FINRA EXAMINATIONS
- 3. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 3 The Financial Industry Regulatory Authority (FINRA) is a self‐regulatory organization authorized by the United States Congress to protect America’s investors by making sure the broker‐dealer industry operates fairly and honestly. FINRA examines firms and associated persons for compliance with securities laws, regulations and rules, and, where appropriate, also exercises its regulatory powers to investigate, initiate enforcement action and impose sanctions. Examinations are central to FINRA's regulatory operations, and they are one of the principal means by which the organization acts to protect investors and promote market integrity. On December 7, 2018, FINRA published its 2018 Report on Examination Findings detailing observations from recent exams of member firms that it considers worth highlighting because of potential significance, frequency, and impact on investors and the markets. On January 22, 2019, FINRA published its 2019 FINRA Risk Monitoring and Examination Priorities Letter. This year FINRA broadened the scope of the letter to more explicitly include its priorities for risk monitoring. The 2018 Exam Findings and the 2019 Examination Priorities along with practices FINRA has observed to be effective in certain circumstances are discussed in the first two sections below. Finally, the last section below will detail an insider’s look at how to plan for a FINRA exam. Below is a topical summary of key findings highlighted by FINRA during the 2018 exam cycle plus additional observations. Highlighted Findings 1. Suitability for Retail Customers FINRA continues to observe unsuitable recommendations by associated persons to retail investors as well as deficiencies in some firms’ supervisory systems for registered representatives’ activities. The key issues are: Overconcentration Excessive Trading Unsuitable Variable Annuity Recommendations 2. 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. FINRA’s observations found the following common issues. Failure to Enter Information Into the Firms’ Order Entry Systems Improper Adjustments to PMP 2018 Report on Examination Findings
- 4. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 4 Inadequate Disclosure for Trades Conducted on an Agency Basis Failure to Provide Disclosure for Structured Notes Incorrect Designation of Institutional Accounts Failure to provide disclosures to certain customers Improper Security‐Specific Hyperlinks and Brief Descriptions Vendor Challenges 3. Reasonable Diligence for Private Placements FINRA has observed instances where some firms have failed to conduct reasonable diligence on private placements under FINRA Rule 2111 (Suitability) and failed to meet their supervisory requirements under FINRA Rule 3110 (Supervision). Specifically, reasonable diligence was not sufficient in scope or depth to be considered a “reasonable investigation of the issuer and the securities.” Some of those instances are listed below. No Reasonable Diligence Overreliance on Third Parties Potentially Conflicted Third‐Party Due Diligence 4. Abuse of Authority FINRA has observed situations where some firms or registered representatives exposed investors to unnecessary risks and firms had not established controls to mitigate those risks. Some of those instances are listed below. No Authorization Expired Authorizations Mismarking Order Tickets False Statements and Blank Forms Abuse of Trustee Status Summary of Additional Observations FINRA continues to observe challenges in other areas of a firms’ compliance and operations areas: Topic Observations Anti‐Money Laundering Questionable Ownership Status of Foreign Legal Entity Accounts No Documentation of Investigations of Potentially Suspicious Activity Irregular and undocumented 314(a) Searches Liquidity Extended Stress Test Period Improvements to Business Models Accuracy of Net Capital Computations Insufficient Documentation Regarding Expense‐Sharing Agreements Incorrect Inventory Haircuts Inaccurate Operational Charges
- 5. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 5 Topic Observations Segregation of Client Assets Inconsistent Check‐Forwarding Processes Challenges With Possession and Control Inaccurate Reserve Formula Calculations Operations Professional Registration Unregistered Individuals Approving General Ledger Journal Entries Unregistered Supervisors Unregistered Individuals Approving Business Requirements Best Execution No Execution Quality Assessment of Competing Markets No Review of Certain Order Types No Evaluation of Required Factors DBAs and Communications With the Public Failure to Disclose Firm Name No Hyperlink to FINRA’s BrokerCheck Inadequate WSPs or Controls Customer Confirmations Inaccurate Disclosure of Capacity Mislabeled Disclosure of Compensation Incorrect Disclosure of Average Price No Disclosure of Market Maker Status Inadequate Supervision TRACE Reporting Overreliance on FINRA List Late and Inaccurate Reporting Inaccurate Indicators and Identifiers Insufficient WSPs Market Access Controls Inadequate Pre‐Trade Financial Controls Overreliance on Third‐Party Vendors As noted above, FINRA continues to see recurring issues in certain business and operations areas at member firms. Being aware of the trends that FINRA identifies can help member firms evaluate selected