Consistent with prior practice, with the arrival of the new year, FINRA has published its key examination priorities.  The letter may be found at the following link:

As in prior years, the letter covers a broad array of topics.  This year’s topics include:

  • Hiring and monitoring the activities of “high-risk and recidivist brokers;”
  • Sales practices, including protecting seniors, evaluating firm practices relating to reasonable-basis and customer-specific suitability, and monitoring product concentration;
  • Excessive and short-term trading of long-term products, such as mutual funds and closed-end funds;
  • Operational risks, including cybersecurity, supervisory controls testing, consumer protection and segregation of client assets, and anti-money laundering and suspicious activity monitoring; and
  • Market integrity issues, including best execution and trading examinations.

Of course, each member firm should read the letter carefully and assess the identified priorities in the context of its own business and business plans.  Below, we discuss a number of areas that may be of particular interest to a number of market participants and clients, including some specific items that FINRA raises in its letter.

New:  Off-Site Reviews

In the letter, FINRA indicates that in 2017 it will begin conducting electronic off-site reviews that will supplement its traditional on-site examinations.  The off-site reviews are designed to enable FINRA to review selected areas discussed in the letter, without a visit.  These off-site reviews will be conducted only as to a limited number of broker-dealers that are not scheduled for a 2017 cycle exam.  We would expect that this process will help leverage FINRA’s ability to understand market practices as to key issues.

High-Risk and Recidivist Brokers

Consistent with its recent inquiries regarding firm culture and hiring practices, FINRA will focus on the hiring and monitoring of “high-risk and recidivist brokers.”  For example, FINRA will explore the implementation of supervisory and compliance controls for such individuals.  The letter indicates that FINRA will, among other things, review whether a firm or a third-party agent reviews available public records to verify the accuracy of the relevant individuals’ form filings.

Sales Practices

  • Senior Investors:  FINRA continues to take a strong interest in protecting senior investors.  FINRA’s concern arises from its ongoing observations that brokers have continued to recommend unsuitable products to senior investors, including complex or novel exchange-traded products, structured products, leveraged and inverse exchange-traded funds, non-traded REITs, and unlisted BDCs.  FINRA reminded firms of a variety of tools that can be used to help protect elderly clients from exploitation under questionable circumstances, including contacting the investor about orders placed through an on-line brokerage account, or about instructions to transfer funds to persons who may be linked to an issuer.
  • Suitability:  FINRA remains concerned that brokers are recommending unsuitable complex products to customers.  Accordingly, examinations will assess how firms discharge their reasonable basis and customer specific suitability obligations. The letter notes:
    “…we will assess how firms conduct reasonable-basis and customer-specific suitability reviews.  This may include examining firms’ product vetting processes, supervisory systems and controls to review recommendations.  Firms should be attentive to the adequacy of their supervision and training when new products come to market, new features of existing products are introduced or market conditions change in ways that could affect product performance.  Firms that hire registered representatives who sell products with which the firm is not familiar should educate themselves on the products and then carefully evaluate their ability to supervise recommendations.  Training should ensure that registered representatives, compliance and supervisory staff understand the objectives, risks and pricing factors of the products sold, including any changes in the features of those products.”

FINRA will also focus on the controls that brokers use to monitor recommendations that could result in excess concentration in client accounts.

Social Media

FINRA will review firms’ compliance with their supervisory and record-retention obligations with respect to social media and other electronic communications.

Excessive and Short-term Trading of Long-Term Products

FINRA will evaluate firms’ ability to monitor the short-term trading of long-term products.  FINRA’s concern is that registered representatives may recommend that clients trade long-term products, including mutual funds, closed-end funds and UITs, on a short-term basis, resulting in increased costs to investors or other adverse results.  This review follows on the heels of FINRA’s September 2016 targeted exam relating to rollovers.   FINRA believes that some registered representatives are using early UIT rollovers to increase their sales credits to the detriment of clients.

In addition, FINRA urges firms to evaluate whether their supervisory systems can detect activity intended to evade automated surveillance for excessive switching activity.  For example, FINRA believes that some registered representatives may be switching customers across products to evade surveillance that focuses on switching within the same product class.

Regulation SHO

FINRA indicates that it will continue to assess firms’ compliance with SEC Regulation SHO.  The letter notes:

“In light of recent SEC enforcement actions, FINRA will focus on the locate process to ensure firms have reasonable grounds to believe securities are available for borrowing prior to accepting a short sale.  FINRA will assess firms’ preparation and use of the easy-to-borrow list as well as evaluate the adequacy of firms’ automated locate models.  FINRA has observed fails-to-deliver on settlement date, when locates are granted without the requisite reasonable grounds to believe that the security could be borrowed. Firms should continue to monitor their close-out processes and ensure that they appropriately close out fails-to-deliver by the designated close-out date pursuant to Rule 204 of Regulation SHO.”

Our Take

As is usually the case, FINRA’s letter is useful because it highlights what broker-dealers should expect from FINRA this year, and it offers practical examples. This year’s letter is noteworthy for its focus on objective criteria and factual processes, which should help broker-dealers prepare an appropriate course of action.