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FINRA Releases Exam Findings

 

FINRA has released its 2019 Report on Examination Findings and Observations, offering insight on enforcement cases and risk management concerns.  FINRA provides a long list of examination and enforcement findings including negligent practices related to (i) supervision (failure to amend WSPs for new or amended rules, weak branch office inspections); (ii) suitability (product exchanges, churning); (iii) digital communications (failure to stop individual texting, electronic sales seminars); (iv) anti-money laundering (inadequate transaction monitoring, overreliance on clearing firms); (v) UTMA/UGMA (know your customer); (vi) cybersecurity; (vii) business continuity plans; (viii) fixed income mark-ups; (ix) best execution; (x) market access; (xi) short sales; (xii) liquidity risk management; (xiii) segregation of client assets; and (xiv) net capital.  A senior FINRA official explained the purpose of the Report: “We hope firms find the Exam Findings and Observations Report useful in strengthening their own control environments and addressing potential deficiencies before their next exam.”

The Exam Report is more useful than the annual Exam Priorities letter because it reflects actual cases and findings rather than a regulatory wish list.  We recommend that all compli-pros establish an internal working group to address the issues raised in the Report.

CFTC Announces 2019 Examination Priorities

The Compliance Branch of the Division of Market Oversight (DMO) of the Commodity Futures Trading Commission (CFTC) for the first time announced its annual examination priorities for contract markets and swap execution facilities.  The DMO will prioritize the following areas in 2019: cryptocurrency, disruptive trading, trading practices, block trades, markets, market makers and trading incentive programs, and relationships with service providers.  The DMO expects that most of its regulated entities will undergo at least one examination in 2019.  The CFTC expects that the DMO will announce examination priorities every year in order to enhance industry communication, prioritize risk-based areas of concern, pursue continuous improvement, and create efficiencies.

Expect the NFA to follow the DMO’s lead with respect to the announced priorities as well as the areas required in the Self-Examination Questionnaire.

FINRA Examination Priorities Letter Focuses on RegTech and Digital Assets

FINRA released its 2019 Examination Priorities Letter, spotlighting new areas including online distribution platforms and fintech, regulatory technology, digital assets, and fundraising for outside business activities.  FINRA will closely scrutinize member firms’ participation with online securities distribution platforms and whether firms are aiding the unlawful distribution of unregistered securities by handling customer accounts and/or receiving transaction-based compensation.  When using regulatory technology tools, firms will be asked how they supervise third party vendors and how they protect customer information.  FINRA will work with the SEC to ensure that member firms implement adequate controls and supervision when engaging with digital asset offerings through marketing, clearing, and recordkeeping activities.  FINRA continues its focus on outside business activities with a special emphasis on fundraising for personal benefit.  FINRA also makes clear that it will continue to review firms for compliance with longstanding priorities including suitability, fund share classes, private placements, communications, AML, cybersecurity, senior investors, best execution, and supervision. 

Compli-pros should read this Examination Priorities Letter together with the recently released Examinations Findings to create an inventory of compliance risks that the firm should immediately address through gap analysis and enhanced procedures.  Our experience is that the FINRA examiners hew closely to the announced priorities. 

The Friday List: Top 10 OCIE Priorities for 2019

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

Christmas came early this year as the SEC’s Office of Compliance Inspections and Examinations (OCIE) released its 2019 priorities, which in prior years came out in January or February.  OCIE has expanded its activities under the new Administration, boasting that it completed over 3,150 exams during the past year.  OCIE increased investment company exams by 45% and reviewed 17% of investment advisers, making good on its prior commitment to double adviser exams.  The Exam Priorities letter is long (12 single space pages) and covers many topics.  To help synthesize the data, we offer the Top 10 OCIE Priorities for 2019:

 

