On July 5, 2012, FINRA published Regulatory Notice 12-34 requesting public comment on the scope of FINRA regulation that would be appropriate for member firms active in crowdfunding offerings.
The Jumpstart Our Business Startups Act (JOBS Act) contains key provisions relating to securities offered or sold through “crowdfunding.” The crowdfunding provisions of the JOBS Act provide an exemption from registration under the Securities Act of 1933 (Securities Act) for securities offered by issuers in amounts of up to $1 million over a 12-month period provided that the amount raised from any single investor adheres to strict limits (ranging from $2,000 to $100,000) based on the investor’s annual income or net worth.
The crowdfunding exemption establishes specific eligibility and sales practice standards for issuers and intermediaries that engage in crowdfunding. Intermediaries that seek to engage in crowdfunding must be registered as a broker or a funding portal, a newly created entity. The regulatory scheme established by the JOBS Act requires that each registered funding portal be a member of an applicable self-regulatory organization (such as FINRA), but limited authority to rules “written specifically for registered funding portals.”
Funding Portals – possible rules concerning:
- Anti-money laundering
- Fraud and manipulation
- Just and equitable principles of trade
Broker-Dealers – application of existing FINRA Rules to broker-dealer’s crowdfunding activities:
- Relaxing existing rules for crowdfunding activities
- Isolate crowdfunding activities from other activities
- Implement the limitation on crowdfunding similar to funding portals
- Special conflicts, such as a registered representative referring a client to the crowdfunding portal of the broker-dealer
Comments requested by August 31, 2012.
On October 5, 2011, the Second Circuit in Fiero v. Financial Industry Regulatory Authority, Inc. held that FINRA was not authorized under the Securities Exchange Act of 1934 to enforce disciplinary fines through judicial enforcement.
Apellants, Fiero Brothers, Inc., was a FINRA member firm and broker-dealer registered with the SEC and John J. Fiero was the sole registered representative of Fiero Brothers, and both were subject to FINRA, and its predecessor, the NASD.
In 1998, the Department of Enforcement initiated disciplinary proceedings against Appellants with a hearing panel holding that Appellants violated Section 10(b) of the Securities Exchange Act of 1934, Rule 10b-5 thereunder, and FINRA Conduct rules 2110, 2120 and 3370 and as a result, barred Fiero from association with any member firm and issued a fine of $1 million, jointly and severally. FINRA National Adjudicatory Council (“NAC”) affirmed the decision in its entirety.
Appellants refused to pay the fine and FINRA instituted an action in New York Supreme Court. NY Supreme Court upheld the fines based on ordinary principles of contract law recognizing the right of a private membership organization to impose fines on its members, when authorized to do by statute, charter or by-laws.
Appellate courts in New York initially upheld the Superior Court decision, but granted leave to appeal, and in February 2008, reversed the decision on the ground that state courts lacked jurisdiction – the FINRA complaint constituted an action to enforce a liability or duty created under the Exchange Act, and therefore, fell within the exclusive jurisdiction of the federal courts pursuant to 15 U.S.C. § 78aa.
The United States District Court for the Southern District of New York entered judgment for FINRA based on applicable state contract law.
The Exchange Act does not provide FINRA with the necessary authority
While Section 15A(b) of the Exchange Act, FINRA and other self-regulatory organizations (SROs) have a statutory authority and obligation to appropriately discipline members for violations, there is no express authority or Congressional intent for SRO’s to bring judicial actions to enforce the collection of fines.
1990 Rule Filing does not provide FINRA with authority
FINRA filed a rule proposal with the SEC pursuant to Section 19(b)(1) of the Exchange Act NASD stated its intent “to pursue other available means for the collection of fines and costs imposed…in disciplinary decisions.” The NASD reiterated the policy Notice to Members 90-21.
However, the court determined that for “FINRA to have obtained authority [thereunder], the rule must have been properly promulgated under the procedures established by the Exchange Act [and it] was not.” Section 19(b) of the Exchange Act requires SRO’s must file any proposed rule change with the SEC, with a general statement of the basis and purpose, and then the SEC is required to publish notice and give interested individuals an opportunity to comment prior to either approving or disapproving the rule.
