January 10, 2014
SECURITIES & DERIVATIVES ENFORCEMENT AND REGULATORY UPDATE
FINRA Issues Priorities for 2014 On January 2, 2014, FINRA released its 2014 Regulatory and Exam Priorities Letter (“Letter”). This Letter, issued annually, highlights significant risks and issues that could adversely affect investors and market integrity in the coming year. FINRA encourages firms to use the guidance along with their own analysis to enhance their programs as they will be examining this year for strong controls and robust compliance efforts in these areas. Firms should use the Letter to review their compliance and written supervisory procedures and make revisions if necessary. Among the new priorities noted by FINRA are the focus on recidivist brokers, conflicts of interest, qualified plan rollovers, private placements, and crowdfunding portals. The letter also discusses many of the same issues addressed in prior years, including suitability, cyber-security, insider trading, anti-money laundering, senior investors, high frequency and algorithmic trading, and financial and operational priorities. The regulatory and examination priorities are classified into four broad categories defined as Business Conduct Priorities, Fraud Priorities, Financial and Operational Priorities, and Market Regulation Priorities. The following is a discussion of some of the more salient points of the FINRA letter to member firms. A copy of the Letter is available here.
Business Conduct Priorities The business conduct priorities are largely consistent with topics from last year. Suitability remains a primary concern of FINRA Staff, in particular the suitability of recommendations to retail investors of complex products that may be difficult for investors to understand. In its examinations, FINRA will focus on concentrations in longer duration instruments and speculative equities positions in retail accounts. FINRA also highlights a number of specific products due to heightened investor protection concerns. FINRA also will review the training administered to brokers to ensure that the brokers understand the products and are capable of making sufficient disclosures. The letter discusses FINRA’s focus on recidivist brokers and announces the creation of a specific Enforcement team to prosecute brokers with a pattern of complaints or sales practice abuses identified through FINRA’s recently launched High Risk Broker initiative. Consistent with its publication of its Report on Conflicts of Interest in October 2013, FINRA provides notice that its examiners will be reviewing firms’ approaches to identifying and managing conflicts and the participation of senior management in the process. These reviews will also focus on the firm’s policies regarding new product reviews, post-launch reviews, the ability of the wealth management business to make independent decisions Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, 212.839.5300; One South Dearborn, Chicago, IL 60603, 312.853.7000; and 1501 K Street, N.W., Washington, D.C. 20005, 202.736.8000.
SECURITIES & DERIVATIVES ENFORCEMENT AND REGULATORY UPDATE Page 2
about the products they offer, and the firm’s compensation structure and review of sales activity around compensation thresholds. In late December 2013, FINRA issued Regulatory Notice 13-45, Rollovers to Individual Retirement Accounts, to remind firms of their responsibilities with respect to IRA rollovers. FINRA’s focus in this area stems in part from a government report noting that employees may be encouraged to roll over their assets into IRAs without a full explanation of the options available or a determination that doing so is in the individual’s best interest. FINRA intends to examine firms’ marketing materials, the suitability of its recommendations, and supervision of qualified plan rollovers. FINRA continues to focus on firms’ activities with respect to private placements, particularly in light of recent amendments to Rule 506 of Regulation D. The amendments permit general solicitation and advertising of private placements to accredited investors. Firms should review their procedures regarding advertising and for determining that participating investors meet the definition of an accredited investor. FINRA noted that it also will be reviewing the timeliness and accuracy of private placement filings required to be submitted via FINRA’s Firm Gateway. In the anti-money laundering arena, FINRA addressed the Customer Identification Program (CIP) requirements for DVP/RVP accounts. FINRA noted what it termed as a “misconception” among executing brokers that CIP did not apply or that the prime broker was responsible for CIP. As noted by FINRA, absent a formal reliance agreement, the executing broker is responsible for performing CIP for such accounts. The Letter also discussed an executing broker’s obligation to make a reasonable inquiry when a DVP/RVP customer account is attempting to liquidate a large volume of a low-priced security, as, depending on the relevant facts, such activity could raise a red flag regarding possible violations of AML and Section 5 of the Securities Act of 1933.
