• FINRA Issues 2010 Annual Examination Priorities Letter
  • April 12, 2010 | Authors: Paula Golonka; Jessica F. Longobardi
  • Law Firm: Wilson Elser Moskowitz Edelman & Dicker LLP - White Plains Office
  • The Financial Industry Regulatory Authority (FINRA) conducts annual examinations of its member firms.  These examinations are risk based and their frequency, scope and content will depend on the risk, scale and nature of a firm’s operations.  On March 1, 2010, FINRA issued its 2010 Annual Examination Priorities Letter, which discusses the issues and topics that FINRA examiners will be focusing on in the upcoming year.  While we will summarize and highlight these priorities below, it is imperative that firms also review priorities letters from years prior because a member firm’s obligations under FINRA rules and regulations are ongoing.
    Areas responsive to market conditions

    In its letter, FINRA highlights several new areas of focus that reflect current industry trends.  In light of recent securities fraud headlines, it is not surprising that FINRA is taking steps on numerous fronts to tighten regulatory protections against some of the most common causes of consumer complaints.  

    These include:

    1. Growth in retail market for principal-protected notes (PPNs) and sales of reverse convertible notes.  FINRA warns firms of the need for a general suitability analysis (whether the product would be suitable for some of the firm’s clients) and then a specific suitability analysis (whether the product is suitable for the particular client seeking to invest).  Member firms should fully understand the nature of the product and ensure that sale of that product can be adequately supervised.

    2. Mergers and acquisitions between firms.  In the past year and a half, the financial industry has seen its share of mergers between firms.  It is logical that FINRA wishes to warn firms to ensure that they have adequate procedures in place.  Specifically, firms must ensure that supervisory systems are in place, that branches do not overlap and that system entitlements and trading platforms have been updated throughout and following the merger.  Firms should review the merger process to ensure proper integration, and should be cognizant of the threat of retaliation from recently laid off or disgruntled employees.

    3. Growth of high-frequency trading in an increasingly automated equities market.  This type of trading puts a heightened focus on sponsored access whereby a broker-dealer allows a third party to electronically rout orders directly to various market centers without the active participation of the sponsoring firm.  Notwithstanding, the sponsoring firm is ultimately responsible for certain legal, financial and regulatory risks associated with such an arrangement.  These firms should have written internal control and supervisory procedures to monitor this activity, including those that ensure that trade orders are free of errors and in compliance with FINRA and exchange rules.  Firms should also establish controls that systematically limit exposure arising from the trading activity.  For example, limits should be in place to reduce market exposure, including size or monetary restrictions.

    4. Increase in life settlements utilizing existing life insurance.  Firms must file a continuing membership application pursuant to the change in NASD Rule 1017 that supervisory systems are in place to review these transactions, and that firms provide guidance to their registered representatives regarding these transactions.

    5. Rule 5122 regulating Member Private Offerings, or the sale of a firm or control entity’s own unregistered securities to investors.  Under Rule 5122, firms must provide the investor with a private placement memorandum (PPM) containing certain disclosures, “file the PPM with FINRA,” and certify that 85% or more of the assets acquired will be used as stated in the PPM.  FINRA reports an increase in complaints concerning private placements in general, and advises firms to be particularly cognizant of suitability and supervision issues.

    6. SEC warnings against enhanced compensation agreements that may encourage registered representatives to act in their own best interest instead over their clients’ best interests.  FINRA also warns firms of policies concerning the transfer or liquidation of proprietary and non-propriety funds when a registered representative is hired by a new firm.  FINRA will continue to scrutinize the activities of new hires to ensure that registered representatives are acting in the best interest of their clients.

    7. Effect of economic downturn on municipalities.  FINRA reminds firms about Municipal Securities Rulemaking Board (MSRB) requirements to acquire and disclose information concerning municipal securities.  Specifically, FINRA reminds firms to ensure compliance with MSRB Rule G-17 requiring them to provide an investor with a description and material information on the municipal security, and MSRB Rule G-32 requiring the firm to provide the investor with information on how to obtain the MSRB official statement online.

    8. Recent cases involving misappropriation of client funds.  Firms must have supervisory policies and procedures in place to confirm that a request to withdraw funds from a customer account is legitimate.

    9. Rule 4110 effective February 8, 2010.  This rule requires firms to hold equity capital for one year unless special written approval is obtained from FINRA.  In addition, firms cannot withdraw capital exceeding 10% of its own excess net capital in a rolling 35-day period without prior approval from FINRA.

    Areas of operational obligations

    1. Liquidity.  Firms must have adequate liquidity, even under stressful market conditions or unexpected environmental changes.  Stress tests should be conducted to review and evaluate liquidity concerns.

    2. Market manipulation.  Firms must be aware of the potential for cross-market manipulation and should have surveillance systems in place that monitor trading for this issue.

    3. Rumors influencing market prices.  Registered representatives are prohibited from spreading rumors or information in an attempt to influence market prices.  Firms must have policies in place to prevent and monitor this type of behavior.

