Alert January 21, 2014

FINRA Identifies 2014 Examination Priorities

In a letter to all FINRA member firms (the “FINRA Priorities Letter”), FINRA set forth its regulatory and examination priorities for 2014, highlighting significant risks and issues that could adversely affect investors and market integrity in the coming year. 

FINRA’s 2014 examination priorities are as follows:

Business Conduct Priorities

Suitability.  FINRA remains concerned about the suitability of recommendations to retail investors for complex products whose risk-return profiles, including their sensitivity to interest rate changes, underlying product or index volatility, fee structures or complexity may be challenging for investors to understand.  In this regard, the FINRA Priorities Letter states that, among other things, FINRA will be focused on the sale and suitability of:

  • Complex structured products
  • Non-traded real estate investment trusts
  • Frontier funds (often investing in politically unstable regions of the world)
  • Interest Rate Sensitive Securities, including mortgage-backed securities, long duration bonds and bond funds, emerging market debt, municipal securities, and baby bonds.

Recidivist Brokers.  FINRA noted that a small number of brokers have a pattern of complaints or disclosures for sales practice abuses that could harm investors as well as the reputation of the securities industry and financial markets.  FINRA will be expanding the High Risk Broker initiative, which was commenced in 2013 to identify such individuals and expedite investigations, and will create an enforcement team to prosecute such cases.

Conflicts of Interest.  FINRA stated that its examiners will explore topics addressed in its October 2013 report on conflicts of interest including firms’ approaches to identifying and managing conflicts as well as the participation of senior management in this process.  FINRA will evaluate firms’ conflicts management practices to help further inform its view on industry practices by focusing primarily on actions taken by firms and the impact on their clients, rather than focusing strictly on regulatory requirements.

Cybersecurity.  FINRA stated that its primary focus will be the integrity of firms’ policies, procedures and controls to protect sensitive customer data, and that its evaluation of cybersecurity matters will take the form of examinations and targeted investigations. 

Qualified Plan Rollovers.  FINRA noted that it shares concerns, articulated by the U.S. Government Accountability Office (“GAO”) in its 2013 Report, that the financial industry generally encourages employees to roll over their assets into IRAs without fully explaining the options that are available to these investors or making a valid determination that a rollover into an IRA is in the investor’s best interest.  Reviewing firm rollover practices will be an examination priority, and staff will examine firms’ marketing materials and supervision in this area.  FINRA will also evaluate securities recommendations made in rollover scenarios to determine whether they comply with suitability standards in FINRA Rule 2111.

Initial Public Offering Market.  FINRA noted the increase in the initial public offering (“IPO”) market during recent periods, and stated that for firms engaged in the public underwriting business, FINRA will review the firm’s due diligence activities, monitor the completeness and accuracy of firms’ filings regarding public underwritings with FINRA’s Corporate Finance Department, and review compliance with rules concerning the sales and allocations of IPO securities, including whether firms are incenting associated persons to sell cold offerings with client allocations of hot offerings.

Private Placement of Securities.  The FINRA Priorities Letter identifies private placements of securities as a priority, including a focus on:

  • General Solicitation and Advertising of Private Placements.  FINRA reiterated its longstanding concern about abuses in the sale and marketing of private placement of securities, noting that recent amendments to Rule 506 of Regulation D permit, subject to certain limitations, general solicitation and advertising when offering some private placements.
  • Due Diligence and Suitability of Private Placements.  FINRA stated that it will examine firm private placement activity to determine whether firms are taking reasonable steps to validate that investors meet accredited investor standards prescribed by Rule 506.
  • Offerings of Securities through Private Placements.  FINRA will verify that firms are making required filings under FINRA Rules 5122 and 5123.

Anti-Money Laundering.  FINRA stated that in 2014 it will focus on anti-money laundering issues associated with the institutional business, noting emerging trends related to the utilization of executing broker-dealers by certain DVP/RVP (Delivery versus Payment/Receipt versus Payment) customers to liquidate large volumes of low-priced securities.  FINRA also noted the misconception among some executing brokers that Customer Identification Program Requirements do not apply to DVP/RVP customers.  In this regard, FINRA stated that it is important that all firms, regardless of business model, develop a risk-based AML program designed to address the risk of money laundering specific to their firm.

Municipal Advisors.  FINRA noted recent rules regarding municipal advisors promulgated by the SEC and that FINRA has been designated as the examining authority for municipal advisors that are FINRA members. 

Crowdfunding Portals.  FINRA noted that under the Jumpstart our Business Startups Act (the “JOBS Act”) retail investors are permitted to purchase unregistered securities offered through crowdfunding websites, and that FINRA has proposed rules with the objective of ensuring that the capital-raising objectives of the JOBS Act are advanced in a manner consistent with investor protection.  FINRA stated that as funding portals become FINRA members, FINRA will implement a regulatory program designed to protect investors while recognizing the distinctions between funding portals and broker-dealers.