Fraud Priorities FINRA remains concerned with firms’ activities involving speculative microcap and low-priced over-the-counter (OTC) securities. FINRA suggests that firms review their policies and procedures to provide heightened supervision of employees involved in outside business activities with microcap and OTC companies; provide accurate and balanced research; monitor accounts liquidating such securities; monitor for suspicious activity; and oversee the suitability of recommendations. Not surprisingly in light of the media headlines, insider trading remains a top priority. Firms are encouraged to review the adequacy of information barriers and risk controls. This includes the routine review of electronic communications, monitoring of employee trading activity, and regular review of proprietary and customer trading in securities on a firm’s watch or restricted lists.
Market Regulation Priorities The recent number of algorithmic trading malfunctions present reputational risk to firms as well as raise concerns regarding the reliability and integrity of the U.S. markets. FINRA plans to employ a dual strategy of examinations and targeted investigations to assess the adequacy of a firm’s testing and controls related to highfrequency trading and algorithmic trading strategies. Firms should review their policies and procedures for testing and monitoring these activities both pre- and post-implementation.
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FINRA continues to investigate questionable trading activities that distort the true market or appear intended to induce market participants to trade. Firms should review their due diligence procedures related to the onboarding of sponsored access clients and are reminded of their obligations under the SEC’s Market Access Rule. FINRA noted that it has observed significant, prolonged and wide-scale deficiencies related to Large Options Positions Reporting (LOPR) by firms. Firms should review their policies and procedures with respect to determining reportable options positions, the determination and reporting of in-concert positions, and position deletions and modifications. In addition, Firms should perform a top-to-bottom review of the lifecycle of an options order to determine whether the proper capacity is captured. Firms should be prepared for the Staff’s new approach to the quarterly/trimester markup/markdown and fair pricing reviews. FINRA announced new surveillance patterns for both equity and fixed income securities. The best execution surveillance for equity securities will focus on the treatment of limit orders. The fixed income surveillance will assess the execution price relative to other recently executed customer transactions on the same side of the market by the firm. There has been no dearth of fixed income pricing reviews and final disciplinary actions in the past year, and we expect Market Regulation to remain very active in this space. Firms should also review their trading activities across markets. FINRA is highly focused on trading activity across multiple market venues and has found that almost half of its manipulation-based alerts involved conduct on two or more markets.
Financial and Operational Priorities FINRA will continue to examine firms’ funding and liquidity risk and will administer a liquidity stress test to larger firms. The stress test will focus on four areas: (1) stressed funding of proprietary positions; (2) stressing of repo book; (3) stressing settlement payments and clearing deposits; and (4) funding loss of customer balances or increases in obligations to lend to customers. Firms should review their contingent funding plans and counterparty credit risk management programs. Firms also are reminded of recent amendments to Rule 17a-3 requiring certain firms to document their credit, market and liquidity risk management controls. Firms should review their policies and procedures for computing net capital and ensure that the personnel performing such functions have the requisite expertise. FINRA noted that it has observed a lack of auditor independence, particularly among small broker-dealers.
Conclusion FINRA consistently is very transparent in providing its membership with a roadmap of what to expect in the coming year. While this is helpful, it also is true that the list of priorities seems to expand each year. As stated above, firms are well-served to review their written supervisory policies and procedures in each of the priority areas and to make necessary amendments outside of the examination process.
SECURITIES & DERIVATIVES ENFORCEMENT AND REGULATORY UPDATE Page 4 If you have any questions regarding this update, please contact one of the following Sidley lawyers.
Timothy B. Nagy +1.202.736.8054
[email protected]
Hardy W. Callcott +1.415.772.7402
[email protected]
Michael D. Wolk +1.202.736.8807
[email protected]
Sidley Securities & Derivatives Enforcement and Regulatory Practice Sidley’s Securities & Derivatives Enforcement and Regulatory group advises and defends clients in a wide range of securities- and derivatives-related matters. With more than 150 lawyers in 10 offices worldwide, we provide comprehensive regulatory, enforcement, and litigation solutions in matters involving the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Financial Industry Regulatory Authority (FINRA), self-regulatory organizations (SROs), state attorneys general, and state securities regulators. Our team is distinctive in that it combines the strength of nationally recognized enforcement lawyers with the skills of equally prominent counseling lawyers. We work collaboratively to provide our clients with informed, efficient, and effective representation. To receive future copies of this and other Sidley updates via email, please sign up at www.sidley.com/subscribe
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