The much-anticipated release of the Financial Industry Regulatory Authority, Inc. (“FINRA”) 2020 Risk Monitoring and Examination Priorities Letter occurred on January 9, 2020. Why is this annual release so important to broker-dealers? In short, it serves as a roadmap to identify compliance and supervisory topics that will underpin FINRA’s examination program as 2020 unfolds. After we dig into the letter’s contents, we’ll leave you with action steps for CCOs to consider.
What’s in the FINRA letter?
In short, it highlights the areas of focus for FINRA’s risk monitoring, surveillance and examination programs for 2020 and references numerous links to Regulatory Notice to Members, FINRA Reports and other tools/resources to assist broker-dealers in complying with the examination topics. A summary of topics covered by the letter is as follows:
A. Sales Practice and Supervision
Before venturing into 2020 sales practice examination priorities, FINRA first spelled out certain areas of continued sales practice concerns noted in prior letters, including complex products, such as structured notes and leveraged ETFs, variable annuities, private placements, fixed income mark‑up/mark‑down disclosures, and representatives acting in positions of trust or authority and senior investors.
With regards to new sales practice and supervision topics of focus, FINRA went on to cover the following:
1) Regulation Best Interest (“Reg BI”) and Form CRS will be a part of examinations throughout 2020. Prior to the June 30, 2020 compliance date for Reg BI and Form CRS, FINRA plans to review firms’ readiness plans for Reg BI to obtain an understanding of implementation concerns. After the June 30 compliance date, FINRA will pivot to examining firms’ compliance with Reg BI, Form CRS and related SEC guidance and interpretations.
2) Communications with the public will continue to be evaluated for adherence with FINRA Rules 2210 (Communications with the Public), 3110(b)(4) (Supervision) and 4510 (Books and Records Requirements) along with Securities Exchange Act of 1934 (“Exchange Act”) Rules 17a-3 and 17a-4 (Books and Records Requirements). As part of this effort, FINRA will focus on:
- Private placement retail related communicationswith a focus on how firms’ review, approve, supervise and distribute such communications regarding private placement securities via online distribution platforms as well as traditional channels; and
- Digital communications will garner FINRA’s attention as they explore how firms supervise such communication channels in view of their rapid expansion (e.g., texting, messaging, social media or collaboration applications).
3) Cash management and bank sweep programs will come under scrutiny for compliance with a range of FINRA and SEC rules. While FINRA recognizes the useful features of the programs for many customers, the letter lists a number of factors that it will consider when reviewing cash sweep programs including factors addressing firms’ disclosure of the arrangements to clients. FINRA will evaluate firms’ compliance with, for example, FINRA Rule 1017 (Application for Approval of Change in Ownership, Control, or Business Operations), FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade), FINRA Rule 2210 (Communications with the Public), SEC Rule 15c3-1 (Net Capital Rule) and SEC Rule 15c3-3 (Customer Protection Rule).
4) Sales of initial public offering shares will be examined for compliance with obligations under FINRA Rules 5130 (Restrictions on the Purchase and Sale of Initial Equity Public Offerings) and 5131 (New Issue Allocations and Distributions). For example, among other areas, FINRA may review practices to detect and address potential instances of flipping.
5) Trading authorization procedures and controls will be examined to determine if supervisory systems are reasonably designed with regards to client trade authorization, discretionary account supervision of Reps and key transaction data points such as solicited versus unsolicited trades. In particular, FINRA will be on the lookout for situations where Reps are exercising discretion over client account trading without written authorization.
B. Market Integrity
1) First, FINRA outlined topics of continued focus mentioned in prior examination priority letters, including market manipulation, Trade Reporting and Compliance Engine (“TRACE”) reporting, short sales and short tenders. FINRA also reminded firms to devote sufficient resources to accuracy in Order Audit Trail System (“OATS”) reporting, along with reporting to the Consolidated Audit Trail (“CAT”) that is slated to begin for some firms in April 2020.
2) As the use of direct market access controls continue to grow, FINRA will examine for compliance with SEC Rule 15c3-5 (Market Access Rule) focusing on issues relevant to firms’ business activities and associated risks.
3) Best execution practices will remain on the FINRA radar with a focus on issues including potential conflicts in order routing decisions, such as the impact of recent increases in zero-commission brokerage activity; odd-lot handling; reasonableness of policies and procedures for best execution and fair pricing for U.S. Treasury securities; and option order execution pricing.