While FINRA (then NASD) defined such rule as “House-Keeping,” whereby FINRA was just stating a current policy of an existing rule, the Court determined that this was not “simply a stated policy change…that could bypass the required notice and comment period of Section 19(b)[, but rather,] it was a new substantive rule.” Therefore, the rule was never properly promulgated and “cannot authorize to judicially enforce the collection of its disciplinary fines.”
On May 18, 2011, FINRA issued Regulatory Notice 11-25, which provides further guidance on new consolidated consolidated FINRA rules governing Know Your Customer (Rule 2090) and Suitability (Rule 2111) and extending the implementation date to July 9, 2012 (previously, October 7, 2011).
FINRA Rule 2090 (Know Your Customer) requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer….” The rule explains that essential facts are “those required to (a) effectively service the customer’s account, (b) act in accordance with any special handling instructions for the account, (c) understand the authority of each person acting on behalf of the customer, and (d) comply with applicable laws, regulations, and rules.”
FINRA Rule 2111 (Suitability) requires that a firm or associated person “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.
Discussion and Guidance
FINRA provided guidance on the following:
Know Your Customer
Authority of Person Acting on Behalf of the Customer – firms need to know: (1) names of persons authorized to act and (2) any limits on their authority. (FINRA notes that firms may decide to limit business to persons without limited scope of authority).
Customer’s Investment Profile
Updating Documentation – firms are not required to update all customer account documentation, and does not contain any explicit documentation requirements, but allows firms to take a risk-based approach with respect to documenting suitability determinations.” The suitability rule applies to recommendations, but the extent to which a firm needs to evidence suitability generally depends on the complexity of the security or strategy in structure and performance and/or the risks involved. However, firms must keep in mind that when suitability is not evident from the recommendation itself, lack of documentation may create examination and enforcement issues.
As a reminder, Rule 2111 adds additional, specific factors to consider in making suitability determinations prior to any recommendation, including customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation ((old rule only included financial status, tax status, and investment objectives).
Lack of Certain Customer-Specific Information – absence of some customer information that is not material under the circumstances generally should not affect a firm’s ability to make a recommendation. To meet its suitability obligations, a firm must obtain and analyze enough customer information to have a reasonable basis to believe the recommendation is suitable. The significance of specific types of customer information generally will depend on the facts and circumstances of the particular case, including the nature and characteristics of the product or strategy at issue. Firms should document the rationale for factors not requiring analysis.
Guidance on Terms:
- Liquidity Needs: extent of customer’s desired ability or financial obligations that dictate the need to quickly and easily convert to cash all or a portion of an investment or investments without experiencing significant loss in value
- Time Horizon: expected number of months, years, or decades of planned customer investment to achieve a particular financial goal
- Risk Tolerance: ability and willingness to lose some or all of the original investment in exchange for greater potential returns.
Different Investment Profiles on Separate Accounts – possible, but firm should evidence customer’s intent and must not allow factors from other accounts to justify recommendations
Terminology – specific terminology is not required when seeking relevant information
Scope of Term “Strategy” – interpreted broadly, including recommendations that: (i) do not result in a securities transaction, (ii) do not reference a specific security, (iii) explicit recommendation to hold a security regardless of involvement in original purchase (but not an implicit one)
Firm Approval Does Not Mean Suitable for Particular Customer – Even if a firm’s product committee has approved a product for sale, an individual broker’s lack of understanding of a recommended product or strategy could violate the obligation. Reasonable-basis suitability has two main components: a broker must (1) perform reasonable diligence to understand the potential risks and rewards associated with a recommended security or strategy and (2) determine whether the recommendation is suitable for at least some investors based on that understanding. A broker can violate reasonable-basis suitability under either prong of the test. Firms should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend.
Contact our firm for experienced regulatory and legal counsel regarding broker-dealer operations, including drafting new account forms and customer agreements, subscription agreements, written supervisory procedures or any broker-dealer and investment adviser, arbitration, regulatory or securities matter at firstname.lastname@example.org.