areas of its business and operations to identify potential shortcomings and take steps to remediate those shortcomings. FINRA has historically taken firms’ proactive and timely corrective action measures into consideration when determining examination outcomes. The identification and timely remediation of deficiencies can potentially help your firm avoid or minimize formal action, including censures and/or fines, taken by FINRA. The 2019 Examination Priorities letter published in January begins with new priorities and then discusses priorities in areas of ongoing concern with an emphasis on aspects of those topics FINRA has not articulated in prior letters. Firms should expect FINRA to cover the typical areas as well as a focus on risks related to associated persons who have a problematic regulatory history. Below, we’ll review the key areas FINRA discussed in this year’s letter. 2019 Annual Examination Priorities
- 6. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 6 Highlighted Topics 1. Online Distribution Platforms FINRA has found that firms increasingly are involved in the distribution of securities through online platforms in reliance on Rule 506(c) of Regulation D and Regulation A. FINRA is concerned that some member firms assert they are not selling or recommending securities when involved with online distribution platforms despite evidence to the contrary, including handling customer accounts and funds, or receiving transaction‐based compensation. 2. Fixed Income Mark‐Up Disclosure FINRA will review firms’ compliance with their mark‐up or mark‐down disclosure obligations on fixed income transactions pursuant to amendments to FINRA Rule 2232 (Customer Confirmations) and MSRB Rule G‐15, which became effective on May 14, 2018. FINRA will also review for any changes in firms’ behavior that might be undertaken to avoid their mark‐up/mark‐ down disclosure obligations. 3. Regulatory Technology FINRA has found that member firms are using a variety of innovative regulatory technology (RegTech) tools to make their compliance efforts more efficient, effective and risk‐based. FINRA will likely engage with firms to understand how they are using such tools and addressing related risks, challenges or regulatory concerns, including those relating to supervision and governance systems, third‐party vendor management, safeguarding customer data and cybersecurity. Items of Ongoing Concern and Focus FINRA identified the below as areas of ongoing concern. Firms should expect that FINRA will review for compliance regarding these ongoing areas of focus. Topic Focus Areas Suitability Deficient quantitative suitability determinations and/or related supervisory controls; Overconcentration in illiquid securities; and Recommendations to purchase share classes that are not in line with the customer’s investment time horizon or held for a period that is inconsistent with the security’s performance characteristics.
- 7. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 7 Topic Focus Areas Senior Investors How firms are protecting senior investors and those approaching retirement from fraud, sales practice abuses, and financial exploitation; Supervision of accounts where registered representatives serve in a fiduciary capacity; and Controls regarding firm’s obligations under amendments to FINRA Rule 4512 (Customer Account Information) and new FINRA Rule 2165 (Financial Exploitation of Specified Adults). Outside Business Activities and Private Securities Transactions Controls related to associated persons’ outside business activities and private securities transactions, including associated persons raising funds from their customers away from their firm and outside of their firm’s supervision. Supervision of Digital Assets Business Processes related to digital assets as well as the related supervisory, compliance and operational controls associated with activities related to digital assets. Customer Due Diligence and Suspicious Activity Reviews Compliance with FinCEN’s Customer Due Diligence (CDD) rule, which became effective on May 11, 2018; and Data integrity of suspicious activity monitoring systems, as well as the decisions associated with changes to those systems. Best Execution Firms’ best execution decision‐making; and How firms check additional venues for potential price improvement and quantify the benefits to customers from firms’ receipt of order routing inducements. Market Manipulation Manipulative trading in correlated ETPs, including those that track common, broad market indices; and Potential manipulation across correlated options products (e.g., options on broad market indices and options on ETFs overlying the same indices). Market Access Compliance with the Market Access Rule (Rule 15c3‐5), focusing on application and testing of appropriate controls and limits; and addressing of exceptions; and Monitoring of customers’ activity and maintenance of policies and procedures, to detect and prevent potentially manipulative or other prohibited trading activity. Short Sales Structuring of aggregation units in a manner that is consistent with the requirements and demonstration of the independence of the units through measures such as separate management structures, location, business purpose, and P&L treatment. Short Tenders Accounting for options positions when tendering shares in an offer.