Senior Investors.  FINRA stated that in 2014 its examiners will continue to focus on how firms engage with investors who are approaching retirement and who control a substantial portion of investable assets.

Fraud Detection Priorities

Microcap Fraud.  FINRA stated that microcap and low-priced over-the-counter (“OTC”) securities continue to be an area of significant concern. 

Insider Trading.  FINRA stated that insider trading continues to be a top regulatory priority and reiterated its points made in its 2013 examination priorities letter (the “2013 Priorities Letter”).  Specifically, FINRA stated that firms must continue to be vigilant in safeguarding material, non-public information, and should periodically assess information barriers and risk controls to ensure they are adequate.

Financial and Operational Priorities

Funding and Liquidity Risk.  FINRA stated that it will continue to be focused on funding and liquidity risk in 2014, noting that in 2014 it will ask many larger firms to perform a liquidity stress test that incorporates factors FINRA believes are important to understanding the resiliency of the firm’s liquidity position.  Specifically, FINRA will require stress-testing in the following four basic areas of the firm’s business: (a) stressed funding of proprietary positions (loss of counterparties, loss of funding for less liquid assets, widening of haircuts); (b) stressing of repo book (loss of counterparties, loss of internally generated liquidity, widening of haircuts); (c) stressing settlement payments and clearing deposits with clearing banks, central counterparties (CCPs) and clearing organizations; and (d) funding loss of customer balances or increases in obligations to lend to customers.

Risk Control Documentation and Assessment.  FINRA noted recent amendments to Rule 17a-3 of the Securities Exchange Act of 1934 which will require firms that hold more than $1 million in aggregate customer credits or $20 million in capital, including subordinated debt, to document their credit, market and liquidity risk management controls, and stated that it will examine these risk controls in 2014.

Accuracy of Firm’s Financial Statements and Net Capital.  FINRA stated that firms must be in a position to prepare accurate financial statements throughout the year, noting that areas of continued concern include: (a) failure to apply Open Contractual Commitment Charges, haircuts, undue concentration or blockage charges; (b) failure to comply with the Net Capital Rule at all times and, as a related item, failure to cease operations when a firm is under required capital until the net capital deficiency is cured; (c) failure to prepare books and records on an accrual basis, or only making proper accruals at the end of a broker-dealer’s fiscal year; and (d) netting transactions in the absence of authoritative accounting guidance which permits such netting.

Auditor Independence.  FINRA noted recent findings by the Public Company Accounting Oversight Board regarding the lack of independence by auditors of small broker-dealers.

Market Regulation Priorities 

Algorithmic Trading and Trading Systems.  FINRA noted that there have been a number of algorithmic trading malfunctions in recent years that have caused substantial market disruptions and raise concerns about firms’ ability to develop, implement and effectively supervise these systems.  In this regard, FINRA reiterated a number of comments from the 2013 Priorities Letter, noting that it will continue to assess whether firms’ testing and controls related to high frequency trading (“HFT”) and other algorithmic strategies and trading systems are adequate in light of the Market Access Rule and firms’ other supervisory obligations.

High Frequency and Other Algorithmic Trading Abuses.  FINRA noted the growth of HFT strategies in recent years and noted that some HFT strategies may be used for manipulative purposes.  In this regard, FINRA stated that firms’ need to be vigilant and outlined certain specific areas of concern that will be a focus of FINRA’s 2014 examinations.

Audit Trail Integrity.  FINRA notes that it has perceived significant, prolonged and wide-scale deficiencies in Large Options Positions Reporting (“LOPR”) and in properly marking the capacity of firm option orders.  FINRA stated that firms should assess their supervisory controls in these areas and that in 2014 FINRA anticipates focusing on in-concert reporting deficiencies, improper position deletions, non-reporting of positions, and the process that firms use to internally determine whether an OTC position qualifies as a reportable options position.

Best Execution of Equities, Options and Fixed Income Securities.  FINRA noted that has introduced new surveillance patterns to monitor best execution in equities and fixed income securities, and new procedures to monitor for best execution with respect to options transactions.  Among other things, FINRA stated that it will focus more closely on firms’ practices to ensure compliance with their best execution obligations with respect to limit orders in equity securities, and will review situations where a firm potentially ignores a favorable price on one options market and executes a trade on another to the detriment of the Customer.


FINRA encouraged firms to use the FINRA Priorities Letter, along with its own analysis, to enhance their compliance programs, stating that FINRA will be examining for strong controls and robust compliance efforts in the areas identified in the FINRA Priorities Letter.