FINRA’s Top 14 Exam Findings from 2018
FINRA recently published its 2018 Report on FINRA Examination Findings, its second annual report detailing observations from recent exams of firms. The report is the latest resource FINRA makes available to firms as a result of its ongoing organizational improvement initiative, FINRA360.
The 2018 Report on FINRA Examination Findings includes a collection of FINRA’s observations from recent examinations that it considers worth highlighting because of their potential significance, frequency, and impact on investors and the markets. It describes practices the organization has observed to be effective in certain circumstances. Below is a list of highlighted observations included in the Summary Report.
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. FINRA warns that firms should also consider the guidance in Regulatory Notice 18-15 to determine whether certain representatives engaging in repeated misconduct should be subject to special supervisory procedures, such as a heightened supervision plan.
FINRA observed situations where registered representatives did not adequately consider the customer’s financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors when making recommendations; in others, they failed to take into account the cumulative fees, sales charges or commissions.
In some cases, unsuitable recommendations involved complex products (such as leveraged and inverse exchange-traded products (ETPs), including exchange-traded funds (ETFs) and notes (ETNs)). In other cases, they involved overconcentration in illiquid securities, variable annuities, switches between share classes, and sophisticated or risky investment strategies.
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, which require firms to provide additional transaction-related information to retail customers for certain trades in corporate, agency and municipal debt securities (other than municipal fund securities). This information includes the mark-up or mark-down for principal trades with retail customers that a firm offsets on the same day with other principal trades in the same security. Disclosed mark-ups and mark-downs must be expressed as both a total dollar amount for the transaction and a percentage of prevailing market price (PMP).
To ensure effective implementation of the rules, FINRA is telling firms to consider performing a regular review of confirmations to ensure that they include the new disclosures on all confirmations that require them. In particular, firms should consider reviewing samples of their confirmations for all of the required disclosure elements, including the mark-up or mark-down, the time of execution and the security-specific link (with CUSIP).
Reasonable Diligence for Private Placements
FINRA has observed instances where some firms that have suitability obligations under FINRA Rule 2111 (Suitability) failed to conduct reasonable diligence on private placements and failed to meet their supervisory requirements under FINRA Rule 3110 (Supervision). FINRA Regulatory Notice 10-22 describes the circumstances under which firms have an obligation to conduct a “reasonable investigation” by evaluating “the issuer and its management; the business prospects of the issuer; the assets held by or to be acquired by the issuer; the claims being made; and the intended use of proceeds of the offering.”
FINRA reminds firms conducting diligence required by the reasonable-basis suitability obligations to document both the “process and results” of such reasonable diligence analysis. Although firms may use a risk-based approach to documenting compliance with the suitability rule, even when using such an approach, firms ordinarily would be expected to document their diligence efforts regarding recommendations of private placements.
Abuse of Authority
FINRA has observed situations where some firms or registered representatives exposed investors to unnecessary risks and firms had not established controls—including those to comply with obligations under NASD Rule 2510 (Discretionary Accounts)—to mitigate those risks.
Some registered representatives exercised discretion in customer accounts without the customers’ prior written authorization or the firm’s approval of the discretionary account. In some instances, this occurred when a registered representative executed transactions in a single security across multiple customer accounts in a short period of time. Additionally, FINRA found that some registered representatives violated the requirements of NASD Rule 2510 (Discretionary Accounts) when they executed transactions in customer accounts as an accommodation without receiving specific customer authorization to execute that transaction.
In some cases, registered representatives exercised discretion after the authority to do so had expired or mismarked order tickets to obscure unauthorized discretionary trading. FINRA also uncovered situations where representatives convinced senior investors to establish trusts and name the representative as trustees in order to take control of the trust assets and direct funds to themselves.
FINRA continues to observe challenges in some firms’ compliance with their anti-money laundering (AML) obligations pursuant to FINRA Rule 3310 (Anti-Money Laundering Compliance Program), the Bank Secrecy Act (BSA) and U.S. Department of the Treasury regulations.17 Further, FINRA notes that FinCEN’s Customer Due Diligence (CDD) rule became effective on May 11, 2018, and requires that firms identify beneficial owners of legal entity customers, understand the nature and purpose of customer accounts, conduct ongoing monitoring of customer accounts to identify and report suspicious transactions, and—on a risk basis—update customer information.
