On January 11, 2013, FINRA released its 2013 examination priorities letter (the “Letter”). The Letter identifies four primary categories as the focus of FINRA’s upcoming examinations and enforcement efforts – Business Conduct and Sales Practice Priorities, Insider Trading, Financial and Operational Priorities, and Market Regulation Priorities. Within each category, FINRA identifies the broad concerns, products and investment types that will be subject to closer regulatory scrutiny. This year, the Letter also identifies some specific areas of caution.
In the first category, Business Conduct and Sales Practice Priorities, FINRA warns that “retail investors have been challenged to find attractive returns within their risk tolerance”, and cautions of sales practice abuse and yield-chasing behavior for retail investors with a low risk tolerance. In this context, FINRA will continue to focus on suitability and complex products, highlighting in the letter FINRA’s recently revised suitability rule, and adding business development companies (“BDCs”) and closed-end funds to its list of complex products. FINRA warns that BDCs expose investors to significant market, credit and liquidity risks and the newer “non-traded BDC funds” can limit investors’ exit opportunities to “periodic share repurchases by the BDC at high discounts.” FINRA also warns that some closed-end funds are returning capital to maintain high distribution rates, causing the fund to trade at high premiums compared to the fund’s NAV. Also new to the list of complex products is FINRA’s focus on automated investment advice programs. FINRA is concerned that such programs, used to dispense automated investment advice to retail clients, may not gather the necessary information attributes of the investor to determine an investment profile, or that the platforms may fail to properly match securities with the investor’s risk appetite.
FINRA notes that examiners will focus on “suitability of recommendations, the broker’s level of product-specific knowledge, the level of due diligence in assessing the risk tolerance and liquidity needs of the customer when making investment recommendations, the manner in which material risk exposures are disclosed to customers and the impact on broker compensation associated with competing investment alternatives.”
In the second category, Insider Trading, FINRA emphasizes that member firms must be vigilant in safeguarding material, non-public information and periodically assess information barriers and risk controls to ensure they are adequate. FINRA lists six examples of such risk controls, including routine review of electronic communications, maintaining information barrier policies, monitoring employee trading activity, maintaining watch/restricted lists, employee training and creating a process for identifying suspicious customer trading in securities of their employer or corporate affiliates.
The majority of FINRA’s discussion on the third category, Financial and Operational Priorities, centers around GAAP and firms’ accurate accounting for guarantees and contingencies, stating “[r]ecent net capital reviews have detected deficiencies by firms regarding the accounting of guarantees and contingencies…FINRA is focused on whether firms are identifying all contingencies and guarantees, and have documented the basis for any associated liability accrual or lack thereof.” The Letter also highlights concerns in the area of margin lending and emphasizes the need for accurate recording and reporting of required liabilities, securities valuation issues and the concentration of market, credit and liquidity risk concentrations on the balance sheet.
The Letter’s final major category, Market Regulation Priorities, notes FINRA’s concern as to the effect of a disruption to the financial services market structure and highlights several areas of risk such as, algorithmic trading and the potential for algorithmic trading failures; high-frequency trading abuses and manipulation such as “momentum-ignition switches” and “layering”; alternative trading systems (“ATS”) and the manner in which they are being operated including routing, disclosure of order types and error handling; options origin codes and improper coding and order priority; large option position reporting and misreporting positions as required by exchange rules; and fixed income trading issues such as best execution and inter-positioning. For each of these focus areas, FINRA outlines specific areas of potential review and in certain circumstances informs of upcoming sweep examinations.
Other areas included in the 2013 priorities letter that were not in the 2012 letter include cyber-security and data integrity, and as mentioned above, ATSs. Notably, social media and electronic communications were among the more significant items in FINRA’s 2012 letter that were not addressed in the 2013 letter.
Firms subject to FINRA review should read the 2013 letter and, with the assistance of counsel, ensure that the firm has policies and procedures in place to effectively address the areas so outlined.
