FINRA Annual Regulatory and Examination Priorities Letter

On February 8, 2011, FINRA published its 2011 Annual Regulatory and Examination Priorities Letter to member broker-dealer firms to highlight new and existing areas of significance to their regulatory programs. The following provides a summary of the letter, including an overview of the recent regulatory developments and an outline of the examination priorities for member firms.

I.  Recent Developments

Suitability – FINRA Rule 2111: requires a broker to have reasonable basis to believe that a recommended transaction or investment strategy involving or securities is suitable (see Regulatory Notice 11-02)

Know Your Customer – FINRA Rule 2090: requires a firm use “reasonable diligence” in regard to the opening and maintenance of every account, to know the “essential facts” concerning every customer (see Regulatory Notice 11-02)

Financial Responsibility – FINRA Rules 3110, 4120, 4140, 4521, 9557 and 9559 – enable FINRA to prescribe greater net capital requirements for carrying and clearing member firms in certain circumstances (see Regulatory Notice 10-21)

Reporting Requirements – FINRA Rule 4530 – requires member firms to report certain events (see Regulatory Notice 11-06)

II.  Examination Priorities

Fraud Detection

  • Spot and investigate red flags that may indicated fraudulent behavior
  • Rule 4160 – strengthens FINRA’s ability to verify independently customer and proprietary assets maintained by member firm at a non-member financial institution

Fraudulent Activity Associated with Customer Accounts

  • Maintain robust supervisory systems and AML monitory systems that are reasonably designed to detect and report suspicious transactions

High-Frequency Trading, Algorithms, Sponsored Access, Direct Market Access and Trading Pauses

  • Establish effective controls over electronic order routing and market access arrangements, including surveillance of algorithmic trading and HFT strategies (see Securities Exchange Act Rule 15c3-5 and NTM 04-66)

Short Sales and Regulation SHO

  • Regulation SHO amendments – implement a short-sale related circuit breaker for NMS stocks

Information Barriers

  • Concern over weak information barrier controls around the flow of material, non-public information within the firm and with its affiliates, clients and others

Private Placements and Private Self-Offerings

  • Focus on the retail sales of private placement interests due to failures identified in firms’ compliance with suitability, supervision and advertising rules as well as potential fraud and participation in illegal distribution of unregistered securities
  • Regulatory Notice 10-22 – obligation to conduct reasonable investigations into Regulation D offerings
  • Regulatory Notice 11-04 – proposed expansion of Rule 5122 to cover all private placements in which broker-dealers participate

Trading in Non-Public Securities

  • Following trends in unregistered shares of companies that report no public information

High-Yield Investments

  • Concern over retail investors attracted to high yield may not understand risks associated with credit risk and liquidity – reasonable-basis and customer-specific suitability analysis

Municipal Securities

  • Must meet disclosure, suitability and pricing obligations and obligation to deal fairly with customers

Non-Conventional Investments

  • Focus on firms that offer structured products and certain riskier asset-backed securities – brokers must understand the risks and costs associated with the products they recommend and disclose them to customers
  • Non-traded REITS – risk of attracting investors who do not understand the extent of risks, including lack of liquidity, lack of accurate and up-to-date valuations, impact of fees, potential conflicts between their interests and those of REIT managers and dividends that may represent a return of capital rather than operating income
    • Recent events of concern: share devaluations, dividend cuts and suspension of share buyback programs
    • Examiners will review sales to unsophisticated investors to ensure firms conducted appropriate pricing due diligence and suitability analyses and disclosed all risks

Exchange-Traded Funds and Notes

  • See Regulatory Notices 09-31 and 10-51

Vulnerable Customers

  • Firms must be sensitive so that brokers do not place vulnerable customers (retired, elderly or ill) into inappropriately risky products

Electronic Communications and Social Media

  • Firms must establish an adequate system to retain and supervise all electronic business communications
  • Any electronic communications sent to a customer or prospective customer regardless of medium or origination is subject to FINRA and SEC rules regarding communication with the public, including supervision and retention
  • See FINRA’s Guide to the Internet for Registered Representatives and Regulatory Notices 07-59 and 10-06

Consolidated Account Reports

  • Firms must have procedures in place to conduct due diligence on the valuation of such wide variety of asset classes prior to inclusion on financial account reports to customers
  • Regulatory Notice 10-19 – guidance and reviews rules on consolidated financial account statements, including when assets are not in the broker-dealer’s possession or control

Hiring and Compensation Practice

  • Attention to supervision of newly hired individuals and enhanced compensation practices

Outside Business Activities and Private Securities Transactions

  • FINRA Rule 3270 – prohibits registered persons from engaging in OBA unless prior written notice, provides firm’s obligations and recordkeeping requirements
  • Firms must understand the nature and extent of approved private securities transaction, document the process for review, and effectively supervise any approved transactions
  • Examinations will continue to focus on notification and approval requirements, but also substantive reviews of the activities (see Regulatory Notice 10-49)

Master/Sub-Account Relationships

  • FINRA will review firms’ systems for monitoring, detecting and reporting suspicious activity in such structures, whether or not the sub-account should be considered the firm’s customer for CIP purposes (see Regulatory Notice 10-18)

Funding and Liquidity Risk Management

  • Firms must be prepared to manage their daily operations under severe and prolonged adverse market conditions – independent risk oversight by senior management

Intercompany Transactions/Affiliate Relationships and Activities

  • Accurate books and records for affiliate transactions – see NTM 03-63

Governance and Control over Margin Lending

  • Governance process designed to control risks around margin lending, including assessing the type and sufficiency of collateral, credit worthiness of the borrower, valuation and liquidity of the collateral, concentrations of collateral, ability to fund the loan and other factors.

Please contact our firm if you need assistance modifying your written supervisory procedures, provide a compliance assessment, assist with any regulatory examination, or any other regulatory or arbitration related legal advice at

Link: Broker-Dealer Advisory Services

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