The Financial Industry Regulatory Authority published its 2020 Risk Monitoring and Examination Priorities Letter (Priorities Letter)1 on January 9, 2020. The Priorities Letter identifies four core areas on which FINRA will focus its risk monitoring, surveillance and examination efforts in the coming year (collectively, Examination Priorities):
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Sales Practice and Supervision;
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Market Integrity;
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Financial Management; and
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Firm Operations.
Many of the topics and sub-topics addressed in the Priorities Letter have been highlighted in prior years; however, the Priorities Letter identifies certain “new and emerging areas,” including: newly adopted Securities and Exchange Commission Regulation Best Interest and Form CRS; cash management and bank sweep programs; and sales of initial public offering (IPO) shares.
As the Examination Priorities will inform FINRA’s risk monitoring, surveillance and examination programs for 2020, they provide important information about FINRA’s current areas of focus, as well as practical considerations for FINRA-supervised firms to use to assess their risk management, compliance and supervisory programs. Nevertheless, it is important to remember that the Priorities Letter is not an exhaustive list of potential examination topics for 2020. It is also important to note that this year’s FINRA examinations will be different than in prior years. FINRA has integrated its previously separate three examination programs into a single examination framework, in order to “better direct and align examination resources to the risk profiles and business models of member firms.” Under the new examination program, FINRA will group firms into one of five “main firm business models”: Retail; Capital Markets; Carrying and Clearing; Trading and Execution; and Diversified. Within each category, firms will be further categorized into sub-groups with similar business models and activities. Furthermore, each firm will be assigned a senior FINRA examination leader responsible “for the ongoing risk assessment, risk monitoring, planning and scoping of examinations tailored to the risks of the firm’s business activities.”
Sales Practice and Supervision
The Priorities Letter reaffirms FINRA’s commitment to evaluating firms’ compliance with relevant sales practice obligations and supervision requirements outlined in prior letters – these include a focus on: complex products; variable annuities; private placements; fixed income mark-up/mark-down disclosures; representatives acting in certain positions of trust or authority; and senior investors. Consistent with its 2019 examination priorities, FINRA stated that it would: continue to review firms’ compliance with obligations relating to communications with the public;2 and evaluate whether firms maintain “reasonably designed” supervisory arrangements concerning trading authorization, discretionary accounts and key transaction descriptors (e.g., solicitation indicators).
Regulation Best Interest and Form CRS
Regulation Best Interest will require firms and their associated persons (who are natural persons) to act in the best interest of a retail customer at the time of making a recommendation of any securities transaction or investment strategy involving securities to the retail customer, without placing the firm or associated persons’ financial or other interest ahead of the retail customer. In addition to this general obligation, Regulation Best Interest will impose disclosure, care, conflicts and compliance obligations on firms. Further, Rule 17a-14 under the Exchange Act will require firms to deliver the Form CRS customer relationship summary to retail investors at the earliest of: making a recommendation; placing an order; or opening an account for such investors.
In advance of the June 30, 2020 compliance date for the new requirements, FINRA plans to examine firms for their readiness to comply with Regulation Best Interest and Form CRS, in order to understand implementation challenges facing firms. Following the compliance date, FINRA, as well as the SEC, will review firms’ compliance with Regulation Best Interest and Form CRS. FINRA may take the following factors, among others, into consideration when reviewing a firm’s compliance: the firm’s procedures and training relating to the best interest standard; the application of the best interest standard by the firm and its associated persons (including in regard to account monitoring, if offered by the firm); whether the firm and its associated persons take into account the new disclosure, care, conflicts and compliance obligations under Regulation Best Interest; whether the firm and its associated persons consider “reasonably available alternatives” when making recommendations; the policies, procedures and controls the firm has in place in regard to the obligations and disclosure requirements of Regulation Best Interest; how the firm identifies and addresses conflicts of interest; and the policies and procedures of the firm in relation to production and delivery of Form CRS.
Communications with the Public
FINRA will continue to examine firms’ compliance with their obligations regarding communications with the public under FINRA Rule 2210 and related regulations. FINRA’s focus also will extend to private placement retail communications, including reviewing how firms produce and distribute to customers communications regarding private placement securities. FINRA also will review communications via digital channels, including how firms evaluate, test and solve issues with such channels.
Cash Management and Bank Sweep Programs
FINRA will assess firms’: cash management services that sweep customers’ cash into affiliated or partner banks or money market funds, for compliance with FINRA and SEC rules;3 and disclosure of such sweep programs and any available alternatives for cash management. FINRA also will review how firms reconcile customer balances at each bank within the firm’s bank sweep program, as well as how the firm presents material information regarding its cash management and bank sweep programs (e.g., amount of FDIC insurance coverage for the deposits; nature and structure of accounts; relationship of brokerage accounts to any partner banks in the program; timing of transfer of funds; nature and terms of arrangement; and risks of the program).