FINRA Rule 4360 requires each member firm that is required to join the Securities Investor Protection Corporation (SIPC) to maintain blanket fidelity bond coverage with specified amounts of coverage based on the firm’s net capital requirement, with certain exceptions. Such firms must maintain fidelity bond coverage that provides for per loss coverage without an aggregate limit of liability. The new rule is based on NASD Rule 3020, taking into account certain requirements under NYSE Rule 319 and its Interpretation.
A firm not qualifying for a fidelity bond with per loss coverage and no aggregate limit of liability must maintain substantially similar cover with compliance with all other provisions of the rule, providing that the firm is able to show through correspondence from two insurance carriers that the firm does qualify for such coverage.
A firm’s fidelity bond must provide against loss and have Insuring Agreements covering at least the following: fidelity, on premises, in transit, forgery and alteration, securities and counterfeit currency. Also, the rule replaces the specific coverage provisions in the NASD and NYSE rules that permit less than 100 percent of coverage for certain agreements, thus coverage for all Insuring Agreements must be equal to 100 percent of the firm’s minimum required bond coverage. A firm’s fidelity bond must include a cancellation rider providing that the insurer will use its best efforts to promptly notify FINRA in the event the bond is cancelled, terminated or substantially modified.
The minimum required coverage increased under the new rule for firm’s with minimum net capital requirements that are less than $250,000 to the greater of 120% of its required minimum net capital or $100,000 (presently $25,000).
Deductibles are allowed up to 25% of the fidelity bond coverage purchased by a firm, but any deductible amount greater than 10% of the coverage purchased must be deducted from its net worth in the net capital calculation for purposes of Exchange Act Rule 15c3-1.
A member firm (even for a multi-year insurance policy) must review annually the adequacy of its fidelity bond and make required adjustments to its coverage, based on its highest net capital requirement for the preceding 12-month period.
Further, Rule 4360 removes the historical exemption of NASD Rule 3020(e) for a one-person firm.
FINRA Rule 4360 takes effect on January 1, 2012.
Contact Evans & Kob PC for experienced legal representation regarding securities, broker-dealer and investment advisers, arbitration or litigation or any other regulatory related matter at email@example.com.
FINRA announced in Regulatory Notice 11-17 that a revised Discovery Guide and Document Production Lists for Customer Arbitration Proceedings was approved by the SEC and will be effective May 16, 2011 (and apply to customer cases filed on or after such date). The revised Discovery Guide changes not only the format, but also substantive changes that expand the scope and number of presumptively discoverable documents.
The original Discovery Guide was adopted in 1999, including document production lists for use in customer arbitration proceedings, and provides direction on which documents parties should exchange without arbitrator or staff intervention, and the Lists specifically identify the documents parties should exchange before the hearing, depending on the type of dispute.
Per the Notice, the Discovery guide is revised to expand and update the Lists. FINRA is replacing the current 14 Lists with just two Lists of presumptively discoverable documents: one for firms/associated persons to produce and one for customers to produce. The revisions include additional types of documents that users indicated are needed to develop a case and while each will be presumptively discoverable in every customer case, the revisions encourage arbitrators to tailor the Discovery Guide to the facts and circumstances to each case.
Discovery Guide Introduction
The introduction was revised to provide guidance to parties and arbitrators, including:
- Flexibility – one-size may not fit all – arbitrators retain flexibility to order production not provided in the lists, to refuse to compel production of documents in the list and to alter the production schedule
- Objections based on Cost/Burden
- Requests for Additional Documents
- Party and Non-Party Production
- Consideration of Firm Business Models and Customer Claims
- Electronic Discovery – electronic files are considered “documents”
- Privilege – protection for privileged documents
- Affirmations for no responsive documents in possession
- No Obligation to Create Documents
- Admissibility – production does not create a presumption of admissibility at hearing
Expanded and Increased Production
Notable additions to documents presumed to be discoverable by claimant include:
- Telephone logs related to the claimant’s transactions;
- All advertising materials sent to customers of the firm that refer to the securities and/or account types at issue or that were used to solicit and provide services to the claimant;
- All customer complaints filed against the associated persons assigned to the accounts at issue for the three years prior to the statement of claim;
- Increased scope relating to associated person’s disciplinary history;
- Documents related to trading or investment strategies utilized/recommended in the claimant’s account;
- Associated person’s compensation for the transaction at issue;
Notable additions to documents presumed to be discoverable by the firm include:
- Research report(s) claimants received from the firm;
- All non-confidential settlements claimant(s) entered in civil actions involving securities matters and/or securities arbitration proceedings;
- All documents the claimant received related to the investments at issue;
- All materials received by claimant or obtained from any source relating to the transactions or products at issue;
- All correspondence related to the accounts at issue (not just with the firm).