Top 10 OCIE Priorities for 2019

  1. Fees and Expenses:  OCIE will review disclosure and calculation of fees charged to clients.
  2. Portfolio Management: The staff will scrutinize how firms allocate investment opportunities and whether assets are managed according to stated investment objectives.
  3. New Advisers: OCIE continues to focus on never-before examined advisers and advisers that have not been examined in many years.
  4. Mutual Fund Share Classes:  The SEC will focus on which mutual fund share classes are recommended and whether reps have a financial incentive.
  5. Wrap Fee Programs: Firms must monitor wrap programs to make certain that the bundled fee is the best deal for clients.
  6. Affiliated Products/Services:  OCIE will examine the use of affiliated services or products for undisclosed conflicts of interest.
  7. Senior Investors:  The regulators are concerned about unsuitable recommendations to senior investors and supervision of reps.
  8. ETFs: The staff has prioritized ETFs with custom indexes, limited secondary market trading, and risky assets.
  9. Digital Assets: Concerned about the volatile cryptocurrency markets, the SEC remains vigilant about the sale, trading, and management of digital assets.
  10. Cybersecurity: OCIE wants firms to identify and manage cybersecurity risks including devices, governance, and policies and procedures.

FINRA Releases 2018 Examination Results

FINRA has released its 2018 Examinations Findings as a “resource for firms to strengthen their compliance programs and supervisory controls.” FINRA says the report selected certain observations because of “their potential significance, frequency, and impact on investors and the markets.” The report highlights widespread deficiencies in suitability policies and procedures including “quantitative suitability” (i.e. series of transactions), overconcentrations, excessive trading, and variable annuities. FINRA also cites widespread failures to ensure fulsome disclosure of fixed income mark-ups, reasonable private placement due diligence, and abuse of discretionary authority. The broker-dealer regulator summarizes other concerns including anti-money laundering, net capital and customer protection calculations, best execution and outside business activities.

This extensive list (15 pages) covers many of FINRA’s greatest regulatory hits. It’s a great document for new compliance officers because it covers a wide range of broker-dealer compliance requirements. Rather than helping compli-pros focus resources, it works better as a checklist to verify that the firm has addressed the most serious regulatory requirements.

SEC Is Examining Registered Funds and ETFs for Oversight, Policies, and Conflicts

 

The SEC’s Office of Compliance Inspections and Examinations has announced a sweep of certain mutual funds and ETFs. The OCIE staff will target smaller ETFs and funds/ETFs that use custom indexes, allocate to securitized assets, exhibit aberrational underperformance, or employ inexperienced managers or private fund sponsors that manage a similar mutual fund.  The SEC will assess compliance policies and procedures and fund oversight of risks and conflicts, disclosures to shareholders and the Board, and oversight processes.  Among some of the issues of concern to the OCIE staff include bid/ask spreads for secondary market trading of smaller ETFs, portfolio management for underperforming funds, the effect of unexpected market stresses on securitized assets, and side-by-side allocations for private and public funds.  OCIE is encouraging fund sponsors and boards “to consider improvements in their supervisory, oversight, and compliance programs.”

Compli-pros and fund lawyers should mobilize to review policies and procedures for affected advisers and boards, consult about changes, and implement enhanced oversight and processes.  We recommend taking action before the OCIE staff arrives for its examination. 

SEC Examined 15% of Advisers Last Year and Wants to Expand Exam Program

In recent testimony before Congress, SEC Chairman Jay Clayton reported that the SEC examined approximately 15% of all investment advisers in fiscal 2017, a 40% increase over the prior year.  Mr. Clayton said that the SEC achieved these results through the reallocation of resources, advancements in technology, and “other efficiencies.”  He advocated for continuing to increase investment adviser coverage levels by requesting 24 additional positions in his 2019 budget request.

OUR TAKE: The SEC still falls short of FINRA who claims to examine 40% of broker-dealers per year.  Perhaps, Chairman Clayton should reconsider requiring third party compliance reviews, a revenue-neutral policy idea, championed by former Republican Commissioner Dan Gallagher.  Regardless, the chance of an exam continues to increase every year.