- 8. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 8 Topic Focus Areas Credit Risk Policies and procedures for identifying, measuring and managing credit risk; and Identification and addressing of all relevant risks upon extension of credit. Funding and Liquidity The updating of stress testing assumptions in light of changes in the marketplace, such as the increased volatility experienced at various points in 2018. As a best practice, we recommend that member firms review FINRA’s annual priorities letters to be aware of what topics FINRA is focusing on in a given year. Even if your firm underwent a FINRA exam the year prior, as a member firm you should have an understanding of what FINRA finds to be of particular interest and concern on an ongoing basis. As you evaluate the soundness of your firm’s compliance program, you may want to consider FINRA’s latest areas of focus and if they apply to your firm’s business lines and activities, it may be a good idea to determine the effectiveness of your firm’s compliance program as it relates to FINRA’s focus areas. FINRA determines its examination plan at the end of each year in preparation for the year ahead. The organization maintains a risk‐based examination framework and determines the frequency of examinations based on its identification and assessment of risks at member firms. Historically, every member firm has been subject to a FINRA examination at a minimum once every four years, with the riskiest firms being examined as often as annually. FINRA uses nine risks to inform its examination and surveillance program. These risks are continuously monitored by FINRA’s surveillance department and are important factors considered during FINRA’s exam planning process. Nine Risks These nine risks are separated into two categories: financial and operational risks, and sales practice and business conduct risks. Financial and operational risks focus on the firm’s finances and infrastructure established to effectively run its business. Sales practice and business conduct risks focus on the firm’s sales practices and interactions with the investing public. Overview of the Examination Planning Process
- 9. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 9 Risk Category Expectations Liquidity Financial and Operational Risk FINRA recommends that firms: o rigorously evaluate their liquidity needs related to both market‐wide and idiosyncratic stresses; o develop contingency plans so that they have sufficient liquidity to weather those stresses; and o conduct stress tests and other reviews to evaluate the effectiveness of their contingency plans. Credit Financial and Operational Risk FINRA expects firms to pay attention to, and manage, the margin borrowing of their clients. Market Financial and Operational Risk FINRA expects firms to understand the marketable securities it carries and how they may impact the firm. Firms should evaluate positions they hold and understand how sensitive they are to market changes. Nine Risks used in FINRA's Examination and Surveillance Program Liquidity Credit Market Net Capital Operational Segregation of Client Assets Fraud and Deception Money Laundering Sales
- 10. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 10 Risk Category Expectations Net Capital Financial and Operational Risk FINRA expects firms to monitor the accuracy of its net capital computation and the adequacy of its net capital as it relates to the business it is conducting. Firms must take steps to ensure that the FOCUS reports they file are accurate. Operational Financial and Operational Risk FINRA expects firms to: o have governance over technology and cybersecurity; o maintain accurate books and records; and o ensure that its compliance department is functioning properly. Segregation of client assets Financial and Operational Risk Firms are required to protect customer funds and securities per the Customer Protection Rule of the Securities Exchange Act of 1934 (Rule 15c3‐3). A firm that is obligated to maintain custody of customer securities and safeguard customer cash must segregate these assets from its proprietary business activities. Fraud and deception Sales Practice and Business Conduct Risks FINRA expects firms to establish adequate frameworks to prevent, detect and deter fraudulent and deceptive activity. Some examples of this type of deceptive activity includes misrepresentations or omissions, unauthorized trading, churning, insider trading, misappropriation, and financial fraud. Money Laundering Sales Practice and Business Conduct Risks FINRA expects firms to comply with AML rules under FINRA Rule 3310, which sets forth minimum standards for a firm’s written AML compliance program. Sales Sales Practice and Business Conduct Risks FINRA expects firms and registered representatives to meet their suitability obligations. Being aware of the above nine risks can help a member firm understand what goes into FINRA’s risk based assessments which then drive regulatory responses, one of which is an examination. Other FINRA regulatory responses include “Cause” and “Branch” exams, High Risk Registered Representative exams, sweep initiatives, and a number of others.
