FINRA Examination Report:
On December 7, FINRA published its 2018 Report on FINRA Examination Findings (“2018 Report”). The 2018 Report includes a collection of FINRA’s observations from recent examinations of firms, highlighted due to their potential significance, frequency and impact on investors and the markets. Areas of focus in the 2018 Report include:
Suitability for Retail Customers
- FINRA observed that firms with comprehensive supervisory practices for suitability identified risks, developed policies and implemented controls tailored to their products and customer base.
- FINRA’s findings included overconcentration in customer accounts, excessive trading, unsuitable variable annuity recommendations and findings from a targeted examination of volatility-linked products.
Fixed Income Mark-Up Disclosure
- On May 14, 2018, FINRA and the Municipal Securities Rulemaking Board (MSRB) implemented amendments to FINRA Rule 2232 (Customer Confirmations) and MSRB Rule G-15, requiring firms to provide additional transaction-related information to retail customers for certain trades.
- FINRA found that, in implementing the required changes, some firms failed to enter information into their order entry systems, performed improper adjustments to prevailing market price, inadequately disclosed trades conducted on an agency basis and incorrectly designated institutional accounts, among other challenges.
Reasonable Diligence for Private Placements
- FINRA observed firms that have suitability obligations under FINRA Rule 2111 failed to conduct reasonable diligence on private placements and failed to meet their supervisory requirements under FINRA Rule 3110.
- FINRA noted firms that performed reasonable diligence conducted meaningful, independent research on material aspects of the offering, identified any red flags with the offering and the issuer and addressed and resolved concerns that would be relevant to a potential investor.
- Firms’ diligence processes included: creating a due diligence committee or formally designating one or more qualified persons to determine whether to approve the offering for sale to investors; independently verifying information key to the performance of the offering; and receiving support from due diligence firms, experts and third-party vendors.
- FINRA observed instances where some firms failed to perform reasonable diligence on private placement offerings prior to recommending the offerings to retail investors, including failing to perform additional research about new offerings, failing to discuss the offering in greater detail with the issuer or independently verify, research or analyze material aspects of the offerings, overreliance on third-party vendors and utilizing potentially conflicted third-party due diligence reports.
- FINRA reminded firms conducing diligence by the reasonable-basis suitability obligation to document both the “process and results” of such reasonable diligence analysis.
Abuse of Authority
- FINRA reminded firms that roles where customers give registered representatives authority to act on their behalf can expose investors to material risks unless firms implement appropriate controls. To mitigate these risks, FINRA observed that firms generally established and maintained robust supervisory procedures and controls.
- FINRA observed situations where some firms or registered representatives exposed investors to unnecessary risks and firms had not established controls to mitigate those risks including registered representatives who exercised discretion in customer accounts without the customers’ prior written authorization or the firm’s approval and after the authority to do so had expired, among other issues.
Anti-Money Laundering (AML)
- In the 2018 Report, FINRA continued to highlight challenges observed in some firms’ compliance with AML obligations, previously discussed in the 2017 Report on FINRA Examination Findings. These challenges include:
- Questionable ownership status of foreign legal entity accounts.
- Lack of documentation of investigations of potentially suspicious activity; firms that used exception reports did not document initial reviews and investigations into potentially suspicious activity identified by the reports and failed to establish a formal investigation management process.
- Failure to comply with Section 314(a) of the USA PATRIOT Act and failure conduct reviews of FinCEN’s Secure Information Sharing System on a bi-weekly basis, or lack of documentation of these reviews.
- Additionally, FINRA continued to find problems with the adequacy of AML programs overall, the allocation of AML monitoring responsibilities (particularly responsibilities for trade monitoring) data integrity in AML automated surveillance systems (especially in suspense accounts for processing foreign currency money movements and conversions), firm resources for AML programs and independent testing of AML monitoring programs.
Accuracy of Net Capital Computation
- FINRA observed firms that faced challenges in complying with the Securities Exchange Act of 1934 (“Exchange Act”) Rule 15c3-1 (“Net Capital Rule”) and related guidance from the SEC staff. FINRA’s observations focused on:
- Insufficient documentation regarding expense-sharing agreements, including documentation to substantiate a methodology for allocating specific broker-dealer costs to the firm or an affiliate, and expense-sharing agreements that did not establish a method of payment of certain expenses by the firm as opposed to a third party.
- Incorrect inventory haircuts caused by firms that did not adequately design or document policies and procedures for assessing the creditworthiness of certain securities or money market instruments to determine whether these products have a “minimal amount of credit risk,” pursuant to Exchange Act Rule 15c3-1(c)(2)(vi)(i).
- Inaccurate operational charges due to misinterpretations of the Net Capital Rule, e.g. by failing to take appropriate haircuts in non-purpose equity securities borrowed transactions or in certain underwritings.
FINRA highlighted several other areas in the 2018 Report including liquidity management practices, segregation of client assets, registering certain firm personnel engaged in “back office” covered functions as Operations Professionals, maintaining adequate supervisory programs and disclosure requirements relating to customer confirmations, best execution and market access controls, among other things. The 2018 Report can be read in its entirety here.
Updated SEC Guidance:
The Division of Trading and Markets provided updated guidance as of November 29, 2018 concerning amendments to the broker-dealer reporting rule, Rule 17a-5 under the Securities Exchange Act of 1934 (“Rule 17a-5”), adopted on July 30, 2013 titled “Frequently Asked Questions Concerning the July 30, 2013 Amendments to the Broker-Dealer Financial Reporting Rule.”
The new frequently asked questions cover a variety of areas regarding the Rule 17a-5 amendments, including:
The scope of Internal Control Over Compliance as it relates to compliance with the Account Statement Rule of a broker-dealer’s designated examining authority (“DEA”).
Establishing a “Special Account for the Exclusive Benefit of Customers” if a broker-dealer makes a claim of exemption from Rule 15c3-3 under paragraph (k)(2)(i).
Circumstances in which broker-dealers that act as an intermediary pursuant to Exchange Act Rule 15a-6 would be required to prepare a Computation for Determination of Reserve Requirements and maintain a reserve in a Special Account for the Exclusive Benefit of Customers and also adhere to possession or control requirements.
The content of a broker-dealer’s exemption report with regard to identifying both paragraphs (k)(2)(i) and (k)(2)(ii) of Rule 15c3-3 as the exemptions under which the broker-dealer claims in its exemption report.
The appropriate treatment under the Rule 15c3-3 Customer Reserve Formula for research and brokerage services with commission dollars generated by account transactions ("soft dollar") liabilities under section 28(e) where the broker-dealer does not remit cash to the counterparty but pays invoices meeting the safe harbor.
How a broker-dealer can demonstrate that it has “verified” all securities subject to paragraph (b)(3) of Exchange Act Rule 17a-13.
Fingerprint Fee Change:
Broker-dealers are advised of the upcoming fingerprint fee change. Effective January 1, 2019, the FBI fingerprint fee will increase from $10.00 to $11.50 for both electronic and hard copy submissions. The total fingerprint fees (the FBI fee together with the FINRA fee) that firms may be assessed for each fingerprint transaction submitted to FINRA will increase to $26.50 for electronic submissions and $41.50 for hard copy submissions. More information can be found here.