 

The Friday List: 2018 Examination Priorities

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

Both FINRA and the SEC OCIE staff recently released their 2018 examination priorities.  Today’s list synthesizes their missives into the 10 most significant regulatory priorities for investment management firms.   Several of these priorities are new this year including cryptocurrency, wrap fee programs, and thinly-traded securities.  Others such as AML, suitability and best execution are regulatory greatest hits that appear nearly every year.   Compli-pros should use these letters to prepare their compliance programs and exam readiness.

 

10 Most Significant 2018 Examination Priorities

 

  1. Disclosure of fees and expenses: Both OCIE and FINRA champion full transparency of fees and expenses so that clients can make informed decisions and understand possible conflicts of interest.
  2. Cryptocurrency:  Expect a lot of attention paid to initial coin and cryptocurrency offerings including recommendations, disclosure, volatility, and security.
  3. Cybersecurity:  The regulators want to ensure that firms implement adequate cyber policies and procedures to protect client information and data systems.
  4. AML and KYC:  This is an area that both regulators have identified for many years, although the focus has moved to customer due diligence and firms’ gatekeeper role to keep securities markets safe.
  5. Protecting senior investors: Both regulators want to protect senior investors.  The SEC focuses on recommendations to retirement accounts.  FINRA will review compliance with rules to prevent exploitation.
  6. Wrap fee programs: The SEC continues its persecution and prosecution of wrap fee programs, including due diligence, best execution, and conflicts.
  7. Thinly-traded ETFs and microcaps:  The regulators have raised the red flag about recommending thinly-traded securities that are subject to market manipulation and pay exorbitant commissions.
  8. High risk brokers:  FINRA wants firms to enhance hiring and supervision practices to keep bad actors out of the industry.
  9. Suitability: Firms must implement procedures to vet products and train reps.
  10. Best execution:  FINRA is particularly concerned about order-routing practices and resulting conflicts of interest.

OCIE Releases 2018 Exam Priorities

The SEC’s Office of Compliance Inspections and Examinations released its 2018 examination priorities, focusing on retail investors, market infrastructure, FINRA, cybersecurity, and anti-money laundering.  As part of its mission to protect retail investors, OCIE will focus on (i) disclosure and receipt of compensation that could suggest a conflict of interest, (ii) robo-advisers, (iii) wrap fee programs, (iv) poor-performing mutual funds and ETFs, and (v) cryptocurrency offerings.  OCIE also plans to supervise FINRA’s “operations and regulatory programs” including the quality of its examinations.  OCIE also intends to scrutinize cybersecurity and anti-money laundering practices including risk assessment and customer due diligence.  OCIE makes clear that its priorities list is “not exhaustive” and could be expanded as a result of regulatory developments, examination information, complaints and tips, and other regulators.

OUR TAKE: OCIE is fairly transparent.  Now that the staff has identified these issues, compli-pros should expect a heavy focus during examinations.  Compliance departments should review policies and procedures and testing to get ready.

 

FINRA Releases Annual Exam Priorities Letter

FINRA released its annual Regulatory and Examination Priorities Letter identifying areas of FINRA focus for 2018.  FINRA announced a focus on fraud including insider trading, microcap pump-and-dump, Ponzi schemes and the resulting referrals to the SEC, even if the wrongdoing is outside of FINRA’s jurisdiction.  FINRA will also target supervision practices including the hiring and review of high-risk brokers, branch offices, and outside business activities.  New this year is a focus on cryptocurrency offerings and the role registered reps play in effecting transactions.  FINRA also highlights best execution, cybersecurity, anti-money laundering, and business continuity.  Consistent with prior years, FINRA will devote resources to customer protection and net capital, suitability, and liquidity risk.

OUR TAKE: Compli-pros should use the Priorities Letter as a checklist to review the Written Supervisory Procedures.  FINRA generally means what it says and addresses these topics during exams.