Notable deletions include:
- Firms are no longer required to produce holding pages, or account statements/confirmations for the claimant’s accounts and transactions at issue.
- Claimant’s are no longer required to produce prior complaints involving securities matters and the firm’s response, or documents showing actions claimant took to limit losses in the transaction at issue.
The revised Discovery Guide becomes effective and applicable to all customer cases filed on or after May 16, 2011. Broker-dealers should take steps to ensure that their procedures for responding to newly-filed customer cases are in compliance with the changes. As always, it is essential to be proactive to implement these changes. Contact Evans & Kob PC if you need experienced legal representation and advice regarding FINRA arbitration or updating your current procedures to accommodate these changes at firstname.lastname@example.org.
In March 2011, FINRA issued Regulatory Notice 11-14, requesting comments on proposed new rule 3190 clarifying the scope of a member firm’s obligations and supervisory responsibilities for functions or activities outsourced to a third-party service provider.
FINRA Rule 3190 clarifies that:
- Outsourced functions of a broker-dealer to a third-party service provider does not relieve the firm of its obligation to comply with applicable securities laws and regulations
- The firm cannot delegate its responsibilities for, or control over, any outsourced functions or activities
- The firm must maintain supervisory procedures, including due diligence measures, reasonably designed to ensure that third-party service provider arrangements achieve compliance with applicable securities laws and regulations
- Additional restrictions and obligations apply solely to clearing and carrying member firms and third-party service provider arrangements
Comments Requested by May 13, 2011
Member Firms’ Responsibilities for Activities Outsourced to Third-Party Service providers and Activities Requiring Registration and Qualification
FINRA Rule 3190(a)(1) – member firm’s use of a third-party service provider (including any sub-vendor) to perform functions or activities related to the firm’s business as a regulated broker-dealer does not relieve the firm of its obligation to comply with applicable securities laws and regulations.
- Third-party service provider (including any sub-vendor) – defined to include any person controlling, controlled by or under common control with a member firm, unless otherwise determined by FINRA.
- Prohibits the firm from delegating its responsibilities for, or control over, any functions or activities performed by such provider
FINRA Rule 3190(a)(3) – proper registration and qualification required to engage in activities requiring such under FINRA rules
Member Firms’ Supervision and Due Diligence Analysis of Third-Party Service Providers
FINRA Rule 3190(a)(2) – requires firms to establish and maintain a supervisory system and written procedures reasonably designed to achieve compliance with applicable securities laws and regulations for any functions or activities performed by a third-party service provider
FINRA Rule 3190(b) – requires firms include in their WSPs an ongoing due diligence analaysis to determine, at a minimum, whether:
- the provider is capable of performing the activities being outsourced; and
- as to such activities, if the firm can achieve compliance that are reasonably designed to achieve compliance with applicable securities laws and regulations
Clearing or Carrying Member Firms’ Restrictions and Obligations Regarding Outsourced Activities
The proposed rule imposes heightened requirements on a clearing or carrying firm’s outsourcing arrangements designed to address concerns regarding the potential harm that could result from its third-party service providers’ non-compliance. FINRA believes the concerns are mitigated by limiting certain activities to persons directly subject to the control and supervision of the firm, having additional supervisory procedures to oversee third-party service providers and notify FINRA of its outsourcing arrangements.
FINRA Rule 3190(c) – requires a clearing or carrying member firm to vest an associated person of the firm with the authority, responsibility and necessary registrations and qualifications for the following activities:
- the movement of customer or proprietary cash or securities;
- the preparation of net capital or reserve formula computations; and
- the adoption or execution of compliance or risk management systems.
FINRA Rule 3190(d) – requires that a clearing or carrying member firm include additional supervisory procedures to:
- enable the firm to take prompt corrective action where necessary to achieve compliance with applicable securities laws and regulations; and
- require the firm to approve any transfer of duties by a third-party service provider to a sub-vendor.