Sales of IPO Shares
A new priority in 2020, FINRA will focus on firms’ compliance with FINRA Rules 5130 (Restrictions on the Purchase and Sale of Initial Equity Public Offerings) and 5131 (New Issue Allocations and Distributions). In this regard, firms should review their existing IPO-related policies and procedures to determine the appropriateness of enhancements related to issue detection, offering controls and record-keeping.4 When assessing a firm’s IPO practices, FINRA may consider the following factors, among others: the firm’s policies and procedures to detect possible “flipping” activity; in instances where the firm acts as book-running lead manager, whether it provides issuers’ pricing committees with information about aggregate demand (particularly, aggregate retail demand); the firm’s controls with respect to allocations to restricted persons, as well as detecting and assessing possible “spinning” activities; and the firm’s recordkeeping and customer verification policies and procedures with respect to IPO allocations.
Trading Authorization
FINRA will continue to review firms’ supervisory systems for trading authorization, discretionary accounts and key transaction descriptors (e.g., “solicited” or “unsolicited”), in order to confirm that firms have reasonably designed supervisory systems for identifying and addressing instances of registered representatives acting with discretion in the absence of client authorization required by FINRA Rule 3260. FINRA may consider the following factors, among others, when reviewing a firm’s trading authorization practices: the firm’s surveillance of registered representatives for red flags of possible unauthorized exercise of discretion; the firm’s training of supervisory personnel to identify and address issues relating to FINRA Rule 3260; and the firm’s systems and controls for designating trades as unsolicited.
Market Integrity
FINRA will continue its focus on firms’ compliance with ongoing obligations related to market integrity, including: market manipulation; Trade Reporting and Compliance Engine (TRACE) reporting; short sales; and short tenders. FINRA noted that it will continue to provide guidance to firms preparing to report for the Consolidated Audit Trail (CAT), and that following the April 2020 compliance date, FINRA will commence its surveillance and investigative programs with respect to CAT reporting requirements.
FINRA also stressed the importance of firms devoting sufficient resources to ensure a high level of accuracy in their Order Audit Trail System (OATS) reporting.
Direct Market Access Controls
In light of continued automation and the increased speed of trading, in 2020 FINRA will evaluate firms’ compliance with Rule 15c3-5 (Market Access Rule) under the Exchange Act, with a focus on “issues relevant to firms’ business activities and associated risks.” FINRA may consider the following factors, among others, when reviewing a firm’s direct market access controls: the firm’s management and use of technology for market access systems, including controls (e.g., kill switches) to monitor for and address aberrant behavior by trading algorithms or other events having a market-wide impact; how the firm adjusts credit limit thresholds for institutional customers; whether the firm has automated its process for reversing temporary credit limit changes; whether the firm uses third-party vendor tools to comply with the Market Access Rule and the firm’s vendor due diligence; whether the firm uses third-party vendor tools for retention of direct and exclusive control over applicable thresholds; and the firm’s training for its traders related to requesting ad hoc credit limit adjustments.
Best Execution
As in prior years, FINRA reminded firms of their best execution obligations to customers. FINRA noted that, when reviewing the quality of execution provided to customers, firms should consider: changes in market structure (particularly, the continued automation of equity markets); the standardization of options; and advances in trading technology and communications in fixed income markets.
FINRA will focus its examinations on: potential conflicts of interest in order routing decisions (including the impact of the growth of zero-commission brokerage activity); odd-lot handling; U.S. Treasury securities; and options. FINRA may consider the following factors, among others, when reviewing a firm’s best execution practices: the controls the firm has in place for best execution for fixed income and options trading; whether the firm exercises its best execution obligation with respect to regular and extended-hour trading; and whether the firm considers informational risk in execution orders to a particular venue.
Disclosure of Order Routing Information
FINRA will continue to review firms’ compliance with amended Regulation National Market System (NMS) Rule 606, which requires broker-dealers to publish reports on their routing of held orders in NMS stocks and listed options. FINRA may consider the following factors, among others, when reviewing a firm’s compliance with Rule 606: the firm’s technical compliance with Rule 606; policies and procedures the firm has in place for the accuracy and timeliness of its reports; if the firm claims an exemption from reporting “not held” orders, the policies and procedures in place to ensure that an order does not meet the relevant Rule 606 reporting threshold; and the firm’s receipt and analysis of third-party routing services and data from other sources for the firm’s reports.