    4. Best execution.  FINRA reminds firms that they have an obligation to get the best price possible in fixed income transactions and to charge a reasonable mark-up or mark-down.  Furthermore, effective March 1, 2010, agency or government-sponsored fixed income instruments will be reported and disseminated TRACE-eligible securities.  Some primary market transactions will only be reportable but not disseminated.

    5. OATS system.  Firms are reminded to understand the FINRA Order Audit Trail System (OATS), which is the automated surveillance system.  Firms have a responsibility to complete accurate reporting via the OATS systems and to monitor OATS reports.  Firms will now receive a preliminary report card on the eighth business day each month warning of any compliance issues.

    Examination priorities

    In addition to highlighting new areas of focus reflecting changes in the market and certain operational obligations for member firms, the letter also outlines specific areas of focus during FINRA’s examination process this year.  FINRA will focus on examining a member firm’s policies and procedures related to each of the following areas:

    • Fraud Detection - FINRA will now investigate all allegations or conduct constituting fraud in the registered firm’s legal entity.  Firms should have complete systems in place to monitor for fraudulent activities.  Furthermore, measures must be in place to prevent fraud at the senior management level, which includes separation of duties.

    • Weak Information Barriers - Weak information barriers that do not prevent the distribution of non-public information continue to be a common problem.  It is important to have adequate controls in place to prevent the dissemination of such materials, and to monitor and identify issues of insider trading.

    • Variable Annuities - FINRA will specifically be reviewing exchanges and recommendations for annuity purchases to senior investors.

    • Protection of Customer Information and IT/Cyber-Security - Firms must have policies in place to protect customer information.  Firms must be aware of both potential threats and existing weaknesses.  Furthermore, firms should consider insider threats from former or disgruntled employees.

    • Anti-Money Laundering - It is important for firms to note that FINRA Rule 3310, effective January 1, 2010, eliminated the independent testing exception.  This will likely impact smaller firms, who may have to meet the independence requirement with a third party.  FINRA noted disciplinary action against firms for improper AML monitoring and reporting in 2009, and indicated that this will again be a focus in 2010.

    • Pandemic Preparedness/Business Continuity - Firms must have a plan in place to ensure business continuity in the event of a pandemic, natural disaster or crisis.

    • Branch Office Supervision - FINRA will conduct examinations of branches and registered representatives with multiple complaints or disclosures.  Firms should conduct internal inspections designed to address the specific business of the branch.

    • Outsourcing - While firms may outsource operational functions, firms must maintain supervision over the entities completing these functions.  Firms must complete due diligence when choosing an entity to outsource functions to, and maintain a system of control and supervision over the actions of these outsourced entities.

    • Inventory and Collateral Valuation - Policies and procedures should be in place to ensure that illiquid, structured or complex securities have an accurate market valuation.  FINRA examiners will also review the supervisory process of these valuations and the procedures for escalating discrepancies to management.

    • Customer Margin Debits Collateralized by Nonmarketable Securities - Firms should consider salability and marketability when accepting securities as collateral for margin accounts.

    • Accounting and Spreadsheet Controls - FINRA seeks to ensure that information is recorded in a manner that is accurate and can be readily maintained.  FINRA will review systems to ensure accounting accuracy and completeness of information that is not automatically posted.

    • Day-Trading Margin - Firms should ensure that customers participating in day-trading activities meet the requirements to conduct such transactions, including the use of a margin account and maintenance of a minimum of $25,000.00 equity in the account.

    • Fully Paid Lending Programs - Customers should understand that participation in lending programs with fully paid securities can result in the elimination of Securities Investor Protection Corporation (SIPC) protection and proxy voting rights.  FINRA will examine both the disclosures made concerning these transactions and the recording of said transactions.

    • Market Regulation Options Examination Program - FINRA is implementing a pilot program to review options trading activity that cannot be reviewed through automated systems.  This program will be similar to the Trading and Market Making Examination Program System (TMMS).

    • Short Sales and Regulation SHO Compliance - Short sale requirements continue to be at issue in examinations.  Firms should ensure that all short sale supervisory requirements are being met.  In addition, the SEC adopted amendments to Regulation SHO Rules 200(g) and 201 to prevent short sales from impacting the price of a stock that has decreased ten percent over the course of the trading day.  This change will become effective sixty days from publication in the Federal Register, and will give firms six months to conform to the new rule.  In addition, SHO Rule 205, effective July 31, 2009, requires a firm to deliver long equity or short sale securities by T+3.  Failure to deliver must be resolved by the purchase or borrowing of the security at the beginning of trading on T+4.  This may be extended to T+6 if the failure to deliver was due to “bona fide market making.”

    • Algorithmic Trading Controls - FINRA will complete additional examination of algorithmic trading in a firm’s proprietary accounts or consumer accounts.  There should be systems in place to ensure the proper functioning of the algorithms and proper supervision.

    As described above, FINRA has outlined a variety of different issues that it will be focusing on in its 2010 examinations.  During examinations, member firms should be prepared to address these highlighted topics, new or amended FINRA rules that require additional oversight—ensuring adequate supervisory measures, and any issues raised in prior examinations.  Specifically, firms should be prepared to gather the relevant information in a timely and organized fashion and be ready to demonstrate appropriate procedures addressing each area, and if necessary, a remedy for any deficiency.