4) Disclosure of order routing information will be reviewed by FINRA for compliance with amended Regulation National Market System (“NMS”) Rule 606, which added to the requirements for broker-dealers to publish reports on their routing of held orders in NMS stocks and listed options. As discussed in the letter, “the amended rule requires broker-dealers to provide new customer-specific reports for not held orders in NMS stocks. These disclosures serve an important role in enhancing the transparency of the U.S. securities markets with respect to broker-dealers’ handling and routing practices for both institutional and retail customer orders.”
5) Pursuant to the SEC’s Vendor Display (Rule 603) FINRA will evaluate the adequacy of a broker-dealer’s controls and supervisory systems to provide their customers with the current consolidated NBBO as required by the Vendor Display Rule.
As pointed out in the letter, capturing and reporting the current consolidated NBBO assists customers in evaluating order routing decisions made by firms. Rule 603 of Regulation NMS (Vendor Display Rule) generally requires broker-dealers to provide a consolidated display of market data for NMS stocks for which they provide quotation information to customers.
C. Financial Management
1) As in prior years, FINRA will continue to review firms’ compliance with SEC Rules 15c3-3 (Customer Protection Rule) and 15c3-1 (Net Capital Rule) as well as firms’ overall financial risk management programs.
2) Additionally, FINRA will tackle some rather new and complex regulatory issues involving digital assets. The letter points out that “FINRA will work closely with the SEC to understand firms’ usage of and involvement with digital assets, corresponding compliance with applicable laws and whether a firm has filed a Continuing Membership Application to cover the activity.”
3) FINRA will continue to review firms’ controls regarding liquidity management practices. FINRA will focus on areas that have been addressed in Regulatory Notice 15-33 (Guidance on Liquidity Risk Management Practices), as well as those that may create challenges for clearing and carrying firms’ contingency funding plans.
4) Underwriting activities will be reviewed for compliance with net capital treatment under SEC Rule 15c3-1(c)(2)(viii), including firm procedures to assess moment-to-moment and open contractual commitment capital haircuts to a firm’s net capital computation.
5) Although not part of the examination program, FINRA noted in the letter that it will be engaging in the transition away from the use of the London Interbank Offered Rate (LIBOR) as a benchmark.
C. Firm Operations
1) As noted in its prior examination priority letter, FINRA will continue to focus on supervisory controls relating to SEC Rule 10b-10 and FINRA Rule 2232 (Customer Confirmations) and firms’ compliance with FINRA Rule 3310 (Anti-Money Laundering Compliance Program),
2) As cybersecurity threats become more prevalent, the importance of maintaining an effective cybersecurity program cannot be understated. Broker-dealers can anticipate that FINRA will assess whether their policies and procedures are reasonably designed to protect customer records and information consistent with SEC Regulation S-P Rule 30. As outlined in the letter, “FINRA recognizes that there is no one-size-fits-all approach to cybersecurity but expects firms to implement controls appropriate to their business model and scale of operations.”
3) As the use of technology platforms to operate most aspects of a broker-dealer’s business grows, firms must be aware of potential problems with change management practices, which can expose firms to operational failures that may compromise firms’ ability to comply with a range of rules and regulations, including FINRA Rules 4370 (Business Continuity Plans and Emergency Contact Information), 3110 (Supervision) and 4511 (General Requirements), as well as Exchange Act Rules 17a-3 and 17a-4.
Key Action Items:
- After reviewing the letter, CCOs, with input from senior management, should undertake a review of their written policies and procedures and annual review focus (pursuant to FINRA rules 3120 and 3130) to ensure that compliance and supervisory concerns raised by the letter are being dealt with adequately. To illustrate, if your firm isn’t conducting surveillance for relevant sales practice concerns outlined in the letter, start now by implementing a plan to do so. Furthermore, as a best practice, broker-dealers may wish to add relevant topics covered in the letter to their risk assessment inventory, which should identify risks and how such risks are mitigated by mapping to control procedures.
- If you haven’t already done so, provide the letter to senior management with some talking points describing how it relates to your firm. Clearly, getting senior management buy-in for developing and maintaining a strong compliance program is key for all firms, so providing the letter will aid the process by highlighting significant topics on FINRA’s radar that are applicable to your firm.
- And, just as importantly, don’t forget to update your training program to reflect or expand upon issues raised by FINRA’s exam priorities. Don’t hesitate to highlight portions of the letter in your training programs to capture the attention of Registered Reps and key senior management stakeholders.
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