Member News, News

Pepper Hamilton Client Alert: FINRA’s 2014 Regulatory & Examination Priorities Address Existing and Emerging Investor Protection and Market Integrity Issues

On January 2, the Financial Industry Regulatory Authority (FINRA) published its annual regulatory and examination priorities letter. The letter identifies and sets forth how FINRA intends to address significant risks and issues that could adversely affect investors and market integrity in 2014. FINRA addresses four categories of priorities in its letter, and a number of sub-issues in each category: (1) Business Conduct Priorities, (2) Fraud Priorities, (3) Financial and Operational Priorities, and (4) Market Regulation Priorities.

This client alert summarizes some of the issues that FINRA highlights in its annual letter.

FINRA Executive Vice President of Regulatory Operations Susan Axelrod stated that the purpose of the letter is to “provide insight to the industry on specific areas of concern for [FINRA’s] regulatory programs in the coming year.” FINRA “encourage[s] firms to use this guidance along with their own analysis to enhance their programs as [FINRA] will be examining for strong controls and robust compliance efforts in these areas.” FINRA-regulated firms should review their written supervisory procedures to determine whether they are reasonably designed to address the issues identified by FINRA, and continue to update them as FINRA revises its view on risks throughout the year.

(1) Business Conduct Priorities

FINRA identifies a number of Business Conduct Priorities for 2014, and notes that they are broadly consistent with those raised in 2013. Some of the key Business Conduct Priorities include:

Suitability: FINRA remains concerned with the suitability of complex products recommended to retail investors, especially because the fee/compensation structure for such products often provides a strong incentive for brokers to recommend them. FINRA notes that complex products’ risk-return profiles, volatility, fee structures, or complexity may be challenging for investors to understand. FINRA urges firms to make more effective disclosures regarding the risks associated with investments in complex products, and provide “a balanced discussion of the risks and potentially negative scenarios that might result in customer losses.” FINRA examinations will review firms’ training programs to determine whether they provide brokers with an adequate understanding of complex products, and will focus on the following products, among others: Complex Structured Products, Private Real Estate Investment Trusts (REITs), Frontier Funds, and Interest-Rate-Sensitive Securities.

Pepper Point: FINRA devotes a significant portion of its 2014 letter to complex product suitability issues. This suggests that FINRA will further increase its regulatory and enforcement activities relating to such products in the coming year. For example, if and when interest rates rise, interest-rate-sensitive complex products will likely decline in value. Such decline could prompt regulators to scrutinize – with the benefit of 20/20 hindsight – whether interest-rate-sensitive products were suitable for investors at the time that they invested in them. FINRA-member firms should be aware of this possibility and must adhere to all suitability requirements. Firms should consider whether their policies and procedures require adequate documentation of risk disclosures provided to purchasers of complex products and provide representatives with an adequate understanding of the complex products they recommend.

Recidivist Brokers: In 2013, FINRA launched its High-Risk Broker initiative to (1) identify brokers with a pattern of complaints or disclosures for sales practices abuses and (2) expedite investigations of them. In 2014, FINRA will expand the High-Risk Broker program by creating a dedicated enforcement team to prosecute such brokers. FINRA also will focus on high-risk brokers’ clients’ accounts when conducting sales practices reviews.

Cybersecurity: FINRA notes that over the past several years, many of the largest financial institutions were the targets of a range of electronic hacking attacks, and that the frequency and sophistication of the attacks is increasing. FINRA will conduct examinations and targeted investigations into the integrity of firms’ policies, procedures, and controls designed to protect firm infrastructure and sensitive customer data from such attacks.

Senior Investors: As a large number of American investors are approaching retirement and control a substantial portion of investable assets, FINRA examiners will continue to focus on how firms engage with these senior investors, “especially with respect to suitability determinations as well as disclosures and communications.” Recently, FINRA barred two brokers from the securities industry for wrongfully converting $300,000 from an elderly widow.

