On January 22, 2019, the Financial Industry Regulatory Authority (“FINRA”) issued its annual letter describing its current risk monitoring and examination priorities. See
FINRA, Risk Monitoring and Examination Priorities Letter
(Jan. 2019). Although there are no major surprises in terms of priorities, firms would be well-advised to review the letter to ensure that their own compliance policies are meeting with FINRA’s expectations. Indeed, the letter can arguably read as a roadmap to potential future enforcement activity, particularly when coupled with FINRA’s recent efforts to restructure internally to increase efficiency and coordination among its enforcement teams.
Among its new priorities, FINRA highlighted the following:
- Online Distribution Platforms. FINRA noted the increasing use of online distribution platforms, including by firms that do not own and operate the platforms themselves. FINRA commented that some member firms have asserted that they are not selling or recommending securities through online distribution platforms, when in fact there may be evidence of transaction-based compensation or handling of customer accounts and funds. Accordingly, FINRA asserted that it will continue to evaluate how firms supervise communications with the public, and will also seek to ensure that firms meet anti-money laundering requirements when using online distribution platforms.
- Fixed Income Mark-Up Disclosure. FINRA stated that it will review firms’ compliance with their mark-up or mark-down disclosure obligations on fixed income transactions pursuant to amendments to FINRA Rule 2232 and MSRB Rule G-15, which were put in place following the Litvak case and those that followed.
- Regulatory Technology. FINRA stated that it will focus on understanding how firms are using RegTech tools to manage compliance efforts, while also accounting for associated risks, such as risks to supervision and governance systems, third-party vendor management, safeguarding customer data and cybersecurity.
Meanwhile, FINRA also highlighted continuing priorities. Specifically, FINRA indicated that it will remained focused on the following:
- Suitability. Long a mainstay of FINRA’s examination and enforcement efforts, FINRA made clear that this remains front and center. FINRA noted in particular that it will focus on “(1) deficient quantitative suitability determinations or related supervisory controls; (2) overconcentration in illiquid securities, such as variable annuities, non-traded alternative investments and securities sold through private placements; and (3) recommendations to purchase share classes that are not in line with the customer’s investment time horizon or hold for a period that is inconsistent with the security’s performance characteristics.”
- Senior Investors. Another mainstay, FINRA reiterated its focus on protecting senior investors. In particular, it noted that it will monitor compliance with amendments to FINRA Rule 4512, which requires firms to make reasonable efforts to obtain information about trusted contacts for non-institutional accounts and new FINRA Rule 2165, including whether firms have clearly defined policies and procedures or practices for placing temporary holds on accounts.
- Outside Business Activities and Private Securities Transactions. FINRA noted a particular concern about FINRA members raising money from customers away from their firms, and thus outside of established supervision.
- Supervision of Digital Assets Business. Despite the still evolving status of rules in this space, FINRA made clear that it expects member firms to implement controls and supervision over compliance with rules related to the marketing, sale, execution, control, clearance, recordkeeping and valuation of digital assets, as well as AML/Bank Secrecy Act rules. Indeed, FINRA encouraged firms to proactively notify FINRA about any expansion into the digital asset space, given FINRA’s intense focus on it.
- Customer Due Diligence and Suspicious Activity Reviews. While a priority in recent years as well, FINRA stated that it will focus in particular on the data integrity of firms’ suspicious activity monitoring systems pursuant to FinCEN’s Customer Due Diligence (“CDD”) rule. The CDD rule became effective on May, 11 2018, and requires firms to identify beneficial owners of legal entity customers, understand the nature and purpose of customer accounts, monitor accounts to identify suspicious transactions, and update customer information.
- Best Execution. FINRA stated a general concern with ensuring that firms are using reasonable diligence to obtain best execution for their customers, and explicitly noted that it “will review firms’ best execution decision-making where the firm routed all or substantially all customer orders to a small number of wholesale market makers from which they received payment for order flow or an affiliated broker-dealer or an alternative trading system (ATS) in which the firm had a financial interest.” Given the often inherent conflicts of interest in this space, FINRA’s continuing focus on it is no surprise.
- Market Manipulation. While FINRA is always focused on this topic, it noted that this year it will focus in particular on “manipulative trading in correlated [Exchange Traded Products], including those that track common, broad market indices” and correlated option products.
- Market Access. FINRA will continue to review compliance with the Market Access Rule, Rule 15c3-5 under the Securities Exchange Act of 1934, and the policies and procedures member firms have in place.
- Short Sales. For firms with separate aggregation units to permit increased short sales, FINRA will examine whether they are set up with sufficient independence in compliance with Exchange Act Rule 200(f).
- Short Tenders. FINRA plans to examine how firms account for option positions (in particular short call options at below a tender price) when tendering shares in an offer to ensure compliance with Exchange Act Rule 14e-4.
- Credit Risk. FINRA will review how firms manage credit risk, including risk that arises when firms become responsible for transactions that their customers and correspondents execute “away” from the firms, without the firms’ participation until after execution.
- Funding and Liquidity. FINRA will continue to evaluate firms’ liquidity planning, especially whether firms update their stress test assumptions in light of changes in the marketplace. FINRA highlighted as an example the increased volatility in the market in 2018, but given that the guidance is forward-looking, firms will also need to take into account any future market developments.
FINRA expects that member firms will consider the topics in its annual letter as they assess their compliance, supervisory, and risk management programs. Accordingly, firms can expect that if they do not address one or more of the listed topics, and are found to be lacking adequate policies or procedures in respect of a listed topic in a 2019 examination, an enforcement action may well follow.
While the potential enforcement risk will vary for every firm, at the very least firms should revisit the specific rules noted in the letter to ensure that their policies and procedures account for recent amendments. Even if FINRA later takes issues with policies and procedures a firm puts in place, being able to document a good faith effort to review the letter and update policies and procedures should help minimize any enforcement risk.