Vendor Display Rule
FINRA will evaluate firms’ compliance with Regulation NMS Rule 603 (Vendor Display Rule), which requires broker-dealers to deliver a consolidated display of NMS stock market data for which the broker-dealer provides quotation information to customers, as well as the firm’s controls and supervisory systems to provide their customers with the current consolidated national best bid or offer (NBBO). FINRA may take the following factors, among others, into consideration when reviewing a firm’s controls related to its compliance with the Vendor Display Rule: the firm’s systems and platforms that provide quotation information to customers; the firm’s monitoring of whether current quotation information is provided to customers; how the firm makes quotation information available when customers place orders; and how the firm reviews its compliance with the rule.
Financial Management
FINRA will continue to evaluate firms’ compliance programs related to Exchange Act Rules 15c3-3 (Customer Protection Rule) and 15c3-1 (Net Capital Rule), and, more broadly, firms’ financial risk management programs. FINRA also will continue to review firms’ compliance programs related to digital assets, liquidity management and contractual commitments arising from underwriting activities, as well as their preparation for the transition from using LIBOR as a reference rate.
Digital Assets
FINRA will examine firms’ digital asset activities in light of the heightened use of digital assets, as well as the increase in applications for new and continuing FINRA membership from firms seeking to engage in such activities. In July 2019, FINRA and the SEC released a joint statement on digital assets, which focused on custody, non-custodial services and firms’ obligations under relevant regulations.5 FINRA noted in the Priorities Letter that, when reviewing a firm’s digital asset activities, FINRA will focus on, among other things: whether the firm has filed any required continuing membership applications; descriptions of the firm’s digital asset activities in marketing materials; the firm’s communications regarding such activities, including clearing and custody activities (for example, with respect to potentially misleading communications implying that activities conducted through an affiliate are offered under the supervision of the broker-dealer); and the firm’s controls and procedures for digital asset transactions.
Liquidity Management
FINRA reiterated that firms should be mindful of Regulatory Notice 15-33 when assessing the effectiveness of their current liquidity management plans.6 FINRA noted that, among other things, it will focus its evaluation on: how the firm’s risk management practices respond to stress scenarios impacting the firm’s market; credit and liquidity risks; whether the firm’s contingency funding plan takes into consideration the quality of collateral, term mismatches and potential counterparty loss of the firm’s financing desks (particularly with respect to repo and stock loan transactions); and the firm’s consideration of operational risks if the firm is a Fixed Income Clearing Corporation member.
Contractual Commitment Arising From Underwriting Activities
FINRA will continue to assess firms’ compliance with their obligations pursuant to Rule 15c3-1(c)(2)(viii) under the Exchange Act when they engage in underwriting activities. In reviewing a firm’s underwriting activities, FINRA may take the following factors, among others, into consideration: the firm’s understanding of its underwriting activities (particularly, the distinction between best efforts and firm commitment underwriting) and maintenance of a list of all deals in which it participates; whether the firm makes a record of the appropriate contractual commitment charges; the firm’s processes for determining moment-to-moment and open contractual commitment charges; the firm’s tracking of the appropriate net capital treatment of the firm’s underwritings; and the firm’s documentation of its compliance with regulatory requirements.
Transition from LIBOR
Outside of its examination program, FINRA will engage with firms to assess how they are preparing for the discontinuance of LIBOR as a reference rate in December 2021. In this regard, FINRA will focus on: firms’ exposure to financial products linked to LIBOR; steps firms are taking for the transition; and the impact of LIBOR’s discontinuance on firms’ customers.
Firm Operations
FINRA will continue to assess firms’ supervisory controls related to certain areas of firm operations, including customer confirmations and anti-money laundering compliance programs.7
Cybersecurity
Cybersecurity remains an examination priority. Acknowledging that it will tailor a particular examination to the examined firm, FINRA noted that its cybersecurity examinations will focus on the firm’s policies and procedures to safeguard customer information and records in compliance with Rule 30 under Regulation S-P.
Technology Governance
FINRA will continue its reviews of firms’ technology governance programs, with particular emphasis on compliance with regulations related to firms’ policies regarding: change- and problem-management practices; and technology governance.8 FINRA expects to review firms’ controls and mitigation systems related to customer access and information and technology governance programs testing. Factors that FINRA may consider include, among others,: if there have been material changes in the firm’s business and whether those changes have been reflected in the firm’s business continuity plan (BCP) as required by FINRA Rule 4370; how the firm will maintain customers’ access to their funds and services, as well as the firm’s managed back-office operations, if a BCP occurs; how the firm controls for mitigating system capacity performance and integrity issues; what procedures the firm uses to document system change requests and approvals; how the firm tests system changes prior to their introduction into a production environment; and how the firm tracks information technology problems and their remediation.
Conclusion
FINRA’s Examination Priorities continue to provide a useful tool for broker-dealers to evaluate their current practices and procedures, and to determine whether updates to their existing practices are necessary or appropriate. Moreover, FINRA’s description of its new examination process, as well as the new examination items, may be helpful to firms when contemplating preparation for examinations over the coming year.
Footnotes