Pepper Point: Firms and brokers should anticipate similar FINRA enforcement actions as baby boomers who control substantial investable assets advance in age. FINRA will likely actively pursue enforcement actions in instances where brokers are alleged to have taken advantage of unsophisticated, aged investors or those with diminished mental capacity. Firms should review their policies and procedures to determine whether adequate training on transactions with senior investors is being provided to registered representatives.

(2) Fraud Priorities

FINRA identified two issues as Fraud Priorities:

Microcap Fraud: FINRA has “significant ongoing concern” about speculative microcap and low-priced over-the-counter (OTC) securities. FINRA urges firms to ensure that all activities relating to microcap and OTC securities are compliant with FINRA rules and federal securities laws. Firms also should perform heightened supervision of employees with outside business activities relating to microcap and low-priced OTC securities, and of traders who trade them.

Insider Trading: Insider trading continues to be one of FINRA’s top regulatory priorities. FINRA said that firms must be vigilant in safeguarding material, non-public information. For instance, firms should (1) routinely review electronic communications of investment banking and research department personnel who may come into possession of material, non-public information during the normal course of business and (2) maintain appropriate information-barrier policies designed to restrict the flow of material, non-public information on a “need-to-know” basis. FINRA encourages employee training on the use and handling of material, non-public information.

Pepper Point: It is important for FINRA-member firms to monitor employee trades, both at and away from the firm, to identify suspicious activity. FINRA Conduct Rule 3040, entitled “Private Securities Transactions of an Associated Person,” addresses member firms’ responsibilities relating to outside trading activities.

(3) Financial And Operational Priorities

In 2014, FINRA will focus on the following Financial and Operational Priorities, among others.

Funding and Liquidity Risk: During its 2014 examinations, FINRA will ask larger firms to perform a “liquidity stress test that incorporates factors FINRA believes are important to understanding the resiliency of their liquidity position.” The testing will require stressing the following four areas of a firm’s business: (1) stressed funding of proprietary positions, (2) stressing of repurchase books, (3) stressing settlement payments and clearing deposits with clearing banks, central counterparties, and clearing organizations, and (4) funding loss of customer balances or increases in obligations to lend to customers. FINRA is particularly concerned about whether a funding gap exists that has not been adequately addressed within a firm’s contingent funding plan.

Accuracy of Firm’s Financial Statements and Net Capital: FINRA emphasizes that broker-dealers must be able to prepare accurate financial statements throughout the year, and not just at fiscal year-end. FINRA will look to determine whether firms have the proper expertise and necessary resources to maintain books and records that are accurate and prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP).

(4) Market Regulation Priorities

Algorithmic Trading and Trading Systems: FINRA has concerns about the ability of firms to develop, implement, and supervise algorithmic trading systems because in recent years, such systems have suffered a number of malfunctions that caused substantial market disruptions. FINRA notes, among other things, that firms subject to review “should be prepared to address whether they conduct separate, independent and robust pre-implementation testing of algorithms and trading systems and whether the firm’s legal, compliance and operations staff are reviewing the design and development of the firm’s algorithms and trading systems for compliance with legal requirements.” FINRA will also probe whether firms actively monitor algorithms and trading systems post-implementation.

Audit Trail Integrity: FINRA has observed that some firms have significant deficiencies relating to Large Options Positions Reporting (LOPR). FINRA is committed to pursuing such cases, and recommends that firms review their systems to ensure that they are filing accurate and complete LOPR reports.

Best Execution: FINRA reiterates that firms have an affirmative duty to regularly and rigorously review execution quality to assure that order flow is directed to markets providing the most beneficial terms for customers. In 2014, FINRA will focus on firms’ compliance with their best execution obligations relating to equities, options, and fixed-income securities.

Also see: A Publication of Pepper Hamilton LLP

Ivan B. Knauer |
Matthew D. Janssen |