering. In some cases, FINRA staff have found that the level of due diligence performed has not complied with the broker-dealers’ procedures, and appears to be inadequate to support the broker-dealer’s suitability determinations. FINRA staff have also identified offering documents and investor communications with misrepresentations, omissions of material information and inconsistencies with FINRA’s communication rules. Examiners will be paying particular attention to these issues in 2015.
High-risk and recidivist brokers
In the Letter, FINRA also noted that in 2015, firms that hire or seek to hire high-risk brokers, including statutorily disqualified brokers or brokers with lengthy disciplinary histories, can expect rigorous regulatory scrutiny. FINRA plans to review firms’ due diligence with respect to prospective hires and will also review the supervision of high-risk registered representatives to determine whether such supervision is tailored to address the risk associated with the particular individual based on prior misconduct.
In 2015, FINRA examiners will also focus on SEC and MSRB municipal advisor requirements. They will review for appropriate application of exclusions and exemptions, as well as potentially unregistered activity.
Financial and operational issues
Funding and liquidity
With respect to financial and operational priorities, FINRA noted, among other things, that firms need to update and monitor funding and liquidity risk management programs. FINRA has witnessed many firms’ funding and liquidity plans that rely on being able to sell or enter into repurchase transactions at or near the prices at which the firms have marked their inventory to market. However, the issue of mark-to-market pricing is critical for infrequently traded positions in corporate, asset backed and municipal debt securities. Therefore, FINRA will examine the marks-to-market for such securities and for supervisory programs surrounding the securities’ valuation process.
The Letter also stated that in 2015, examiners will review firms’ approaches to cyber security risk management. In January 2014, FINRA initiated a sweep to understand the types of cyber security threats to which member firms are subject, as well as their responses to those threats. FINRA expects to publish the results shortly, which will include principles and effective practices firms should consider in developing and implementing their cyber security programs.
In addition, the Letter reminded firms that outsourcing firm activities does not eliminate the broker-dealer’s responsibility for compliance with applicable securities laws and regulations or for supervising the service provider’s performance. FINRA noted that outsourcing will be a priority area of review during 2015 examinations and will include an analysis of the due diligence and risk assessment that firms perform on potential service providers, as well as their supervision of outsourced activities.
Supervision and governance surrounding trading technology
With respect to FINRA’s focus on market integrity, FINRA noted that maintaining a robust technology governance framework for electronic trading is a critical responsibility for broker-dealers. FINRA examiners plan to review firms’ technology with an emphasis on the development and supervision of algorithms. Examiners will also review the segregation of duties for technology staff performing the developing, testing, deploying and modifying of new and existing technologies. In addition, examiners will focus on firms’ risk management and financial and operational controls, with an emphasis on net capital, because the speed with which orders are entered and executed can produce risk to the financial soundness of high-frequency trading firms.
FINRA also stated that it views abusive trading algorithms as one of the most significant risks to the integrity of the markets. Therefore, FINRA plans to pursue firms whose traders or customers use algorithms to manipulate the market. FINRA will also enhance its surveillance program to detect new types of manipulative trading activity conducted through abusive trading algorithms.
In addition, the Letter noted that even four years after the Market Access Rule (Rule 15c3-5 under the Securities Exchange Act of 1934) was adopted, FINRA continues to see examples of firms’ inadequate market access controls in the equities and options markets. FINRA has also witnessed confusion regarding the applicability of the Market Access Rule to fixed income markets. FINRA has often determined that firms have not developed sufficient financial controls around fixed income market access with respect to principal trading activity. Therefore, in 2015, FINRA plans to begin a pilot program to provide firms with information obtained through its cross-market surveillance program in order to supplement firms’ supervision efforts with respect to detecting and preventing manipulative market access activity.
Audit trail integrity
In 2015, FINRA will also continue to focus on late reporting in TRACE-eligible and municipal securities that appear to result from inadequate processes and procedures on trading desks. FINRA has found some firms have been reporting large trades several hours late. These delays can potentially affect FINRA’s audit trail and its ability to assess whether a firm was at risk when executing a trade. Therefore, FINRA has created a new team to focus on identifying potential equity and audit trail issues not typically detected through routine compliance sweeps and reviews.
As the topics discussed above are only a subset of the areas highlighted by FINRA in the Letter, it is important for FINRA firms to review the entirety of the Letter so that they can understand FINRA’s concerns with respect to each area that may be applicable to their business. Firms should use the topics discussed in the Letter as a starting point for updating their policies and procedures in the new year.