FINRA Rule 3190(e) – requires a clearing or carrying member firm to notify FINRA within 30 days after entering into any outsourcing agreement and such notification must include:
- the function(s) being performed by the third-party service provider;
- the identity and location of the third-party service provider;
- the identity of the third-party service provider’s regulator (if any); and
- a description of any affiliation between the firm and the third-party service provider.
Further, the firm would be required to maintain a copy of each notification and underlying agreement in accordance with SEA Rule 17a-4(b).
Exceptions to Proposed FINRA Rule 3190’s Requirements
FINRA Rule 3190 excepts from its requirements ministerial activities performed on behalf of a member firm, unless otherwise prohibited, and clarifies it does not restrict activities performed pursuant to carrying agreement approved under FINRA Rule 4311.
Assuming the rule is approved, there is not a substantial change from the previously issued guidance in NTM 05-48, except for heightened restrictions on certain clearing and carrying member firms’ activities. However, please contact our firm if you need experienced legal representation and advice or if you need assistance updating your written supervisory procedures, providing comments to FINRA, or any other regulatory or arbitration related legal assistance at email@example.com.
In March 2011, FINRA issued Regulatory Notice 11-11 requesting comments on a concept proposal to apply objectivity safeguards and disclosure requirements to the publication and distribution of debt research reports. The proposal would provide retail debt research recipients with most of the same protections provided to recipients of equity research, while exempting research provided solely to institutional investors from many of the provisions.
Comments must be received by April 25, 2011
FINRA is concerned over firms’ management of conflicts of interest related to the publication and distribution of debt research, including certain cases where firms lacked any policies and procedures to manage debt research conflicts to ensure compliance with applicable SRO ethical and anti-fraud rules and recent allegations of misconduct in the sale of auction rate securities (ARS). Currently, FINRA’s research rules apply only to “equity securities” as defined under the Securities Exchange Act of 1934, subject to certain exemptions.
In response, FINRA developed this concept debt research rule that would recognize a bifurcated debt research regulatory approach – the proposed rule extends protections similar to equity research to retail investors, while research distributed solely to institutional investors would require a more general “health warning,” but would allow such institutional investors to choose to receive the full protections accorded to retail investors.
Standards Applicable to Retail Debt Research
The majority of NASD Rule 2711 would apply to debt research with the proposed addition addressing conflicts between debt research and sales and trading personnel. Thus, the rule would:
- Require member firms to establish, maintain and enforce policies and procedures reasonably designed to identify and effectively manage conflicts of interest
- Prohibit prepublication review, clearance or approval by investment banking and sales and trading, as well as restrict (or prohibit) such by a subject company (except for fact checking)
- Prohibit input by investment banking and sales and trading into the determination of the research department budget.
- Limit the supervision and compensatory evaluation of debt analysts to persons not engaged in investment banking services or sales and trading.
- Require similar compensation rules and review as equity analysts
- Restrict or limit debt analyst account trading in the securities, derivatives and funds related to the securities covered by the debt analyst
- Prohibit promises of favorable debt research coverage.
- Prohibit retaliation against debt analysts by investment banking personnel or other employees as the result of an unfavorable research
- Restrict or limit activities by debt analysts that can reasonably be expected to compromise objectivity
- Prohibit investment banking from directing debt analysts to engage in sales or marketing efforts
Further, FINRA envisions disclosures applicable to equity research largely should apply to debt, including:
- personal and firm financial interests;
- receipt of investment banking services compensation from the subject company; and
- the meaning of each rating employed in any rating system used by the member firm in the research report.
Institutional Investor Exemption
The general exemption is based on the assumption that institutional investors are aware of the types of potential conflicts that may exist between a member’s recommendations and trading interests, and are capable of exercising independent judgment in evaluating such recommendations (and instead incorporate the research as a data point in their own analytics) and reaching pricing decisions. However, the institution-only exemption, if not opted out by the institution, requires a “health warning” disclosure on the first page, including:
- the research is intended for institutional investors only and is not subject to all of the independence and disclosure standards applicable to research provided to retail investors;
- if applicable, that the firm trades the securities covered in the research for its own account and on behalf of certain clients; such trading interests may be contrary to the recommendations offered in the research and the research may not be independent of the firm’s proprietary interests; and
- if applicable, that the research may be inconsistent with recommendations offered in the firm’s research that is disseminated to retail investors.