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Accuracy of Net Capital Computations
FINRA found that many firms did not maintain sufficient documentation to substantiate their methodology for allocating specific broker-dealer costs to the firm or an affiliate. Other firms’ expense-sharing agreements have not clearly set forth a method of allocation for payment of certain expenses by the firm as opposed to a third party. As a result, the books and records of such firms may not accurately reflect their operating performance and financial condition.
Some smaller firms did not adequately design or document policies and procedures for assessing and monitoring 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)
An effective liquidity risk management program helps protect customers by supporting firms’ operations under normal and stressed conditions. FINRA has identified some firms’ stress test analyses were limited to a single time horizon, but performing stress tests over multiple time horizons helps firms assess whether they have sufficient liquidity to cover potential funding shortfalls. Some firms did not incorporate the results of their stress tests into their business model.
Segregation of Client Assets
Exchange Act Rule 15c3-3 (Customer Protection Rule) imposes certain requirements on firms that are designed to protect customer funds and securities. Firms that are obligated to maintain custody of customer securities and safeguard customer cash must segregate these assets from the firm’s proprietary business activities. FINRA observed that some firms faced challenges with Possession and Control. In some instances, FINRA found that some firms improperly used customer fully-paid-for or excess-margin securities to fund their operational needs. Similarly, some firms with an independent contractor business model faced challenges with implementing consistent processes for check forwarding across their branch network.
Operations Professional Registration
FINRA Rule 1230 (Associated Persons Exempt from Registration) and FINRA Regulatory Notice 11-33 state that certain firm personnel engaged in “back office” covered functions must qualify and register as Operations Professionals because they play an important role in helping firms comply with their regulatory responsibilities relating to customer funds, accounts and transactions. FINRA has observed that some firms continued to permit unregistered staff to engage in certain activities that would require Operations Professional registration, such as the ability to approve general ledger journal entries.
In some instances, firms designated unregistered individuals to act as supervisors of various financial functions, including disbursement of funds, settlement, buy-ins and fails and possession or control.
FINRA observed that some firms did not maintain adequate supervisory programs relating to confirmations or comply with certain confirmation disclosure requirements under Exchange Act Rule 10b-10 and FINRA Rule 2232 (Customer Confirmations) for transactions with customers in equity securities.
Some firms inaccurately disclosed their trading capacity (such as agent, dual agent, principal or riskless principal, as necessary), including whether they served in multiple capacities. In some instances, firms mislabeled their compensation because they did not list it as commission, mark-up or mark-down, or commission equivalent, as appropriate.
DBAs and Communications with the Public
While FINRA does not prohibit the use by a registered representative of a “doing business as” or “DBA” name, some registered representatives used such names to conceal outside business activities that were not disclosed as FINRA Rule 3270 (Outside Business Activities of Registered Persons) requires.
Additionally, FINRA observed deficiencies relating to FINRA Rule 2210 (Communications with the Public) at some firms that permit their registered representatives to conduct firm business activities using a DBA name. Some firms using the independent contractor business model faced additional challenges because of the relative autonomy of their registered representatives and branches.
As discussed in the 2017 Report on FINRA Examination Findings, FINRA has observed firms that receive, handle, route or execute customer orders encountering challenges with meeting their duty of best execution in equities, options and fixed income securities trading. In particular, in 2018, FINRA observed that some firms did not comply with FINRA Rule 531022 (Best Execution and Interpositioning) because they relied upon a deficient “regular and rigorous review” of customer order execution quality. As a result, such firms failed to assure that order flow was directed to markets providing the most beneficial terms for their customers’ orders.
FINRA observed that some firms engaging in institutional sales of fixed income securities did not comply with certain key TRACE reporting rules, specifically FINRA Rules 6730(a)(7), 6730(b)(1) and (2), 6730(c)(8) and 6730(d)(4)(E) (Transaction Reporting) (as well as many of the same rules discussed in the 2017 Report on FINRA Examination Findings).
Market Access Controls
Some firms FINRA examined did not maintain effective pre-trade financial controls, and other firms could not substantiate credit and capital thresholds for clients. For instance, in one examination, FINRA noted that a firm set a credit limit at several billion dollars for a client whose daily average credit usage was in the hundreds of thousands of dollars. Other firms failed to establish policies and procedures to govern intra-day changes to their credit and capital thresholds, including requiring or obtaining approval prior to adjusting credit or capital thresholds, documenting justifications for any adjustments, and ensuring thresholds for temporary adjustments revert back to their pre-adjusted values.