On Jan. 5, 2016, the Financial Industry Regulatory Authority (“FINRA”) issued its annual Regulatory and Examination Priorities Letter (“2016 Examination Letter” or “Letter”), along with a press release from FINRA chairman and CEO Richard Ketchum summarizing the Letter. In addition to announcing broad categories of new priorities for 2016, FINRA also emphasized many other areas of focus, several of which are described below in greater detail.
Broad Issues. The letter begins by addressing three broad areas of focus for 2015: (1) culture, conflicts of interest and ethics; (2) supervision, risk management and controls; and (3) liquidity.
Culture, Conflicts of Interest and Ethics – While recognizing that member firms may have different definitions of “firm culture,” FINRA nonetheless notes its intent to craft its own definition of firm culture and formalize its assessments of culture in 2016. A firm’s culture is identified as a significant factor in how a firm manages conflicts of interest and questions of ethics; accordingly, FINRA will assess five indicators of a firm’s culture: (1) whether control functions are valued within an organization; whether policy or control breaches are tolerated; (3) whether an organization proactively seeks to identify risk and compliance events; (4) whether supervisors are effective role models of firm culture; and (5) whether sub-cultures (e.g., at a branch office, trading desk or investment banking department) that do not conform to firm culture are identified and addressed.
Supervision, Risk Management and Controls – Noting that FINRA rules require firms to maintain systems to supervise activities of their associated persons to assist the firm in complying with securities laws and FINRA rules, the agency will focus on four areas where it has observed repeated concerns regarding firm business conduct and market integrity: management of conflicts of interest (in particular, a firm’s incentive structures); technology (with an emphasis on cybersecurity); outsourcing (reminding firms that they remain responsible for supervision of third parties); and anti-money laundering (particularly, where certain customer transactions are automatically excluded from portions of AML surveillance, the reasoning for the decision should be documented for FINRA to check).
Liquidity – Noting the failure to adequately manage liquidity by some firms has led to financial failure and systemic crises, FINRA will continue to focus on firms’ liquidity risk management practices, guided by the framework established by the agency in its Regulatory Notice 15-33. FINRA also plans to emphasize the adequacy of liquidity controls at high-frequency trading firms, given the ability of high frequency trading to suddenly affect market liquidity.
Other Areas of Focus. FINRA also identified other areas of focus in its 2016 Examination Letter, including:
Suitability and Concentration – FINRA notes that effectively discharging suitability obligations is a fundamental duty, particularly in the context of higher-risk products, such as interest rate-sensitive and alternative products. The agency has observed that the product review committees and training programs of many firms do not go far enough in educating employees about the potential risks of these products, and will continue to examine this shortfall. Relatedly, FINRA has noted that some member firms have failed to avoid excess concentration in products identified as higher-risk, which raises suitability issues and may exacerbate the effects of periods of market stress.
It is noteworthy that FINRA also identifies alternative mutual funds, emerging market funds, and non-traditional exchange-traded products (“ETPs”) as potentially “high-risk” investments. The SEC regulates many of these products (some ETPs are excluded), and it will be interesting to see how FINRA adjusts its examination procedures for certain non-traditional ETPs and alternative mutual funds in light of the SEC’s proposed rule limiting the use of derivatives by mutual funds and ETFs (if, in fact, the SEC’s final rule mirrors the proposed rule’s significant restrictions on the use of derivatives and other forms of leverage by these products).
Private Placements, the JOBS Act and Public Offerings – FINRA’s examinations of private placements will emphasize concerns regarding suitability, disclosure, and due diligence, and will particularly reflect the recent development of the permissibility of general solicitation pursuant to Rule 506(c) of Regulation D under the Securities Act of 1933. The agency will also review clearance filings made pursuant to the so-called Regulation A+ amendments of the JOBS Act, including reviewing the regulatory histories of issuers, insiders and broker-dealers involved in the placements; monitoring non-compliance with escrow agreements; and checking indicators of inadequate underwriter due diligence. The agency will also more broadly track the development of the JOBS Act’s incipient public offerings market.
Non-Traded REITs and Direct Participation Programs (“DPPs”) – FINRA notes that many sponsors of non-traded REITS and DPPs, in anticipation of the agency’s amended Customer Account Statement Rule and corresponding changes to the DPP Rule (each going effective in April 2016), have restructured their products and added new share classes. These sponsors are also offering unlisted business development companies (“BDCs”) to their product lines. Noting that each of these new products will be available to retail investors, who may be vulnerable to the complexity, high fees, and illiquidity of these investments, the agency will subject these products to “rigorous reviews.”
Outside Business Activities – FINRA plans to focus on evaluating firm procedures related to outside business activities (“OBAs”), as required by FINRA Rule 3270 (or, where applicable, Rule 3280, which requires firms to determine whether OBAs should be treated as a private securities transaction). The agency notes that one of its most common exam findings is firms’ failure to adequately assess their registered representatives’ written notifications of OBAs.
Client Onboarding – Noting that firms facing capital and liquidity issues generally have poor practices related to onboarding professional clients (e.g., institutional, trading, hedge fund and broker-dealer clients), FINRA will assess member firms’ client onboarding policies and controls. In addition to examining practices related to onboarding individual clients, the agency will also review how firms aggregate onboarding information to conduct aggregate risk assessment.
Regulation SHO – The agency will scrutinize member firms’ compliance with SEC Regulation SHO (applicable to “short sales”) and particularly Rule 204, which requires close-out of fail to deliver positions. The scrutiny comes as a result of FINRA examinations uncovering deficiencies with firms’ compliance with the Regulation’s requirement to be net flat or net long on the Rule 204 close‑out date. Additionally, FINRA is concerned about the ability of Authorized Participants for ETPs to ensure that they have sufficient positions to prevent Rule 204 violations in connection with ETP redemption orders.
Exchange-Traded Funds (“ETFs”) – FINRA will review broker-dealers’ role as Authorized Participants (“APs”) in the process of transacting with ETFs in creation and redemption baskets. Because of the rapid growth of the ETF market and the significant role of APs in providing liquidity and structural integrity to the ETF marketplace, FINRA will continue to monitor the credit risk of APs in the creation and redemption process, particularly by monitoring the way APs reflect their counterparty credit risk computations as part of their net capital computations per Rule 15c3-1 of the Securities Exchange Act of 1934.
Conclusion. Though FINRA’s 2016 Letter contains broad statements of policy concerning culture, risk management, and conflicts of interest, FINRA members are encouraged to use as guidance the more specific policies and procedures that the agency plans to implement in enforcing its 2016 examination priorities. Reference should be made to FINRA’s Regulatory Notices and weekly Update emails, as well as FINRA’s website where appropriate, to keep apprised of developments to, and further explication of, the agency’s 2016 priorities. We will continue to monitor and report on significant guidance and developments affecting compliance responsibilities.