In addition, specific prohibitions and restrictions are placed on:
- promises of favorable research;
- debt research analyst involvement in pitches, road shows and other marketing;
- certain three-way meetings with analysts, investment banking and issuer management
- input into research coverage by investment banking personnel;
- retaliation against debt research analysts for unfavorable research;
- review of research by the subject company (beyond fact-checking) or investment banking personnel; and
- FINRA rules would continue to apply to member conduct, including Rules 2010 and 2020
Communication Firewalls Unique to Debt
While certain communications between debt analysts and sales and trading personnel are necessary to allow each to perform their primary functions, the following are expressly prohibited:
- Sales and trading personnel attempting to influence a debt analyst’s opinion
- Debt analysts identifying or recommending specific potential trading transactions to sales and trading personnel not contained in such debt analyst’s published reports; disclosing the timing of, or material investment conclusions in, a pending debt research report; or otherwise having any communication for the purpose of determining the profile of a customer
Assuming the rules are approved, broker-dealers will need to significantly alter policies and procedures regarding debt research to ensure and monitor compliance Please contact our firm if you need experienced legal representation and advice if you need assistance updating your written supervisory procedures, providing comments to FINRA, or any other regulatory or arbitration related legal assistance at firstname.lastname@example.org.
New FINRA Rule 4530, representing a consolidation of NASD Rule 3070 and NYSE Rule 351, takes effect on July 1, 2011. The rule increases the level of self-reporting by firms by requiring firms to not only report when a court or self-regulatory body determines a securities violation, but also when the firm concludes or “reasonably should have concluded” that the firm or an associated person violated securities laws.
In particular, FINRA Rule 4530(b) requires the firm to report to FINRA within 30 calendar days after the firm has concluded, “or reasonably should have concluded” that the firm or an associated person of the firm violated any securities-, insurance-, commodities-, financial- or investment-related laws, rules, regulations or standards of conduct of any domestic or foreign regulatory body or self-regulatory organization. As Regulatory Notice 11-06 spells out, the reporting is limited to only “conduct that has widespread or potential widespread impact to the firm, its customers or the markets, or conduct that arises from a material failure of the firm’s systems, policies or practices, involving numerous customers, multiple errors or significant dollar amounts.” The standard of “reasonably should have concluded” is defined as “[i]f a reasonable person would have concluded that a violation occurred, then the matter is reportable[.]” The determination is to be made by the person designated as such in the firm’s written supervisory or operating procedures.
Obviously, a reasonable conclusion as to a potential violation may differ among firms as well as with FINRA due to its subjective interpretation leaving the door open for confusion and potential liability by member firms. Further, 4530(b) is only one parameter of the new rule with Regulatory Notice 11-06 discussing several other amendments to the self-reporting framework for member firms.
One thing is certain; firms will need to update their written supervisory procedures to account for additional self-reporting. Please contact our firm if you need experienced legal representation and advice if you need assistance updating your written supervisory procedures as a result of FINRA Rule 4530(b) or any other regulatory or arbitration related legal assistance at email@example.com.
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
- 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
- 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
- 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
- Must meet disclosure, suitability and pricing obligations and obligation to deal fairly with customers
- 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
- 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)
- 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 firstname.lastname@example.org.
On February 1, 2011, FINRA amended the Code of Arbitration Procedure for Customer Disputes to allow customers with claims in excess of $100,000 to have two options for panel composition, either: (i) majority-public panel with two public and one non-public arbitrator or (ii) optional all public panel with all public arbitrators. For further information, including full text of the notice and the amended and consolidated rules associated, please see FINRA’s website.
The California-based law firm of Evans & Kob PC represents representatives, firms and supervisors before all regulatory agencies, including FINRA arbitration. Please contact our law firm at email@example.com to discuss with one of our lawyers about representation and our arbitration and litigation practice. Expertise and experience matter and help to provide the best possible outcome.