- 11. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 11 Examinations are central to FINRA's regulatory operations, and they are one of the principal means by which the organization acts to protect investors and promote market integrity. At the end of an examination, FINRA generally prepares a report addressing selected aspects of that firm’s compliance with specific securities laws and regulations. The subject firm must address the issues identified by FINRA, and many firms do so by proactively taking corrective action before FINRA’s exam is concluded. Sia Partners has former FINRA regulatory and examination staff in its talent pool whom have managed and executed FINRA examinations of all types of broker‐dealers in the United States. With nearly 15 years of collective regulatory experience examining broker‐dealers ranging from the largest to the smallest, our staff can help prepare your firm for its next FINRA exam. Sia Partners can assess your firm’s compliance/risk program to determine its current state as it relates to regulations applicable to your firm Sia Partners can identify any areas of potential gaps in your program requiring remediation Sia Partners can prepare a summary report documenting recommendations to resolve any gaps in your firm’s program Sia Partners can assist your firm in implementing an adequate compliance program, which can include, but is not limited to policy and procedure development, independent testing, and ongoing review The Sia Partners team utilizes its in depth knowledge of the most recent global and domestic regulations while performing the assessment Sia Partners’ deep understanding of current industry best practices is used to ensure that any gaps in your firm’s program are identified Sia Partners’ experience with FINRA’s regulations, FinTech and Automation can help your firm’s compliance/risk department operate more efficiently Sia Partners’ team of subject matter experts can provide solutions to fix any identified gaps in your compliance department In addition, Sia Partners can run mock exams with your firm to determine your firm’s readiness for its next FINRA exam. Finally, Sia Partners can assist your firm not only in preparing for a FINRA exam but also getting through a FINRA exam by helping address inquiries and requests for information, draft written responses, and attend meetings with FINRA staff. 1. Assess 2. Identify Gaps 3. Recommend Solutions 4. Implement Solutions How Sia Partners Can Help You
- 12. Sia Partners | INSIGHT | IS YOUR FIRM READY FOR ITS NEXT FINRA EXAM?| March 2019| 12 Your contacts ABOUT SIA PARTNERS Founded in 1999, Sia Partners is an independent global management consulting firm and pioneer of Consulting 4.0 with over 1,400+ consultants and 23 offices in 15 countries. Through unparalleled industry expertise, Sia Partners delivers superior value and tangible results for its clients. True to its innovative approach, Sia Partners explores the possibilities offered by Artificial Intelligence, invests in data science and develops consulting bots. Sia Partners is a global partnership wholly owned by its executives. DANIEL H CONNOR CEO US + 1 (862) 596 ‐ 0649 daniel.connor@sia‐partners.com ZOYA ASHIROV Senior Manager + 1 (917) 330 ‐ 5536 zoya.ashirov@sia‐partners.com LIANA MARZANO Senior Consultant + 1 (732) 403 ‐ 4167 liana.marzano@sia‐partners.com ABU DHABI | AMSTERDAM | BRUSSELS | CASABLANCA | CHARLOTTE | DENVER | DOHA DUBAI | HONG KONG | HOUSTON | LONDON | LUXEMBOURG | LYON | MILAN | MONTREAL NEW YORK | PARIS | RIYADH | ROME | SEATTLE| SINGAPORE | TOKYO | TORONTO CHRISTOPHER PEARSON Associate Partner + 1 (917) 969 ‐ 8457 christopher.pearson@sia‐partners.com